1.a
Figure 1: Demand and supply of a risky asset
The figure above depicts market condition of a risky assets. Factors determining an asset demand include expected rate of return, associated risk with the asset, liquidity and wealth. The concept of law of demand is also applicable to the demand for assets. A higher price of assets indicates a lower yield causing asset demand curve to be downward sloping. The law of supply indicates a positive association between quantity supplied and price. The same is hold in asset market as well. The supply curve of asset is upward rising. DD and SS thus represent the respective demand and supply curve of an asset. Equilibrium in the market occurs at E, a point where asset demand and asset supply curve meet. The equilibrium point determines asset price and quantity as P* and Q* respectively.
Figure 2: Demand –Supply diagram with risk free assets
Figure 1 portraits demand and supply curve of a risky assets. There are several factors that can cause a change in demand and supply of asset. Risk is one such factor that changes asset demand curve and causes a shift in the demand curve. Risk has a negative impact on assets demand. If the asset perceived as risk free, the confidence of investor increases. Being lured by assured return from the asset, people demand more assets. The increase in demand of asset causes the asset demand curve to move to the right. Given the supply, an increase in assets demand increases asset prices shifting the equilibrium to a new position at E1.
b . When an asset suddenly revealed to be risky then there is a breakdown in financial market. For a risk free asset, people willing to invest more and more in the asset. Now if the asset suddenly revealed as risky, then people starts to withdraw their money from the asset. New investors also fear to invest in such a market. Consequently, there would be a contraction in asset demand. as the asset demand falls, the demand curve shifts inward. The decline in asset demand reduces value of asset. There would be a contraction in asset market with a lower price and reduced supply of the concerned asset.
c . The perception of risk free assets encourages people and investors to invest more in the asset. The risk free assets attract more investors. As more and more people investment in the asset there is an economy wide demand of the concerned asset and price increases accordingly. The higher price again attracts more investors. This creates a bubble in the market of concerned financial assets. Now, sudden revelation of the asset to be a risky one increases volatility in the asset market. Confidence of the investors tumbled and they start withdrawing their money from the asset. Under such circumstances, the asset is often sold at a very lower price. As the asset is exposed to be a risky asset, its demand falls. People try to get rid of such asset. This causes a sudden decline in asset prices. With sudden decline in asset the bubble formed in the asset market burst suddenly causing an economy wide crisis. One example of such consequence of change in perceived risk of the asset is the break-down on financial market in US during 2007- 2008. With rising price of house people invest more and more in housing. During this time the holding of mortgage bond increased rapidly. The mortgage bonds were initially sold as a risk free asset. The growing demand and asset price formed bubble in the housing market. With a sudden decline price, the market broke down leading to the Global Financial Crisis. The incorrect assessment of risk of a financial asset is thus responsible for broader financial crisis in the long run.
2.a
Figure 3: Effect of tariff removal on beef market of China
The figure above presents the impact of tariff removal on beef market of China. In the China’s beef market, the respective line of DD and SS. presents market the demand and supply. An import tariff increases price of import in the domestic market. P1 is the price of beef in China’s market inclusive of tariff. With tariff, the surplus to the consumers is show by the area A + G. The surplus to the producers with tariff is B + F. At the price inclusive of tariff, domestic demand is Q2 and domestic supply is Q1. The volume of import thus equals (Q2 – Q1). The revenue to the China’s government from the import tariff is shown by the area D. Total surplus with tariff thus is the sum of consumer surplus, producer surplus and tariff revenue. Total surplus thus is given as A + G + B + F + D. The imposed import tariff causes a welfare loss given by the area C + E. This is the deadweight loss from the tariff. Now, as China eliminates tariff, price of imported beef in China reduces to PW, which is the world price. At the lower price demand of Australia’s beef in China’s, market increases to Q4. Domestic supply on the other hand reduces to Q3. Consequently, the volume of import increases to (Q4 – Q3). With a lower price, consumer surplus now increase by the area B + C + D + E. The surplus to domestic producer lowers by the area B. The surplus to consumer and producer is given as A + B + C + D + E + G and F respectively. The loss in producer surplus redistributes completely to consumers. Total surplus thus increases to A + B + C + D + E + F + G after elimination of tariff.
b. It is claimed that free trade increases welfare of the participating nations. As discussed above China is benefitted from an increased surplus after tariff removal because of free trade agreement. Not only welfare of the importing nation improves but also exporting nation that is Australia benefitted from increased volume of beef export to China. This is however not the complete story. The effect of free trade is not only restricted to its welfare consequences, there is some adverse consequences of tariff as well. A considerable large volume of beef export from Australia to China reduces availability of beef for domestic consumers in Australia. Free trade though benefits beef sellers in Australia and some other sectors but this is not a good news for agricultural sector in Australia. The agricultural sector that is not related to beef export or is not directly affected from tariff reduction suffer from a contraction of output. There is an economic effect both in terms of change in exchange rate and change in use of resources. Because of switching use of resources including land, the sector directly related to beef become more profitable over others after the removal of tariff. The theoretical assertion that economic welfare increases because of free trade agreement is not entirely correct. Other aspects needs to be considered as well for complete evaluation of the impact of tariff removal on the overall economy.
3. a Negative externality is an economic term that reflect the cost imposed on a third party following an economic transaction. In the transaction process, consumers and producers are the first and second party while the third party can be any individual, property owner, organization or the society. The negative spill-over effect from the transaction is known as negative externality. The figure below explains negative externality and its likely consequences
Figure 4: Effect of negative externality
In the presence of negative externality, marginal social cost exceeds the marginal private cost. The socially efficient quantity is lower than free market output. With negative externality, free market price fails to reflect the efficient pricing in the market. In the debt market, the presence of a negative externality is realized as loss to the homeowners during economic downturn has an adverse effect on prices of house in the neighborhood. During economic downturn, price of houses fall which is not reflected in the mortgage payment. The market-determined price thus fails to represent the actual valuation of the house. In debt mortgage, homeowners thus suffer a loss from a fall in house prices. As price of a house declines, there is an associated decline in house price located in the same neighborhood. This external cost of debt contract however is not reflected in house price. Any example of such externality is foreclosure. It is the direct effect of debt contract. Under this circumstance, homeowner has to bear the cost of decline in house. Foreclosure imposes an external cost on homeowner in the neighborhood.
b . The presence of external cost hampers the efficient free market outcome. A market with external cost calls for government intervention to internalize the external cost and restore efficiency in the market. Transaction in the debt contract thus needs government intervention to mitigate the external cost of such transaction. Shared responsibility mortgage is an alternative approach of debt contract. With shared responsibility mortgage, the principal mortgage balance and payment of interest is subject are linked with a house price index. When there is a decline in housing price in the neighborhood both the principle and interest automatically revise downward. This helps the homeowner to escape from the loss during economic downturn. The debt contract can be improved if homeowner and lender agree on agree terms of a shard responsibility contract. As mortgage payment adjusts with economic condition, the external cost of direct debt contract is mitigated. In references to the presence of negative externality in debt contract, government should intervene in the market and promote the new product of mortgage payment.
c . Research conducted in mortgage market shows that human mind is always bias towards safety choices. The tendency of people to investment in secure assets government to drive for asset securitization. Securitization refers to the process of pulling out risk free assets from the risky mortgages and then selling the risk free assets separately to the investors. The process of securitization thus helps to create safe debt. Individual and financial institutions crave for making safe debt. The human brains lead to a disproportionate choice to safety debt. This causes a fall values of risky mortgages. The concept of securitization thus is closely integrated with the disproportionate preference for safety. The securitization increases safety of the assets and thus attract more investors to invest in the risk free assets.
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