Paradoxes from Everyday Economics

 If you are fascinated by the heavenly wonders of astronomy, then look back towards earth and you will find that economics is an equally fascinating area! Here are a few paradoxes from everyday economics which seem absurd at first sight but are real (and sometimes funny!).

1. The tail wags the dog: Suppose you are extremely thirsty - you go to a wayside store and buy a water bottle. What is the worth of the first sip of water? Way more than the price you pay for the bottle right!? With each subsequent gulp of water the utility of water decreases due to diminishing marginal utility. Similarly, any good or service that you purchase includes remuneration to the producer for undertaking the risk of production and the price that  you pay may be way more than the costs of production.

In the figure above, the demand curve represents the marginal utility derived by a consumer by consumption of the good. As you can see, it is downward sloping because, with each successive unit of consumption, the utility that you derive from the good decreases. The upward sloping supply curve, represents the marginal cost of production. Fixed inputs like land are limited in nature whereas the variable inputs like labor can be increased even in the short term. So as we keep increasing the inputs, although the total product increases, their productivity (increases initially) decreases and the costs of production keep climbing with increased production. Therefore, the marginal cost of production or supply curve is upward sloping.

The demand curve and supply curve intersect at an equilibrium, in other words, buyers and sellers interact with each other to arrive at the desired quantity and price. The price paid is determined by the marginal cost and marginal utility of the last unit of consumption/production. In other words, the tail wags the dog in economics!

2. Giffen's Paradox: When the price of inferior goods like canned foods, instant noodles and  frozen foods falls, their demand decreases.

 

When people have lower incomes they depend on these type of goods for survival but when incomes increase they move on to more expensive goods and services!

3. Agriculture Output: When one farmer has a good harvest, her income increases but when all the farmers have a bumper harvest their collective incomes fall!

As shown in the figure above, the demand curve for agricultural products specially food grains is  largely inelastic. So when there is a bumper harvest, prices fall drastically and the aggregate incomes fall, smaller farmers are worst effected.

This highlights the need for planned production, minimum support prices/income credits and effective pricing mechanisms in agriculture which is subject to vagaries of nature.

4. Labor and Wages: When wages increase more people are willing to work, so the supply of labor increases as wage rate increases. But in some situations, it has been found that as wage rate increases the supply of labor increases initially but begins to decline beyond a threshold level of wage rates.

 Research has shown that when wage rates go over board, labor go on a holiday - for fishing or gardening! They prefer to work for lesser number of hours or days as the income effect of increased wages, augments their total wages, so much so that they want to spend time on leisure activities.

5. Imperfect Competition and Long Term Economic Growth: The three well known forms of imperfect competition are monopoly, oligopoly and monopolistic competition.

The structure of most industries depends on the costs of production and their economies of scale and scope. When the lowest cost of production can be achieved at low market share of revenues, then there are a large number of producers like in a perfect competition. The best example is the market for agriculture products where there are large number of small producers with very little product differentiation. Similarly, when the lowest cost of production can be achieved only with a significant share of the market revenues then there will only be a few producers an oligopoly- like in airlines industry or oil industry. And then there are natural monopolies like utilities  -  water and electricity where it does not make any sense to have more than one player in one geographical area. 

(Looking at the turmoil in the airlines industry around the world, one wonders if this is the case for a natural monopoly!)

The general thinking which is true to a large extent, is that monopolists and oligopolists corner super normal profits by decreasing consumer welfare and increasing dead weight loss. 

So regulators around the world step in to ensure fair competition in markets and contain market power.

Technological advancements are crucial in disrupting industries and breaking new grounds.But how do technological advancements happen ? On many occasions with billions of dollars of investment in research and development! Can all firms afford this kind expenditure on R & D? For that matter, can governments which need to balance between welfare and growth (a tight rope walk by any standards!), afford research expenditure? So some amount of super normal profits for private players may be a necessary evil, to ensure long term economic growth, innovation and most importantly for the advancement of mankind as a whole and the super normal profits that these companies enjoy may be the price that society pays in return. Examples big tech firms and pharma companies.

The principal reason for the billions of dollars of investment in R & D by the big tech firms is the record earnings they clock, quarter after quarter, year after year. 

Another example of positive externalities of imperfect competition is found in monopolistic competition, which has a large number of sellers with slightly differentiated products. The best example for this kind of structure is found in the market for breakfast cereals and cookies. Consumers are pampered with a variety of choices and the buying decision happens in a split second. 

So the bottom line, imperfect competition in spite of all its imperfections is actually a necessary evil for long run economic growth and human welfare.

6. Private vs Public: When a private firm makes losses and cannot repay its debts, it has to go through bankruptcy proceedings and the promoters may also face legal action for misconduct. But when a public firm makes losses....well...it is infused with additional capital!

When an individual or a firm spends more than they can afford, the results are not very good for the entity. But when a government spends more (on development!) than its income, it is welcomed!

References: Economics by Samuelson and Nordhaus, Google Search