Microeconomics: Risk Premium, Deter Entry to Markets and Externalities - Coursework Example

? Microeconomics: Risk Premium, Deter Entry to Markets and Externalities Microeconomics: Risk Premium, Deter Entry to Markets and Externalities Q1. Risk Premium and Mechanism to Minimize Risks Uncertainty in various outcomes of an event may make one to be a risk averse. The lack of willingness to make a fair bet in a given event that has attached varied benefits and possible losses may subject one to pay more to avoid incurring huge losses. Perloffin his book, Microeconomics, defines risk premium as “the amount that a risk averse person would pay to avoid taking a risk.” In real market situation, the decision to invest either in stock, government bonds or keep the cash may be problematic. Keeping the cash will mean there will be no gain, but one enjoys a high liquidity preference of their cash. However, the future of the market performance is oblique. In the event inflation hit the economy, the money will have greatly lost its value and one would have wished making an earlier investment on either stock or bonds could have been a better option. Investing their money in either stock or bonds is always dilemmatic. An individual is ever sure of safety of money value invested in government bonds than in corporate stock. The value of government bonds depends on the performance of GDP; it could either decrease or increase annually. Assuming a GDP of 7%, the value of the bond that year would be similar to GDP. In such cases, the stock value is always higher than that of bond by 1% or 2%. A person who decided to invest in corporate stock that year will enjoy accrued savings of their investment at either 8% or 9% while one who invested in bonds will only enjoy 7%. The difference of the two becomes the risk premium. Risky situations have a high attached risk premium. There are many mechanisms an individual can explore to minimize risk. To begin with, one can just say no. For example, uncertain luxurious investments to improve one’s status in the society can be avoided. One may have a strong desire to purchase the most coveted natural Cornflower Blue Sapphire.There are two possible outcomes: purchasing a genuine sapphire or duped with a copy. Bearing in mind that one lacks the capacity to distinguish between a genuine and a counterfeit, there are two underlying benefits of varied proportions. If one goes ahead and it is a genuine one, he becomes $ 120 rich otherwise, $10 richer. In such scenario, saying no would avert possible looming risk. Secondly, one can obtain factual information before making a decision. An investor who is interested in a particular corporate stock and lacks information or have scanty facts regarding the stock performance can inquire before putting life savings into it. Information gathered in light of the corporate stock performance in the past few years or quarters may lead one to make informed decisions. A clear indication of a possible decline in the stock value that particular period would deter one from investing because at the end of the day everyone wants to see the value of their assets rising and with great stability. When one obtains information about something whether it has monetary value or not, the decision made will ultimately avert risk associated with it. Thirdly, an individual can diversify the risk. This can be done when the two events are perfectly negatively correlated (Perloff, 2011). A perfectly negatively correlated event according to Perloff refers to an event where one of the two possible outcomes must happen with great certainty. Assuming the government wants to give the tender to either IBM or Apple to supply its various departments with computers and other accessories during the next financial year. There are two possible outcomes: a win and a loss. It is absolutely clear one company must win the tender. When an individual purchase the shares of the winning company, each share value is $50 otherwise $10. One may then decide to purchase an equal share of each company just to be at the fair edge. Assuming a purchase of 5 shares, the total stock valuation will be $300 after the tender regardless of which company win or lose. Finally, one may decide to insure the valuable asset. This makes it possible to seek compensation when the risk finally occurred. Insurance company acting on principle of indemnity which ensures one is completely restored to their previous financial position, will quickly arrange for timely compensation after assessing the value of the damage caused to the policyholder. Q2. Firms actions to deter entry to Markets The existence of high initial capital or explicit cost that applies only to potential new firms may make it absolutely difficult for the new firms establish themselves. Perloff (2011) points out two possible scenarios under which large sunk cost can be a barrier to entry. First, he points out a large sunk cost for new firms in the capital markets that do not work so well. As a result, new firms will not be able to raise the money to venture into profitable industries. Secondly, a firm must incur large sunk costswhich will translate to a great loss in case of a premature exit. Therefore, such firms will be reluctant to enter a market in whichit is uncertain of success. The consumers will have to continue paying more or higher prices for products and services consumed. Barrier to entry makes it difficult to stir healthy competition among the existing firms. Thismay lead to poor quality products and services. Barrier to entry creates a partial monopoly market structure in a perfectly competitive market (Mankiw, 2012). The existing firms will behave in a manner that creates a monopoly atmosphere in the market aware that no firm can dare make an entry. They may focus on generating more revenue and disregard health and safety standards of their products. It is the consumer who will bear all the risk and dig deep into their pockets to acquire what is available in the market. The government may be forced to intervene when its citizens feel exploited especially in the provision of basic commodities such as sugar, among others. In case the government decides to set the ceiling price of those commodities, it will have cushioned consumers from unscrupulous traders. Firms will have no option other than to find ways to ensure efficient and effective operation strategies for its own survival. Barrier to entry offers existing producers ample time to continue with their daily production without many worries. Consequently, they may dedicate most of their time researching on how to improve their service delivery to customers. As a result, they will have to incur high cost in assessing how their products are performing and how best to improve. This is an advantage forconsumers. Every move undertaken by a single firm in the industry will make the rest of the firm to do much more to continue remaining relevant and attaining profitability at the same time. This may include the cost of advertising popular brands, and the cost it has to incur introducing new products or brands. The barrier may bring more harm than good to the producers themselves. In such market scenario which we can now consider ‘closed market’ the firms themselves will be engaging in internal cold wars. A firm that enjoys large economies of scale has the potential of making other firms exit. It enjoys increasing return to scale. Any small changes in inputs lead to unequal increase in output as shown below. A firm that enjoys increasing return to scale may develop tendency to engage in unhealthy competitions which can finally compel other firm to exit the market (Penrose, 2009). It can lower its prices at will making the products of other firms appear expensive. This makes consumers to shift to products of a firm that charges low rates (Mackenzie, 2010). Fig.1 Increasing return to scale Continuation of this trend may land other firms to bankruptcy in trying to match the prices of the firm that enjoys large economies of scale. However, they will not do this for long due to persistent losses. When the heat in the market is too much to bear, there will be limited options for such firms: exit, merge, or risk being absorbed. In the communication industry, it is very difficult for a new firm to successfully enter. It will have to incur billions just to set the platform before proving to consumers that it is the best service provider. This will be very difficult and costly for a new firm to set all the equipment and conducts massive advertisement to get a good number of subscribers for a good start off. The firm can exhaust all the resources at its disposal before positioning itself in the market and this will be an automatic failure if it will not be ready to add value to its products and services periodically. Two major mobile service providers T-Mobile, and Metro PCS resorted to merge to provide better services in the fiercely competitive industry. Metro PCS could not withstand the heat brought by competition any longer due to high operating cost in the industry with fewer subscribers and offering quality services. Q3. Externalities Externality can refer to the direct impact of an individual or a firm’s action on another person’s welfare or a firm’s production capability. It can be classified as either positive externality or negative externality (Perloff, 2011). Positive externality is an externality that benefits a person or a firm. For example, bee-keeping firms adjacent to flower firms, the bees pollinate the flowers and that benefits horticulture farmers. Negative externality refers to an externality whose direct impact harms another person or impairs a firm production capability. For example, a paper milling plant next to residential estates pollutes the air and water through discharge of chemical waste into the nearest water body used by the public. Market structures can aggravate the harm already inflicted on the public welfare. In a competitive market structure, there are excessive negative externalities. Each firm will be trying to outshine each other so as to develop competitive advantage in the market. Firms in a competitive market concentrate on the production cost and how to maximize their revenue. In their cost computation they work with private cost, the actual cost incurred in producing certain amount of output exclusive of externalities, while disregarding social cost, actual production cost plus proportionate cost of the harm caused to the public. This results to a deadweight loss in their final computation as they equate price of their products and services with their private marginal cost and not the social marginal cost as expected. As a result, the public suffers from firms’ negligence and failing to engage in healthy corporate social responsibility. Their revenue seems more valuable to them than the well-being of the consumer who is the king to the business. In monopoly market structure, the effect of externality can be less or much, but not as excessive as that of competitive market structure. This because it sets its price above the marginal cost making it achieve satisfaction and partial maximum revenue by just producing a few units of output. However, it can resort to produce much more as it focuses on the private marginal cost instead of expected social marginal cost in its computation. These market structures tend to serve their selfish interest while endangering the lives of consumers. Effective policies may put an end to this negligence committed by firms. Government regulations such as setting optimal pollution level of pollution to be met by each firm. This will bring sanity to producers. They will be cautious and embrace the law. The government can also decide to tax total output of a firm to lessen the damage caused to the public and over public goods. However, there are challenges to such regulations. First, the firms may fail to disclose their total output and this may lead to great disparity in the amount collected by government and the benefits to the public through programs that will eliminate the waste and damage caused by the firms’ production activities. Also, the firms may be tempted to over exploit the available natural resources claiming they will pay for the marginal harm of the externality created. In addition, the government can issue property rights to certain firms to curb the rate of pollution. Consider firm K which dumps its waste chemicals in a lake being used by a boat hiring firm L. The clients of firm L accepts their services if they lower their charges to cater for the risks they are exposed to such as bad smell of the industrial waste among other possible health risks. If the Government Issues firm L with property rights to ensure free pollution, firm K will not dump its chemical waste any more. On the other hand, firm K can be awarded with property right to dump their chemical waste by paying pollution tax. In such a case, it will be careful and this will also benefit firm L. Similarly, firm L may allow firm K to dispose their chemical waste upon paying agreed daily cost as a compensation to lose cause to L. Bothfirms are able to attain efficiency in their operations regardless who owns the property right. Perloff (2011) argues that two firms with a common interest cannot benefit from award of property right if they do not understand the cost benefit of reducing externalities. It will lead to inefficiency and more often can fail to agree when either firm with the property right set a high transaction cost making it difficult for the other firm to sign off the deal. Bibliography Mackenzie, I. E. (2010).English for business studies: a course for business studies and economics students. (3rd ed.). Cambridge: Cambridge University Press. Mankiw, N. G. (2012). Principles of microeconomics (6th ed.). Mason, OH: South-Western Cengage Learning. Penrose, E. (2009). The Theory of Growth of the Firm (4 ed.). New York: Oxford university press. Perloff, J. M. (2011). Microeconomics (6 ed.). Boston: Pearson Addison Wesley. Read More