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INDUSTRIETECHNIK

SRI LANKA INSTITUTE of ADVANCED TECHNOLOGICAL


EDUCATION

Electrical and Electronic


Engineering
Instructor Manual

Training Unit

Economics 2
Theory

No: AS 053

Training Unit
Economics 2
Theoretical Part
No.: AS 053

Edition:

2009
All Rights Reserved

Editor:

MCE Industrietechnik Linz GmbH & Co


Education and Training Systems, DM-1
Lunzerstrasse 64 P.O.Box 36, A 4031 Linz / Austria
Tel. (+ 43 / 732) 6987 3475
Fax (+ 43 / 732) 6980 4271
Website: www.mcelinz.com

List of Content

CONTENTS

Page

Learning Objectives .............................................................................................................6


1

Supply, Demand and Product Markets.........................................................................7


1.1

Definition of Elasticity ...........................................................................................7

1.2

Elasticity of Demand and Supply .........................................................................7

1.3

Price Elasticity of Demand ...................................................................................8

1.3.1

Calculating Elasticities .....................................................................................9

1.3.2

Price Elasticity in Diagrams............................................................................12

1.3.3

Numerical Calculation of Elasticity Coefficient ...............................................15

1.3.4

Elasticity and Slope are not the same............................................................16

1.3.5

Elasticity and Total Revenue..........................................................................18

1.3.6

Factors affecting the Price Elasticity ..............................................................19

1.4
1.4.1
2

The Utility Theory...............................................................................................24

2.1.1

Marginal Utility and the Law of Diminishing Marginal Utility...........................24

2.1.2

Ordinal Utility..................................................................................................28

2.1.3

Cardinal Utility ................................................................................................28

2.2
2.2.1
2.3

Deriving the Law of Demand from the Law of Equal Marginal Utility per Dollar.29
Why Demand Curves slope downwards ........................................................30
Income Effects and Substitution Effects ............................................................31

2.3.1

The Substitution Effect ...................................................................................31

2.3.2

The Income Effect ..........................................................................................31

2.4

Factors affecting Supply Elasticity .................................................................22

Demand and Consumer Behavior ..............................................................................24


2.1

Price Elasticity of Supply....................................................................................20

Consumer Surplus .............................................................................................33

Geometrical Analysis of Consumer Equilibrium .........................................................34


3.1

The Indifference Curve ......................................................................................34

3.2

The Budget Constraint .......................................................................................36

3.3

Utility Maximization ............................................................................................38

Production and Business Organization ......................................................................39


4.1

Theory of Production and Marginal Products.....................................................39

4.1.1

The Production Function ................................................................................39

4.1.2

Total Product..................................................................................................39

4.1.3

Marginal Product ............................................................................................40


3

4.1.4
4.2

Constant returns to scale ...............................................................................43

4.2.2

Increasing returns to scale .............................................................................43

4.2.3

Decreasing returns to scale ...........................................................................43


Short Run .......................................................................................................44

4.3.2

Long Run........................................................................................................44

4.4

Productivity ........................................................................................................44

4.5

Business Organizations .....................................................................................45

4.5.1

Sole Proprietorship.........................................................................................45

4.5.2

Partnership.....................................................................................................45

4.5.3

Corporation ....................................................................................................45

Analysis of Costs ........................................................................................................47


5.1

Economic Analysis of Total, Fixed, and Variable Cost.......................................47

5.2

Definition on Marginal Cost ................................................................................49

5.3

Average Cost .....................................................................................................51

5.3.1

Unit Cost or Average Cost .............................................................................52

5.3.2

Average Fixed Cost........................................................................................53

5.3.3

Average Variable Cost ...................................................................................53


Opportunity Costs ..............................................................................................54

Analysis of Perfectly Competitive Markets .................................................................55


6.1

Perfect Competition ...........................................................................................55

6.2

The Efficiency of Competitive Markets...............................................................56

6.3

Special Cases of Competitive Markets ..............................................................59

6.3.1

Constant Cost ................................................................................................60

6.3.2

Backward-Bending Supply Curve ..................................................................61

6.3.3

Shifts in Supply ..............................................................................................62

6.4
6.4.1
6.5

Short Run and Long Run ...................................................................................44

4.3.1

5.4
6

Returns to Scale ................................................................................................42

4.2.1

4.3

Average Product ............................................................................................41

The Concept of Efficiency ..................................................................................62


Efficiency of Competitive Equilibrium .............................................................62
Market Failures ..................................................................................................63

6.5.1

Imperfect Competition ....................................................................................63

6.5.2

Externalities....................................................................................................63

6.5.3

Imperfect Information .....................................................................................64

Imperfect Competition ................................................................................................65


7.1

Patterns of Imperfect Competition .....................................................................65

7.2

Definition of Imperfect Competition ....................................................................65


4

7.3
7.3.1

Monopoly........................................................................................................66

7.3.2

Oligopoly ........................................................................................................66

7.3.3

Monopolistic Competition ...............................................................................66

7.4

High Cost of Entry ..........................................................................................67

7.4.2

Legal Restrictions...........................................................................................67

7.4.3

Product Differentiation and Advertising..........................................................68

7.4.4

Control of Strategic Resources ......................................................................68

7.5.1
7.6

Marginal Revenue and Monopolies ...................................................................68


The Concept of Marginal Revenue ................................................................69
Fallacies and Facts of Monopolies.....................................................................70

7.6.1

Fallacies .........................................................................................................70

7.6.2

Facts ..............................................................................................................71

7.7
7.7.1

Barriers to Entry .................................................................................................67

7.4.1

7.5

Varieties of Imperfect Competition .....................................................................66

Price Discrimination ...........................................................................................72


Two Main Methods of Price Discrimination ....................................................73

Between Monopoly and Competition..........................................................................74


8.1

Perfectly Contestable Markets ...........................................................................74

8.2

Monopolistic Competition ...................................................................................74

8.3

Oligopoly ............................................................................................................77

Game Theory..............................................................................................................79
9.1

Basic Concept of Game Theory.........................................................................79

9.1.1

Alternative Strategies .....................................................................................80

9.1.2

The Prisoners Dilemma.................................................................................81

Learning Objectives
The student should
know the behavior of individual firms, consumers, and markets.
understand the applications of supply and demand.
know how to derive demand curves and supply curves.
know why demand curves slope downwards.
know about the different concepts of costs.
be able to analyze product markets.
know where consumer demand comes from, how businesses make decisions, and how
prices and profits coordinate the allocation of resources in a competitive market.
know about factor markets and the role of government in a modern mixed economy.
be able the name various elasticity concepts and know about the elasticity of demand
and supply.
be able to differentiate elastic price, inelastic price and unitary elastic price.
be able to numerically calculate the elasticity coefficient.
be able to explain consumer demand by the concept of utility.
know the law of diminishing marginal utility.
know how to construct the indifference curve and a budget constraint.
know what utility maximization is.
know what the law of diminishing returns is.
be able to analyze fixed cost, variable cost, average cost and opportunity cost.
know what the income effect and the substitution effect is.
know what factors make the supply curve bend backwards.
know the supply behavior of competitive firms.
know the definition, patterns and varieties of imperfect competition.
be able to name special cases of competitive markets.
understand how perfect competition differs from monopolies.
be able to explain what a Monopoly is and how it operates in the market.
know the basic concepts of game theory and be able to name examples of game
theory.

1.1

Supply, Demand and Product Markets

Definition of Elasticity

Elasticity is the ratio between proportional change in one variable and the proportional
change in another. This concept is useful because comparisons of proportional changes
are pure ratios, independent of the units in which the variables, such as price or quantity,
are measured.
Microeconomics studies the factors that determine the relative prices of goods and inputs.
Economists must know how to measure the response output to changes in prices and
income. Later, we will examine the factors affecting demand and supply.

1.2

Elasticity of Demand and Supply

The quantitative relationship between price and quantity purchased is analyzed using the
concept of elasticity.
Supply and demand respond to price changes. Some purchases, such as for vacation, are
very sensitive to prize changes, whereas others, such as electricity, are very little sensitive
to price changes.

1.3

Price Elasticity of Demand

The price elasticity of demand measures the responsiveness of the quantity demanded of
a good to a change in its price. It is the percentage change in quantity demanded divided
by the percentage change in price.
Goods vary enormously in their price elasticity. They are very sensitive to price changes.
A good is elastic when the price elasticity of that good is high. A good is inelastic when
the price elasticity of that good is low and its quantity demanded responds little to price
changes.
For necessities, such as food, fuel, medicine etc., the demand tends to be inelastic. These
goods cannot be sensitive to price changes.
On the other hand, goods that have ready substitutes tend to have a more elastic demand
than those that have no substitute. Luxury goods, for example, can easily be substituted
and rise in price.
The length of time that people have to respond to price changes is also an important
factor. Gasoline is a good example. If the price for gasoline suddenly increases, people
unlikely make sudden changes and sell their cars, for example. Therefore, in the short
run, the demand for gasoline is very inelastic. The ability to adjust consumption behavior
implies that demand elasticities are generally higher in the long run than in the short run.
In conclusion, the elasticity is higher when the good can be substituted, and when the
consumer has more time to adjust their behavior.

1.3.1

Calculating Elasticities

By knowing how much quantity demanded changes when price changes, we can calculate
the elasticity. The exact definition of the price elasticity E(QD,P) is the percentage
change in quantity demanded divided by the percentage change in price.
Formally, we have:

E(QD,P) =

Percentage Change in Quantity Demanded


Percent Charge in Price

Where both percent changes are expressed as absolute values (as positive numbers).
When the price elasticity > 1, demand is elastic:
A given percentage change in price causes an even greater percentage change in the
quantity demanded. The quantity demanded responds a lot to price changes.
When the price elasticity < 1, demand is inelastic:
A given percentage change in price causes a smaller percentage change in the quantity
demanded. The quantity demanded does not respond much to price changes.
When the price elasticity = 1, demand is unitary elastic:
A given percentage change in price causes the exact same percentage change in the
quantity demanded.

Example 1:
To illustrate the calculation of elasticities, we take an example, where the price of a good
was 90 and the quantity demanded for that price was 240 units. A price increase from 90
to 110 then led consumers to reduce their purchases to 160 units.
In the figure 1, the move along the demand schedule is shown. Consumers were originally
at point A but moved along their demand schedule to point B after the price increased.
The price increase is 20 percent. The demand decrease is 40 percent. Therefore, the
price elasticity of demand is, ED = 40/20 = 2. The price elasticity is greater than 1 (ED > 1)
and elastic. This means that the good has a price-elastic demand in the region from A to
B.

Point A: Price = 90 and Quantity = 240


Point B: Price = 110 and Quantity = 160
Percentage price change = P/P = 20/100 = 20 % (increase)
Percentage quantity change = Q/Q = -80/200 = -40% (decrease)
Price elasticity = ED = 40/20 = 2

Note, that we drop all the minus signs from the numbers so that all elasticities are positive.
That means that all elasticities are written as positive numbers even though in the
example the demand curve has a downward-slope and moves in opposite direction. Also
note that percentage changes rather than absolute changes are used for the definition of
elasticity.

10

(Figure 1)

The market equilibrium is originally at point A. In response to a 20 percent price increase,


quantity demanded decreases 40 percent (point B). From point A to B, demand is
therefore elastic.

11

1.3.2

Price Elasticity in Diagrams

Price elasticity can also be determined in diagrams. The figures below illustrate the
different elasticity.
Figure 2 shows a perfectly inelastic demand curve (ED = 0). Completely inelastic demands
(zero elasticity) are ones, where the quantity demanded responds not at all to price
changes (vertical demand curve).

(Figure 2)

12

The opposite of a perfectly inelastic demand curve, is the perfectly elastic demand curve.
A small change in price will lead to an indefinitely large change in quantity demanded.
Figure 3 shows the perfectly elastic demand curve (horizontal demand curve)

(Figure 3)

In figure 4, a halving of price has tripled quantity demanded. Like in the example of before,
this case shows price-elastic demand.

(Figure 4)

13

In figure 5, cutting the price in half led to a 50 percent increase in quantity demanded
(inelastic demand).

(Figure 5)

An example of unitary-elastic demand is illustrated in figure 6 below. The doubling of


quantity demanded matches the halving of price.
(Figure 6)

14

1.3.3

Numerical Calculation of Elasticity Coefficient

The table below gives a detailed set of elasticity calculations using the same technique as
seen in example 1. This table shows that linear demand curves start out with high price
elasticity (price is high and demand is low), and end up with low elasticity (price is low and
quantity is high).

Numerical Calculation of Elasticity Coefficient


Q1 + Q2
Q

10

15

25

Q
(Q1 + Q2)/2

ED =

6
10

10
5

2
5

10

P
(P1 + P2)/2

elastic

4
10

20

15

=1

unitary-elastic

2
10

30

P 1 + P2

10
25

= 0.2

inelastic

P denotes the change in price. For example, P = P2 - P1, while Q = Q2 - Q1. To


calculate numerical elasticity, the percentage change of price equals price change, P,
divided by average price [(P2 + P1) / 2]. The percentage change in output is calculated as
Q divided by average price, [(Q2 + Q1) / 2]. The resulting ratio gives a numerical price
elasticity of demand, ED (all figures are positive numbers). Note that for a straight line,
elasticity is high at the top, low at the bottom and exactly 1 in the middle.

15

1.3.4

Elasticity and Slope are not the same

It is important to note, that it is not true that a steep slope for the demand curve means
inelastic demand and a flat slope signifies elastic demand. The slope is not the same as
the elasticity because the demand curves slope depends upon the changes in P and Q,
whereas the elasticity depends upon the percentage changes in P and Q. Exceptions are
completely elastic and inelastic demands. Elasticity is different from slope. This is shown
in figure 6. The demand curve is clearly not a straight line with constant slope. Yet it has a
constant demand elasticity of ED = 1 because the percentage change in price is
everywhere equal to the percentage change in quantity.
Figure 7 shows an example of how easy it is to confuse elasticity and slope. This figure
plots a linear demand curve (straight line). It has the same slope everywhere because it is
linear. But at the top of the line, near A, a very small percentage change in price and a
large percentage change in quantity are to be seen. The elasticity there is very large. We
can observe that at the top of the DD curve, price elasticity is relatively large and at the
bottom part of the curve, price elasticity is close to zero.
Above the middle of the curve (point M), demand is elastic (ED > 1). At the midpoint itself,
demand is unitary-elastic (ED = 1) and below the midpoint, demand is inelastic (ED < 1).
In summery, while completely elastic and completely inelastic demand can be determined
from the slopes of the demand curves alone, for the cases in-between, elasticities cannot
inferred by slope alone but by calculation of the elasticity from a diagram.

16

(Figure 7)

All points on the DD curve have the same slope. Above point M, demand is elastic, below
point M, demand is inelastic and at point M, demand is unitary-elastic.

17

1.3.5

Elasticity and Total Revenue

Economists use elasticities to tell what will happen to total revenue when prices change.
Total revenue is by definition equal to price times quantity (P x Q). If you know the price
elasticity of demand, you also know what will happen to total revenue when the price
changes:
1. When demand is price-inelastic, a price decrease reduces total revenue.
2. When demand is price-elastic, a price decrease increases total revenue.
3. When demand is unitary-elastic, a price decrease leads to no change in total
revenue.
And:
1. If E(QD,P) > 1, then price and total revenue are negatively related.
2. If E(QD,P) < 1, then price and total revenue are positively related.
This equation measures the percentage change in total revenue:

Percent change in total revenue = (1 - E(QD,P)) x Percent change in price

Example:
Problem: The price elasticity of demand for wheat is 0.3. If a good harvest results in 20
percent lower wheat prices, what will happen to the total revenue of farmers?
Solution: Total revenue will decrease by about 14 percent (0,7 x 20 percent).

18

1.3.6

Factors affecting the Price Elasticity

1. The fraction of income spent on the good: The more people spend on a good, the
more important it is in their budget. So, if the price of that good increases, they are
more willing to search for a substitute good.
2. How narrowly defined the good is: Bread is a more narrowly defined good than
wheat product is. White bread is more narrowly defined than bread is. The
narrower the definition is, the more substitute the good is likely to have and thus
the more elastic its demand will be.
3. How easy substitute goods are to find out about: The easier a consumer can find
out about the price and availability of substitutes, the more elastic demand will be.
Advertising, for example, plays a big role in increasing the availability of
substitutes.
4. How much time is available to adjust to price changes: The more time consumers
have to find out about substitutes, the more elastic demand becomes.
When more substitutes for a good become available, demand becomes more elastic.

19

1.4

Price Elasticity of Supply

The price elasticity of supply measures the responsiveness of the quantity supplied to
price changes. It is the percentage change in quantity supplied divided by the percentage
change in price.
As with demand elasticities, there are polar extremes of high and low elasticities of supply.
Between these extremes, we call supply elastic or inelastic, depending on whether the
percentage change in quantity is larger or smaller than the percentage change in price.
The definitions of price elasticity of supply are the same as those for price elasticity of
demand. The only difference is that for supply the quantity response to price is positive,
while for demand the response is negative.
Formally, we have the equation:
E(QS,P) =

Percentage Change in Quantity Supplied


Percent Charge in Price

20

Figure 8 shows three important cases of supply elasticity:


1. The vertical supply curve (a): It shows a completely inelastic supply (ES = 0). A
higher price does not increase output at all.
2. The horizontal supply curve (s): It shows a completely elastic supply (ES = ). It
displays an indefinitely large quantity response to price changes.
3. An intermediate case of a straight line (b): It goes through the origin (ES = 1). It
displays a case of unitary-elasticity.
(Figure 8)

When supply is fixed, supply elasticity is zero (curve a). Curve s displays an indefinitely
large quantity response to price changes. Curve b shows an intermediate case and arises
when the percentage quantity and price changes are equal.

21

1.4.1

Factors affecting Supply Elasticity

1. How much time is available to adjust to price: A basic rule of economic life is, that
the faster a good has to be produced, the more it will cost. So, when the price of a
good goes up, firms at first increase output very little. The firms adjust by
expanding, increasing input factors etc. With more time to adjust, the supply
response becomes larger. For example, in figure 9, an increase of price from P0 to
P1 will not immediately affect output (Q A). Given some time (the short-run
supply curve is A). Given some time, B becomes the supply curve and Q B the
quantity supplied. With even more time, new firms enter the market and existing
ones expand, so the supply curve becomes C and Q - C the quantity supplied.
2. How easy it is to store goods: When the prices of a good decrease, firms have to
choose whether of selling or putting it into their inventory. Therefore, the cheaper it
is to store goods, the more elastic the supply will be for temporary changes in
price.
3. How cheap output increase is: Increasing output is costly. If a factory buys more
input, the price of input increases. Similarly, some production processes are
expensive to set up. The less input costs rise and the smaller costs of production
processes are the more elastic the supply curve will be.

22

(Figure 9)

This diagram shows the elasticity of various supply curves.

23

Demand and Consumer Behavior

Individual choices are what underline the demand curves and price elasticities. Patterns of
market demand can be explained by the process of consumer behavior.

2.1

The Utility Theory

Consumers choose those goods and services that they value the most. To describe
consumer behavior among different consumption possibilities, economists developed the
notion of utility.
Utility denotes satisfaction. It refers to how consumers rank different goods and services.
The notion of utility is a scientific construct that economists use in order to understand
how rational consumers divide their limited resources among the commodities that provide
them satisfaction.
Example:
If good A has a higher utility than good B, then the consumer prefers good A over good B.

2.1.1

Marginal Utility and the Law of Diminishing Marginal Utility

To illustrate the basic theory of demand, assume economists can measure a consumers
satisfaction in utils. Total utility measures a consumers total satisfaction from a good.
The expression marginal means additional or extra. So, marginal utility denotes the
additional or extra utility you get from the consumption of an additional unit of a
commodity.

24

For example, if you are thirsty and drink a bottle of water, it gives you a certain level of
satisfaction. By consuming a second unit of that commodity (a second bottle of water),
your total utility increases, because that second unit gives you additional or extra
satisfaction. But after drinking more (third or fourth bottle of water) you eventually have
enough. This is the fundamental concept of marginal utility.
The law of diminishing marginal utility is a law that states that the amount of additional or
marginal utility declines as more of that good is consumed but their total utility inclines at a
slower and slower rate. Growth in total utility slows because the marginal utility diminishes
as more of the good is consumed. As the amount of a good consumed increase, the
marginal utility of that good tends to diminish.
Example:
The table below shows in the second column (2) that total utility (U) increases as
consumption (Q) grows, but it increases at a decreasing rate. Column (3) measures the
marginal utility as the extra utility gained when 1 extra unit of the good is consumed. So,
when 2 units are consumed, the marginal utility is 7 4 = 3 units of utility. Column (3)
clearly shows that marginal utility declines with higher consumption and this illustrates the
law of diminishing marginal utility.
(1)

(2)

(3)

Total Utility

Marginal Utility

MU

Quantity of a good
consumed

4
1

4
3

7
2

9
1

10
0

10

25

Figure 10 and 11 show graphically the data on total utility and marginal utility from the
table of before. In figure 10, the gray blocks add up to the total utility at each level of
consumption. The curve illustrates the utility level for fractional units of consumption. It
shows utility increasing but at a decreasing rate.
Figure 11 depicts marginal utilities. Each of the gray blocks of marginal utility is the same
size as the corresponding block of total utility in figure 10. The straight line in figure 11 is
the curve of marginal utility.
The law of diminishing marginal utility implies that the marginal utility (MU) curve in figure
11 must slope downward.

26

(Figure 10)

Total utility rises with consumption at a decreasing rate, showing diminishing marginal
utility.

27

(Figure 11)

This figure shows the fact that total utility increases at a decreasing rate by the declining
steps of marginal utility.

2.1.2

Ordinal Utility

The principle of ordinal utility is an approach to examine only the preference raking of
bundles of commodities.

2.1.3

Cardinal Utility

Cardinal utility assumes that welfare differences can be measured. It is referred to as a


measurable utility that is attached to consumption of ordinary goods.

28

2.2

Deriving the Law of Demand from the Law of Equal Marginal Utility per Dollar

The law of demand states that the quantity of a good demanded will fall when the price of
the good rises. This law can be derived from the law of equal marginal utility per dollar.
Equimarginal principle: The fundamental condition of maximum satisfaction or utility is the
equimarginal principle. It states that a consumer having a fixed income and facing given
market prices of goods will achieve maximum satisfaction or utility when the marginal
utility of the last utility spent on each good is exactly the same as the marginal utility of the
last dollar spent on any other good.
If good 1 gave more marginal utility per dollar, one would increase the utility of good 1 by
taking money away from other goods and spending more on that good until the law of
diminishing marginal utility drove its marginal utility per dollar down to equality with that of
other goods. If any other good gave less marginal utility per dollar than the common level,
one would buy less of it until the marginal utility of the last dollar spent on it had risen back
to the common level. Marginal utility of income is what the common marginal utility per
dollar of all commodities in consumer equilibrium is called. It measures the additional
utility that would be gained if the consumer could enjoy an extra dollars worth of
consumption.
Consumer equilibrium can be written formally in terms of the marginal utilities (MUs) and
prices (Ps) of the different goods in following way:
MU f
Pf

29

MU c
Pc

2.2.1

Why Demand Curves slope downwards

When the common marginal utility per dollar of income is held constant and the price of
good 1 is increased, with no change in quantity consumed, the first ratio (MUgood1/P1) will
be below the MU per dollar of all other goods. Therefore the consumer will have to
readjust the consumption of good 1. This can be done by either lowering the consumption
of good 1 or by raising the MU of good 1 until at the new marginal utility per dollar spent
on good 1 is again equal to the MU per dollar spent on other goods.
A higher price for a good reduces the consumers desired consumption of that commodity
and this shows why demand curves slope downward.

30

2.3

Income Effects and Substitution Effects

When a goods price increases, two things occur:


1, its relative price increases, and
2, consumers real income decreases (they can buy less)
To describe how price changes affect consumers, economists separate the effect of a
higher price into these two effects: substitution effect and income effect.

2.3.1

The Substitution Effect

The substitution effect is the decrease in demand when a goods relative price increases,
holding real income constant. A higher relative price for good 1 causes consumers to buy
less of good 1 because the higher price reduces the marginal utility per good 1 dollar
(MUgood1/Pgood1). This is true even if the higher price does not reduce the real income of
consumers. Real income is defined to be constant if consumers can buy the same amount
of good 1 and other goods as before. More generally, the substitution effect says that
when the price of a good rises, consumers will tend to substitute other goods for the more
expensive good. It is also the most obvious factor for explaining downward-sloping
demand curves.

2.3.2

The Income Effect

The income effect is the change in demand when real income changes (holding the
relative price of the good constant). For a given money income, an increase in the actual
price of a good will reduce real income. This lower real income in itself will reduce the
quantity demanded of a normal good. But it will increase the quantity demanded of an
inferior good.

31

The table below summarizes these two effects. The total change in the quantity
demanded is the sum of these two effects.

Substitution
Price Change

Type of Good

Effect
(1)

Up
Down

Income Effect
(2)

Net Effect on
Quantity
(3) = (1) + (2)

Normal

Inferior

Normal

Inferior

Note, that it is possible for a higher price to increase demand. This occurs with inferior
goods and when the income effect is strong. (This case is called the Giffen Paradox,
which has rarely, if ever, been observed.)
Example:
Problem: Suppose the government puts a tax on food. To predict the effect of the tax on
food consumption, should one use the substitution effect, the income effect, or
both?
Solution: Use only the substitution effect because the nations income has not changed.
The tax merely shifts income from food consumers to those whom the
government gives the tax dollars.

32

2.4

Consumer Surplus

The gap between the total utility of a good and its total market value is called consumer
surplus. It is the maximum amount consumers would pay for a certain amount of a good
minus the actual dollars they did pay. The surplus arises because we receive more than
we pay for as a law of diminishing marginal utility.
In figure 12, the demand curve for a consumer is shown (DD). The consumers pays 3 $
for each of good 1 and buys 10 pieces of good 1 a month. The distance between the
demand curve, which reflects the maximum amount that consumer would pay, and the
price line T, which reflects the actual dollars that consumer paid, is the units consumer
surplus. For example, the consumer would have paid up to 7 $ for the fourth piece of good
1 but in fact only paid 3 $. In this case, the consumer surplus for the consumer is 4 $ (7 $ 3 $). The total consumer surplus from all ten pieces of good 1 equals 35 $ (triangle VTU,
also the base (TU = 10 pieces of good 1) times the height (VT = 7 $) divided by 2).
(Figure 12)

33

3.1

Geometrical Analysis of Consumer Equilibrium

The Indifference Curve

The indifference curve represents the preferences of an individual. If the amounts of two
goods consumed are shown on the axes, an indifference curve connects combinations of
the two goods giving equal welfare. Combinations above any indifference curve are
preferred to those on it, and these are preferred to those below.
Figure 13, shows combinations diagrammatically. We measure units of good x on one
axis and good y on the other.

34

(Figure 13)

Getting more of one good compensates for giving up some of the other good (figure 13).
The consumer likes situation A just as much as B, C, or D. The combinations that yield
equal satisfaction are plotted as a smooth indifference curve.
There are different possibilities for preferred consumption situations, which can bring the
consumer a higher level of satisfaction. Figure 14 below, shows four such curves. A
consumer, who moves along a single indifference curve, enjoys neither increasing nor
decreasing satisfaction from the change in consumption. Assuming that the consumer
gets greater satisfaction from receiving increased quantities of both goods, we reach
higher level of satisfaction, if we move towards curve U4.

35

(Figure 14)

Curve U3 stands for a higher level of satisfaction than curve U2 and U4 for a higher level
of satisfaction than U3 etc.

3.2

The Budget Constraint

The budget constraint shows the combinations of goods the consumer can buy with his
current income. It is a constraint because the consumer could buy less than his income,
but not more. To keep the analysis simple, we assume that the consumer spends all his
income on good x and good y.
Figure 15 shows the budget constraint for a person who earns 100 $ a day. The price of
good x is 20 $ and the price of good y is 10 $.

36

(Figure 15)

At any point of the budget constraint, the consumers spending is 100 $. If the consumer
buys only good y and no good x, only 10 units of good y can be bought (= income divided
by the price of y). This is the vertical intercept.
If the consumer buys only good x and no good y, only 5 units of good x can be bought (=
income divided by the price of x). This is the horizontal intercept.
The slope of the budget constraint is 2. The consumer must give up 2 units of y to get 1
more unit of x. The supply price equals the price of x divided by the price of y.
An increase in income will move the whole budget constraint up and to the right without
changing the slope.
An increase in the price of good x would leave the vertical intercept unchanged but would
cause the curve to become steeper, moving the horizontal intercept to the left.
An increase in the price of good y would leave the horizontal intercept unchanged but
would cause the curve to become flatter, moving the vertical intercept down.

37

3.3

Utility Maximization

The indifference curves show what the consumer wants (the higher the better) and the
budget constraint shows what the consumer can afford. So given that the consumer is on
budget constraint, the consumer tries to get to the highest indifference curve possible.
Figure 16 shows, that point E is the highest level of utility the consumer can achieve,
given his income and the prices of good x and y. The consumers equilibrium is at point E.
Any other point than point E makes the consumer worse off.
(Figure 16)

Ig is the highest indifference curve the consumer can get. The consumer would prefer to
be at point J, but the consumer has not enough income to reach that point. Point G and H
have a lower utility than point E. If at any point on the budget constraint, the indifference
curve cuts through the budget constraint, the consumer can move to a higher curve. At
point E the indifference curve is tangent (it just touches the curve once).
Also, at point E, the demand price for good x equals its supply price. The consumer is in
equilibrium.

38

Production and Business Organization

4.1

4.1.1

Theory of Production and Marginal Products

The Production Function

The relationship between the amounts of output that can be obtained is called the
production function. It specifies the maximum output that can be produced with a given
quantity of input. The concept of a production function is a useful way of describing the
productive capability of a firm.

4.1.2

Total Product

The total product can be calculated by the production function. The total product
designates the total amount of output produced in physical units.
Figure 17 shows the total product curve rising as additional inputs of labor are added. As
additional units of labor is added the total product rises decreasingly.

39

(Figure 17)

4.1.3

Marginal Product

The marginal product of an input is the extra output produced by one additional unit of that
input (other inputs held constant).
Figure 18, shows the declining steps of marginal product. Each rectangle is equal to the
equivalent rectangle of figure 17. The sum of the rectangles in figure 18 under the
marginal product curve adds up to the total product.

40

(Figure 18)

4.1.4

Average Product

The average product equals total output divided by total units of input.
The table below shows the average product of labor as 2000 units per worker with one
worker, 1500 units per worker with two workers etc. The average product falls through the
entire range of increasing labor input. Figure 17 and 18 plots the total and marginal
product from the table below.

41

1
Units of Labor
Input

Total Product

Marginal Product

Average Product

0
2000

2000

2000
1000

3000

1500
500

3500

1167
300

3800

950
100

3900

780

The table shows the total product that can be produced for different inputs of labor when
other inputs are unchanged. From the total product, we can derive important concepts of
marginal and average products.

4.2

Returns to Scale

Diminishing returns and marginal products refer to the response of output to an increase
of a single input when all other inputs are held constant. If an n % rise in all inputs
produces an n % increase in output, there are constant returns to scale. Three important
cases should be noted:

42

4.2.1

Constant returns to scale

It is a constant ratio between inputs and outputs. A change in all inputs leads to a
proportional change in output.
Example: If labor, land, capital etc. are doubled, then (under constant returns to scale)
output would also double.

4.2.2

Increasing returns to scale

The average productivity increases with the output. Increasing all inputs in the same
proportion, results in a more than proportional increase in output.
Example: Engineering companies, that increase the inputs by n %, such as labor or
capital, will result in an increase of output more than n %.

4.2.3

Decreasing returns to scale

It occurs when a balanced increase of all inputs leads to a less proportional increase in
output.
Example: Productive activities involving natural resources, such as clean drinking water,
show decreasing returns to scale.

43

4.3

Short Run and Long Run

Efficient production requires time as well as conventional inputs. To measure the role of
time in production and costs, we distinguish between two different time periods.

4.3.1

Short Run

The short run is the period of time in which only the variable inputs can be adjusted. Firms
can adjust production by changing variable factors such as labor and materials. Fixed
factors such as equipment and capital cannot be changed in the short run.

4.3.2

Long Run

The long run is the period of time in which all factors can be changed. It is sufficiently long
enough that all factors including capital can be adjusted.

4.4

Productivity

Productivity is one of the most important measures of economic performance. It is a


concept measuring the ratio of total output to an average of inputs.
Labor productivity calculates the amount of output per unit of labor.
Total factor productivity measures output per unit of total inputs (labor and capital).

44

4.5

4.5.1

Business Organizations

Sole Proprietorship

A sole proprietorship has one owner. That sole owner may engage in any form of legal
business activity and runs the business without partners or incorporation. The advantage
of sole proprietorship is the unity of control. Owner and management are the same.

4.5.2

Partnership

Partnership is a business which has more than just one owner but is not incorporated. The
partners agree to provide some fraction of the work and capital, to share some percentage
of the profits and also losses or debts. The biggest disadvantage of partnerships is
unlimited liability. General partners are liable without limit for all debts contracted by the
partnership.

4.5.3

Corporation

A corporation is a form of business organization, owned by a number of individual


stockholders. The corporation is a legal entity separate from the persons forming it. That
person may, on its own behalf, buy, sell, produce goods, enter into contracts etc. The
corporation has limited liability. Each owners investment is limited to a specified amount.
The ownership of a corporation is determined by the ownership of the companys common
stock. N percent shares, means n percent ownership. Publicly owned corporations are
valued on stock exchanges.

45

Shareholders collect dividends in proportion to the fraction of the shares they own. They
also elect the director and vote for many important issues. The corporation directors have
the legal power to make the decisions for the corporation. Shareholders own the
corporation but the managers run it.
Corporations are predominant in the market economy because of the efficient way they
engage in business. Limited liability of the corporate stockholders protects them from
acquiring the debts or losses of the corporation beyond their initial contribution. The
corporations income is doubly taxed, as corporate profits and as individual income on
dividends. Corporations with limited liability can attract large supplies of private capital,
produce a variety of related products, and pool risks.
Extra taxes on corporate profits are a major disadvantage. Any income after expenses for
un-incorporate businesses, for example, is taxed as ordinary personal income.

46

5.1

Analysis of Costs

Economic Analysis of Total, Fixed, and Variable Cost

Total Cost:
Total cost represents the lowest total dollar expense needed to produce each level of
output q.
The table below shows the total cost (TC) for each different level of output q. Columns 1
and 4 show how the TC increases as q increases. A reason for this is, when more goods
need to be produced, more labor and other inputs must be increased.
Fixed Cost:
Fixed cost represents the total dollar expense that is paid out even when no output is
produced. Fixed cost is unaffected by any variation in the quantity of output.
Columns 2 and 3 of the table below divide TC into two components: total fixed cost (FC)
and total variable cost (VC).
Fixed costs consist of items such as rent, interest payments for equipments or debts etc.
These payments must be paid even if the firm produces no output.
For example, a firm might have an office lease which runs 10 years and remains an
obligation even if the firm shrinks to half its previous size. FC must be paid and remains
constant at 55 $ in column 2.

47

Variable Cost:
Variable cost represents expenses that vary with the level of output and includes all costs
that are not fixed.
Column 3 of the table below shows the variable cost (VC). Variable costs are those which
vary as output changes. For example, the materials required to produce output, the labor
etc. are variable costs.
VC is zero when q is zero. VC is the part of TC that grows with output.

Quantity

Fixed Cost ($)

Variable Cost ($)

Total Cost ($)

FC

VC

TC

55

55

55

30

85

55

55

110

55

75

130

55

105

160

55

155

210

55

225

280

The major elements of a firms cost are its fixed costs, which do not vary when output
changes, and its variable cost, which increase when as output increases. Total costs are
equal to fixed costs plus variable costs: TC = FC + VC.

48

5.2

Definition on Marginal Cost

Marginal cost (MC) denotes the additional cost from an increase in activity. It is the
additional cost of producing 1 extra unit of output. MC is the addition to total cost resulting
from a unit increase if it varies discretely, or the addition to total cost, per unit of the
increase, if it varies continuously. Marginal cost may be short-run, when only some inputs
can be changes, or long-run, when all inputs can be adjusted.
The table below illustrates how to calculate the MC. The MC numbers from column 3
come from subtracting the TC in column 2 from the TC of the subsequent quantity (the
first MC is 30 $ (= 85 $ - 55 $).

Output

Total Cost ($)

Marginal Cost ($)

TC

MC

55
30

85
25

110
20

130
30

160
50

210

49

Figure 19 and figure 20 show the data from the two tables of above. Marginal cost in
figure 20 is found by calculating the extra cost added in figure 19 for each unit increase in
output. A smooth curve is drawn to connect the points of TC in figure 19, and a smooth
MC curve in figure 20 links the discrete steps of MC.
(Figure 19)

(Figure 20)

50

5.3

Average Cost

The average cost is the total cost of production divided by quantity produced (output). The
table below expands the tables from above and includes three new measures: average
cost, average fixed cost, and average variable cost.
1

Quantity

Fixed

Variable

Total

Cost ($)

Cost ($)

Cost ($)

FC

VC

55

Marginal

Average

Cost per

Cost per

unit ($)

unit ($)

TC =

MC

FC + VC
55

Average

Average

Fixed

Variable

Cost per

Cost per

unit ($)

unit ($)

AC =

AFC =

AVC =

TC / q

FC / q

VC / q

Infinity

Infinity

Undefined

85

55

30

55

27,5

27,5

43,33

18,33

25

40

13,75

26,25

42

11

42

46,66

9,16

37,5

52,85

7,85

45

60

6,87

53,16

30
1

55

30

85
25

55

55

110
20

55

75

130
30

4*

55

105

160
50

55

155

210
70

55

225

280
90

55

315

370
110

55

425

480

*minimum level of average cost

51

5.3.1

Unit Cost or Average Cost

AC is a concept commonly used in businesses. By comparing the average cost with


average revenue, businesses can determine if they make a profit or not.
Average Cost = Total Cost / Output = TC / q
Figure 21 and 22 plots the cost data shown in the table from above and depicts the total,
fixed, and the variable costs at different levels of output. Figure 21 illustrates how the total
cost moves with variable cost while fixed cost remains unchanged.
Figure 22 shows the different average cost concepts along with a smooth marginal cost
curve. This plots the U-shaped AC curve and aligns AC right below the TC curve from
which it is derived.
(Figure 21)

The total cost consists of fixed cost and variable cost.

52

(Figure 22)

The MC curve falls and then rises, as indicated by the MC figures given in column 5 of the
table from before. MC intersects AC at its minimum.

5.3.2

Average Fixed Cost

AFC is defined as FC/q. The average fixed cost becomes smaller as output expands. In
column 7 of the table from page 48, we can see a steadily falling average fixed cost curve.
This is due to a constant total fixed cost, which is divided by an increasing output.
In figure 22 the AFC curve is a hyperbola.

5.3.3

Average Variable Cost

AVC equals variable cost divided by output. AVC = VC/q. In figure 22 and in the table of
page 48 we can see that the AVC first falls then rises again.

53

5.4

Opportunity Costs

When a good is scarce, choosing to use the good in one way means giving up some other
goods to use. The opportunity cost is the value of the most valuable good or service
forgone. It is the value of the best forgone alternative use.
Example:
Problem: A firm needs to hire some employees. Assume that each employee has time to
solve only one task. Task A is worth 100,000 $, task B is worth 75,000 $, and
task C is worth 50,000 $. The firm hires only two employees. One has to do task
A and the other one has to do task B. What is the opportunity cost of task B.
Solution: The opportunity cost of task B is the value of the forgone task that otherwise
would have been accomplished, which in this case is task C. So the opportunity
cost of task B is 50,000 $. The opportunity cost of task A is also 50,000 $ since,
with the two employees, task C is forgone, given up to do task A.

54

6.1

Analysis of Perfectly Competitive Markets

Perfect Competition

It is the condition that exists when there is enough competition among sellers. No seller
can raise its prize without losing its customer to another seller. A perfectly competitive firm
sells homogeneous products. These products are identical to the products sold by others
in the industry.
We can depict a price-taking perfect competitor by examining the way demand looks to a
perfectly competitive firm. Figure 23 shows the demand curve (DD) facing a single
competitive firm. Because a competitive industry is populated by firms that are small
(relative to the market), the firms segment of the demand curve is only a tiny segment of
the industrys curve. The firms demand curve is infinitely elastic and looks completely
horizontal.

(Figure 23)

55

Key points for a Perfect Competition:


-

Under perfect competition, there are many small firms. Each firm is
producing an identical product and each to small to affect the market price.

The perfect competitor faces a completely horizontal demand curve.

The extra revenue gained from each extra unit sold is therefore the market
price.

6.2

The Efficiency of Competitive Markets

When an economy is efficient, it is getting the best value for the least cost. Efficiency is
one of the main concerns of economists.
Suppose an economy has the marginal benefits (MB) and marginal costs (MC) shown in
the table below. In order to maximize net benefits, we should determine how much an
economy is supposed to produce of a good (optimal production rate).
Quantity

MB in $

MC in $

2.5

Using marginal analysis, the first good should be produced, because the total benefits is 6
$ and the total cost is 1 $. Also good 2 and 3 add more to benefits than to costs (MB >
MC). It increases net benefits. On the 4th good MB = MC. This is the optimal combination
to maximize societys net benefits.

56

In a competitive market the socially optimal quantity should be produced. For example,
the consumers will pay 4 $ for the third good because that is the marginal value. It adds
up to their utility. Since demand equals supply in competitive markets, it follows that the
demand price (PD) = supply price (PS) and marginal benefits (MB) = marginal costs (MC).
This means that the optimal numbers of goods will be produced.
Economists measure the gain in net benefits by the total surplus from producing a good.
The difference between MB and MC contributes to the net benefits. For example, the first
good added 5 $ to net benefits (6 $ - 1 $). The total surplus when Q = 4 is 9.50 $ (5 $ + 3
$ + 1.50 $ + 0 $).
The consumer surplus is the surplus going to the consumers. It is the amount consumers
would pay for the good less what they actually did pay for the good. For the good with Q =
4, the consumer surplus equals 6 $ (the total value of 6 $ + 5 $ + 4 $ + 3 $ less the
payment of 12 $ for all 4 goods).
The producer surplus is the surplus going to producers. It is what producers paid less their
marginal costs. For the good with Q = 4, this equals 3.50 $ (the price of 3 $ x 4 minus the
sum of MCs of 1 $ + 2 $ + 2.50 $ + 3 $, or 12 $ - 8.50 $).

57

(Figure 24)

Figure 24 illustrates the consumer and producer surplus. The total surplus is largest when
the marginal benefit equals the marginal cost and when demand equals supply.
In figure 24, at the competitive level of output (Q0), the consumer surplus is the area
below the demand curve but above the price (P0). It is the area GFI.
The producer surplus is the area below the price (P0) and above the supply curve. It is the
area HFG.
The total surplus is the sum of the consumer surplus and the producer surplus. It is the
area HFI.

58

6.3

Special Cases of Competitive Markets

Demand rule:
Generally, an increase in demand for a commodity will raise the price of the commodity.
For most commodities an increase in demand will also increase the quantity demanded. A
decrease in demand will have the opposite effects.
Supply rule:
Generally, an increase in supply of a commodity will lower the price and increase the
quantity bought and sold. A decrease in supply has the opposite effects.
These two rules summarize the qualitative effects of shifts in supply and demand. The
quantitative effects on price and quantity depend on the exact shapes of the supply and
demand curve.

59

6.3.1

Constant Cost

The long-run supply curve (SS) in this case is a horizontal line at a constant level of unit
cost. A rise in demand from DD to DD will shift the new intersection point to E, raising Q
but not P. This is shown in figure 25.
Example: A factory that produces at a particular rate and then expands by duplicating
factories, machinery, and labor. The factory then produces on a doubled scale.

(Figure 25)

60

6.3.2

Backward-Bending Supply Curve

Figure 26 shows how the supply curve for labor might look like. At first the labor supplied
rises as higher wages coax out more labor. After point T the supply curve for labor
decreases in quantity of labor supplied as an increase in demand raises the price of labor
making the supply curve bend backwards.
Example: When wages for workers double, instead of working full time the workers work
less and enjoy more of free time. Also, in high-income countries real wages can be raised
by improved technology making the people use their higher earnings for more leisure or
even early retirement.

(Figure 26)

61

6.3.3

Shifts in Supply

Considering the law of downward sloping demand, increased supply must decrease price
and increase quantity demanded. An increased supply will decrease P most when the
demand in inelastic and increase Q least when demand is inelastic.

6.4

The Concept of Efficiency

The concept of allocative efficiency occurs when no possible reorganization of production


methods can make someone better off without making someone else worse off. In this
concept ones utility or satisfaction can be increased by decreasing someone elses utility
or satisfaction.
In terms of the PPF (Production Possibility Frontier) an economy is clearly inefficient it is
inside the PPF. But not only is efficiency about the right combination of goods, it is also
about these goods be allocated among consumers to maximize consumer satisfactions.

6.4.1

Efficiency of Competitive Equilibrium

One important result in economics is that the allocation of resources by perfectly


competitive markets is efficient. This assumes that all markets are perfectly competitive
without externalities or imperfect information.

62

6.5

Market Failures

Three market failures are listed below that spoil the idyllic picture of efficient markets.

6.5.1

Imperfect Competition

It is a market situation with a limited number of sellers (monopolistic competition). The


prize firms can charge is a decreasing function of the quantity it sells. It faces a
downward-sloping demand curve.
Example: A firm that has market power in a particular segment (e.g. patented product) can
raise the prize of its product above its marginal cost. Then the consumers buy less of such
a good than they would under competition. This reduces consumer satisfaction and this is
typical of the inefficiencies created by imperfect competition.

6.5.2

Externalities

Externalities are another very important market failure. Externalities occur when side
effects of production or consumption are not included in market prices. Externalities can
be categorized in external costs and external benefits. External costs are damages to
other people or the environment such as pollution, which do not have to be paid for by the
ones carrying out those activities.
External benefits are effects of an activity which are pleasant or profitable for other people
who cannot be charged for them.
Example: A company pollutes a river causing damage to the neighboring homes and
peoples health. If the company does not pay for the harmful impacts, pollution will be
inefficiently high and consumer welfare will suffer.

63

6.5.3

Imperfect Information

A theory assumes that buyers and sellers have complete information about the goods and
services they purchase and sell. We assume that firms and industries know all about the
production functions and that consumer know all about the quality and prices of goods on
the market. Unfortunately this kind of perfect information is not present. Informational
deficiencies such as imperfect information are economically significant.
Example: Consumers know all about the product and therefore the loss of efficiency in
some can be slight (too sweet or not too sweet candies) but also very damaging (safety of
pharmaceuticals).

64

7.1

Imperfect Competition

Patterns of Imperfect Competition

There various kinds of imperfect competition such as monopoly, oligopoly, and


monopolistic competition. In perfect competitive markets no firm is large enough to affect
the market price. There are few very large firms that can affect the market price by simply
changing the quantity they sell. They have some control over the price of their output.

7.2

Definition of Imperfect Competition

A firm is classified as an imperfect competitor if it can affect the market price of its
output.
Imperfect competition does not necessarily imply that a firm has absolute control over the
price of its product. The amount of discretion over the price will differ from industry to
industry. In some industries the degree of monopoly power is very small. For example, in
the computer retail business a small change in price will have a significant effect on the
companys sales. In contrast, in the market for computer systems, Microsoft, for example,
has a virtual monopoly and has a great discretion about the price of its Windows software.
Figure 27 shows the difference between the demand curve faced by perfectly competitive
firms and imperfectly competitive firms. In perfect competition the competitor faces a
horizontal demand curve. This means that the competitor can sell all he wants at the
going market price. In imperfect competition the competitor faces a downward-sloping
demand curve. This means that if the competitor increases his sales, he will depress the
market price of its output as he moves down the demand curve (dd).
The price elasticity can also be determined by the graphs. For the perfect competitor,
demand is perfectly elastic and for the imperfect competitor the demand is inelastic. Price
elasticity in figure 27 is around 2 at point B.

65

7.3

Varieties of Imperfect Competition

Imperfectly competitive markets can be classified in three different market structures.

7.3.1

Monopoly

A firm is a monopoly when it is the only firm selling the good and when it has no potential
rivals. Its goods have no close substitutes. The customer of a monopolistic firm cannot go
elsewhere.

7.3.2

Oligopoly

In an oligopoly, there are few sellers or firms. Each firm can affect the market price and
each firm has a sufficiently large share of the market to consider the individual reactions of
the others to changes in its price or output.

7.3.3

Monopolistic Competition

It is a market situation with a limited amount of sellers producing differentiated products.


Its structure resembles perfect competition in that there are many sellers; none of them
have a large share of the market. Each seller practices product differentiation, trying to
sell products different from its competitors. Due to this product differentiation, each seller
faces a downward-sloping demand curve.

66

7.4

Barriers to Entry

Barriers to Entry are factors that make it hard for new firms to enter the industry. It can
prevent effective competition. When barriers are high, an industry has only few firms and
limited pressure to compete. Economies of scale are one common type of barrier to entry.
High costs of entry, legal restriction, advertising, or product differentiation, control of
strategic resources are other forms of barriers to entry.

7.4.1

High Cost of Entry

This implies that the price of entry is very high. The high costs discourage potential
entrants into the market. This gives big firms advantages, who build up intangible forms of
investment, which are too high for competitors to match.

7.4.2

Legal Restrictions

Governments are capable of restricting competition in certain industries. They can do so


by legal restriction such as patents, foreign-trade tariffs, or entry restrictions. Without the
prospect of monopoly patent protection, a company might be unwilling to devote time and
investments in research or development. Common areas where governments impose
entry restrictions are electricity distribution, telephone, water supply etc. In theses cases,
the firms providing these services get an exclusive right from the government. They
therefore also have to agree to limit their profits and provide universal services in its
region. Import restrictions are also very common restrictions given by the government.
They have the effect of keeping out foreign competitors.

67

7.4.3

Product Differentiation and Advertising

Product differentiation and advertising are methods used by firms and companies to
create barriers to entry for competitors. It can create product awareness and loyalty to
certain brands. Product differentiation produces greater concentration and more imperfect
competition.

7.4.4

Control of Strategic Resources

The ownership of a strategic resource needed to produce a good prevents competitors


from entering the industry.

7.5

Marginal Revenue and Monopolies

A monopoly faces a downward-sloping demand curve: To sell more, it must lower its
price. The table below shows the effect of price on marginal revenue.
Demand Curve

Revenue
Total Revenue

Marginal Revenue

(P x Q)

($)

10

10

18

24

28

30

30

Price ($)

Quantity Demanded

10

At the first two columns the decrease of price as they sell more is shown. Marginal
revenue is the change in total revenue due to one more unit of output.

68

7.5.1

The Concept of Marginal Revenue

Marginal revenue = Price Loss. In the table above the fourth unit, for example, has a
price of 7 $. To sell the fourth the firm had to lower the price by 1 $, which means that it
lost 3 $ on the first three units of output. Therefore it generated 4 $ in earnings, which
equals the MR of the fourth unit.
The marginal revenue is lower than the price whenever the firm has to cut its price to sell
more. A firm will never produce when MR is negative. This will lower its total revenue and
its profits.
The total revenue is largest at the level of output at which MR = 0. Up to this point, each
unit added increases the total revenue. Total revenue is not total profit. A firm will produce
where total profit is highest but not where total revenue is highest.
When demand is elastic, more output increases total revenue (MR > 0). When demand is
inelastic the firm will not produce.
The marginal revenue curve is twice as steep as the demand curve when the demand
schedule is a downward-sloping straight line. The marginal revenue curve intersects the
horizontal axis at half the output the demand curve does.
In figure 27, the demand curve intersects the horizontal axis at Q = 10 and the marginal
revenue curve intersects the horizontal axis at Q = 5.

69

(Figure 27)

The total revenue curve shows the total revenue at each level of output. MR is the slope
of the total revenue curve; it is the rise in total revenue over the run of one more
additional unit.

7.6

7.6.1

Fallacies and Facts of Monopolies

Fallacies

7.6.1.1 Monopolies charge the highest price possible


The highest price comes from producing just one unit of output. A monopoly will profit by
selling more, as long as MR > MC, which requires it to lower its price.
monopolies always make a profit it can take on losses in the short run.

70

Because

7.6.1.2 Monopolies produce where they make the highest average profit per unit
A firm making the highest profit per unit is not making the highest profit. A firm should
always produce more when the additional output adds to profits, even if its adds less to
profits than the average profit and thus lowers average profits.

7.6.2

Facts

7.6.2.1 Monopolies do not necessarily produce at the lowest average cost


In the long run, with perfect competition, firms must produce at their lowest average cost.
They may produce where the average total cost is falling, is it at its minimum, or,
depending upon where MR = MC, is rising.

7.6.2.2 Monopolies do not have a supply curve


The monopoly is not the price taker. It sets its own price. A supply curve showing the
quantity a monopoly will produce at a given price is impossible to construct because the
same price on a different demand curve will elicit different quantities from a monopoly.

7.6.2.3 Price exceeds marginal costs


P > MR. Since MR = MC at the monopolists profit maximizing level of output, it follows
that P > MC.

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7.6.2.4 Monopolies produce only where demand is elastic


Only at a level of output where demand is elastic is MR > 0. Since MC > 0, it can only be
over this range that the profit maximizing condition can hold: MR = MC.

7.6.2.5 Monopolies produce less than competitive firms when costs are the same
Total output will be bigger when the industry is competitive than when it is monopolized by
one firm only (if an industry has the same costs regardless of whether it has many or just
one firm). If there is only one operating monopoly, it will see the industrys demand curve
as its own, such as MR < P. When there are many firms, each firms share of total output
will be so small that each firms marginal revenue will equal the price. Therefore
competitive firms will produce until the price equals the marginal costs.

7.7

Price Discrimination

Monopolies may be able to charge different prices for different units. This is called price
discrimination if the differences in price do not reflect cost differences. Consider:

MR = P Loss on Prior Units from Price Cuts


By charging different prices, the monopoly does not have to cut its price on its prior
output. As a result, the marginal revenue will be bigger.
Price discrimination results in: - More profits (because of the higher MR)
- More output (because of the higher MR)
Perfect price discrimination occurs when the monopoly gets the demand price for each
unit. It produces the same output that a competitive industry would with its costs.

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7.7.1

Two Main Methods of Price Discrimination

- Volume Discounts:
With volume discounts, customers pay less per unit when they buy more. If these
discounts do not reflect a cost saving to the seller, then they are a form of price
discrimination.
Example:
Examples of volume discounts are bonus points for each purchase such as frequent
travelers offered by airlines, or buy one, get one free offers.
- Segregated Markets:
The monopoly may be able to segregate (separate) markets and charge a different price
in each. This will increase profits if the different markets have different elasticities of
demand. Without separating the markets, the monopolists demand curve, at its optimal
output, has an elasticity that equals a particular average of the elasticities in each
separate market. The markets that have the more inelastic demands will make the
monopolies to raise prices in those markets and lower prices in the markets that have the
more elastic demands.
The basic rule of making the most profits from separate markets is to sell to each until the
last unit sold in each has the same marginal revenue and have MR = MC.
Example:
Example of ways businesses segregate markets include discounts on drugs and travel for
senior citizens, special subscription rates for students, or lower rental for apartments to
new tenants.

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Between Monopoly and Competition

In this chapter some of the in-between cases of monopoly and perfectly competitive
markets will be described.
There are two forces pulling at any market. One force is the pull of the monopoly profits
that could be earned if all firms colluded by agreeing to charge a high price. The other
force is the pull of the profits that one firm could make if it competed with other firms by
cutting its price to get more business. The force that leads the market to monopoly is the
force of collision and the force that leads the market to perfect competition is the force of
competition.

8.1

Perfectly Contestable Markets

The central feature of this type of market is that any firm can enter or exit without costs.
There are no start-up costs, or legal barriers. Output and prices will be at the competitive
level. Economic profit equals 0 and P = MC in the short run and P = MC = Minimum ATC
in the long run.
If any firm makes an economic profit, another entering firm can undercut its price and take
away its business. In order to prevent this, a firm can set its price as low as possible
(minimum price is the minimum of the firms long run ATC curve.

8.2

Monopolistic Competition

The characteristics of monopolistic competition are similar to the ones of perfect


competition. Both have many firms, easy to enter the market, and perfect information. In a
monopolistic competition the firms sell similar products but not identical products.
Each seller practices product differentiation. The consequence of this is that each seller
faces a downward-sloping demand curve.

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Each firm, that faces a downward-sloping demand curve, produces where MR = MC but
P > MC.
In the long run, we still have MR = MC and P = ATC but because of product differentiation
P > Minimum ATC. But since a firm does not produce at a minimum ATC, it has excess
capacity, which means that more could be produced at a lower cost.
Figure 28 shows the short run results before any new firm can enter the market. The firm
faces a downward-sloping demand curve. Like a monopoly it chooses to produces where
MR = MC but P > MC. In the example below the firm produces 100 units, MR = MC = 10 $
and the price is 15 $. The ATC equals 11 $. So, the economic profit is 400 $: P ATC =
profit per unit x 100 (15 $ - 11 $ = 4 $ x 100 = 400 $).
(Figure 28)

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In figure 29 the demand curve shifts to the left because of free entry, which makes new
firms enter, offering similar but not identical products. The demand curve shifts to the left
until the firm makes no economic profit. The long-run results are shown in figure 29. At
point F the demand curve touches the ATC curve. This tangency is what differentiates
monopolies from monopolistic competition.
(Figure 29)

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8.3

Oligopoly

As already said before, in an oligopoly there are many few firms. They face high barriers
to entry. There is mutual interdependence because selling-behavior from one affects the
others. In perfect competition it is different, where cutting the price can take away a large
part of another companys business. The actions of one have no effect on the others or on
the market price. The automobile industry is a very good example of an oligopoly.
In figure 30 shows an example of a firm in an oligopoly. The demand curve DD shows the
quantity demanded of one firm out of four different firms and is acting alike. If all firms
charge the same price, we assume that one firm receives a quarter of the quantity
demanded. If all firms charge 10 $, each will sell 100 units (total demand is 400 units). If
all firms charge 9 $, each firm will sell 117 units (total demand is 468 units). If the other
three firms charge 10 $, then the demand curve facing this one firm (dd) is acting alone.
However, if one firm charges 9 $ and the others still charge 10 $, it gets some of the other
firms customer, selling 150 units.
(Figure 30)

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If the firm does charge 9 $, it will sell 117 units if others also reduce their price to 9 $. If
the other firms do not, it will sell 150 units. So the results are indeterminate because of
mutual interdependence. This interdependence makes it difficult to predict how oligopolies
will act.
A firm in an oligopoly faces a kinked demand curve when other firms maintain their price
when it raises its price but other firms match its price cuts. Figure 30 shows a kinked
demand curve (FEG).

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Game Theory

Game theory analyzes the way how people interact when each persons actions
significantly affect the others. The theory of game is used to study the interactions of
oligopolies, countries trade policies, environmental agreements etc. Game theory is used
in analyzing industrial organization and economic policy.

9.1

Basic Concept of Game Theory

The duopoly price game is a way to illustrate the basic concept of game theory. It is a
situation where the market is supplied by two firms, who are competing by undercutting
each-others prices. The firms profit in a duopology depends on the strategy of the rival
firm.
To represent the interaction between two rivalry sides a payoff table can be used (as
shown in the table below). It shows the strategies and the payoffs of a game between two
sides. In the table below the payoffs in the duopoly price game of company A and
company B is shown. In the payoff table the firm can choose between the strategies listed
in its rows and columns. Company A can choose between its two columns and company
B can choose between its two rows. In this example each company can decide whether to
charge its normal price or start a price war by choosing a lower price.
Company A

Company B

Normal Price *
Normal Price *
Price War

A+

Price War

10 $

10 $
C

- 100 $

- 10 $
- 10 $

100 $

D
- 50 $

* Dominant Strategy
+ Dominant Equilibrium

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- 50 $

The entries in the cells show the profit for the two companies. In block C, company A
chooses the normal price while company B chooses price war resulting in a blue profit for
company B (- 100 $) and a black profit for company A (- 10 $). Trying to find the best
strategy for each company leads to the dominant equilibrium in block A.

9.1.1

Alternative Strategies

Alternative strategies are important for a firm to have in order to outwit your opponent.
This new element in game theory is to think what the opponents goals and actions could
be and make decisions accordingly.
Dominant Strategy:
The dominant strategy is the strategy where one side has a single best strategy no matter
what strategy his opponent follows. Changing the normal price is a dominant strategy.
When both sides have a dominant strategy, the outcome is a dominant equilibrium.
Nash Equilibrium:
It is an equilibrium in which no side can improve his payoff given the other sides strategy.
Each sides strategy is the best response to the other sides strategy.

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9.1.2

The Prisoners Dilemma

It is one of the most famous of all games in game theory. It illustrates a unique solution
because both sides have the same dominant strategy.
The table below illustrates the prisoners dilemma. Person A and person B are partners in
crime. If both do not confess their crime they will be sent to jail for one year. If one alone
confesses, the person will get 6 months only, while the partner will serve 8 years. If both
confess, they will be sentenced for 4 years.
Person A

Person B

Confess
Confess
No Confess

A*

No Confess
4 years

4 years
C

8 years

6 months
6 months

8 years

1 year

1 year

* Nash Equilibrium
The significant result here is that when both prisoners act selfishly by confessing, they
both end up with long prison sentences. Only when both act collusively will they end up
with short prison breaks. So, no matter what one does, when faced with these terms, it is
always better for each person to confess and act selfishly. Only through cooperation can
they avoid long prison terms.

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AS 053

Economics 2
Theoretical Test

82

AS 053 ECONOMICS 2
TEST

1. What is the definition of Elasticity?


2. When the price elasticity is smaller than 1, what is the elasticity of demand?
3. When the price elasticity of a good is 2.0, what does it mean?
4. Why does one usually buy more of a good when its price falls?
5. Does demand change when the price changes?
6. What causes price to exceed marginal revenue for a monopoly?
7. Can monopolies make losses?
8. What force pushes an industry toward monopoly?
9. Why does a monopolistic competitor face a downward-sloping demand curve?
10. What does the Nash Equilibrium describe?

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AS 053 ECONOMICS 2
TEST
(Solution)

1. It is the ratio between proportional change in one variable and the proportional change
in another.
2. The demand is inelastic.
3. It means that the quantity demanded will increase 2 percent for every 1 percent
decrease in price.
4. Because of the income and substitution effect.
5. No. The quantity demanded changes when the price changes.
6. Because the demand curve facing a monopoly is downward-sloping, to sell another unit
of output, a monopoly has to reduce P for all its output. MR = P Loss due to price cut
on prior output. So MR < P.
7. Yes. In the short run.
8. The promise of monopoly profits.
9. Product differentiation results in its customers differing in their loyalty to its product. A
higher price drives away those less loyal and a lower price attracts new customers.
10. It says that no side can improve his payoff given the other sides strategy.

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KEY TO EVALUATION

PER CENT

MARK

88 100

75 87

62 74

50 61

0 49

85