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University of Essex Session 2011/12

Department of Economics Autumn Term

EC111: INTRODUCTION TO ECONOMICS


CAPITAL AND INVESTMENT

Like labour, capital is a factor input. But because capital takes time to install it is a
long run decision for the firm. The firms decision is whether or not (and if so how
much) to invest now in the expectation of returns (additional profits) in the future.

This is a cost-benefit calculation. If the benefits exceed the (opportunity) costs then
it is worth investing. But to make this calculation a way must be found to compare
costs incurred now with benefits that accrue in the future.

Present Values

Suppose you invest 100 today in a project that will pay you:
55 one year from now, and
70 two years from now

Should you invest?

Note that 55 one year from today is worth less than 55 today. This is because you
can put a smaller sum in the bank and accumulate interest, such that the total value
in a years time is 55.

V
1
invested now would be worth V
1
(1+R) in a years time, where R is the interest
rate. If V
1
(1+R) = 55, then V
1
= 55/(1 +R). This is the Present Value of 55 in one
years time

Similarly V
2
invested now would be worth V
2
(1+R)(1+R) in two years time. So the
present value 70 in two years time is V
2
= 70/(1+R)
2
.

The Net Present Value of the investment is the present value of the (future) benefits
minus the (current) cost. Suppose the interest rate is 10 percent (0.1):

85 . 7 100 85 . 57 50 100
21 . 1
70
1 . 1
55
NPV


The cost-benefit rule is that the investment is worth undertaking if the NPV is
positive.


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Note that:

Future returns (or benefits) are discounted by the interest rate.

The higher is the interest rate the more heavily they are discounted and the
less likely the NPV will be positive. If the interest rate was 20 percent over
these two years the NPV would not be positive. Q: what would it be?

The further away are the future returns the more heavily they are
discounted. Thus if the returns were nothing after one year 55 after two
years and 70 after three years the NPV would be negative even at R = 0.1.
Q: Check this calculation.

The future benefits are expected returns, they are uncertain and therefore the
discount factor used may need to take account of the riskiness of the project.

What of there is inflation? 55 in a years time has lower purchasing power if prices
have risen than if they have not. In that case we need to discount by the real interest
rate:

Real interest rate = nominal interest rate rate of inflation.

The real interest rate is uncertain even if the nominal interest rate is not since we
would need to forecast the rate of inflation over the lifetime of the investment.

The demand for capital services and the user cost of capital

A firm considers an investment opportunity as follows:

Purchase of a machine (i.e. one extra unit of capital) today at price
0
.

At the end of the period the machine is sold at price
1
(
1
is less than
0

and could be zero if the machine is scrapped).

The return from the investment is the value of the additional output for as
long as the machine is in use, This is the Marginal Value Product of Capital,
MVPK = P MPK, where P is the price of the firms output. (Q: what if the
firm is not a perfect competitor?

The one-period NPV is:

0
1
R 1
MVPK
NPV

If NPV is positive then the firm should invest.

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Rearranging this expression, we find that NPV > 0 is the same as:

MVPK > R
0
+ (
0

1
)

The left hand side is simply the Marginal Value Product of Capital. The right hand
side is the User Cost of Capital (in earlier lectures we denoted this as r; it is
sometimes called the Rental Price of Capital).

Note that this is an opportunity cost: interest forgone on the sum invested plus
depreciation.

Note also that even if the firm paid for the investment from its retained earnings
there is still an opportunity cost: the return that could have been obtained from
leaving the money at the bank.

More generally note that:

The user cost of capital plays the same role in the demand for capital services as the
wage does in the demand for labour.

The MVPK curve is downward sloping. MVPK declines as K increase because of
diminishing marginal returns to capital.

The firm will install capital up to the point where the MVPK is equal to the user
cost. Beyond that the NPV is negative so a further investment does not add to
profits.

The firms demand for capital decreases as the user cost increases (because the
marginal machine becomes unprofitable).

Thus, the demand for capital will be higher:

The lower is the interest rate.
The lower is the price of capital goods.
The lower the rate of depreciation
The higher the price of the firms output.

The aggregate demand for capital by an industry is the (horizontal) sum of the
demand curves of all the individual firms in the industry.

Note that this is the demand for the stock of capital (just as labour demand is the
demand for the stock of workers). Investment over a given period is the change in
the stock i.e. the increase in the stock.



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The market for capital services


















The supply of capital services may be upward sloping in the short run and perfectly
elastic in the long run (particularly if capital goods are produced under conditions
of perfect competition).


















If the demand curve shifts out, the price, , increases in the short run, so the UC
K

rises. In the long run the as the output of capital goofs expands the price falls back
to the original level. The total amount of new investment is K
2
K
1
.
MVPK,
UC
K




UC
K1
K
1
K
MVPK
MVPK,
UC
K




UC
K1
K
1
K
2
K
D
K
D
K

S
KLR
S
KSR
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WELFARE ECONOMICS


Welfare economics assesses how well the economy works from the point of view of
welfare and if and how it can be made to work better. The two key elements are
efficiency and distribution.

Pareto Efficiency

The Pareto criterion is a key value judgement. It says that situation A is preferred to
situation B if in A at least one person is better off and no one is worse off than in B.

This is a very stringent criterion. The reason we use it is that we have no way of
weighing one persons utility against another persons utility. If we did then we
could say that A could be superior to B even if some people were worse off under A
as long as the value of the gains to the gainers outweighed the value of the losses to
the losers.

Example: sharing a cake between two people.






















At point A individual A has the whole cake and gets utility U
A
; at point B individual
B gets the whole cake and gets utility U
B
.

We cannot say whether allocation C is Pareto superior to either A or B because as
compared with C one person is worse off.
D
E
B

A
Utility Possibility Frontier
U
A
U
B
C
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Allocation E is Pareto superior to C, because both individuals are better off. But D
is not superior to C.

At any point inside the frontier there is a range of Pareto superior allocations. Note
that here some of the cake is lost or wasted; at least one person could be made better
off if this inefficiency was eliminated.

Points like D and E (and A and B) are Pareto efficient. One person cannot be made
better off without making another person worse off.

Pareto efficient points are points of maximum efficiency

Note that Pareto efficiency is of no help in resolving distributional issues. A, B, D
and E are all Pareto efficient. We have no way of choosing between them unless we
are willing to make additional value judgements.

Necessary conditions for a first-best Pareto efficient allocation

Exchange (or consumption) efficiency

Suppose there are two individuals in the economy, A and B, and two goods, beer
and pizza.

A is willing to exchange 2 beers for one pizza.

B is willing to exchange 4 beers for one pizza.

That must mean that MRS
A
MRS
B
; the ratio of marginal utilities cannot be the
same for the two individuals.

The following exchange will make both persons better off:

B gives 3 beers to A

A gives one pizza to B

As long as MRS
A
MRS
B
there is scope for exchanges that make one person better
off without making the other worse off. (So there is a Pareto superior allocation).

Exchange efficiency requires that MRS
A
= MRS
B
.





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Production efficiency

This requires being on the Production Possibility Frontier






















Being on the PPF implies that there is no way of reallocating inputs across
industries that would result in higher output in at least one industry without a
reduction in the output of the other industry.

Assuming two factors K and L, this means that:

MRTS
KL
beer
= MRTS
KL
pizza


Factors of production are allocated across industries with maximum efficiency when
the marginal rate of technical substitution between factors is the same across all
industries.









Slope of PPF = Marginal
Rate of Transformation
Q
beer
Q
pizza
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Output choice (or allocation) efficiency

We need to ensure that the resource cost of the goods produces corresponds to the
valuation that consumers place on them.

The rate at which the economy can transform one good into another (by shifting all
factors between industries) is the MRT. The rate at which consumers want
substitute one good for another is the MRS.

Allocation efficiency requires that MRS = MRT.

Suppose that the economy can give up two beers to produce one more pizza: MRT =
2. Consumers are willing to give up 3 beers for one more pizza: MRS = 3. We have
MRS > MRT. Consumers would be better off if the economy produced more pizza
and less beer.





















Drawing an indifference curve for the representative consumer, at point A we
have MRS > MRT. Consumers could be better off (i.e. on higher indifference
curves) at a point like B.







Q
pizza
B

A

MRT of economy
Q
beer
MRS of consumers
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The Fundamental Theorems

What are the efficiency properties of market outcomes?

In particular, is a perfectly competitive general equilibrium first-best Pareto
efficient?

A perfectly competitive general equlibrium is where there is perfect competition in
all markets. The specific conditions are:

Individuals maximise utility
Firms are price takers and maximise profits
All markets for goods and factors clear.

First Fundamental Theorem of Welfare Economics

In the absence of externalities (discussed next week), and under certain conditions
that ensure that an equilibrium exists, any perfectly competitive equilibrium is first
best Pareto efficient.

This can be shown by examining the three necessary conditions:

Exchange efficiency

All individuals will have the same MRS between any two goods provided that they
maximise their utility and they all face the same set of prices. Thus for all
individuals in the economy:

Y
X
XY
P
P
MRS

Production efficiency

Each firm minimises the cost of production (a necessary condition for maximising
profits) and they all face the same set of factor prices. Thus for all firms:

r
w
MRTS
LK


Output choice efficiency

Perfectly competitive firms maximise profits so that

Y
X
Y
X
P
P
MC
MC

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The ratio of marginal costs is the marginal rate of transformation MRT, or the slope
of the Production Possibility Frontier. This is because it is the ratio of opportunity
costs.
Thus we have:
XY
Y
X
Y
X
XY
MRS
P
P
MC
MC
MRT

Conclusion Perfect competition achieves a first best Pareto efficient allocation of
resources. There is no explicit coordination: the price mechanism provides the right
signals for an efficient allocation.

But this says nothing about distribution. As the cake-sharing example showed, there
are many Pareto efficient allocations each with a different distribution of utility
between consumers. Thus a perfectly competitive equilibrium generates a particular
Pareto efficient allocation. What determines which one?

Second fundamental theorem of welfare economics

People have different abilities and different wealth (or endowments).

Under certain conditions that have to do with the kind of preferences consumers
have and the kind of technological constraints that firms face, any first-best Pareto
efficient allocation can be achieved for some distribution of initial endowments across
individuals.

I mplication: The issue of efficiency and the issue of distribution can be separated in
principle. To change the distribution of income in an economy, one needs to change
only the distribution of initial endowments. Under the new set of initial endowments
the price system will achieve a new Pareto efficient final allocation.

This seems to suggest that there is no trade-off between equity and efficiency. All ex-
post income distributions can in principle be equally efficient.

The conditions required under the first and second fundamental theorems are
rarely satisfied in practice. There are a number of sources of inefficiency in the
market economy.










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Application: Taxation

One way of redistributing income is through lump sum tax which is independent of
a persons income (or any other economic characteristic).

Lump sum taxes seem a good way of modifying peoples initial endowments. But
how do you redistribute e.g. from the rich to the poor without using income as a
criterion. Example: Mrs Thatchers Poll Tax: why was it so unpopular?

So the government must impose taxes on earnings and goods, which create
distortions and deadweight loss because they affect economic incentives and
decisions of individuals and firms. As a result the conditions of the first fundamental
theorem will not be satisfied.

Recall the example of a tax on a good:



















Without the tax total welfare is consumer surplus + producer surplus = AEB

With the tax we have consumer surplus (ACD) + producer surplus(GBF) + tax
revenue (CDFG). The deadweight loss is DEF.

Assuming that the supply curve represents firms marginal cost curves we have:
MC + T = P

Suppose in the situation above the tax is placed on is good X and there is no tax on
good Y.


T
G
C
D
E
P
X
A
B
F
Q
X
S
S
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In general equilibrium we have:

XY
Y
X
Y
X
Y
X
XY
MRS
P
P
MC
T MC
MC
MC
MRT






















At point A before the tax the representative consumers MRS is equal to the slope of
the PPF which is the MRT and which is also the ratio of marginal costs. .

After the tax the ratio of marginal costs is lower than the price ratio, because of the
tax wedge. We have move to a point like B where the indifference curve (which is
MRS
XY
) is steeper than the PPF (which is MRT
XY
).

The tax on good X has reduced the output of X, releasing factors of production to
produce more of good Y.

One interpretation of the deadweight loss is that it is the (lump sum) payment that
consumers in situation B would require to make them just as well off as they were in
situation A.


A similar analysis could be applied to an income tax, which distorts the labour
supply decision by altering the after tax price of leisure. This imposes a distortion
such that prices fail to reflect true marginal costs (i.e. opportunity costs). Q why is
this?

Q
X
A


B
MRT of economy
Q
Y
MRS of consumers
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Income redistribution takes place through taxes and subsidies.

Most tax-transfer systems are progressive (they transfer from the rich to the poor)
to some degree.

Because these taxes are distortionary there is some trade-off between equity and
efficiency. It may be worth some loss of efficiency to have greater equity in society.
This is a normative issue that must be decided in the political process.

The theory of the second-best

Will removing a distortion always improve economic efficiency?

Clearly, removing the tax (or other distortion) that causes the economy to settle at B
would push it back to A, where MRS = MRT.

It is important to note that there is no other distortion in the economy. If there were
two (or more) distortions then removing one of them does not necessarily increase
efficiency.

Similarly, in the presence of one distortion introducing another one could improve
things. Take the example of the tax on good X. Putting a tax on good Y could move
the economy from point B towards point A (less Y, more X)

This is an important for policy in the real world. Policies are often evaluated as if
the conditions for Pareto efficiency were met in the rest of the economy, which
usually they are not.

Note that this does not just apply to taxesthey are not the only source of
inefficiency. There are other sources of inefficiency or market failure that make
the choice of policy even more difficult.