Economics Education

21.9.20 Mundell-Fleming Model-Perfect Capital Mobility

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Introduction

In an open economy, domestic spending no longer determines domestic output. Instead, spending on domestic goods determines output. A currency depreciation (increases in R) has two distinct effects on this measure: (i) value effects, and (ii) volume effects. A currency depreciation is equivalent to an increase in the relative price of imports to domestic goods. Even if the volume of trade does not change, the measured value of imports unambiguously increases. The volume effects run in the opposite direction. Exports should rise and imports should fall due to the reason imports are now relatively more expensive.

The domestic income is now dependent on both foreign income and the real exchange rate. The IS curve is steeper in an open economy setting due to the marginal propensity to import. The fact that some of our income is spent on imports decreases the amount of induced spending in our economy. For a given reduction in the interest rate, a smaller increase in output and income is required to restore goods market equilibrium.

Capital Mobility

Lets consider a very simplified version of the international economy. Let us assume the following:

(i) exchange rates are fixed forever at a given level,

(ii) taxes are the same everywhere, and

(iii) foreign asset holders face no political risk.

In this setting, capital would chase the highest return. As such, interest rates would have to equate across economies. These assumptions do not hold in reality. Although a very slightly unrealistic assumption, we will assume perfect mobility of capital, in which investors can purchase assets in any country they choose, quickly, in unlimited amounts, and with little transaction cost. With this assumption, differences in interest rates will induce capital flows between economies. These flows put pressure on interest rates until they are once again equated between nations.

Mundell-Fleming Model with a Floating Exchange Rate

In an open economy with external trade and financial transactions, how are the key macrovariables (GDP, inflation, balance of payments, exchange rates, interest rates, etc) determined and interact with each other? What are the effects of fiscal and monetary policies? The Mundell-Fleming model is the standard open macroeconomic model that tries to answer these questions. Theoretically, it is the most popular model. But its applicability to actual policy making is not as high as we would hope (especially for developing and transition countries). In 1963 when he was young, Prof. Robert Mundell was working with Marcus Fleming at the IMF and wrote a paper which gave birth to this model. He has been at Columbia University (New York) for the last 25 years. He has been a strong advocate of stabilization of major currencies and establishment of euro. In 1999, he won the Nobel Prize in economics, partly because of the Mundell-Fleming model.

The Mundell-Fleming model is an open macro application of the standard IS-LM analysis. More precisely, it is an IS-LM analysis with trade and international capital mobility. Consider the following three aspects of the macroeconomy:

(1) Aggregate demand (IS and LM curves, representing goods and money markets)

(2) Aggregate supply (production function and labor market)

(3) Balance of payments (current account and capital account)

The usual textbook exposition (with no trade or capital mobility) combines (1) and (2), with a downward sloping AD (aggregate demand) curve and an upward-sloping AS (aggregate supply) curve. The Mundell-Fleming model combines (1) and (3), namely AD and B (balance of payments) curves. This means that the Mundell-Fleming model (in its simplest version) has no supply side constraint. As in the most elementary Keynesian model, it implicitly assumes that capital and labour are generally underemployed so that any demand stimulus will expand real GDP (rather than cause inflation).

Aggregate Demand - IS curve

Aggregate demand is composed of two parts: absorption (A, namely, domestic demand) and trade balance (T, namely, foreign demand). We ignore service trade, factor income and transfers, so the current account is the same as the trade balance.

Y = A + T (GDP by expenditure decomposition)

where

A=C + I + G (definition of absorption)

= A (Y, i; G) A1 >0, A2 <0, A3 >0; G is an exogenous spending (shift parameter) [A1 means partial derivative of A with respect to first variable, etc.]

and

T = M*- qM (definition of trade balance, measured in domestic currency)

= T (q, Y*, Y) T1 >0, T2 >0, T3 <0; foreign

income Y* is assumed fixed (Y: income C: private consumption I: private investment G: government spending M: imports M*: foreign imports (=our exports), i: interest rate) Note that A and T are defined as real variables (deflated by domestic price P). The real exchange rate q is defined thus:

q = EP*/P (a rise in q means real depreciation of home currency) Please note that T1 >0, namely, partial derivative of trade balance with respect to q is positive. This means that the Marshall-Lerner condition is satisfied, so real depreciation will improve the trade balance (when other variables remain unchanged). From above, we have

Y= A (Y, i; G) + T (q, Y*, Y)

= F (Y, i, q; G) Note: 0 < F1 < 1

Collecting Y to the left-hand side,

Y = f (i, q; G) f1 <0, f2 >0, f3 >0

This is our IS curve. It is downward-sloping in the (i, Y) plane. Moreover, a rise in q (real depreciation) or a rise in G (government spending) shifts the IS curve up and to the right.

Aggregate Demand - LM curve

The LM curve is the same as in the domestic macro version. It shows the condition for money market equilibrium. In particular, we ignore the possibility of "currency substitution," a phenomenon where domestic citizens hold foreign currency (typically US dollar) as well as domestic currency, and change their relative shares as circumstances change. No currency substitution is a reasonable assumption in developed countries, where people hold only domestic currency. But in many developing countries, currency substitution may be a big factor that influences the money demand. Currency substitution is also called "dollarization." But dollarization has two meanings: (1) the situation where people use dollars in addition to domestic currency because they do not trust the latter (in this case, the monetary authority usually tries to prevent the use of dollar); (2) the situation where the government declares that the national currency is the US dollar, abolishes the central bank, and gives up independent monetary policy. Currency substitution is equivalent to the first (traditional) meaning of dollarization.

The LM curve is simply:

Ms/P = LD(i, Y) LD1 <0, LD2 >0

(Ms: money supply P: price level)

As in the domestic version, it is upward-sloping in the (i, Y) plane. A rise in money supply Msshifts the LM curve down and to the right. In this formulation, the price level P is assumed fixed. This may be unrealistic in a small open economy where exchange rate pass-through (E -> P) is significant.

Balance of payments

The balance of payments (B) is the sum of current account (T) and capital account (K). Remember, for simplicity we have assumed away the flows of service, factor income and transfers so that the current account is identical with the trade balance.

B= T + K

= T (q, Y) + K (i - i*) T1 >0, T2 <0; K1 >0

= 0

Assumptions:

The exchange rate is floating (the real exchange rate q is also flexible).

1) The monetary authority does not intervene in the foreign exchange market. This means that there is no change in international reserves, the monetary account is zero, and, therefore, the current account and the capital account must always add up to zero (T + K = 0).

2) Additionally, we assume perfect capital mobility. This means that i = i*, K1 = +∞, and K is indeterminate. In other words, if i > i* there will be a massive capital inflow into the home country and if i < i* there will be a massive outflow, so the only way K can remain finite is when i = i*. When that happens, K can take any value (positive or negative) to offset T, so that T + K = 0 holds.

3) The exchange rate expectation is static. That is to say, people expect that the future exchange rate will be the same as today's (even though the exchange rate is floating). This is a simplifying assumption. If we depict this situation in the (i, Y) plane, we have a horizontal line at i*. The domestic interest rate must be equal to the worldinterest rate. There will be a massive capital inflow above that line and a massive capital outflow below that line.

Equilibrium

Under a freely floating exchange rate and perfect capital mobility, the following

three equations derived above determine the equilibrium position.

Y = f (i, q; G) f1 <0, f2 >0, f3 >0 <IS>

Ms/P = LD(i, Y) LD1 <0, LD2 >0 <LM>

i = i* <BOP>

Recall that foreign income, foreign interest rate and domestic price are all fixed (Y*, i*, P).

The equilibrium can be pictured as follows:

Comparative Statics

Comparative statics means checking how the equilibrium changes if one input variable is changed. More technically, it is a matrix of signs (+ or -) indicating the changes in endogenous variables in response to a change in each exogenous variable.

In this model, we ask two specific questions:

(1) Can we increase Y by an expansionary fiscal policy (an increase in G)?

(2) Can we increase Y by an expansionary monetary policy (an increase in Ms)? G and Ms are the input variables and Y is the output variable in question. (We may add that these questions themselves reflect the rather old-fashioned mentality of macroeconomic fine-tuning. More recently, fiscal and monetary policies are not considered as tools for adjusting real GDP.)

First, consider fiscal expansion,

1. An increase in G shifts the IS curve upward and to the right.

2. This puts an upward pressure on the domestic interest rate (i > i*).

3. But this immediately invites a massive capital inflow.

4. This appreciates the nominal exchange rate E as well as the real exchange rate q.

5. This worsens the trade balance T.

As the model is constructed, no gradual adjustment is allowed; these events are supposed to take place instantaneously. The exchange rate appreciates and the trade balance worsens until the initial increase in G is completely offset. The IS curve is pushed back to the original position and Y cannot increase at all.What happened is that, in Y = A + T, as A is increased by fiscal spending, T is reduced by exactly the same amount. Y is unchanged, and only the relative composition of Y is changed. The conclusion is that under a floating exchange rate and perfect capital mobility, fiscal policy is ineffective. Here, "ineffective" means unable to increase Y.

Second, consider monetary expansion.

1. An increase in Ms shifts the LM curve downward and to the right.

2. This puts a downward pressure on the domestic interest rate (i < i*).

3. But this immediately invites a massive capital outflow.

4. This depreciates the nominal exchange rate E as well as the real exchange rate q.

5. This improves the trade balance T.

Again, the whole sequence is assumed to take place in an instant. Compared with the

domestic version of IS-LM, monetary policy is more powerful because the outward shift of LM invites an additional outward shift of IS. Both LM and IS cooperate to increase income. The conclusion is that under a floating exchange rate and perfect capital mobility, monetary policy is very effective.

These conclusions are significantly different from those of the domestic version of the IS-LM model. In the domestic version, fiscal and monetary policies are both effective, and their relative effectiveness depends on various elasticities and slopes. But in this case, one policy is utterly impotent and the other policy is doubly potent. By now, you should clearly see why (by what mechanism and assumptions) these conclusions are generated.

Equilibrium with no Capital Mobility

With a fixed exchange rate and no capital mobility, how does the equilibrium look? Our three equations are as follows:

Y = f (i, q; G). f1 <0, f2 >0, f3 >0 <IS>

Ms/P = LD(i, Y) LD1 <0, LD2 >0. <LM>

T(q, Y) = 0 T1 >0, T2 <0 <BOP>

But since the real exchange rate q is given and unchanged by assumption, we can ignore it for now. q will matter only when the government devalues or revalues the exchange rate.

Since the trade balance must be zero, output Y and the interest rate i are determined by IS and LM as if in a purely domestic macro model. IS is downward sloping and LM is upward sloping in the (i, Y) plane. The economy goes to the intersection of IS and LM. This is the short-run equilibrium.

But this is not the final outcome. This short-run equilibrium may be off the BOP line (T=0). If it is to the right of T=0, there is a trade deficit because Y is too large. To keep the exchange rate fixed, the central bank is obliged to sell dollars, lose IR and reduce H. Gradually, money supply Ms falls and the LM curve shifts up and to the left until the three lines (IS, LM, T=0) intersect at the same point. After that, there is no more movement; we have reached the long-run equilibrium.

As we said before, the government can resist the shift of LM by sterilization. But eventually, it will run out of international reserves. Then the process above must continue.

Equilibrium under Perfect Capital Mobility

With a fixed exchange rate and perfect capital mobility, what is the equilibrium situation? Consider the following set of equations

Y= f (i, q; G). f1 <0, f2 >0, f3 >0. <IS>

Ms/P = LD(i, Y). LD1 <0, LD2 >0. <LM>

i = i*. <BOP>

The only difference from the case of no capital mobility is the BOP condition. Instead of trade balance, we have interest rate equalization.

Let us do comparative statics with this model. Are monetary and fiscal policies effective (can they change Y)? We already said that money is endogenous under a fixed exchange rate and any attempt for sterilization is futile when capital is perfectly mobile. So we know monetary policy can do nothing. To be more precise, consider an attempt at monetary expansion by increasing DC (open market purchase of domestic government bonds). The LM curve wants to shift down and to the right, but this movement is immediately countered by a massive capital outflow and a loss of IR, at the slightest fall of the domestic interest rate. So the total high-powered money H (=DC+IR) remains constant. LM cannot shift. The conclusion is that under a fixed exchange rate and perfect capital mobility, monetary policy is ineffective.

In the previous section with a floating exchange rate, a massive capital outflow prompted currency depreciation and an export boom. Here with a fixed exchange rate, it simply leads to the loss of international reserves.

If government spending G is increased, the IS curve is pushed up and to the right. But this tends to raise i and generate a massive capital inflow. To prevent an appreciation of the domestic currency, the central bank must buy up dollars, which will increase IR and H. Money supply Ms jumps up and the LM curve shifts out as a consequence. Note that this occurs instantaneously. Unlike the case of no capital mobility, there is no distinction between short-run and long-run. Everything takes place at once.

Since both IS and LM shifts to the right, Y is doubly increased. The conclusion is that under a fixed exchange rate and perfect capital mobility, fiscal policy is very effective.

Conclusion

In the previous sections we have seen that with a floating exchange rate, a massive capital outflow prompted currency depreciation and an export boom and with a fixed exchange rate, it simply leads to the loss of international reserves. The conclusion is that under a floating exchange rate and perfect capital mobility, monetary policy is very effective and under a fixed exchange rate and perfect capital mobility, fiscal policy is very effective.

16.9.20

Exchange Rate

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Introduction

The transactions in the exchange market are carried out at what are termed exchange rates. It is the price of foreign money. Thus, exchange rate may be defined as the price paid in the homes currency for a unit of foreign currency. Or more simply, rate of exchange is the prices of one national currency in terms of another. It can be quoted in two ways :

1. One unit of foreign money units of the domestic currency; or

2. A certain number of units of foreign currency to one unit of domestic
money.

For instance: I. U.S. dollar =Rs.30, or Re. 1 = U.S. 3.33 cents. It is obvious that the reversibility in the mode of quoting exchange rate does not alter the basic value of one currency in terms of another.

Exchange Rate System

Fixed Exchange Rates:

Countries following the fixed exchange rate (also known as stable exchange rate and pegged exchange rate) system agree to keep their currencies at a fixed, pegged rate and to change their value only at fairly infrequent intervals, when the economic situation forces them to do so.

Under the gold standard, the values of currencies were fixed in terms of gold. Until the breakdown of the Bretton Woods System in the early 1970, each member country of the IMF defined the value of its currency in terms of gold or the US dollar and agreed to maintain (to peg) the market value of its currency within ± 1 per cent of the defined (par)value. Following, the breakdown of the Bretton Woods System, some countries took to managed floating of their currencies while a number of countries still embraced the fixed exchange rate system.

Arguments for the Stable Exchange Rate System

A number of arguments have been put forward for the against each system. The important argument supporting the stable exchange rate system.

(i) Exchange rate stability is necessary for orderly development and growth of foreign trade. If exchange rate stability is not assured, exporters will be uncertain about the amount they will receive and importers will be uncertain about the amount they will have to pay. Such uncertainties and the associated risks adversely affect foreign
trade. A great advantage of the fixed exchange rate system is that it eliminates the possibilities of such uncertainties and risks.

(ii) Especially the developing countries, which have a persistant balance of payment deficits, should necessarily adopt the stable exchange rate system to prevent continuous depreciation of the external value of their currencies.

(iii) Exchange rate stability is necessary to attract foreign capital investment as foreigners will not be interested to invest in a country with an unstable currency. Thus, exchange rate stability is necessary to augment resources and foster economic growth.

(iv) Unstable exchange rates may encourage the flight of capital. Exchange rate stability is necessary to prevent its outflow.

(v) A stable exchange rate system eliminates speculation in the foreign exchange market.

(vi) A stable exchange rate system is a necessary condition for the successful functioning of regional groupings and arrangements among nations.

Must see:- Foreign-exchange-market

Flexible Exchange rates

Under the flexible exchange rate system, exchange rates are freely determined in an open market primarily by private dealings, and they like other market princes, vary from day-to-day. Under the flexible exchange rate system, the first impact of any tendency toward a surplus or deficit in the balance of payments is on the exchange rate. A surplus in the balance of payments will create an excess demand for the country's currency and the exchange rate will tend to rise.

On the other hand, a deficit in the balance of payments will give rise to an excess supply of the country's currency and the exchange rate will, hence, tend to fall.

Automatic variations in the exchange rates, in accordance with the variations in the balance of payments position, tend to automatically restore the balance of payments equilibrium. A surplus in the balance of payments increases the exchange rate. This makes foreign goods cheaper in terms of domestic currency and domestic goods more expensive in terms of the foreign currency. This, in turn, encourages, imports and discourages exports, resulting in the restoration of the balance of payments equilibrium. On the other hand if there is a payments deficit, the exchange rate falls and this makes domestic goods cheaper in terms of the foreign currency and foreign goods more expensive in terms of the domestic currency. This encourages exports, discourages imports and thus helps to establish the balance of payments equilibrium.

A number of economists, however, point out that certain serious problems are associated with the system of flexible exchange rates.

1. Flexible exchange rates present a situation of instability, creating uncertainty and confusion. Friedman disputes this view and argues that a flexible exchange rate need not be an unstable exchange rate need not be an ustable exchange rate. If it is it is primarily because there is underlying instability in the economic conditions governing international trade. And a rigid exchange rate may, while itself remaining nominally stable, perpetuate and accentuate other elements of instability in the economy.

2. The system of flexible exchange rates, with its associated uncertainties, makes it impossible for exporters and importers to be certain about the price they will have to pay or receive for foreign exchange. This will have a dampening effect on foreign trade. Under flexible exchange rates, there will be widespread speculation which will speculation a destabilishing effect. Against this, it is argued that normally has a stabilishing influence on exchange rates.

Spot and Forward Exchange Rates

Spot rate of exchange refers to the price of foreign exchange in terms of domestic money payable for the immediate delivery of a particular foreign currency. It is, thus a day-to-day rate. On the other hand, forward rate of exchange refers to the price at which a transaction will be consummated at some specified time in the future. A forward exchange market functions side by side with a spot exchange market. The transactions of forward exchange market are known as forward exchange transactions which simply involve purchase or sale of a foreign currency for delivery at some time in the future; the rates at which these transaction are, therefore, called forward rates. Forward exchange rate is determined at the time of sale but the payment is not made until the

exchange is delivered by the seller. Forward rates are usually quoted on the basis of a discount or premium over or under the spot rate of exchange; thus forward rates may be expressed as a percentage deviation from the sport rates. To illustrate the point suppose an Indian citizen buys goods from America worth $100, payable in 3 months. The 'spot rate' (i.e. rate prevailing at the time of purchase) is Rs.37.50 = $1. In order to avoid exchange risk, he may enter into a forward contract in the forward exchange market to buy $100 three months'forward at a rate agreed on now – the forward rate. If the rate agreed on is 50 paise at a discount then the buyer shall have to pay at the rate of Rs.37=$1. If the rate is fixed at 50 paise at a premium then he shall have to pay whatever, may be the fluctuations in exchange rate in the future, he knows now what he will have to pay for $100. Thus, forward exchange rates enable exporters and importers of goods to know the prices of their goods which they are about to export or import. Thus, in general, the process of covering exchange risks in the forward market is simply a way of eliminating uncertainties of spot rate fluctuations from time to time.

Foreign Exchange Risks, Hedging, and

Speculation

Foreign Exchange Risks

Through time, a nation's demand and supply curves for foreign exchange shift, causing the spot (and the forward) rate to vary frequently. A nation's demand and supply curves for foreign exchange shift over time as a result of changes in tastes for domestic and foreign products in the nation and abroad, different growth and inflation rates in different nations, changes in relatives rates of interest, changing expectations, and so on.

Hedging

The fact that exchange rates can change makes people take different views of foreign currencies. Some people do not want to have to gamble on what exchange rates will hold in the future and want to keep their assets in their home currency alone. Others, thinking they have a good idea of what will happen to exchange rates, would be quite willing to gamble by holding a "foreign" currency, one different from the currency in which they will ultimately buy consumer goods and services. These two attitudes have been personified into the concepts of hedgers and speculators, as though individual persons were always one or the other, even though the same person can choose to behave like a hedger in some cases and like a speculator in others.

Hedging against an asset, here a currency, is the act of making sure that you have neither a net asset nor a net liability position in that asset.

Speculation

Speculation is the opposite of hedging. Whereas a hedger seeks to cover a foreign exchange risk, a speculator accepts and even seeks out a foreign exchange risk, or an open position, in the hope of making a profit. If the speculator correctly anticipates future changes in spot rates, he or she makes a profit; otherwise, he or she incurs loss. As in the case of hedging, speculation can take place in the spot, forward futures, or options markets – usually in the forward marker. We begin by examining speculation in the spot market. If a speculator believes that the spot rate of a particular foreign currency will rise he or she can purchase the currency now and hold it on deposit in the bank for resale later. If the speculator is correct and the spot rate does indeed rise, he or she earns a profit on each unit of the foreign currency equal to the spread between the previous lower spot rate at which he or she purchased' the foreign currency and the higher subsequent spot rate at which he or she resells it. If the speculator is wrong and the spot rate falls instead, he or she incurs a loss because the foreign currency must be resold at a price lower than the purchase price.

Speculation can be stabilizing or destabilizing. Stabilizing speculation refers to the purchase of a foreign currency when the domestic price of the foreign currency (i.e., the exchange rate) falls or is low, in the expectation that it will soon rise, thus leading to a profit. Or it refers to the sale of the foreign currency when the exchange rate rises or is high, in the expectation that it will soon fall. Stabilizing speculation moderates fluctuations in exchange rates over time and performs a useful function.On the other hand, destabilizing speculation refers to the sale of a foreign currency when the exchange rate-falls or is low, in the expectation that it will fall even lower in the future, or the purchase of a foreign currency when the exchange rate is rising or is high, in the expectation that it will rise even higher in the future. Destabilizing speculation thus magnifies exchange rate fluctuations over time and can prove very disruptive to the international flow of trade and investment.

14.9.20 Foreign Exchange Market

Ravinder Foreign exchange market , 0 Comments

Introduction

The mechanism through which payments are effected between two countries having different currency system is called foreign exchange.
In simple words, by foreign exchange we mean foreign currencies. However, in broad sense, the term refers to the system of external or international payments. It covers methods of payment, rules and regulations of payment
and institutions facilitating such payments.

The foreign exchange market is the market where foreign exchange or foreign currencies are bought and sold. The foreign exchange market places at the disposal of buyers and sellers of foreign currencies, the specialised services of intermediaries. It implies that the buyers and sellers claims on foreign money and intermediarids constitute the structure of foreign exchange market. In the words of Kindelberger : 'The foreign exchange market is the market for a national currency (foreign money) anywhere in the world, as the centres of the world are limited in a single market.

Foreign exchange market is described as an OTC (over the counter) market as there is no physical place where the participants meet to execute their deals. It is more an informal arrangement among the banks and brokers operating in a financing centre purchasing and selling currencies, connected to each other by tele-communications like telex,telephone and a satellite communication. network- SWIFT (Society for worldwide interbank Financial Telecommunications).

Foreign Exchange Market

Participants of two levels.

Wholesale level : 95% of the foreign exchange market is whole sale market where the dealings take place among the banks.

Retail level : The retail market refers to the dealings which take place between banks and their customers. The retail segment is situated at a large number of places. They can be considered not as foreign exchange markets, but as the counters of such markets.

Types of Currency Markets

On the basis of transaction, there are two types of currency markets.

Spot market :

In such a market, the spot transactions of foreign exchange is required to deliver the foreign exchange he has sold (i.e. within two days). The buyer, on the other hand, will receive immediately (within two days) the foreign exchange he has bought.

The main participants of spot market are :

Commercial banks : The most important participants of spot market are commercial banks. Banks dealing in foreign exchange have branches with substantial balances in different countries. Through theirbranches and correspondents the services of such banks, usually called 'Exchange Banks', are available all over the world. These banks discount and sell foreign bills of exchange, issue bank drafts, effect telegraphic transfers and other credit instruments and discount and collect amounts for such documents.

Brokers : Brokers help sellers and buyers in foreign bills to come together. They are intermediaries and unlike banks are not direct dealers. Still another category of intermediaries are the acceptance houses. They accept the bills on behalf of the customers and assist in foreign remittances.

Central Banks : Central banks sometimes intervene in the market. Now-a-days, these authorities manage exchange rates and
implement exchange controls in various ways.

Forward market :

The forward exchange market is concerned with such transactions of foreign exchange in case of which, the contract to buy or sell foreign exchange delivery of foreign exchange takes place at a future date at a price agreed upon in advance. The period for settlement of contract between the buyers and sellers of foreign exchange is usually three months.

The main participants of forward market are :

Arbitrageurs: The arbitrage is the act of simultaneously buying a currency in one market and selling it in another market to make profit by taking advantage of price or exchange rate differences in the two markets. If the arbitrage operations are confined to two markets only, they will be known as 'two point' arbitrage. If they extend to three or more markets, they are known as 'three point' or 'multi-point' arbitrage.

Traders : They exchange domestic currency for foreign currency or foreign currency for domestic currency to execute the international
transactions.

Hedgers : Hedging refers to the avoidance of a foreign exchange risk or the covering of an open position. Hedgers in international dealings are persons who have a home currency and insist on having an exact balance between their liabilities and assets in foreign currencies.

Speculators : Speculation is the opposite of hedging whereas a hedger seeks to cover a foreign exchange risk, a speculator accepts and even seeks out a foreign exchange risk, or an open position, in the hope of making a profit.

Clearing systems : In the foreign exchange market there are two types of clearing system.

Chips : Chips stand for clearing House Interbank Payment of System. It is an electronic payment system owned by 12 private commercial banks constituted the New York Clearing House Association. It provides the mechanism for settlement of every day payment and receipts of numerous dollar transactions among member banks at new York, without the need for physical exchange of cheques/funds for each such
transactions.

Fedwire : Fedwire is a networked system for payment processing between member banks themselves or other Fedwire member participants members can consists of depository financial institutions in the United States, as well as US branches of certain foreign banks or government groups, provided that they maintain an account with a Federal Reserve Bank. It is owned and operated by the 12 Federal Reserve Banks.

The Fedwire funds transfer system, operated by the Federal Reserve Bank are used primarily for domestic payments, bank to bank and third party transfers such as interbank overnight funds sales and purchased and settlement transactions. Fed guarantees settlement on all payments sent
to receivers even if the sender fails.

Electronic trading : Electronic trading is mainly concerned with automated trading.

Automated Trading

Forex autotrading is a slang term for automated market, wherein trades are executed by a computer system based on a trading strategy implemented as a program run by the computer system. The main results of automated trading that it reduces the cost of trading, provide liquidity and also threatens traders' oligopoly of information.

Size of the Market

Largest in the world

Unlike other financial markets like the New York Stock Exchange, the forex market has neither physical location nor central exchange. The forex market is considered on over-the counter (OTC) or 'interbank' market due to the fact that the entire market is run electronically, within a network of banks, continuously over a 24-hour period. The dollar is the most traded currency, taking up 84.9 % of all transactions. The euro share is second at 39.1% while that of yen is third
at 19.0%.

Market Centres : London market is by far the largest where 90 billion dollar foreign currency is transacted each day, followed by New York, Tokyo. German, Japan markets respectively. So far as India is concerned, till recently, it was having a regime of strict exchange control. The leading foreign exchange market in India is Mumbai, Calcutta, Chennai and Delhi. As a result of the efforts of Reserve Bank, Cochin, Bangalore, Ahmadabad and Goa have emerged as new centre of forex market.

Swift (Society for Worldwide on interbank Financial Telecommunications )

Foreign exchange markets make extensive use of the latest developments in telecommunications for transmitting as well as settling foreign exchange transaction. Banks use the exclusive network SWIFT to communicate messages and settle the transactions at electronic clearing houses such as CHIPS at New York.

SWIFT: SWIFT is a acronym for Society for Worldwide Interbank Financial Telecommunications, a co-operative society owned by about 250 banks in Europe and North America and registered as a co- operative society in Brussels, Belgium. It is a communications network for international financial market transactions linking effectively more than 25,000 financial institutions throughout the world who have been allotted bank identified codes. The messages are transmitted from country to
country via central interconnected operating centers located in Brussels, Amsterdam and Culpeper, Virginia. 'The member countries are connected to the centre through regional processors in each country. The local banks
in each country reach the regional processors through the national networks.

The SWIFT System enables the member banks to transact among themselves quickly (i) international payments (ii) Statements (iii) other messages connected with international banking. Transmission of messages takes place within seconds and therefore this method is economical as well as time saving. Selected banks in India have become members of SWIFT. The regional processing centre is situated at Mumbai.

Advantages of Swift

The swift provides following advantages for the local banking community:
(i) Provides a reliable (time tested) method of sending and receiving messages from a vast number of banks in a large number of
locations around the world.

(ii) Reliability and accuracy is further enhanced by the built in authentication facilities, which has only to he exchanged with each counterparty before they can be activated or further communications.

(iii) Message relay is instantaneous enabling the counterparty to respond immediately, if not prevented by time differences.

(iv) Access is available to vast number of banks global for launching new cross border initiatives.

(v) Since communication in SWIFT is to be done using structure formats for various types of banking transactions, the matter to be conveyed will be very clear and there will not be any ambiguity of any sort for the received to revert for clarifications. this is mainly because the formats are used all over the world on a standardised basis for conducting all types of banking transactions.

(vi) Usage of SWIFT structure formats for message transmission to counterparties will entail the generation of local banks internal
records using at least minimum level of automation. This will accelerate the local banks internal automation activities, since the maximum utilisation of SWIFT a significant internal automation level is
required.

Functions of Foreign Exchange Market

Transfer function : The most fundamental 'function of a foreign exchange market is to effect transfer of funds or purchasing power from one country and currency to another. The transfer of purchasing power is brought about by various instruments such as foreign hills, bank drafts, telegraphic transfers and direct dialling telephone service. The foreign exchange market facilitates simultaneous international settlement of claims in both directions exactly as happens in the domestic clearing houses.

Credit function : the foreign exchange market performs another function of the financing of trade. It is called as the credit function. Credit is usually required when goods are in transit and also to allow the buyer to resell the goods and make the payment.
In general, the exporters allow 90 days to the importer to pay. This permits the payment to the exporters right away but the commercial banks will eventually collect the payment from importers when due. Thus the foreign exchange market permits time to the importers in making payment, on the one hand, and permits instant payment to
exporters through discounting facility, on the other.

Hedging function: Another function of the foreign exchange market is to furnish facilities for hedging exchange risks. In a free exchange market, the variations in exchange rates result in a gain or loss to the concerned parties. If there is rise in the exchange value of the foreign currency between the time at which obligation arises and the time at which it is discharged, the importer is faced with a risk of loss. To protect himself from such an exchange risk, the importer can avail himself of the hedging facility. Hedging means covering of
an exchange risk, which can be avoided reduced through a forward contract. It is a contract to buy or sell foreign exchange against another currency at some fixed date in the future at a price agreed upon presently.

All the commercial transactions never covered when some traders are confident that the spot rate of exchange will not change or alternatively, when it is possible for them to make accurate
anticipation of the direction or magnitude of its movement, they may not feel the necessity of hedging. It means those traders are clearly engaged in speculation about the rate of exchange.

10.9.20 Kinked demand curve

Ravinder Kinked demand curve , 0 Comments

Kinked Demand curve

The Kinked Demand curve theory is an economic theory regarding oligopoly and monopolistic competition. Kinked demand was an initial attempt to explain sticky prices.The kinked demand curve hypothesis is developed by Paul M Sweezy (Paul M Sweezy, Demand Under Conditions of Oligopoly" Joumal of Political Economy, August 1939, reprinted in American Economic Association, Readings in Price Theory).

Kinked demand curve hypothesis is used for explaining the price and output determination under oligopoly with product differentiation.
The kinked demand curve model assumes that a business might face a dual demand curve for its product based on the likely reactions of other fims to a change in its price or another variable.

The kinked demand curve analysis points to the likelihood of a price rigidity in oligopoly when a price reduction is in order and of price flexibility and conditions warrant a rise in price. There is hardly any disposition to lower price when there is a decline in demand or cost, but the price may be raised in response to increased demand or to rising Cost.

The kinky models of oligopoly are described so because they postulate the demand curve or average-revenue curve facing an oligopolist as a curve which has a kink in it at the current level of price as shown in Fig. 4 below. OP is the current price, the demand curve (AR curve) facing the oligopolist is DD' which has a kink at k corresponding to the current price P. Its companion marginal-revenue curve is MR curve which too has rather two kinks in it at A and B. The solid vertical regiment AB over it is described as
the discontinuity gap which is due to the sudden change in the elasticity of the demand curve from just above

the kink at K to just below it. The portion above it is rather elastic while the portion below it is inelastic. In fact, you can derive this type of kinked demand curve from our Fig. 1 above. The point where, in that figure. DD' and dd' intersect, can be taken as the point indicating the current price. You take the portion of dd' curve (elastic curve) above this point and combine it with the portion of DD curve (inelastic curve) below this point and thus you will get an obtuse-angled kinked demand curve like the DKD curve in our Fig. 4 above.

Note that the kinks A and B in the marginal-revenue curve MR as well as the discontinuity gap AB are exactly below the kink K, that is, if you extend the discontinuity gap AB. vertically upwards, it will pass through K. This model
stipulates that the cost conditions of the oligopolist are such that his marginal cost curve MC cuts the marginal-revenue curve in its discontinuity gap marginal revenue is the profit-maximising output and OP is the profit-maximising price. The oligopolist in this model does not experiment with price-output changes. It is because he is assumed to expect a retaliation by his rivals, if he reduces his price and consequently his sales are expected to increase along the less elastic portion of his demand (sales or average-revenue) curve.

Therefore he will not expect to increase his profits by a cut in his price. He will not experiment with an increase in his price either, precisely because int this case he does not expect his rivals to follow him suit. If our oligopolist raises his price, it does not harm his rivals but, on the contrary, is beneficial for them. Hence they are not expected to match any increase in price that out oligopolist may effect. And, the portion of out oligopolist's demand curve above the kink being highly elastic, any increase in his price will reduce his sales
proportionately much more and thus reducing his total revenue too. Hence he will not increase his price. Thus the tendency would be to stick to the current price and output. This explains the rigidity or stickiness of prices under oligopoly. It can be seen from Fig. 4 above that even when the costs of the monopolist increase or decrease and in consequence of which his marginal cost curve shifts up or down, the equilibrium price and output of the oligopolist will not change, provided the shifted MC curve continues to cut the MR curve in its discontinuity gap.

Paul Sweezy has suggested that the obtuse-angled demand curve as postulated in the model of Fig. 4 above is peculiar to periods of depression when there develop buyer's markets because then in most of the industries demand lags behind supply, in such a situation any cut in price by any one of the oligopolists is sure to be retaliated with similar cuts by the other firms also, while any increase in price by one will not be followed by others.

But, argues Sweezy, during periods of boom and prosperity there develop seller's markets as then demand moves ahead of supply. Therefore
producers do not find any difficulty in selling. In this condition a cut in price by one will not be followed by others. This means that the demand curve below the current price will be elastic. On the other hand, an increase in price by any one will be followed by others which means thatthe portion of demand curve above the kink will be inelastic. This behavioural assumption read to boom period will give a reflex-angled kinked demand curve like the one in Fig. 5 this type of demand curve can also be derived form Fig. 1 by continuing the portion of inelastic demand (sales) curve DD' above the point of intersection between DD' and dd' with the lower portion of the elastic of dd.' curve.

In this case also the equilibrium price will be OP and equilibrium output PC which will tend to be rigid so long as the marginal cost curve continues to cut the marginal revenue curve in the discontinuity gap.

It is sometime observed that kinky models of oligopoly explain the rigidity of prices under oligopoly but they do not explain how equilibrium price is determined under oligopoly. This observation is not quite correct because as we
have seen above the kinky models are consistent with the conventional profit- maximising principle of price determination, it is, though a different matter, if the current price is made to be determined by some other principle such as the
“cost-plus” or “mark up” or full-cost principle and then kinky models are relied on to explain the rigidity of prices. We shall consider the full-cost principle of Hall and Hitch in the lesson on the Marginalist Controversy.

8.9.20 Economics policies:internal and external balance

Ravinder Policies for Internal and External Balance , 0 Comments

Policies for Internal and External Balance

A deficit in the balance of payments implies an excess of expenditure over income. To correct it, expenditure and income should be brought into equality. Expenditure-reducing policies aim at reducing aggregate demand through higher taxes and interest rates thereby reducing expenditure and output. The reduction in expenditure and output, in turn, reduces the domestic price level. This gives rise to switching of expenditure from foreign to domestic goods. Consequently, the country's imports are reduced. Expenditure-switching policies aim at increasing the demand for domestic goods and to change expenditure from imported goods to domestic goods. Such expenditure-switching increases domestic output. So long as the marginal propensity to spend is less than unity, it will improve the country's balance of payments.

To achieve both objectives of internal and external balance simultaneously a judicious combination of expenditure-reducing and expenditure-switching instruments is needed. For instance, if the economy is already at the full employment level, a policy of devaluation may cause inflation within the economy. So expenditure-switching policy of devaluation must be accompanied by expenditure-policies of tighter fiscal and monetary controls to maintain full employment and balance of payments equilibrium.

In order to explain this type of policy measures which may be required to achieve internal and external balance simultaneously, we take eight possible cases of disequilibrium in Figure 5.3. These cases require different combinations of policy measures. A country at point A has equilibrium in the balance of payments and
unemployment (or recession). Such a situation requires expansion of the domestic economy through increase in domestic expenditure: This will reduce net exports.

In order to counteract this tendency, devaluation should be combined with increase in domestic expenditure. If unemployment and a deficit in the balance of payment exit simultaneously, as at point K in zone ill, there should be increase in domestic expenditure. A policy that raises internal demand through expansionary measures also increases domestic employment-But this policy widens the deficit in the balance of payments. This is described as the "dilemma zone", because instead of an expansionary policy, devaluation is the preferable policy. If the economy combines full employment with a deficit in the balance of payments, as at point D, devaluation is the remedy. This will create a large export surplus and excess foreign demand will lead to inflation in the domestic economy. To counteract these tendencies, a smaller devaluation will have to be combined with a cut in domestic expenditure. Take point tf in Zone IV where domestic inflation is combined with a deficit in the balance of payments. Inflation should be combated with reduction in domestic expenditure which would also reduce the deficit in the balance of payments and ultimately move the economy towards the equilibrium position E. If the country has balance of payments equilibrium and inflation as at point f; it should appreciate its exchange rate and reduce domestic expenditure.

Take point G in Zone I where a surplus in the balance of payments is combined with inflation. In this situation, the exchange rate should be appreciated to correct the surplus and expenditure be reduced to combat inflation. But reduction in expenditure would increase the surplus. This again represents the "dilemma zone". If the country has full employment and a surplus in the balance of payments, as at point C, it should appreciate its exchange rate. But appreciation would create
unemployment. To avoid it, it should increase domestic expenditure.

Finally, move to point F in Zone n where a surplus in the balance of payments is combined with unemployment. Here the increase in domestic expenditure would be appropriate for both internal and external balances. Such a policy will raise
employment and also induce an increase in imports to reduce the size of the surplus.
The above discussion reveals that if the economy is on neither the FF (internal balance) curve nor the XX (external balance) curve, it is in one of the four zones. When the economy follows only one policy or both expenditure-switching and domestic expenditure policies simultaneously to achieve one target (say, internal balance), it moves away from the other target (say, external balance). This problem arises not only in the "dilemma zones" I and HI, but also in the "simple zones" II and IV. For instance, if we take point F in Zone H where a surplus in the balance of payments is combined
with unemployment an expansionary policy will reduce unemployment and reduce the surplus. But to move the economy to full equilibrium point F, appreciation or depreciation of the exchange rate will have to be adopted which will move the economy away from one target or the other.

Mundell discusses the case of relationship between two tools and two objectives. The two instruments are monetary policy represented by interest rate and fiscal policy represented by government expenditure. The two objectives are full employment (internal balance) and balance of payments equilibrium (external balance).

6.9.20 Theory of Economic Policy-Objectives and Conflicts

Ravinder Microeconomics policies , 0 Comments

Introduction

Macroeconomic Policy means the monetary and fiscal policy it refers to the instruments by which a government tries to regulate or modify the economic affairs of the country in keeping with certain objectives; In other words, it tries to assess the behaviour of the economy as a whole and to seek ways in which its aggregate performance might be improved. These are achieved through certain instruments and objectives of macroeconomic policy. Its two main instruments are monetary and fiscal policy, and its four major objectives are full employment, price stability, economic growth, and balance of payments equilibrium. The policy targets are the specific values which a government attaches to its various objectives of macroeconomic policies. For instance, the government may have policy objectives like to achieve full employment, to achieve price stability and to attain the targeted growth rate for the economy. Thus, the policy targets of the government are to reduce unemployment rate, control inflation rate and to increase growth rate per year. On 'the other hand, policy instruments are those exogenous variables that can be directly influenced by the government. The government can influence macroeconomic policies by such instruments of monetary policy as bank rate, changes in reserve ratios, open market
operations, selective credit controls, etc. Similarly, it can use such fiscal policy instruments as tax rates, budgetary policy, compensatory fiscal policy, etc.

Objectives of Macroeconomic Policy

The following are the objectives of macroeconomic policy.

(1) Full Employment

Full employment has been ranked among the foremost objectives of economic policy. But there is no unanimity of views on the meaning of full employment. The classical economists always believed in the existence of full employment in the economy. To them unemployment was a normal situation and any deviation from this was regarded as something abnormal. Full employment existed when everybody at the running rate of wages wishes to be employed. Those who are not prepared to work at the existing wage rate are not unemployed because they are voluntarily unemployed.

There is, however, no possibility of involuntary unemployment in the sense that people are prepared to work but they do not find work. However, this classical view on full employment is consistent with some amount of frictional, voluntary, seasonal or structural unemployment.

(2) Price Stability

One of the policy objectives of monetary and fiscal policy is to stabilise the price level. Both economists and laymen favour this policy because fluctuations in prices bring uncertainty and instability to the economy. Rising and falling prices are both bad because they bring unnecessary loss to some and undue advantage to others. Again, they are associated with business cycles. The policy of price stability keeps the value of money stable, eliminates cyclical fluctuations, brings economic stability, helps in reducing inequalities of income and wealth, secures social justice and promotes economic welfare.

(3) Economic Growth

One of the most important objectives of macroeconomic policy in recent years
has been the rapid economic growth of an economy. Economic growth is measured by
the increase in the amount of goods and services produced in a country. A growing economy produces more goods and services in each successive time period. Thus, growth occurs when an economy's productive capacity increases which, in turn, is used to produce more goods and services. In its wider aspect, economic growth implies raising the standard of living of the people and reducing inequalities of income distribution. All agree that economic growth is a desirable goal for a country.

(4) Balance of Payments

Another objective of macroeconomic policy is to maintain equilibrium in the balance of payments. The achievement of this goal has been necessitated by the phenomenal growth in the world trade as against the growth of international liquidity. It is also recognised that deficit in the balance of payments will retard the attainment
of other objectives. This is because a deficit in the balance of payments leads to a sizeable outflow of gold. But it is not clear what constitutes a satisfactory balance of payments positions. Clearly a country with a net debt must be at a surplus to repay the debt over a reasonably short period of time. Once any debt has been repaid and an adequate reserve attained, a zero balance maintained over time would meet the policy objective. But how is this satisfactory balance to be achieved on the trading account or on the capital account? The capital account must be looked upon as fulfilling merely a short-term emergency role in times of crisis.

Conflicts or Trade-off in Policy Objectives

The four policy objectives discussed above are not complementary to each other. Rather they are conflicting with one another. If a government tries to fulfill one objective, some other objective moves away. It has to sacrifice one objective in order to attain the other. It is, therefore, not possible to fulfill all these policy objectives simultaneously. We discuss below conflicts between different policy objectives.

Full Employment and Economic Growth

The majority of economists hold the view that there is no inherent conflict between full employment and economic growth. Full employment is consistent with 4 per cent unemployment in the economy. So the relationship between full employment and economic growth boils down to a trade-off between unemployment and growth. Periods of high growth are associated with low level of unemployment and periods of
low growth with rising unemployment.

In 1961 Aurther Okun established a relationship between real GNP and changes in the unemployment rate. This relationship has come to be known as Okun's Law. This law states that for every three percentage points growth in real GNP,
unemployment rate declines by one percentage point every year. This is illustrated in Figure 5.1 where the curve U represents unemployment and curve G the real growth of an economy for a few years.

To begin with, the economy is growing at 3 per cent with an unemployment rate of 4 per cent. During the year 1970, when the real GNP increases by 4.5 per cent (from 3 per cent to 7.5 per cent), the unemployment rate feel by 1.5 per cent (from 4 per cent to 2.5 per cent). In the next year 1971, the growth rate of the economy falls to zero arid the unemployment rate rises to 5 per cent. In the subsequent year 1972, the real growth rate increases to 3 per cent and the unemployment rate declines to 4 per cent.

Economic Growth and Price Stability

There is conflict between the goals of economic growth and price stability. The rise in prices is inherent in the growth process. The demand for goods and services rises as a result of stepping up of investments on a large scale and consequent increase in incomes. This leads to inflationary rise in prices, especially when the level of full employment is reached. In the long-term, when new resources are developed and growth leads to the production of more commodities, the inflationary rise in prices will be checked. But the rise in prices will be there with the growth of the economy and it will be moderate and gradual.

Full Employment and Price Stability

One of the objectives of macroeconomic policy is to have full employment with price stability. But the studies of Philips, Samuelson-Solow and others in the 1960s established a conflict between the two objectives.

These findings are explained in terms of the Philips curve. They suggest that full employment can be attained by having more inflation and that price stability can be achieved by having unemployment to the extent of 5 to 6 per cent. Economists do not find any conflict between unemployment and price stability. They hold that so long as there are unemployed resources, there will be price stability. Prices start rising only when there is full employment of resources. This is illustrated in Figure 5.2 where the percentage of resources unutilized (or unemployed) are taken on the horizontal axis and the percentage change in price level is taken on the vertical axis. Thus, each point indicates the percentage of resources unemployed along with the price level. According
to this theory, so long resources U1, U2 and U3 are unemployed the price level remains constant at P0. It is only when the economy reaches the full employment level F, prices 'rise from P0 to P1 to P2 to P3 with successive increases in demand. Thus,there is no conflict between unemployment and stable prices as shown by the shaded
area of the figure.

However, the macro policy implications of such a relationship are that there can be no conflict between full employment and price stability so long as the economy is in the shaded area. This is because when there is full employment, resources are not in excess supply and if the government controls the excess demand through appropriate monetary and fiscal policy, there will be stability of the price level. But if the economy happens to be at point P, which may be taken to be a point on the Phillips curve, there will be conflict between the objectives of full employment and price stability.

Full Employment and Balance of Payments

There is a major policy conflict between full employment and balance of payments. Full employment is always related to balance of payments deficit. In fact, the problem is one of maintaining either internal balance or external balance, if there is a balance of payments deficit, then a policy of reducing expenditure will reduce imports but it will lead to increase in unemployment in the country. If the government raises aggregate expenditure in order to increase employment, it will increase the demand for imports thereby creating disequilibrium in the balance of payments. It is only when the government adopts expenditure-switching policies such as devaluation that this conflict can be avoided, but that too temporarily.

Price Stability and Balance of Payments

There appears to be no conflict between the objectives of price stability and balance of payments in a country. Fiscal and monetary policies aim at controlling inflation to discourage imports and encourage exports and, thus, they help in attaining balance of payments equilibrium. However, if the government tries to remove
unemployment and allows some inflation within the economy, there appears a conflict between these two objectives. For a rise in the price level will discourage exports and encourage imports, thereby leading to disequilibrium in the balance of payments. But this may not happen if prices also rise by the same rate in other countries of the world.

Problem of Coordination of Macroeconomic Policy Objectives

We have seen above that there are four policy goals which are often in conflict with each other. The problem is one of achieving them simultaneously. Full employment, economic growth and price stability are the major objectives of economic policy. They are essential for the internal balance of the economy. But balance of payments equilibrium is also an essential policy objective because a disturbance in the balance of payments has serious effects on growth, employment and prices. This objective, therefore, requires external balance. The theory of economic policy has centred around two problems. First, the relation between the number of policy objectives and the number of policy instruments; and second, the assignment of policy instruments to the realisation of the objectives. In order to achieve given objectives with the same number of policy instruments, the second problem of the assignment of instruments to targets arises. The formulation of the assignment problem will eventually lead to equilibrium values of the objectives, despite lack of coordination between them.

Conclusion

Full employment, economic growth, balance of payments and price stability are the major objectives of economic policy. The four policy objectives discussed above are not complementary to each other. Rather they are in conflict with one another. If a government tries to fulfill one objective, some other objective moves away. It has to sacrifice one objective in order to attain the other. It is, therefore, not possible to fulfill all these policy objectives simultaneously. There can be possibility of internal and external imbalance. To achieve both objectives of internal and external balance simultaneously a judicious combination of expenditure-reducing and expenditure-switching instruments is needed.

5.9.20 Average Cost Pricing Theory

Ravinder Average cost pricing theory , 0 Comments

Introduction

In industrial economy it is assume that the major goal of the firm is profit maximisation and the equilibrium price and output is determined by the conditions: MC=MR and MC curve cuts MR curve from below. But during the great depressions of 1930's and afterwards, the economists found that the actual behaviour of the firm in price determination, has not at all so. Marginal analysis of the firm was challenged by empirical analysis of the behaviour of the firm. This sets some economists thinking about the need for building a realistic theory of pricing. Two investigations of pricing behaviour have been made in England, one by a group at Oxford University who interviewed thirty eight business tycoons,mainly engaged in the manufacturing sector and concluded that : It casts doubts on the general applicability of the conventional analysis
of price and output policy in terms of marginal cost and marginal revenue, and suggests a mode of entrepreneurial behaviour which current economic doctrine tends to ignore. This is the basis of price what we shall call the ‘full-cost’
principle.

AVERAGE-COST PRICING PRINCIPLE

We have discussed above that a number of economists have developed Average cost pricing models. The basic characteristic of model is that the price of the product is determined as :

P=AVC + GPM = AC

Where AVC = Average Variable Cost and GPM = Gross Profit Margin In other words, the firm sets a price equal to its total average cost which includes a certain net profit margin.

AVERAGE-COST PRICING AND GOAL OF PROFIT MAXIMISATION

In average-cost pricing model it is assumed, explicitly and implicitly, that the goal of the firm is long-run profit maximisation. However, the profit maximisation goal is not achieved by maximising profits in each one period within the time horizon of the firm. It has been established that short run profit maximisation attained by marginal analysis (MC=MR) in each period does not lead to long-run profit maximisation as postulated by traditional theory. It is mainly because of the Fact that the individual time periods (short run and a long run) are not independent of each other. Decisions taken in anyone period are influenced by decisions in earlier periods and will affect decision in future period. Therefore, marginal analysis does not correctly describe businessman's behaviour. Instead long run profit- maximisation is attained by equating price to the average cost of the firm.

DEMAND SCHEDULE

For analysing long run behaviour of the firm, we would require knowledge of its long run demand and cost schedules. In the wake of uncertainty it is difficult to prepare these schedules. The uncertainty is caused by the fact that tastes of the consumers are continuously changing in the market and the reaction of the competitors is difficult to predict. Past experience do not help much in reducing the uncertainty in this dynamic and continuously changing world. Therefore, A-C-pricing theorists reject the demand schedule as a tool of analysis. However, in the traditional theory of the firm, demand schedule is one of the most important tools of analysis.

Average-Cost-Pricing and Cost Schedule

Long run costs of the firm are also uncertain. Rapid technological change and changes in factor prices make it impossible to obtain reliable estimates of the long run cost schedule. Thus average cost pricing theories take into consideration short-run average cost.

It is assumed that the short-run average variable cost has saucer-type shape. This is mainly because of the fact that firms build into their some ‘reserve capacity’ which is required for various reasons, For example (a) to meet seasonal fluctuations in demand; (b) to allow a smooth flow of production when break-down to plant occurs; (c) to meet a growing demand until further expansion of scale is realised; and (d) to allow for making minor changes in the design of the product whenever there is a change in the tastes of the consumers. The shape of the average variable cost and other costs are shown in the figure 1. The decrease in short-run average variable cost (SAVC) is due to the better utilization of some of the fixed factors. So far the SAVC is falling the SMC is also falling.

The increasing part of SAVC reflects of the wastage of raw material, the higher repair charges and overtime payment to the labour force. When SAVC is rising the SMC lies about it. Over the flat stretch of the SAVC, the SMC is equal to the average variable cost. Pricing is based on the flat stretch of the SAVC. When firms producing the output at a level less than the normal capacity, they will have high costs. But they will not charge a high price in order to cover their costs because they expect to eventually reach the normalange of output. Similarly when due to increasing demand pressure firms produce at increasing part of their average cost, they will not change a higher price to cover such costs because they are afraid of losing their goodwill.

PRICE DETERMINATION : 'THE MARK-UP RULE'

The determination of A-C pricing involves two stages :
(1) The firm defines the desired price (P) in order to cover its total cost when its plant is operating its optimal range of capacity and earn a reasonable' profit.

(2) The firm compares its estimated price with the level of price at which entry would occur, and sets the price at a level (P*) which would effectively discourage entry.
Subjective Estimate of the ‘Desired Price’ For determining the desired price the firm used the mark-up or cost-plus pricing rule. According to this rule :

P = AVC + GPM

AVC is cost-plus :- It is assumed that average variable cost (AVC) is known to the firms with certainty. The flat stretch of the SAVC curve represents normal utilisation of the plant capacity of the firm. The aim of the firm is long-run profit maximisation. However, given the uncertainty in the environment, the firm bases its price decision on the short-run average variable cost (SAVC).

It is because of the fact that the firm believes that its cost will not increase even if it expands its scale in the long-run (rather cost may fall in the long-run due to economies of large scale). Thus the short-run average-cost is thought to be a good approximation to the long-run average-cost.

The ‘Plus’ in A-C Pricing :- The mark-up or gross profit margin (GPM) may be added to average variable cost. This GPM will cover the average fixed cost (AFC) and yield a normal profit :

GPM = AFC + NPM

AFC is calculated by dividing total fixed cost (TFC) with the ‘planned’ or ‘budgeted’ or the ‘normal’ output (X*). Thus AFC = TFC/X*.
The net profit margin (NPM) is known to the established firms as a matter of experience. The firms should yield a ‘fair’ return on capital so that capital keeps flowing regularly in the industry for investment in the long run. For a new product the firm is assumed to add the NPM which is ‘safe’ in the sense that it does not attract the entrants.

Actual Price Setting Actual Price Setting

It is not necessary that the ‘desired’ or ‘standard’ price (as experienced above) will, actually be charged. The ‘desired’ price may be taken as the initial basis of the actual price. The level of actual price depends upon the threat of potential entry. Actual competition by existing firms may be resolved by tacit collusion or price leadership. Tacit collusion takes various forms. The calculations of the actual price of the product are on the basis of average-cost data published by trade associations.

When the firms in an industry are having widely different costs, pricing on the basis of average-cost by each firm indepdently may result in market instability and price wars. For the smooth functioning of the industry, the firm with the lowest cost will be considered as the leader. The less efficient firms will be price takers. Although the price leader calculates the price of the product on the basis of average-cost rule, yet the leader will charge the actual price (P*) depending on two factors. (a) on potential competition; and (b) on
general economic condition (Prosperity and depression). If the entry of new firms is restricted, actual price (P*) will be higher than the leader's normal price (P) who will be earning just normal profits. Thus GPM is competitively—determined by the threat of potential entrants. In other words the average—cost—pricing has a strong link with entry-preventing behaviour.

Let we explain the determination of price in our ‘representative’ average-cost pricing model with the help of Figure-2. The horizontal lines are not demand curves, but show the price that would be charged under certain conditions.In Fig. 2 the SATC curve includes the net profit margin. The price leader would normally desire to charge the price P (or OP) which is equal to short-run average cost (aX*) and his ‘gross profit margin’ (ab). At OP price the price leader would sell the budgeted output (X*).

However, if barriers to entry exist (or their is booming business) the leader would charge the price P*. It is evident from the figure that the effective GPM at P* is ac which is greater than ab (ac > ab). If the threat to entry is strong (or there is depressed business) the leader would charge the price P*. Which is lower than the ‘initial’ or ‘normal’ price P. In this case, effective GPM would be ad<ab.

CRITICAL EVALUATION OF AVERAGE-COST PRICING

Most of the models of the A-C Pricing and based on empirical tests with the help of survey method. The finding of many of these surveys have come under attack on the following grounds :

(a) Small and non-random business survey using questionnaire and interviews are unreliable method of obtaining data on price determination ;

(b) The results of such surveys have been misinterpreted and

(c) The marginalist explanation of price determination has been incorrectly presented and therefore unduly criticised.

Other criticisms of A-C pricing principle are :

1. The average-cost pricing theory is not different from other known theories of the firm. For example, average costing rule of pricing are compatiable with Baumol's sales maximisation hypothesis, Cyert and March's satisficing behavioural model, with short-run marginalistic profit-maximisation behaviour and with long-run profit maximisation.

2. If should be clear that the ‘mark-up’ margin would be different, depending on the goals of the firm, and hence the price level would be different. Thus, unless we know what the goals of the firm are, it is not possible to come to know from the pricing rules of thumb whether it is a sales maximiser, or a satisficer, or a firm aiming at the long run profit maximisation because all these motivations may bet attained by applying an average-cost routine in price setting. However, the empirical evidence regarding the goals of the firm is far from conclusive. However there are certain merits of average-cost princing principle :

(a) Average cost pricing is easier to apply, because the concepts it involves are familiar to business persons and accountants, while the concept of
elasticity is not perhaps understood by the average business person.

(b) Average-cost pricing rule facilitates price setting in multi-product firms. In these firms acquisition of information on price elaticities for all products is both difficult and costly.

(c) Trade associations publicise information of costs of individual product lines. These informations can be very well utilised in calculating the average-cost pricing.

4.9.20 Chamberlin's model of non-collusive oligopoly

Ravinder Chamberlain's oligopoly model , 1 Comments

Chamberlin's Model

Chamberlin questioned the illogical assumption in all the three classical models of oligopoly( Cournot's Model, Bertrand's model and Edgeworth's Model) namely, that the producers do not learn from their experience even when their assumption regarding the behaviour- reaction of the rival producers is falsified again and again. These models imply that the oligopolists are so short-sighted that they are unable to recognise their mutual dependence. Chamberlin does away with this unrealistic assumption and instead assumes that oligopolists are sure to recognise their mutual dependence either intuitively or as a result of experience.

Thus the distinguishing feature of Chamberlin's model of oligopoly is that it is securely based on the assumption that the duopolists or the oligopolists, as the case may be recognise their mutual dependence. Therefore, in his model, the oligopolist does not assume that his rivals will continue to stick to their output or price or both regardless of what he does to his own output or price or both. Instead, he perceives that any move by him to gain advantage at the expense of his rivals will be retaliated. If any individual oligopolist thinks of lowering his price he can easily see that the number of firms in the “industry” or “group” being very small particularly in the case of duopoly, the adverse effect of his price-cutting on the sales of his rivals will be significant. Therefore, he will foresee that his rivals will not stick to their current price and output but will strike back by lowering their prices.

On account of this perception he can easily see that his own sales, as the result of price-cutting, will increase not along the elastic sales curve dd' of Fig. I above but along the inelastic sales curve DD' of this Fig. 1. Such a result of a price cut by any of the oligopolists is not likely to increase his profits. Hence, the oligopolists recognising their mutual dependence, will avoid any engagement in a price war one another.

The same recognition of mutual dependence which prevents the oligopolists from indulging in price cutting competition will induce them to fix their price at the level which would have prevailed under monopoly. Of course, this is based on the heroic assumption that the cost curves of the oligopolists are identical and such that, when added together, will become identical with the cost curves of single monopolists. The equilibrium output of the “industry”or the “group”, in that case, will be the same as the equilibrium monopoly output under a single monopolists and this total output will be equally shared by all the oligopolists. It may be thought that the solution of equilibrium problem under oligopoly as suggested by Chamberlin and explained above points towards “collusion” among the oligopolists. But Chamberlin argues that the monopoly arrangement among the oligopolists that results in his model is not the result of any collusion among them. It rather results from the oligopolist's intuition or business sense or their experience gained through some earlier price war.

It may be thought that the solution of equilibrium problem under oligopoly as suggested by Chamberlin and explained above points towards
“collusion” among the oligopolists. But Chamberlin argues that the monopoly arrangement among the oligopolists that results in his model is not the result of any collusion among them. It rather results from the oligopolist's intuition or business sense or their experience gained through some earlier price war.

However, regardless of the contention of Chamberlin his model is not a model of a purely non-collusive oligopoly. There may not be in his model an open agreement among the oligopolists on the monopoly arrangement, but there is a tacit agreement all the same.

We see that even on the basis of the four models considered above there is no unique equilibrium under oligopoly. There are quite a number of
other models too, some of which we shall examine ahead in this lesson, which point towards still different solutions. In view of it, it is quite apt to state that equilibrium under oligopoly is indeterminate.

We have already pointed out the basic weakness of the classical models, namely, that they implicitly assume that oligopolists do not learn from their experience. That they are permanently short-sighted and therefore fail to recognise their mutual dependence. Chamberlin's model does not suffer from this failing but his model is not a model of a genuine not-collusive oligopoly. But there is another more fundamental weakness which not only Chamberlin's model but also a number of other models share with the classical models.

All models of non-collusive oligopoly are based on the assumption of perfect knowledge and they rule out uncertainty. As soon as we introduce uncertainty into a model of oligopoly, the analysis of equilibrium under oligopoly becomes even more complicated.

This has led some mathematical economists like Von Neumann and Morgenstern to suggest that laws governing the behaviour of oligopolists resemble not to the laws of physics, from which the technique of equilibrium analysis has been borrowed by the economists, but the laws governing the outcome of games and wars which involve strategies and counter-strategies.

There is still another line of reasoning. It is suggested that as fighting out oligopolistic wars in real life is full of uncertainty, it is very likely to prove futile. The quest for maximum profit under conditions of oligopoly involving business wars : strategies and counter- strategies with uncertain results has a very high cost in terms of tensions, strains and anxieties. It is argued that realisation of this truth may induce the oligopolists to abandon the quest for maximum profits. In fact the analysis of the problems of oligopoly has led
economists to question the realism and relevance of the profit- maximising assumption of the neo-classical economics. It is suggested that under
oligopoly, at least, the entrepreneurs are likely to prefer a relatively leisured and less tense life to the strains and stresses of fighting oligopolistic wars, provided they are earning “satisfying” profits. This suggests that prices and output, particularly prices, tend to be rigid under oligopoly. The rigidity or “stickiness” of prices under oligopoly can be accounted for by the factor that the oligopolists might be earning “satisfying” profits at the current price level and they may be uncertain with regard to the behaviour reaction of the rivals on account of which they are afraid of experimenting with price changes. Even when they are not uncertain about the behaviour reaction of the rivals, their
perception of such behaviour reaction may be such that they do not see any.possibility of increasing their profits by changing the price. Consequently, they stick to their prices being currently charged. There are a particular kind of models of oligopoly which explain this last mentioned case of rigidity orstickiness of prices. They are known as the “kinky” or “kinked-demand” models of oligopoly .

21.9.20

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Kinked demand curve

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Theory of Economic Policy-Objectives and Conflicts

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Average Cost Pricing Theory

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Chamberlin's model of non-collusive oligopoly

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