lOMoARcPSD|1712786Summary microeconomics Chapter 1: Preliminaries Microeconomics is the branch of economics that deals with the behavior of individual economic units ranging from consumers, to firms, to workers and as well investors. Microeconomics describes and analyses the trade-offs that are faced by these different entities and investigates the role of prices as well as how they are determined. Microeconomics analysis instruments: - Theories: Used to explain observed phenomena in terms of a group of basic rules and assumptions. - Models: Mathematical representations of economic theories that are used to make predictions. Positive analysis is analysis that describes “cause and effect” relationships. What will happen to the price, the production and to the sales of cars if the US government imposes an importing quota on foreign cars. (no opinion) Normative analysis is an analysis that examines questions of what ought to be. What is the best mix of different sized cars that should be produced to maximize profits when the tax on gasoline is imposed. (opinion) A market is the collection of different buyers and sellers that determine the price as well as the allocation of a product or set of products through actual/potential interactions. - On the markets for goods/products, firms and industries are considered to form the supply side whereas consumers are considered to form the demand side. Market definition refers to the determination of which buyers and sellers are to be included within a particular market. Furthermore, it also refers to which products should be included in a particular market. The extent of a market refers to the geographical boundaries as well as boundaries in terms of product range that are to be produced or sold within the market. Market definition is important for the following three reasons: - A company must define whom its actual and/or possible customers are in order to know which products and/or potential products to sell in the future. - A company must know the product boundaries as well as geographical boundaries of its market so that it can set a price, determine budgets for advertising, and make investment decisions. - Market definition is important for public policy decisions as it impacts various policies on future competition and prices. Distributing prohibited | Downloaded by An And (
[email protected]) lOMoARcPSD|1712786 Arbitrage is the practice of buying something at a low price in one location and then selling it at a much higher price in a different location. Perfect competitive markets are markets with many buyers and sellers, thus no single buyer or seller can have a significant impact on price. In other words, in a competitive market a single price (market price) will prevail. Noncompetitive markets are markets where many firms exist each affecting the price of a product. Chapter 2: The basics of supply and demand Supply curves show the relationship between the quantity of a good that producers are willing to sell at a certain price. The relationship can be expressed in the following format: Qs = Cs(p) - Upward sloping, therefore the higher the price, the more the firms are able to and willing to produce and sell. Change in price and other variables: impact on supply curve: - A change in price, and therefore Qs i.e. quantity supplied, is represented by a movement along the supply curve. - A change in any other supply determining variable, such as lower material costs, result in a shift of the supply curve itself. Importance of supply and demand analysis: - Supply and demand analysis enables us to understand and predict the effects of changing market conditions. - It allows us to analyze the effects of economic policy. - It allows us to carry out an equilibrium analysis, i.e. to find out when the supply and demand are in balance, and to find out how exogenous changes in the economic conditions affect the equilibrium. Distributing prohibited | Downloaded by An And (
[email protected]) lOMoARcPSD|1712786 The demand curve is a curve that represents the relationship between the quantity of a good that consumers are happy to buy as price per unit changes. The relationship is presented by the following equation: Qd=Qd(p) Change in price and other variables: impact on demand curve - An increase in price, as well as income levels, causes a shift on the demand curve to the right. This is referred to as a change in demand. - A change in any other demand-determining variable causes a change in the quantity demanded. This is referred to as a movement along the demand curve. Substitute goods: An increase in the price of good 1 causes an increase in the quantity demanded for good 2. Complementary goods: An increase in the price of good 1 causes a decrease in the quantity demanded for good 2. The market mechanism is the tendency, in a free market, for the price to change until the market clears. The term market clears refers to the price that equates the quantity supplied to the quantity demanded. This is known as the equilibrium price or the market-clearing price. A condition where the quantity supplied exceeds the quantity demanded is referred to as a surplus. A condition where the opposite happens, i.e. the quantity demanded exceeds the quantity supplied, is referred to as a shortage. Distributing prohibited | Downloaded by An And (
[email protected]) As price increases. Price elasticity of demand and supply Ep= P/Q x ∆Q/∆P . A shift in the demand curve will increase price. At any given price. which is what causes the change in Epd as we move along the curve. which will cause an increase in quantity produced. In the absence of close substitutes: a price increase would not result in consumers buying different goods. A shift in the supply curve will induce a price drop which will cause an increase in quantity produces and an increase in sales (due to the price drop). Eid = I/Q x ∆Q/∆I Distributing prohibited | Downloaded by An And (ib. . regardless of the price.anand94@gmail. Completely inelastic demand means that consumers will buy a fixed quantity. hence demand will be price inelastic (Epd < 1) Price elasticity of demand changes as we move along a curve. A market must be at least roughly competitive. Income elasticity of demand refers to the percentage change in quantity demanded resulting from a percentage increase in income. hence demand is highly price elastic (Epd > 1). Epd is measured at a particular point on the demand curve. Price elasticity shows the percent change that will occur in supply (or demand) in response to a percentage increase in price. lOMoARcPSD|1712786 Supply-demand model assumptions . Infinitely elastic demand means that consumers will buy as much as they can at one particular price. quantity demanded decreases. As price increases.com) . the ratio P/Q would change as we move along the curve. a given quantity will be produced as well as sold. . The price elasticity of supply: use Qs . The price elasticity of demand: use Qd . Price elasticity of supply is usually positive: . In the presence of close substitutes: a price increase causes consumers to buy more of the substitute instead. the suppliers have an incentive to increase output Price elasticity of demand is usually negative: . and even though ∆Q/∆P might be constant. e. Supply of durable goods is more price elastic (because goods can be recycled as part of supply if price increases) Distributing prohibited | Downloaded by An And (ib. x ∆Q/∆P Where. The change in quantity demanded is smaller than the change in price. Elasticity of demand of good A with respect to price of good B: Pb/Qa x ∆Qa/∆Pb . Short-run: allowing only a year or less to pass by before measuring changes in quantity demanded of supplied. ∆Qd > ∆P.g. The change in quantity demanded is bigger than the change in price. Supply is less price elastic because firms face capacity constraints . is the average of the initial and final prices in the range and Q. P. It is positive when the goods are substitutes (a rise in price of good 1 will make good 2 cheaper relative to good 1 so customers will demand more of good 2). for coffee.e. i. . Arc elasticity of demand is price elasticity of demand.g. ∆Qd < ∆P. e. .Ep = P. . Inelastic demand refers to the decrease in demand for a certain good that results from a price change. but it is over a range of prices rather than a particular point on the demand curve.com) . Short-run demand . Elastic demand refers to the increase in demand for a certain good that results from a price change. . which results in EpD having a magnitude greater than 1. e. is the average of the corresponding quantity. which results in EpD having a magnitude less than 1 i. Demand for durable goods is less price elastic Short-run supply . Long-run: allowing enough time for consumers/producers to fully adjust to the price change before measuring the changes in quantity demanded or supplied. is more price elastic because consumers have had enough time to change their habits . . . Difference between short-run and long-run elasticities . Demand for durable goods is more price elastic Long-run demand .anand94@gmail. Demand. lOMoARcPSD|1712786 Cross price elasticity of demand refers to the percentage change in quantity demanded for a good that results from a one-percent price increase in another good. It is negative when goods are complements (the two goods tend to be used together). for coffee./Q. Demand. is less price elastic because habits change gradually . the demand is inelastic. the demand is elastic. Market basket refers to a list of quantities of one or more goods. Transitivity: if a consumer prefers A to B and B to C. you would focus on the utility curve that is the highest and the basket on that utility curve would be the basket that generates the highest utility level. . In a case like this. Distributing prohibited | Downloaded by An And (ib. Chapter 3: Producers. consumers. More is better than less: more is always better. Completeness: consumers can compare and rank all baskets. Indifference curves cannot intersect on the map due to the transitivity and more is better assumptions.anand94@gmail. . An indifference curve is a graphical illustration of all market basket combinations that provide a consumer with the same level of utility (satisfaction).e. Also referred to as a bundle. even if it is only a little better. lOMoARcPSD|1712786 Long-run supply .com) . An indifference map graphically presents a set of indifference curves among which a consumer is indifferent. . Indifference curves are always downward sloping (convex) because of the assumption more is better. Supply is much more price elastic . and competitive markets The three basic preferences assumptions . then we can conclude that the consumer prefers A to C. the supply from recycling). Supply of durable goods is less price elastic (due to the contraction of secondary supply i. I increases: budget line moves outward . . Price of one good (on y axis) increases. where less of it is preferred to more. .com) . Bads are goods for which having less is preferred to having more. Goods are chosen to maximize satisfaction given the limited budget that is available. Examples include air pollution. but it is ignored because we cannot make such measurements.∆A (vertical axis) / ∆B (horizontal axis) . Utility function is a formula that assigns a level of utility to individual market baskets. but the magnitude does not say much because we do not know by how much one casket is preferred over another. so the negative sign in from of the equation ensures that MRS is positive. . It is a way of ranking different baskets. They refer to constraints that consumers face due to having a limited income. A budget line is a line that indicates all combinations of goods for which the total amount of money spent is equal to income. Cardinal utility functions tell by how much one market basket is preferred to another. Price of one good (on y axis) decreases. MRS = . I decreases: budget line moves inward Effect of price changes on the budget line: . Effect of changing income on the budget line: . Slope remains the same . Distributing prohibited | Downloaded by An And (ib. budget line rotates inward. Ordinal utility functions rank different market baskets from most to least preferred. ∆A is negative. Utility is a number that represents the level of satisfaction/happiness that a consumer gets from a certain market basket.anand94@gmail. lOMoARcPSD|1712786 Marginal rate of substitution refers to the maximum amount of a good that a consumer is willing to give up in order to obtain one additional unit of another good. budget line rotates outward . Budget constraints are the second element of consumer theory. Marginal Rate of Substitution = Ratio of the prices In other words: . The customer.We also know that utility is maximized when: MRS = Pa/Pb We can conclude that MUa/MUb=Pa/Pb. A corner solution arises when a customer’s marginal rate of substitution does not equal the price ratio for all levels of consumption. It tells the value of each consumer’s MRS . lOMoARcPSD|1712786 The necessary conditions to maximize a basket: . The revealed preferences approach . Marginal utility that yields less and less satisfaction as more and more of a good is consumed is referred to as diminishing marginal utility. The equal marginal principle states that utility is maximized when a consumer’s marginal utility per dollar of expenditure across all goods is equalized. that it is tangent to it). MUa/Pa=MUb/Pb Distributing prohibited | Downloaded by An And (ib. so quantity purchased by two customers can differ even though their MRS is the same. maximizes their satisfaction by only buying one of the numerous goods available for purchase. i. It does not inform us of the quantity of goods that a consumer buys: This depends on individual preferences. The basket must give consumers the most preferred combination of goods. . it must be located on the highest indifference curve that touches the budget line. The basket must be located on the budget line (more specifically. The revealed preferences approach checks whether individual choices are consistent with the consumer theory assumptions.com) . equivalently. When is satisfaction maximized? When: .e. The satisfaction maximizing equation indicates: .MRS= MUa/Mub .anand94@gmail. Marginal benefit = marginal cost Where marginal benefit is the benefit associated with consuming one additional unit of the good and marginal cost is the cost of the additional unit of the good. therefore. Marginal utility measures the additional satisfaction that is obtained from consuming one additional unit of a particular good. . expenditures. PA current price x Abase year quantity + PB current price x B base year quantity PA base year price x A base year quantity + PB base year price x B base year quantity Laspeyres price index is greater than the ideal cost-of-living index Laspeyres price index always overstates the true cost-of-living index The Laspeyres price index assumes that consumption patterns are not altered as prices change. PA current price x A current quantity + PB current price x B current quantity PA base year price x A current quantity + PB base year price x B current quantity Paasche index is lower than the ideal cost-of-living index Paasche index always understates the true cost-of-living index This is due to the assumption that customers will buy the current year bundle in the base period.anand94@gmail. .com) . .It requires information about prices. Laspeyres price index: is the amount of money (at current prices) that a customer needs to purchase a bundle chosen in the base year divided by the cost of purchasing the same bundle at base year prices. as well as preferences (which differ between individuals). The ideal cost-of-living index is the cost of attaining a given level of utility at current prices relative to the cost of attaining the same utility at base-year prices. lOMoARcPSD|1712786 The cost of living index is a ratio of the present cost of a typical bundle of goods compared to the cost of an identical bundle during a base period. The two cost-of-living indexes: . Paasche index: is the amount of money (at current prices) that a customer needs to purchase a bundle chosen in the current year divided by the cost of purchasing the same bundle at base year prices. Distributing prohibited | Downloaded by An And (ib. anand94@gmail. and less of the good that is now relatively more expensive. An income-consumption curve traces all combinations of goods that maximize utility as the income of a consumer changes. A situation where relative prices are constant. When added together they make up the total effect. lOMoARcPSD|1712786 Chapter 4: Individual and market demand A price-consumption curve is a curve that traces all utility maximizing combinations of two goods as the price of one of the goods changes. Consumers buy more of the good that has become cheaper. The market demand curve represents the relationship between the quantity of a good that all customers in a market will buy related to its price.com) . The effects of a price decrease: . MRS= the reatio of the prices of the goods’ condition is satisfied). The level of utility that can be attained changes along the curve. As income changes. demand curve shifts to the left or the right. At every point on the curve the consumer maximizes their utility (because at every point on the curve. while utility remains constant. Normal goods are goods that consumers want to buy more of as their income increases. The properties of an individual demand curve are: . Distributing prohibited | Downloaded by An And (ib. Upward sloping Engle curve applied to normal goods. . . Individual demand can be derived using the price-consumption. Consumers enjoy greater real purchasing power due to one of the goods becoming cheaper. . and a change in consumption of a good is a result of an increase in purchasing power is referred to as the income effect.The market demand curve shifts further to the right as more customers enter the market Factors that influence the consumer demand will also affect market demand. is referred to as the substitution effect. A situation where a change in consumption of a good results from a change in its price. Inferior goods are goods that consumers want to buy less of as their income increases. Engel curves are curves that relate the quantity of a good consumed to income. The market demand curve can be derived by adding up the individual curves of all of the customers in the market Demand curve’s reaction when more consumers enter the market . An individual demand curve is a curve that relates the quantity of a good that a single consumer will buy to its price. . A situation where the quantity of a good demanded by a consumer decreases because others possess that good is referred to as the snob effect.anand94@gmail. These externalities can be negative. .com) . in the case of an increase in demand in response to a growth in purchases by others. It is the difference between how much consumers are willing to pay for a good and how much they actually pay. or positive. Distributing prohibited | Downloaded by An And (ib. lOMoARcPSD|1712786 The building blocks of market demand Consumer Budget Constraints Preferences Consumer Choice Individual Demand Market Demand An isoelastic demand curve is a demand curve that has a price elasticity that is constant. Network externalities are situations in which a consumer’s demand depends on the purchases of others. Situations where the quantity of a good demanded by a consumer increases because others possess that good is referred to as the bandwagon effect -> the bandwagon effect is a positive network externality. Consumer surplus is a measure of how much better off individuals are in the market. if the externality leads to a decrease in demand in response to growth in purchases by others. rather than goods similar to those owned by others The snob effect is a negative network externality.A situation in which a consumer would prefer to own exclusive or unique goods. With respect to labor productivity: . The law of diminishing marginal returns is a principle.e. Maximum when MP=AP (additional labor would be unprofitable). . . A production function is an equation that indicates the highest level of output that a firm can produce for every combination of inputs. so it is not necessary that the returns are negative. Describes a declining marginal product. lOMoARcPSD|1712786 Chapter 6: Production The three steps of production decisions: . buildings.com) . Cost constraints: taking into account prices of labor. .On an incremental basis (∆Q / ∆factor of input) . Distributing prohibited | Downloaded by An And (ib.On an average basis (Q / factor of input) The incremental basis refers to firms focusing on the additional output that results from an incremental addition to an input i. When MP > AP the AP so average output increases with an additional worker. capital and other inputs. . .anand94@gmail. It describes what is technically feasible when the firm operates efficiently. Constant returns to scale . . so inventions or technological improvements can shift the total product curve upwards. Applies to a given production technology. . with other inputs remaining constant. . The law of diminishing marginal returns: . When MP < AP the AP so additional workers do not contribute much to output. Materials: land. Production technology: practical ways of converting inputs into outputs. Marginal product and average product relation: . Assumed that labor input is of the same quality. Increasing returns to scale . the additional output produced will eventually decrease. Capital (K): any goods that can be transformed into final products. Q= F(K. inventories etc. Input choices: how much of each input to use in producing the output. machinery. which states that as the use of an input increases. marginal basis.L) Returns to scale is the rate at which output increases as inputs increase proportionately. Labor (L): skilled and unskilled workers. . Decreasing returns to scale There are two ways of looking at a firm’s benefits and costs: . so diminishing marginal returns would be due to limitations in fixed inputs such as machinery and not worker quality. The three categories that production factors can be divided into: . Technological change: technological development allows factors of production to be used efficiently. This is because productivity of inputs is limited. in other words. is the amount by which capital can be reduced when one additional unit of labor is used. it falls as we move down along an isoquant. Firms can use isoquants when making production decisions as they show how much flexibility firms have. A fixed-proportions production function describes situations where the method of production is limited just like in the case of car production. Adding more of input A. MRTS of labor for capital. . .e.com) . It is also equal to the ratio of the marginal products of the inputs involved.∆K/∆L = MPL / MPK MRTS= . An isoquant is a curve that shows all possible combinations of inputs that would yield the same output. . Stock of capital: the total amount of capital available for production.anand94@gmail. i. The marginal rate of technical substitution is the amount by which the quantity of one input can be reduced when one extra unit of another input is used. so that output remains constant. When and why do firms use isoquants? .∆A / ∆B . MRTS = . so that output remains constant. Distributing prohibited | Downloaded by An And (ib. in place of input B will result in a decrease in the productivity of A because production requires a balanced mix of both inputs. lOMoARcPSD|1712786 Productivity growth sources: . . An isoquant map is a graph that combines numerous isoquants that can then be used to describe production functions. MRTS is diminishing. Isoquants allow managers to choose the ideal input combinations that would minimize costs and maximize profits. . i. . Total costs = Fixed costs + Variable costs .anand94@gmail. then it would become a sunk cost as the equipment would not be used for anything other than what it was made to be used for (its opportunity cost would be zero). Where: Fixed costs refers to any costs that do not vary with output level and can be eliminated only by shutting down the production process. Average costs = Total Cost / Quantity The determinants of short run costs . Economic costs are the costs that a firm faces for utilizing economic resources in production.The production processes . lOMoARcPSD|1712786 Chapter 7: The Cost of Production Accounting costs include actual expenses together with depreciation charges for capital equipment. Average (total) costs constitute of average fixed costs and average variable costs. . Sunk costs do not impact future decisions. Sunk costs are costs that have been incurred and cannot be recovered. . Marginal costs are increase in costs due to the production of one additional unit of output. Marginal Cost = ∆Variable cost / ∆Quantity Average costs refer to a firm’s total costs divided by its level of output. Sunk costs can be treated as fixed costs by amortizing them and the expenditure over a number of years. The rate at which variable and total costs increase in the short-run depends on . A firm contemplating whether to buy a specialized piece of equipment faces prospective sunk costs. Opportunity costs are costs associated with opportunities that have been forgone due to a firm’s resources not being put to their best alternative use.com) . . Variable costs refers to costs that vary with output level. Fixed costs impact future decisions. Prospective sunk costs are considered to be an investment. they face an investment and should analyze whether this investment would be economical (would it generate large revenues?). and it includes opportunity costs. Amortization is a policy of treating a one-time expenditure as an annual cost that can be spread out over time. if the specialized equipment is bought.e.The extent to which diminishing marginal returns to variable costs is involved Distributing prohibited | Downloaded by An And (ib. spreading it over the lifetime of the capital . User cost of capital is the annual cost of owning and using a capital asset rather than selling it or never buying it in the first place. the slope of ∆K/∆L is . The minimum cost for producing a certain output can be found at the point where an isoquant (for that level of output) touches the isocost line. Distributing prohibited | Downloaded by An And (ib. Expressing capital expenditure as a flow . An isocost line is a graphical illustration of all possible combinations of labor and capital that can be purchased for a given total cost. .Diminishing marginal returns implies that the marginal product of one of the production factors declines as the quantity of input of that factor increases. Equivalently. marginal costs increase as output increases.By amortizing the expenditure i. . Rental rate is the rate per year of renting one unit of capital. From the isoquant line we know that.anand94@gmail. .com) . So. Relation between isocost line and a firm’s production process . while keeping quantity constant is : MRTS = -∆K / ∆L = MPl / MPk . Total cost = Labor (wage) + Capital (rental rate) .Forgone interest must be taken into consideration This is exactly what is done through the user cost of capital calculation. lOMoARcPSD|1712786 The impact of diminishing marginal returns on marginal costs . so firms can minimize costs by MPl / MPk = wage / rental rate .e. in terms of capital and labor. Rental rate is equal to the user cost because firms expect to earn a competitive return when renting capital that they own (we assume this is the case when the market is competitive). We know that the amount by which capital can be reduced with the use of an additional unit of labor.User cost of capital = Economic depreciation + (Interest Rate)(Value of Capital) Interest is part of the user cost of capital because a firm could be earning interest by investing capital elsewhere.wage / rental rate . MPl / wage = MPk / rental rate The expansion path describes the cost minimizing combinations when output levels vary. com) . Economies of scale are measured in terms of a cost-output elasticity. when doubling output. the costs would be more than double. The advantage of buying in bulk may disappear once certain quantities are reached because at some point supplies of essential inputs will be limited and hence their costs will rise. Equivalently: Ec = MC/AC Distributing prohibited | Downloaded by An And (ib. Measuring economies of scale . When workers specialize in activities that they are most productive in. lOMoARcPSD|1712786 Economies of scale refers to a situation in which output can be doubled for less than double the cost (input proportions vary). So. Ec: Ec = ∆C/C x ∆Q/Q .anand94@gmail. Diseconomies of scale refers to a situation where the doubling of output requires more than double the cost. . . lOMoARcPSD|1712786 Chapter 8: Profit maximization and competitive supply The perfect competition model relies on the following assumptions: . their decisions do not impact the market price. If the firm is perfectly competitive. Analysis of the firms and their strategic interactions would be necessary. Profit is maximized when MC(q) = MR = P. Firms with such managers are not likely to survive in competitive industries Firms that do survive in competitive industries make long-run profit maximization their priority (otherwise they can be replaced by shareholders or board of directors.Because it requires technical and marketing information which is costly to acquire. each of which satisfies a small proportion of the total market demand.anand94@gmail. to each other. alternatively we can say that profit is maximized when MR – MC = 0 .e. A cooperative organization is an association of businesses or people that is jointly owned and operated by members for mutual benefit.Product homogeneity Products in a market are homogeneous if they are perfectly substitutable. Distributing prohibited | Downloaded by An And (ib.To satisfy shareholders . Some managers deviate from profit maximization behavior: . Profit is the difference between the total revenues and total costs of a firm . to maximize its profits it should ensure that P = MR = MC i. the price it charges should be equal to the firm’s marginal costs. . or a new management could take over the entire firm). it takes the price as it is given. This is the case when a market is made up of several small firms. .Price taking A firm is a price taker if it has no influence over the market price. A market is highly competitive when the firms within the market face demand curves that are highly elastic (with rather easy entry and exit) Remember: competitive behavior does not necessarily indicate that the market is highly competitive.Free entry (or exit) is a condition that states that firms wanting to enter or exit a market/an industry can do so without incurring any special cost.com) . Hence. . Therefore. or nearly identical.To maximize short-run profits at the expense of long-run profit in order to earn a bonus or a promotion. these products are identical.Π=R–C Where revenue is R = PxQ Marginal revenue refers to the change in revenue that results from output increasing by one unit. MR = ∆R / ∆Q Profit maximization . In other words. If a market has free entry and exit. Alternatively.com) .It measures the area above the supply curve (of the producer) and below the market price: PS = R – VC Remember: π = R – C. Zero economic profit means that the firm is earning a normal return on its investment and is doing as well as it would if it had invested its money elsewhere. If the price of the good is less than the average variable cost of production at the profit maximizing output. Exit: a firm would exit when it faces a prospect of making a long-run loss. It is the percentage change in quantity supplied in response to a one-percentage change in price: . Elasticity of supply is perfectly elastic when marginal cost is constant. as MC curves are upward sloping . lOMoARcPSD|1712786 Shut-down condition: . when would a firm choose to enter or exit the market? . this would occur if the price charged for a good exceeds the minimum long-run average cost of producing it (min LAC < P). . Short-run supply curve The price elasticity of market supply measures the industry’s sensitivity to market price. The short-run supply curve is given by the portion of the marginal cost curve for which MC > AVC. Es = (∆Q/Q ) / (∆P/P) . Always positive in the short-run. Elasticity of supply is perfectly inelastic when firms are capacity constrained due to all equipment being completely utilized. . Distributing prohibited | Downloaded by An And (ib.anand94@gmail. Producer surplus is the sum (over all units produced) of the differences between a good’s market price and the marginal cost of production. it should shut down. this would occur if the minimum long-run average cost is greater than the market price (minLAC > P). it is the difference between a firm’s revenue and its total variable cost. Entry: a firm would enter when it can earn a positive long-run profit. . where C = VC + FC The profit maximizing output in the long-run is found at the point where long-run marginal cost is equal to price (LMC = P). Decreasing-cost industry: long-run supply curve is downward sloping. Responses to output tax: An output tax: . both in the short-run as well as the long-run. Increasing-cost industry: long-run supply curve is upward sloping.anand94@gmail. Long-run elasticity of supply for constant-cost and increasing-cost industries: . it will choose output level at which MC + t = P If a firm’s cost are too high. All firms are earning zero economic profit. Constant-cost industry o Long-run supply curve is horizontal so the long-run Es is infinitely large . (Higher prices are needed to cover the increasing cost). even though profit is zero. lOMoARcPSD|1712786 The three conditions of long-run competitive equilibrium: . The price of a good is such that the quantity supplied is equal to the quantity demanded. Constant-cost industry: long-run supply curve is horizontal at P = (minimum) LAC .Raises a firm’s marginal cost . . The long run producer surplus of a firm in a competitive market consists of the economic rent from all its scarce inputs. Increasing-cost industry o Long-run Es is large (positive) but finite Distributing prohibited | Downloaded by An And (ib. In competitive markets this is often positive. The three different cost industries: . it will exit the industry o If every firm in the industry is taxed: marginal costs will increase due to the tax. All firms in the industry are maximizing their profits. firms will reduce their output at the current market price This will reduce the total output supplied by the industry and firms will raise their prices. so there is no incentive to enter or exit the industry. .com) . Economic rent is a term used for the amount that a firm is willing to pay for an input minus the minimum amount necessary to buy it. .Raises a firm’s average variable cost curve o F a single firm is taxed: as long as it can still earn a positive/zero economic profit. A firm’s profit function is : π = Revenues (Q) – Costs (Q) . differentiate in terms of Q if dealing with a demand function to find the marginal revenue: MR = ∆R/∆Q . MR= MC + tax . . no change in quantity o Change in quantity. the MR is the difference between the initial and the subsequent revenue. The profit maximizing quantity is found by using derivatives: ∆π/∆Q = ∆R/∆Q . First. Equivalently: ∆π/∆Q = MR – MC = 0 . find the revenue which is : Revenue = Price x Quantity . Then. solve for Q Managers use a rule of thumb for pricing as it can be applied in practice much more easily due to it requiring a lot less information P = MC / (1 + (1/Ed)) o Where Ed is the elasticity of demand for the firm Output decisions depend on MC and the demand curve. Marginal revenue (MR) is the change in revenue due to an increase in output by one unit. there is no supply curve in a monopolistic market. Since profit is maximized when MR=MC and marginal cost must be equal for all plants. no change in price o Change in both price and quantity Effect of tax on a monopolist . lOMoARcPSD|1712786 Chapter 10: Market power: Monopoly and Monopsony A monopoly is a market where there is only one seller and numerous buyers. Practical rule of thumb for pricing and why it is used: .anand94@gmail. Divide the total output between the plants so that marginal cost of each plant is equal to each other . A monopsony is a market where there are numerous sellers but only one buyer. If you have only numbers. A shift in demand can lead to: o Change in price. The marginal cost curve shifts upwards by an amount t and intersects marginal revenue at a different point o This causes a decrease in Q and an increase in P (this increase can be by more than t) Output decision: for a firm with multiple plants . Market power refers to the ability of a seller or a buyer to affect the overall price of a good. profits will be maximized when MR=MC of each plant Distributing prohibited | Downloaded by An And (ib.∆C/∆Q = 0 .com) . . Finally. . price exceed marginal costs (P>MC). can also be expressed in terms of the firm’s elasticity of demand i.e. Price regulation (by setting a price cap) -> can eliminate the dead weight loss . The elasticity of market demand: a pure monopolist’s demand curve is the market demand curve . The interaction between firms: firms might compete aggressively or not compete much or they might collude and agree to limit output while raising prices The social costs of monopoly power: . we use the Lerner index: . L = (P – MC)/P which. L= -1 / Ed There are three determinants of monopoly power: . lOMoARcPSD|1712786 For measuring monopoly power. maintain or exercise monopoly. The number of firms in the market: monopoly power decreases as more firms enter the market due to increased competition
[email protected]) . Ways for governments in preventing firms from acquiring large monopoly power: . which decreases consumer surplus and increases producer surplus This reduces total social welfare Rent seeking refers to the amount of money that firms spend on unproductive efforts to either acquire. Distributing prohibited | Downloaded by An And (ib. Rate-of-return regulation The maximum price allowed is based on the (expected) rate of return that the firm will earn A natural monopoly is a firm that can meet the demand of the entire market at a cost that is lower than what it would be if there were several firms. It arises from strong economies of scale.In a monopolistic market. E. Apple’s iPhone 6 will start off at a high price attracting consumers that value the product highly. . a single Kinder Bueno bar might cost €0. yet a pack of 3 Kinder Bueno bars might cost €1. with time (and when a newer version is released) the price will begin to fall and will attract consumer who did not value the product as highly Distributing prohibited | Downloaded by An And (ib..Imperfect first-degree price discrimination: o Reservation price of individuals in
[email protected]) . . lOMoARcPSD|1712786 Chapter 11: Pricing with Market Power Different ways of capturing consumer surplus: . Third-degree price discrimination refers to the practice of dividing consumers into several groups and charging each group a different price. Price discrimination o First-degree o Second degree o Third-degree . E.g. Formula for determining relative prices: . as is done by electric power companies and water municipal companies.Perfect first-degree price discrimination: o Each person is charged exactly what they are willing to pay o MR curve becomes irrelevant o Additional profit from selling an incremental unit: D – MC . First-degree price discrimination is the practice of charging customers a reservation price. so several different prices are charged based on estimates of customer’s reservation prices. each bar costs €0. P1/P2 = (1 + 1/E2)/(1 + 1/E1) Intertemporal price discrimination is a practice that involves separating consumers with different demand functions into different groups by charging different prices at different points in time.50 Second-degree price discrimination includes block pricing where customers are charged different prices in blocks of a good. Two-part tariff . Such practices lead to firms having a variable profit as they can charge each customer a different price (because different people have different preferences and would be willing to pay different prices for a similar good). Intertemporal price discrimination . public transport concessions for students and senior citizens.g..e..The goal is to separate high-demand consumers from low-demand consumers by charging a price that is high at first which falls later on For example.50 i. Second-degree price discrimination refers to the practice of charging different prices per unit for different quantities of the same good. which is essentially the maximum price that they would be wanting to pay. Peak-load pricing Price discrimination refers to the practice of charging different prices to various customers for similar goods. For example. Carry out trial-and-error to find the optimal two-part tariff Decision makers must keep in mind the following trade-off: . Entry by new firms ins impeded in a market like this. Short and long-run profits of a monopolist: . P > AC. . lOMoARcPSD|1712786 Peak-load pricing is a practice that involves charging consumers different prices at different points in time. Information required: o Marginal cost o Demand functions o Profit as a function of usage fee and entry fee.anand94@gmail. For monopolistic firms: P > MC In the short-run: . If entry fee is too low and the entrants are too many then profits derived from entry fee will fall Chapter 12: Monopolistic Competition and Oligopoly Monopolistic competition refers to a market in which firms can enter. New entrants become attracted due to the high profits. This reduces the firm’s market share and pushes the demand curve downwards. different toothpaste companies offer toothpaste that is differentiated in taste. members pay an annual membership fee as well as a fee for each use of a court Setting entry and usage fees: . amusement parks charge higher fees on weekends compared to during weekdays Two-part tariff is a form of pricing in which consumers are charged an entry fee as well as a usage fee. this allows the firm to earn a nice profit In the long-run: . P = AV so profits become zero. An oligopoly is a market that consists of only a few firms that compete with each other. each producing and selling their own brand or version of a differentiated product. or consistency. even though the firm still has monopoly power Distributing prohibited | Downloaded by An And (ib. at a tennis club. color. hence more profit from sales .The aim is to increase economic efficiency by charging prices close to marginal cost For example.com) . If entry fee is low there will be more entrants. this will allow the firm to choose the prices that maximize the profit function . The firm should do the following: o Usage fee > MC o Entry fee = remaining consumer surplus of the consumer with the smaller demand Entry and usage fees if there are many consumers: . and exit freely. For example. lOMoARcPSD|1712786 Two sources of inefficiency in monopolistically competitive industry: . Q = Q1 + Q2 . In cournot equilibrium is assumed that Q1=Q2 . Q=2Q1. Both firms will produce this output. The same can be done for firm 2. In the Cournot model. excess capacity is inefficient because the average cost would be lower with fewer firms. New entrants drive profits to zero. so the value (to customers) of additional units of output is greater than the costs involved in producing those units. Cournot equilibrium: The market demand function.com) . Q= Q1 + Q2. market power is small because enough firms compete with sufficiently substitutable brands . So. R1= P x Q1. Since the demand curve for a monopolistically competitive market in downward sloping. oligopolistic firms decide how much they will produce (homogeneous product) simultaneously. the point at which profits are zero is lower than the point at which average cost is minimum. A patent is an entry barrier that works by discouraging entry because it makes it necessary for competitors to spend money (for name recognition or market reputation) to enter the market Setting prices and output in an oligopolistic market. Each firm treats the output of its competitors as fixed. in terms of Q. can be used to calculate the quantity that each firm will produce: . Monopolistically competitive market structure is socially desirable because: .anand94@gmail. Distributing prohibited | Downloaded by An And (ib. . Based on strategic consideration regarding competitors . This can be substituted into the demand function to find the market price. So Q2 in the reaction curve for firm 1 can be replaced by Q1 and a quantity for Q1 can be derived. This is also known as the Nash equilibrium. Generally. and since Q1=Q2. how they work: . Based on the firm’s decision o Firms choose the price and output that allows them to do the best they can. . given the actions of their competitors. . . MR1 = ∆R1/∆Q1 (Derivative) Rearranging would give firm 1’s reaction curve. P > MC. Product diversity balances against inefficiencies because consumers value the ability to choose from a variety of products (it outweighs the inefficiencies) Entry barriers in an oligopoly. Coexistence might be unprofitable (due to economies of scale) . The prisoner’s dilemma is an example in which two prisoners decide separately whether or not to confess to their crime.5 5.1 Admit A payoff matrix shows the profit to each player. then the demand is very elastic. Each firm’s manager know that if they deviate from the collusive price during one interaction. A kinked demand curve model is an oligopoly model in which firms face a demand curve that is kinked at the currently prevailing price. A non-cooperative game is a game in which it is not possible to negotiate or enforce a binding contract. their sentences will be lighter compared to both confessing. Distributing prohibited | Downloaded by An And (ib. then the opponents will punish them during the next interaction by choosing a Nash equilibrium price which would yield lower profits in the long run compared to collusive cooperation (hence.com) . Firms collude in order to increase their profits (the profits obtained from producing at the Nash equilibrium are lower) . Firms do not cooperate without explicitly colluding because they expect that the competitors would deviate from the collusive price level in order to get a higher payoff. if lower. as firms repeatedly interact and therefore can develop trust: . given his/her decision and the competitor’s decision. Kinked demand curve model Can oligopolistic coordination and cooperation prevail? Yes it can. The one who confesses will receive a lighter sentence (higher payoff). but if neither confesses. then demand is inelastic.4 0. lOMoARcPSD|1712786 Why collude rather than cooperate? .0 1.anand94@gmail. Prisoner 2 Refuse Admit Prisoner 1 Refuse 4. If price is any higher. cooperation would be encouraged). Price signaling is a form of implicit collusion in an oligopoly during which firms announce a price increase with the hope that other firms will follow suit This behavior helps in solving the problem of coordinating price. Non-cooperative game is a game in which negotiation is not possible.e. and neither is the enforcement of a binding contract. Dominant strategies are stable An equilibrium in dominant strategies refers to the outcome of a game in which each firm is doing its best regardless of its competitor’s actions. A dominant firm is a firm with a large share of total sales that sets price to maximize profits. regardless of what the opponent chooses to do.e. This behavior solves the problem of coordinating price as everyone charges at the same price as the leader. The goal of game theory: .anand94@gmail. taking into account the supply response of smaller firms. Dominant strategies o I am doing my best. Cooperative game is a game in which players negotiate binding contracts that allow them to plan joint strategies.com) . that take into account other players’ actions and responses. Chapter 13: Game Theory and Competitive Strategy A game is any situation in which players/participants make strategic decisions. regardless of what you do o You are doing your best. regardless of what I do . the rule or plan of action for playing the game. Game theory aims to find the optimal strategy for each player i. Nash equilibrium o I am doing my best given your actions o You are doing your best given my actions Distributing prohibited | Downloaded by An And (ib. which are then matched by other firms. lOMoARcPSD|1712786 Price leadership is a pricing pattern in which one firm regularly announces price changes. These strategic decisions result in payoffs for each player i.. they result in rewards or benefits. which would lead to maximum expected payoff. A dominant strategy is a strategy that is a player’s optimal strategy. Nash equilibrium compared to equilibrium in dominant strategies: . Distributing prohibited | Downloaded by An And (ib. An input allocation is said to be technically efficient if the output of one good cannot be increased without decreasing the output of another.com) . lOMoARcPSD|1712786 Chapter 16: General Equilibrium and Economic Efficiency Partial equilibrium analysis involves determination of equilibrium prices and quantities assuming that one market’s activity has little or no effect on other markets. relative to the cost of producing other goods in 2. This advantage is known as an absolute advantage.anand94@gmail. General equilibrium analysis on the other hand. Technical efficiency is a condition under which firms combine inputs to produce a given output at a cost that is as low as possible. MRT = MCA / MCB What makes an economy efficient? . taking feedback effects into account. The slope of the curve measures the marginal cost of producing one good relation to the marginal cost of producing another (MC1 / MC2) Marginal rate of transformation refers to the amount of a good that must be given up in order to produce one additional unit of another good. In a situation where company 1 has an advantage over company 2 when producing a good because the cost of producing the good at 1 is lower than the cost of producing it at 2.Goods produced at minimum cost only . This curve is downward sloping because in order to produce more of good A efficiently. a firm must switch inputs from the production of B. A production possibilities frontier is a curve that shows the combination of two goods that can be produced with fixed quantities of inputs. . A feedback effect is a price or quantity adjustment in one market caused by price and quantity adjustments in related markets. involves determination of equilibrium price and quantities in all markets simultaneously. and while holding technology constant. which then lowers the production level of B .Goods produced in combinations that match people’s willingness to pay for them MRS = MCx/MCy = Px / Py = MRT A comparative advantage occurs when company 1 has an advantage over company 2 in producing a good because the cost of producing the good in 1 is lower than the cost of producing the good in 2. For example. For example. lOMoARcPSD|1712786 Chapter 17: Markets with Asymmetric Information Asymmetric information is a situation where either the buyer or the seller possess different information regarding the transaction. an owner selling his/her car will know much more about the car and its quality than a buyer. . in the labor market it is only the workers who know their true levels of productivity.anand94@gmail. Hence.com) . so that too much of the low-quality and too little of the high-quality goods are sold. Why do firms offer guarantees and warranties? . more dependable products. They signal product quality because an extensive warranty is more costly for low-quality product producers than for higher-quality producers. Market signaling refer to the process used by sellers to signal conveying information about product quality to its buyers. the insurance company’s payments will be greater than expected and the company may be forced to increase premiums for everyone. people with complete medical coverage insurance will visit their doctors more often (an action that is unobserved by the insurance providers) and make more claims. Guarantees and warranties can convince customers that the firm is offering higher-quality. Firms do not have this information (asymmetric information). For example. because the owner has had experience driving the car. whose actions are unobserved. Adverse selection is a form of market failure that occurs when different quality products are sold at a single price due to asymmetric information. where a low-quality good can drive high-quality goods out of the market. Standardization and reputation are also ways to deal with adverse selection. Distributing prohibited | Downloaded by An And (ib. so they rely on signals from the works about their productivity when hiring. Moral hazard occurs when a group of people. can affect the probability or the magnitude of a payment associated with an event. The lemons problem is a situation with asymmetric information. . or a mechanic. A strong signal of high productivity would be education. The more waste the plant dumps.anand94@gmail. lOMoARcPSD|1712786 Chapter 18: Externalities and Public Goods Externalities are actions. which affect other producers or consumers but are not accounted for in the market price. Yet the firm has no incentive to account for such an external cost. Standards offer certainty about reduction of emissions levels (when information is incomplete) but they leave abatement costs uncertain: the cost of not reducing emissions is high when MEC curve is quite steep and MC of abatement is rather flat. Emissions fee: a charge for each unit of a firm’s emission . Tradable emissions permits are marketable permits that can be bought and sold. the fewer the fish in the river. Advantages depend on the information that the policymakers hold and the cost of controlling emissions . (MSB = D + MEB) The cost of abatement is represented by the cost of abatement curve. . (MEB) Marginal social benefit is the sum of the marginal private benefit (given by the marginal benefit curve) and the marginal external benefit. Fees reduce emissions by the same amount as standards. which measures the additional cost that a firm faces for installing pollution-control equipment. at a lower cost . . Marginal external cost measures the additional cost of an externality that is associated with each additional unit of output. Distributing prohibited | Downloaded by An And (ib. Emission standards: legal limit of how much pollutant firms can emit . . taken by a producer or a consumer. Externalities can be negative: a steel plant dumping waste into a river that fishermen depend on for fish. (MEC) Marginal social cost refers to the sum of the marginal cost of production and the marginal external cost. Externalities can be positive: a home owner repaints their house and renovates their garden. Fees give firms a stronger incentive to install new equipment which can further reduce emissions . the neighborhood benefits from this (as it looks more attractive) even though the home owner did not take such an external benefit into account.com) . (MSC = MC + MEC) Marginal external benefit refers to the additional benefit that other people/firms obtain as a firm produces one extra unit of output. The MCA curve is downward sloping because: o The MC of reducing emissions is low when the reductions have been slight o The MC of reducing emissions is high when reductions have been substantial Correcting market failures: . Tradable emissions permits: a system of marketable permits that specify the maximum level of emissions that can be generated . If a firm produces emissions greater than what the permit allows then they are subject to substantial monetary sanctions. Recycling Advantages of setting standards and fees: . which specify the maximum level of emissions that a firm can generate. and nonrival. Efficient level of providing a public good is determined by the comparison of marginal benefit of an additional unit to the marginal cost of producing that unit (MB = M) . so people cannot be excluded from consuming the goods. Well specified property rights: legal rules stating what people/firms can do with their property . Recycling can be encouraged by: o Refundable deposits The policy works by store owners charging an initial deposit for glass containers. lOMoARcPSD|1712786 A policy to encourage recycling: . Marginal social cost of disposal includes environmental harm from littering: it increases partly due to the marginal private costs increasing and partly because environmental costs are likely to increase as disposal increases. the deposit is refunded when consumers return the container to the store or a recycling center A per-unit refund will encourage households and firms to recycle more Inefficiencies can be eliminated via: . .com) .anand94@gmail. Suing for damages: victim can recover monetary damages equal to the harm suffered . Such resources are externalities because of the fact that they do not require a payment. The owner can set a fee for using the resource which will be equal to the MC of depletion of the resource Public goods are goods that are nonexclusive. which means that they become over utilized. the national defense or the lighthouse: in both cases the MC of providing a benefit to an additional person is zero and both are nonexclusive Efficiency among public goods: . . They act as free riders as they are not willing to pay for a nonexclusive good though they expect others to pay for it This makes it difficult to provide goods efficiently Distributing prohibited | Downloaded by An And (ib.g. MB is measured in terms of how much consumers value the additional unit of output How public goods lead to market failure: . the marginal cost of provision to an additional consumer is zero. o What is the solution? A single owner should be allowed to manage the resource. The efficient amount of recycling is at the point where marginal cost of recycling (MCR) and the marginal social cost of disposal (MSC) are equal. E. Using the Coase theorem: bargaining without cost and to mutual advantage Common property recourses are resources to which anyone has free access .Some consumers understate how valuable a good is to them.