Microeconomics

M croeconom.ss concernedwith the indivdlal padsofth€ economy.lt s concernedwith

the demandandsupplyof parilculaf
goods,servicesandresourc€s.
lt{ocuses in otherwods
on ndviduamarkets.

. A nrarketcanbe defnedasa process or an instiiutionn . Thepartcipanhin a marketeconomyare

whichprodlcersandconsumers nteractin orderto sell produ€ers.
Theinteractonof consumers
and
andbuya goodor a sevice.A mafk€teconomys one / ir^1s'rr -d lF- detFrnine rl.p n dr' oTpri' p o :{rr
wheremarketforces d oneprovid€answers to thethree orodu...ah" 1qp.i ndrL" t.ordi tors l ^ r< r-, J: r '
flrndamentalquestionsandin whichprvaieproperty marketprce changeswh ch set off a ch;ln of a,sE
rightsarewe I definedandenforced.
ln a puremarket aadno l o n oreor Fr. of -h" good bp 1q proiL@
€conomy theres no qovernmentinterventon beyond thusto a changein the a locationof scarceresc---a
seltingandenforcnq propertyrights. An. y5sof how marketsfunction
requresexan
the behavourof consumers
andproduc€rs.

Thebehaviour
of consumers

Ih€ conceptofdemand is a wayof summarizing the Figure2.i Thedemandcurue(and<onsumer

suel6)
beha our o'b ryA\ Spp itnally. e dpr 1p d"n ano d. r'r"
r€latonshipbetw€envariouspossble pricesof a good and
the corresponding quanttesthatconsumers arewilljng
andabeto purchase p€ri meperod,c€ters padbus (i.e.
aliotherfactorsaff€cting demandremaining constant).
Ths reationship is nverse (negative),
meanng tharif the
prceperunt ofthe productdecreases consumers wil be
w ingandableto buymorepefpe od (ceteris padbus).
Tl'ei_/€rs"e dlorshipbFrw"erp-i,"drd qu"1i'
d,"manded is referredto asihe law of demand.Th€law
of demandassears thai if the prce perunitof a good
rsesthenquantry demanded perperodof timewillfal,

A dernand c!fr'enowshowsth s inveEerelalionsh p

the priceperunltof a qoodandthe quantity
bet\rveen
ofthe gooddemanded pert meperiodPriceperunit
ls rneasured
on theverticalaxls;quantitydemanded per
t meperiodi5measured on the horizontal
axis.
Forexampe in Fg 2.l,iftheprceperuntisPthen
oe od. .prp.i<par bLs A der drd d bF -:?
consumers wj bewillingdndab€ to buyQ unts per "L-ve
period,whercas an ndividuacongurner orforthe whole marke: -rE
if prcedecreasedto P'perunitlhen
marketdernand
c!tueisdiagrammatcalyden'e:
consumeBwi bew ingandabeto buyQ'unitsper
horzontalsummaton of theindivdualdemand

Thesubstitutionefiect:if the prceof qoodX rs€s,al . The income€fiect:if the prc€p€runt ol goo. r
othergoodsauromdilcalt become relattyely
cheaper; consumers'rea/ncome(thepurchas ng powerc=;
peoplew ltend to substtuteothergoodsforX.The
thLrs, drops;thus,
peopewil tendto buy €ss.Th€tize
sizeofthe substitution
efiectdepends pr marilyonthe ncomeeffectdepends p mary on the proporc.rd
numbefandcloseness substtutegoods.
of available rncome spenlon the good
 a
l
Goalof
I

t i5assumedthatthe typicalconslimertr es to maxmlze thuschoose thatbundleof goodswhichmaxlmizesher

htJorher utility, defin€das the s.tisfacton dedved s.tisfactonandwhichshecanafford,givenherincom€.nd
from consumng a qood or a bunde of goods Shew I the prices
shefacesn lhe market.

to payto €njoyunts Q/andwhatsh€w llend Lrppayrng

for themin the marketand s knownasthe€onsumer
Notethata demandcurvecanaso b-aread'vertcay' surplus.
Unt Q in Fig.2.1isworthto consumeu Pastheywould
bewl ingto payaithemostPto lrlryt, not a cenrmor-": __::,N
if the prcewasevens/rghtth qher(sayat the levelofthe Tips
..
reddotted ne)thentheywoud not havebeenwill ng to
buyrfiar/asfurla0. Unit Q' isworthto consumers P as Demand curves canbe lin€aror curvedr theymayor
thatisihe mosatheywoird bewii nq to paytoacquref theymaynottouchthe axes;just makesurethatthey
Toconslrme greaterandqrcateramountsperperod, arenegativey soped(unessyouwantto illustrate some
the nrarketpricernundecrease a5consumption o sp€calcase)fyou wishto illustrat-" the notionolthe
rnoreandmoreunitsperperod swoalhessandessto consumer surplus it s easerto havethe dernand curve
consum€rs. Thisrefectsthe lawof d m nishinqmarginal touchthe axes. Not€ thal the abov€ d scLrssonrele6to
ut:lily.1"-F . t dt .l'Fc..r" .L tla.lor de r,pdf ._ the demandfor a producl:the demandfor a factorol
theconsumption of qreateramounlsperperodtypcalv production ('dervedd€mand';say, for laboursewices
byfrrms)i5sirnlarbut not dentical. Also,be careful
u 16 . r l- a ' . r e v €r L j o \ or . e . llF r \ h o w h paLh aboutthe meanngof the1€rm'quantty demand-"d'
- (0Q'HF) arewil ng and
extfa un t ls worth to consLrme6 then the area It refe6to theamountthatcons!mbrs
howmucha//unitsQ areworthto
in Fig 2.1 measures ableto purchase at a I venprceovera glv€ntime
theconsumer, .e.howmuchshewouldbew lingai period.ll doesnot referto whdi peop€wou d srnrply
rhernostto payto enloya//thes€unlts.I th€ marKet wantto consume. Notethat'willngness'refects
prlces P'thenshewill bewi ng andableto consume preferences whereas 'ability'refectsthe ncorn€
al unts up until!nitQ'forwhichtheywou (P')
d spend constr.nt peoplelace
r1e Q'-dea'0O Pr Are. PrE 5f.o"'e'lce
betlveen whattheconsumer wouldat the mostbew ling

changes in consumers' incom€ changesin the priceof other goods

As ncome rses,demand for mostgoods w llr seand Twocasesaredistinqulshedl
the demand curve w shiftto the qht. Such goods a Caseo{ compl€ments: del nedasgoodsthal are
areca ed norrnalgoods.Thereare€xceptlonsto thls consumed iogeih€r('lontiyconsur.ed'),
suchas
generarue, howeverAs peope q€t richel,theyspend peanutbuiterandielly,shoesandshoepollsh,.offee
esson inferiorgoods,suchas ow_quaty foodor andsLrgar,etc.Whenthe prceof a complement of
ow-qualtyclothing, andswtchto betteFqualty goods goodX ris€s,demandfor Xwil drop(shifileft,e g
Thedemandfor inferorgoodsdecreases when incomes fthe priceof coffeeisesthend€mandfor sugarwll
increas€andthusthe demandcuruefor nleior goods
w ll 1if .o I e le . 't'le pe caoil"l"el ot _co-eir ar b Caseo{ subrtitutes:definedasqoodsn compentrve
economy r sesthrough iime,thepatern ot deman.lw I .or'ullptor. a.. offp""10 "". WnpllrrFori.e
-Lcf
change. Thishasimportantmpications for production, of a subsituleof qoodX rises,demandfor X wll rse
'w | 1iFri91.e o it offeeoe.onA' 1lr e e oo'ri.p
Changesin the distributiono{ incom€ thendemandfor te. wi incr€ase).
lf the incomedistrbutionb€cor.esessskewedandmore Sizeofthe market,i.e.numb€roJ consumers
equal,demandfor certainLuxuries maydrop.ndfor Asthe slzeof a market(thenumberoi consume6)
ce ainbasicgoodsandservcesmayrse.Thusa pollcv increases,demandfor mostproducts williendto rse
of redistrlbutnq ncomethrolrghtaxesandtransTe6 may Agedistribution ofthe population
alt€rthe patterns
of demand. A changen theaged stributon wouldaffectthepaltefi
changesin preJerences {tastes) of demandTheclasscexample refersto dn ageng
Themoredeslrab e peoplef nd a good,the morethevwill popuaton (wheretheaverag€ ageis rsing)where
o.n d-d Tasle\ r'p d{ecteoq b ldsFo. demandfor fd seleethwill riseandfor chewinggumw L
"dvprtsrro.
byobserv ng otherconsumers, ol
byconsiderations
 . Expectations (of changes in ma*et pricesor in income) there s a chang€n pdce:w ethen5aytheres a changen
.v Forexampe,f peopleth nkthaith€ priceo{ a good s
goinglo rse nthefuture, theyare likelytobuymore
of it now b€forepricesgo up,shlring is demandcurue
to tlrerght.
Tips
o) _
shiftsofd€mand N e.e s" v rhaLde-" ' l d 5h ., Jp or do,M a_ r-credses
versus movements alongr denandcurve
the chanceof getting confusedand makinga m stake.
')Et. Ths s the source
of a typca m stake.A shft in th. Aways usethe expression d€rnandsh fts right (when it
llrrYt demandc!rveoccurswhena d€temnantotherthanthe increases)and shiftsleft (when t d€creases) Also nore
prc€chanqes:we thensaythaia changendemandhas thatthe new dernandcufr'edoesnot haveto be paralle
.:i occurredA movement alongthe demandc!rveoccLrrswhen

Bengverystronglynferiorqoods,the ncorneeffectruns
prceto eadtoanincreas€
higher n quantity
demanded ln the oppost€direction
of the substitution
effecland
p€rperiod.c ffenqoodsandVeblengoodsaretwo dornnalest, €adingto the perveGe resultdesc.b€d.A I
exceptons
wherea rse in the prc€ eadsto moreof the G ffengoodsareinf€riorgoodsbLrlnot a infero.goods
goodbeingconsumed perperiod. areGiffengoods.
Giffenqoodsw€refirslmention€d in 1895byAlfred
Figurc2.2Positively
slopeddemand
curves:Giffen
and Ma6ha/ln hisPrnc4ries.Th€oriqna exarnple was
brcad,wh ch n SirRobertciffenstime(191hcentury)
wasconsumed bytheverypoor n Londof.Thetypca
t€xtbookexample hassincebeenpotatoes, consumed
by verypoor dshfarmersdurinqthe 1845famlneBoth
F , o " r p e . h a \ a b o a . r 6 Jr r o d b i . r a , . , , o I h . 5 . o . . d"..
Recentres€arch panedatahasshownthat
usnq d€tailed
n Chna,wh€re30%of the popuationnil surviveson
essthana dolara dayperperson,
noodlesin the nofth
ar dILe -lL ".o I F i bI sL.h crffenbehd. oL

goods
Vebl€n
. Veblengoodsarethe otherexceptonto the aw of
demandThese aregoodsviewedasstatussymbos. They
arevaluedbecalsether h 9h prce s beyondthe reachol
other ndviduas
. BeugaGviarandFranck MLrlerwatches se ng for
$750,000 maybegoodexampes. ncreasngtheprce
q/ p€riod
ior thesegoodsmaynot decreasequantitydemanded.
Veb€ngoodseho!d obvousynotbeconfused wth
Giffengoods
Giffengoodshavethe fo ow ng lhreechdrdcterstcs:
. they areverystronglyinferof goods;
. they are conslmed by the verypoori
. expenditlrreon theseqoodsmun representa very j re-.ruer r" i e orsood.L l- -aldrFdl.o i
signficanl proportionof tota consumerexpendtures i G ff€n goods)havetyp ca , negatvelysloped,demand i
Th€rol€of expedations morein thefut!re.Ths is knownasthe 'bandwagon'
effect,wth buye6l!mp ng on the bandwagon'. Nota
Afuftherexceptlonto the lawof demandisthe casewhen econornistsagreeaboutth s lt is perhapsprcferabeto treat
the quanttydemanded of a productrlsesasthe prce expectationsof a futureprce ncrease asa oi a
shiftfactor
o- expectations
'|.es.o"LdL5e l'alr'r"orcewil'i,ee.€r iypcaldownwdrd sopeingdemandc!rve(seepage10)

of producers
Theb_ehaviour
supply':',:.,i.:,3,
. supplyisa wayto anay4cally slmmarzethe behaviour Fisure2.3 Thesupplycurve(andproducersurplut
andth€ goa s of firms.
varouspossble
p b€t\,veen
t is definedasihe relationsh
prcesandlhe corresponding quantit€sthaifirmsare
w llingto offerpertimeperod,ceters parbus.
Thesupplyftrrveisa qraphshowingthe reatonshp
betweenthe prceperunt of a goodandthe quantty
thata fnm (offlrms)lswillingto ofi€rperpedodol t me
lypically,suppys upwardsop ng,meaning that Llthe
priceperunitof a prodlctlncreases thena f m w ll b€
willinqlo offera grcaterquantiyperperiodof time,

n Fq.2.3,lfthepriceisPth€nproducers w lbe willlng

to offefQ unts perperiod,whereas if the prce ncreased
ro p,r-ar p,oouLersr . bp ,^/lli g ro o"F' O' Llits per

. Thequestons why?A s mp sticansw€rs thatat hrgher

pfices,a f rrn! profilmatgn is greatef,
ihusit w ll b€
,^ nq roofle'no'e of rl'Fgooooe'pet:od. Also."ir.e
it becomes moreandmoredlffcl]tfor a firmto produce
moreper periodus,ingexlstmgcapacl4/,it will be wl ing
to do soonly f pricepef unitrises.

;;;;;;;dlG
. \ote t-rat-h"'Lpp) rrveir l ra.).3 ca^dto be ead
a firmwouldbewil ng to offerunitQ on y if
'vertically':
.fe p1 .e ir '1- r "lle. s dr laa ! b. D$t n4m innum P t l .
the firn wauldbe wiling ta accept.
. Evenif the prcewassrghtt ower(atthe rcddottedllne
leve)the f rm woud not b€willng to offerunitQ. Why?
Becaus€ twou d not covefthe extracon of producing
that!nit. Th€vertca distance thusrefectshowmuch
eachextraunitcoststhefirmto produce.
. Thusarea(oQ'TJ) measures how mLrch a//unl15Q'cost
the f rm to produce.t reprcsentsthe minm!m amountit
requrcs n orderto offefa lth€seQ' lnils lf th€ market
prlces P'p€runtthen thefirmwill bewi ingto offera I
unitsup untl!nit Q'forwhich theywouldearn(P')times
(Q')= area(OQ'TP').
Area(lTP')r€presents the differencebetween whalthe
f rm earnswhenprodLrcing andse ng Q' unitsandthe
minimurn anoirntof mon€yit reqLrresto bewill nq to
offertheseunits.Thiss the'producer surpLul.

11
 Changesin inpul prices
' . I or F . a. ] p e .w .o e s
o | d w ma te fl . p ,p \o F..ease Theexpectaton thata prlc€wil be higherin thefuture
then a fim at eachprcewill be w linq to ofier morepe, rnaycEuse suppyof the prodlctto decrease now
p€rlodas producton is now lessconly.The supptycurve Other{actors
wlls hif t t o t h e ri g h t Weather conditonsforobviousreasons affectthesuppy
Changesin technology ol iaffnproducts;
a t€rrodsr
actor a war mayaffecrth€
mprcvementsin technologyower the costsof
producton sincethey permir essto be spenton inputs.
Supplywii thus ncrease andshifrto the rghr.
Changein productivity Tips
Productivltyof a factorisdefinedasoutputperunitof
nput.lf, ior example, labourbecomes rnoreexperenced, Suppycurvesmaybe nfaightlinesof curvesj theymay
bett€rtrainedor healther then abourproductivty or maynot startlrornthevertical(of horzonta)axs
w
increase, meanng thatoutputpefworkerwit be greater lun makesuretheyare(inthe qeneratcase) upward
It lolowsthatsupplyw increase andshiftro rherighr. slopng.Toil ustratethe prcducer surpus t iseasi€r ro
Changesin governmentpolicy haveyoursupplycrrvestairfronrtheverricataxis. The
Covernmenl subsdies (perunt of outputpayments ro , .opy o'. d(.o.ot oroou(-io,] rry o ,dooJr se^ .e.
1rm, will owerproduction costs,whileirnposingindirect by 'workers')issimilarbut not deiticalio thesuppry ol
taxeswllifcreaseproduclion costs.Thesupplydecisons a good.Alsoan increas€ of a decrease n supptyshoutcl
thus n bothcases affected. alwaysbe referrcdto asa shiftto the righror to tlre err,
. Siz€ofthe market respecrively.
Using'!p'or'down' may eadto confusion
Themarketsupplywil beaffecledfthe fumberoffirms as,tor exampe, a shft downon rhediagramrcftects an
in the marketchanges. As,for exampe,morefirmsare incrcasein suppy.t isa shftto therght.
lurcdintoa m.rketth€ mark€t suppyw tttendto rjse

Equilibrium

Theprceatwhicha goodw lbesotdn a compettive lf at somepriceexcess demandexsts{if quantity

rnarketwii bedetermined bythe inreracUon beiween demanded perperodexceeds quantitysupptied)then th€
consumers andproducers, in oiherwordsbythe pricewilltendto rise.
nteraction
of demandandsupply. It fo owsthattherewill be no tendency for the price
'ar .o."r"
orcee,( e . . iupo, e. r. it qLdrry.Lpp eo to changefthere s neither€xc€ss suppynorexcess
perperod exceeds quantitydemanded)then the pricewi demandin the mafket.Thisr€quires thatquanttty
demanded perperodat thatpriceisequaltoquantity
suppliedThs prices theequilibriumprice(ormark€t
cl€aringprice)andthe corresponding quantryisthe
equilibrium quantiry.
;;;;;"a;61;t:
Referrnqto Fig.2.4,coud Pl bethe'€quilbriunr'prce?Figlre 2.4 The determination of equilibrium price ln a
At Pl consLrmers arew llingto buyQdl unitsperp€rod
whilefumsar€wil ngtoofferQslunjtsp€rperoo.
Quantity supped perpe'od s greater thanquantity
demand€d Theres excess supply{asurplus) eqlalto
Qs1 Qd1= HFLrnits perperiodwh ch wil createpressure
for the prceto fal. Sincethe excess supplycreates a
tendency for the mark€tpric€to fall t fo low5thatP1 js
notan'eqlrlibrium' price
Coud P2 be the '€qu libriumprce?At P2consLrmers
drew llinqto buyQd2unitsperperodwh e f rmsare
willnq to offerQsZunitsperperod.Quantity demanded
pqpe! odsq e d .a .h " n q L " n t, i p o l i F dl l er. i
€xc€ssdemand(a shoirdqe)€quato Qd2 Qs2 - lv Lrnits
per peiod wh ch wi createpressure forthe priceto
rise.Sincethe €xressdemdndcreatesa i€ndencyfol the
n ar . 6r pr i o ro .-,o ,t-.ro p fo o \. .n .- " / i . .ro a
' equillbr i L rm ' p rc € . 0 Qd1 Os2 a Qd2 Qs1
Q uanlt yde m a n d e p d e rp € ro d i s e q u a l toq uanti l y Q/ pedod
supp ed on y at prire P At Pth€re i5 no excessdemand
or exc€sssuppy so th€ market'c ears'.PriceP is thusthe :;J:rlliiiliiii,iii..-1.1,
l;;
j e strortaqe
1ora surput s not an areabut the i
i hofizontal
d stancebetvveenthe quantitydemanded
and i
i rheoranrt. --oo ecrdt o.neorc.. i

Thequestion
of resource
allocation
The allocatioh:

A problemdnysocielyfaces is howmuchlo prodlce rigure2.5 Theallocationof<arce resour<es

G)
of eachqood, and thLrshow many resources should
06dlro!.reo n-1oproo,r, io o "r.1. oil . ldre
the problem, th nk of a society endow€d wth 1wo
resources, abourandland,wsh ng to produc€ two
goods,sayapplesandorangesTheproblemt iacesrs
how manyapplesto produce andhow manyoranqes
and,consequently, how muchandandhow muchabour
to allocatein the prodrctonof app€sandhownruch
to oranqes. Sinceresources arescar.e,producing more
appiesimp €sthatfeweroranges canb€ prcduced
Fglrre2.5;n.orporates a lthe nec€ssary iniormalon
to determnethe answerThed€mandcurvedrawn
howmucheachextraunt of dppess valued
reflects
byconslrmers andmoregeneray by socety.Thesupply
cLrrvereflects how mucheachextraunitot appescosts
to produc€ (ast showsthe minimumprcerequired for
the unitto beofiercd) thIn s s mpe s€tup t shoud be
cl€arthatproducnq an extraunt ot applesrequresmore
resourcesd ocatedin appleproduction, sothe.on ol
eachextraunitof appesproduced arethe oranges thai
needto besacriliced.

13
rh;;i;;;;;;;;;;
. Shouldunt Q] be produced frcmsociety's po nt ol view? asit consto produce it. In Fig 2.5thiswoLrldbe unitQ
Theanswerwillbeyes,if t s valuedmorethanwhat t Stopping shoftofthat unt (produc nq a t ny bit essthan
consto prodlceit. Thedemandcurvelor appleslniorrils !nit Q)wouldbegthequeston whynotproduce.llny
usthatunt Q] svalu€dbysocetyat P1do lars(oryuan),
asthatis how muchcofsumels wou d arthe mosfbe . Thestdri nSr€sultof compei/flv€ rnarkets isthrt ever
wr rngrc pay. thoLrqheachconsumer and€achproducer js lookjnqafter
Ihe suppycurv€for app€snformsusthatit costs hisown self nterest(consurn€G aimingat maxmizng
C1dollars (oryuan)to produce unt Q1asthati5the ut ty andprodLrce6 a mingdt maxm zingprofit)th€
ninimum supplieswouldbe willing to acceptta offer rnarketoutcomes precisely the bestpossbe from
fhaft]rli. SnceunitQi s valuedmor€thanwhal ft cons, socetyS pont of vew;thisdeawasfrst expressed bythe
the answers ihal it shouldbe prodlced. famolseconomist AdamSmithln a compettvem.*et,
Thus,moreunis of appes(n general, moreot anyqood prcewi indeed gravtate to Pdo aG(oryuan)per unt
'x )shouldbeproduc€d as ongasthevaluaton of the and outputw I be exactyQ lnits perperod,5oal unts
extraunit(whatpeope woud be atth€ monw llnq 10 worthmorethanwhattheycostto prodlceare nde-ad
pay)exceeds ihe €xtracostof producinqit.
ll fo owsthatth€very astunitof appessocetywolrd
wantto be prodrcedisthatunitwh ch i5vauedasmlch

The power ofl

Assume nowthatpreferences in th s society

chang€and Figure2.6 TheaLlocation (b)
ofscarceresources
rhat,for ex.mpl€,morcappesarc n d€mandWhyand
howwi moreapp€sbeproduced andihusadditona
scarceregources.ttractedandempoyedln appe
prodLrction?Whatmechanisms w lcomeintopldyto
glaranteethatthesechang€d preferencesot socetywi
b€satisfed7
Focusing on Fg.2 6,letth€priceof appes nitallybePl
p€runi andthe outputof the app€lndlstryQ1 !nits
p€rperod.A grearerdemandfor applescanbeshown
asa shft ofth€ demandfor applesto the rlghtto D2 Of
n the marketsee5theshft but nowthere
wil be€xcess demandfor applesequaltoHFunitsper
p e o d. a. d F L D . no lo1gFr FqL ib L1 p . i . "
"' r
Thereis pressure forthe priceto rse.
Theriseln the priceof applesisvisibe and t lnitlates
chanqes n thebehavour of bothfrmsandconsumeE.
Changing reativeprices thushave'siqnaingpowel.
Someconsumers wil drcpout of the marketorw Q/ pe r iod
cut downon the r purchases. Ontheotherside,higher
prcesmeanincr€dsed proftsfor exstngfrmsandan The prce r.echansril thus eadsto a chang€ n resourc€
oppoftuniiy for otherfirmsto €nterthe rnarketand alocaiionas rsing r€lativepricesand prof ts provde
partaken theseproflts,Asa resullquantitysupp€d the slqnalandthe inceniiveforfirms to producemore.
perp€rodrisesbut t shoud be reazedthatfor th s Eventuay, the extensionof supply(from H to J)and the
to happenmoreresolrces w haveto shft nto appe contracionof demand(from (Fto J)wi stop when th-b
new equilibfiumpriceP2p€r un i is r€achedand ndustry
output s h gherat Q2 un ts p€r perod.
Elasticity
In qeneral,elasticity i5def ned asth€ responeier€isol someeconomicvarab€, when
anothereconomc vari.blechang€s.

Definit'on:TheresDonsiveness to a
of ouantitvdernanded Priceelasti(ityof demandvariesalonga typicaldemand(urve
Notethatevena onga inearnegatively sloped,demand
:ymbol: PED curvePEDcontinuouslyvaries,takingon a lvaluestrorn
Measure:The percenlaqe changen quantiyd€manded
divdedbyth€ percentage changen price: . Referrins to FiS.27, at themidpolnt M ofth€demand
PtD-ooAOd/ooAD -usP D- Ao/OIrAP,D.= curveABthai corresponds to pric€Pm(located attlre
(AQ/P).(P1lQ1) midpont of segment 0A),PED = 1.
P D s rl^Jq-heratioo{ ihe chargeso h^o.d dbes . Wthn neseSmentAlvlcorr€spon din9 to priceshiglrer
(priceand qu.ntty demand€d)that moven opposte thdnPmwithinthesegm€nt APm,demands priceeastc
d.F.ror": if rhFp i e ot l.pqoodgop.Jp. ler Lhe (PED >1).
quantitydemanded goesdownandviceversa,mpying . Withn nesegment MBcorrespond ng 10pricesow€r
that fthe denominator h.sa plussgn(th€price .l-"nDr v\ h.r le .egm" pTB.defrrd s ori.p
jncreased)then thenumeratorw lhavea negatvesiqn Lne astic (0<PED <1)
. Lastly, at pointA prceelasticty of demandtendsto
Chequanttydemanded will haved€creased).
Asa r€sultPEDisalwaysa ,egaalve number.Noteth.t inf n tywh € dt pointB prlceeasticlyof der.andiszero.
oftentheminus signisignored.But in anycaLculaton
rigure2.7 PEDalonga negatively
dopedlineardemand
curue
questonsneverforget to usethe m,inuss/qnevenif t is

of priceelasticity
Rang€s of demand
. Denrands elastic(forsma changes aroundthe init al
prce)ifthe perc€ntage changein quanttydemanded
is argerthanthe percentage changen pric€(PED >1).
Atern.tiveywe cansaythatf a changen priceleadsto
a prapaftianately Eearetchangen quanttydernand€d
thendem.ndfortheprodlctspr.eelanc
. Dernand is inelastic(forsma changes aroundth€ nital
price)ifthe percentage ch.ngein quantiiydemanded s
smalerthanlhe percentage chanqein pric€(0<PED<1)
Altematlv€ly we cansayihai if a changein prce eadsto
a propaftianately sma€r chang€ln quantitydem.nded
ihendemandforthe productis pric€inelastc.
. D-1d d . unit elasti( f .l_"p"rce ..9echa1o"i_
quanttydemanded is€quato the percentage changein
prce(PED
. DFr
"ro ,
= r).
pefectlyelasti(if d,ad Lctra-qe rr o ' F l ;'o; '. ii',,
leadsto an nfnitelyargechangein quanltydemanded A or11o- aa,6 q ro.ors oF" r-e prrceeasr cr wo
(PED the prceof :
-+ -) Thismeans that f, for example, d€mandfor' ar lineardemand cuwethatisat a 45 degree
i
a productfls€sevensrqhrt, nothnq wi be boughtby i dnq€ to bothaxesasconstant and€quato 1.Thisi5not
consum€rs. A demandcuryeof nfinte plce elastictysa th;case.Priceeancityfor sucha clemand curvea/so
Ine paralle io th€quantityaxs. i
i vareslrcm inl n iy to zerc.Theslopeof sucha cufr'-"is 1
. D€mdrd i, perfectly inelasti('.3-a lchalqen or (€
i bui slopeieror€lasticry. Stdctyspeakinqtis nconect
eadsto no changenthequanttydemanded(PED=0) to characierze anylinear demand aspric€eastcfit
Pric€changes haveno effecton theamoLrnt purchased i
i s fat, andaspriceinelastic f it issteepB!1,5ncefor
perperod.A demand curve of 2€roprce€lasticty sa two lntersecting I neardernand thef alterone s
curves,
i
ineparalelto thepriceaxis. i indeedmoreprceelastic then, fot pri.echanges
snatl
,
Notethatthe minuss gn s gnor€d. i arcundthe inErsectianpr,ae, t is acceptedto clam that
i a fatterdemandcurv€s reatively prceelastic
wher€.sa
I reativelyne€poneis r€lative y priceinelastic.

15
Dema

. The caseo{ a perfectlyinelasticdemand€urve: Figure2,10 Unitaryetasticdemand.utue

PED=0
Thedemandcurve(Fiq2.8)isthusvertical at some
quartityAnychangen pricew ll leadto no changen
quantitydemanded.

Figure
2.a P€rfectly
price-inelastic
demandcurv€
equa tototare&endirures

a/Period

A lareasbeowthecurvereprcsent fnm revenuesandare

equaIn size n otherwordsin a untary€lasUcdemancl
clrrvea changein prcedoesnotchangetota firmrevenues.

Q / period Relationship betwe€n PEDandtotalrevenues

. Whatwill happenio flrmy revenues (andhence!u
Oltenusedto describe the caseof hlghyaddtctivegoods consLrm€r expenditur€s)if thereisa changein price?The
suchasdrugsorto descr betheindivdualdemano ror answerdepends on rheprceelasticiyof demandTota
pharrnaceLrtcalproducisforwhich nosubstitutesexist. rev€nLr€s(TR)whch a firmcollects arerheproductoTthe
. The(aseof a perfectlyelasticdemandcurvei prceperunt andthe qLrantiq? sod (TR= PQ).t is nor
PED'J thesameasprofts wh ch arethe d tferefcebetween the
-
Thedemand (Fg.29)ishorizontalar
curve some totalrev€nues co lectedandthetota costsincurred.
prce.ft s usedto describ€the demandihara perfectly Threecases canbe distnqrish€d:
competitve f rrnfdces.Sucha f rrnisso'tiny'lnsze
. Caseli Pricechanges whenPED>l (demandrs
compared to thema*etthattcanse anyamount at the
gorngmarketprce.lt s asif t isfacinga perf€crly price elasti<)
elastic
demandat the marketprice A changein prceleadsto a changen the opposife
dre, io'r. o ,"--rr\oF^
"noao.W.er oe-onoi p.i.e
Figure y priceelastic
2.9 Perfect demand curue elanic,qlanlitydemanded .hanges propottionatetymorc
thanprce.Thusthechangen quantity hasa bqgef
effecton revenu€s thandoesth€ chanqein prc€.th!s, tf
derandiset..i . rorale'pprdir .ro--a-ge\i lF .j-p
dlrectonasquantrydemanded. t.fp rsesthene falk
proportionatelymorefhusTRw ll fal/ Burif Pfa s, then
Q rres propoftionat€ly moreandthusTRwill,se.
Case2: Pricechangeswhen 0< pED<1 (demandis
prjceinelastic)
h lh s case,price sespfoportlonaret morethan
qlantrty.Thus,the chanqein prcehasa bigger€fiecr
on totalrevenue thandoesthe changein quantity. Tota
rcvenues changein thesamed recton asprice.f Pr/Jes
thenQ fa s propononateyless,rhusTRr6es.But J p
lal/s,Q risespropononateyless,thusTRfal/s.
Case3: Pri(e(hanges whenPED= I (demand it
unitaryelasti()
Inth s cdse,prceandquantitychangen exactty the
sameproportof.Thedemandcurv€isa'rcctangutar
Thecareof a unitaryelasticdemandcurve:pED= 1 hyp€rbola' A changein pricewill haveno effecton
lhe d€mand curve (Fg.2.10) n thiscaseisasymptolicto lotalrevenues. Ona qraphof bra/ reyerueJ aqainne,
bothaxes,.e t nevertouches eitherThedemandcurue the functionwil bea nra ght lin€parale to the
s a rectanguar hyperbola.
PEDandth€shapeof theTRcurve . (Hl ont) Defnemargna revenue asthe extrarevenue
t lo owsiromtheabovethatthereisa closereationship lromselingonemoreunitof output.I\rtR isthusthe
betweenpriceelastjciq/ of demandandthe shapeofth€ change in TRbecause of a change nQsoit sthesope
totalevenuescurvea firmfaces. oltheTRcurveAt Qmwh€reTRis maxmum tfo ows
that MRiszero lfdemafd s a negatvelystoped nethen
Focusing on Fig.2.lla whichillustratesthe typ;cat, NIRhasdolblethesope.lnFq 2.11atiw thuj 90
linear,negativelyslopeddemand<urve:
throughoutputQm.
At zeroquantty(attheorgin)roralrcvenues arezercand Fo(usingon Fig.2.11bwhich illustratesa un;tary
at zeroprice(pointH)totalTevenues elastic
arca sozero.
4sp':cedecre"se,4h nl of wdllr'gdo*n .l.ep:ce . Thepercentage increase n qu.ntty demand€d sequal
axis)ftompointFto Pm,quanUty d€manded increases to th€ percent.gedecreas€ in price.Asa resuttota
lrom0 to Qrn.Sncedenrand for that pricerangeis prce revenues (constant).
remainunchanged In the bottom
elastic the resultng ncrease in quanrrydemanded is draqram TRisthusdrawnasa straighttineparatteto the
proportonatey greatersotota revenu€s rise. quanityaxisillustraUngthai rotalrevenues do not chanqe
Now skipto the rndpointprcePrn.tf prlcecontinu€s
to decrease pastPmallthewaydownro zero,qudntiy
demanded increasesfrcmQrnto H. Slncedemands Focusing on Fig.2.11cwhichillustrates the caseof a
now pricernelastic, perfectlyelasticdemandcurve:
th€ resultingincrcase n quantity
demanded s proportionalelysmallef,sototalrevefues . Herethefim issotinythatt cansellalltwanh.t the
prceP',say,for example, f3.00 pefunii.ttfottowsthat
Sincewe established that revenues rse attrheway the totalrevenuecurveisa rlsingstEight neslanng
r o t e Tidoo-.Or drdrher.rightdf,arOr.-l^ej fromthe orign asthe revenues fromoneunt sotdwi be
decrease, it necessanyfollowsthatai Qmtheyareat a f3.00,the revenues fromtwo unirssoldwi be f6.00,
ra\ TL1. ThLs.gl . belowtLe Tidpo1t o+rhe inedr the €venues lrornthreeunitssod will be f9.00 erc.
demand curvewherePEDisequalto 1, tota revenles ar€

Figurc2.tl Priceelasticityof demandandthe shapeofthe total

l4 (b)

P E D= 1

equa to tota expenditures

17
;;i;;;;;'
Thenumbe'dnd(loseness ot available subnitutes ' Th€ time period involved
Themoresubnitutes therearefor a qood,andthecloser Wlrenprceof a prodlctrsesit takessom€t mefof
theseare,the moreeasiypeopewillswtchto these peopeto findalternatves andadjustth€n consumprion
.e'ni-i\Fs
{he'l r' e or' e o--_. oood'se<.L_eor€..€l patterns.lt lolows that the longerth€ t me periodafter
"
th€refor,.wr bethe price€lastictyof demand. (Aso a pflcechang€, the morepriceeastcdemandis likely
th nk of how brcadlyor narrowytheqoodis defined
e.g Pepsivssoftdr nks ihe broader the definitlon,
the The natureof the good,:.e.whetheror not it is
fewerthe subnitut€s availableto theconsLrmer andthLrs
the moreprcejnelastlc demandisexpected to befor Demand for addct v€ prcduclsi5relatveypriceinetanrc
smallprcechanges ) (cqarettes, alcohoetc).Ths hasprofoundmpicarions
The propo(;on of incomespenton the good on the decsionof governments to imposea taxon such
Theh ghertheproportonof ncomespenton a 9ooo,
the moreconsum€rs w lbe fofcedio lowercons!mption
when B priceris€s(theb qgerwillbethe incomeeffect)
andthe moreelanicw bethe demandf we spend
a smalproporton of ourincome on a good(f it s
'nsgnfcant)thena changen price willnotaffectour ; Studentoftenconfuse thefactorsaffecting the demandi
i lor p odLL\^il -_. raclols a' e, i g r' ori p i
so€di,o bll d!ror'.de- p..e n"d.- " "
".rd \i op i p" | , ,
"r, ^ ""--^^ '^ , ^,^^ i

Usesof pficd el

. t permitsa f rnrto predictthe d recton of chanqeof its (Hront) lt hepsa firmd€termnewhatpropodon of an

totalrevenues givena pricechang€. Forexanrple
a f rm nd recttaxcanbe pass€d on to the consumer
wishinglo increase 1srevenues w lowerthe pricef t permitsa gov€rnment to estmatethesizeol th€
dernand isthouqhtto b€ priceeastcanditwil ncrease necessary taxrequiredto decrease consumption ol a
the pricelf itsdemands priceinelastic. 'demerit'good, suchascgarettes or alcoholtc
beverages
. lt allowscomparlsof of quantirychange\withnanetary fHLontl t peffnitsthe government to determnethe
(le.price)changes ncdeiceof an nd recitax.
. (Ht ort) lt permitsa firmto,"mpoyprlc€d scrm nalion. t hepsd governmenl predicirheeflectof currency
Th€h gh€rprcewillbecharged n themarketwth the devaudtionon thetrade balanceofth€ country
reldtivelyneastcdemand.

Incomeetastici!,i,j

Definition Theresponsiveness
of demandwhenconsumer canthusdistnguishbetweennormalandinferorgoods
basedon wh€therYEDis positv€or negative
Symbol:YED . f YED>0:thegoodisa normalgoodsince demand
percentag€ (d€creases)
ncreases asconsum€r ncomeincreases
Measure:The changein qlrantiydemanded
d videdbythe percentage changen ncome: . lt YED<0 thegoodisan inferiorgood s ncedemand
vtD = o;AOooo^\.tLusvtD = Ao/O,/A"n
j.- decreases (rncrease, a! consurner
ncomeincrcas€s
(AQ/ YFry,/Q,) (d€creaset.
. Sincencorne eastcity
of demand stheratoofthe Focusing nowon normalgoods:
perc€niag€ changesin demandandincomeeves t . YED>1:thisirnplesihat %AQd> o/oAY therefore
we say
folowsthat f bothcharg€sar€postive(plussign)or
(m
f botharenegatve nussiqn)thenYEDisa posltve fa. den drd r),r, o ne F d.- acarseInrnrome €oos
numbert onechange (plussgn)andtheother to a tasterrse (aproporrlbratetgreaterncr-6ase)in
ispositiv€
(minlssgn)then
s negative demand.Luxurygoods(aswe asrnostservices) usuatty
YEDisa n€gaiivenumber
Forexdmp€f an incr€ase ar€considercd ncomeeastc,lor exarirple demandfor
n ifcome €adsto a decrease
planicsurg-ary or for spaiherapyor for hautecouiure
!n quantitydemanded thenYEDs a negatvenumb€rWe
lxome e

. -< YED<1:this mpiesthato/o^Qd < %AYtherefore we low evelsof lncomeandup to someincomeeve Y]

is ncomeneasticasa risein ncome
:.y rhatdernand the EngelcurveisABil ustrating thatthe qoodis norma
:dd5to a slowerrise(apropo,'tlonaiely
smaer ncrease) dsde-li'rds r yrg w, I .EDpos. /e ._d rhe'pi. "
"
- demand. goods(everyday
Baslc goodsi'stapie'qoods) verticalintercepigreaterthan one) 16 nconres fse more
.r. usuay ncomeinelastic(e.9.d€mandforfood asa fromleveY1allthewayto someieveY2the quantity
1. . : d . , 1 r . ^ n , k n . ^m o i.!l:< ii.l demafdedp€rperodstayscofstantsoYEDiszero'and,
f lncomes ris€furtherpastY2 perperiodthendemand
: YFD= 0 then demandfof the good ls not affectedby a for th s goodstartsto shrinksignlfying
thatthe good
' behav€s asan nfedorproductandthatYEDs n€gative
c.d ngeI n nc om e
i YED= 1 then ihe perceniagechange n ncomeis equal
-o the percenlagechange n quantitydemanded. nps
hgel curves Rememb€r thatelastcityandsopearenotthesam€
:.aphsthatshowhowquantitydemanded vareswlh lhe th ng so€ven{ threeEngelcutues areparalletheir
€ve of consum€r ncomeareknownasEngelcurves. Lncom€ elastcitlesd fferas n Fig.2.12a.A so,Engecurvesne€d
5.rsuallyonthevertcalaxs.
notb€lnear n thiscaseludging whetherat somepont
theyare ncorneeastcor in€lastic becom€sa bit more
. ln Fig.2.12athree Engelcurveraredepicted.A three
representnormagoodsasa threear€postiveys oped
ustraUngthatasincome€vesrse,quanttydemanded Someindunresare considercd'cyclical' andsome
perperod alsoris€s.But, ncomeelasuciues d ffe( 'acyclical'as
a resultofthelrincomeelasticrly of
Engecurve1 wh ch hasa verticaini€rcept at po nt F d€mandasov,arall economic actvityfluctuates n
s incorne
eanicthroughout itslength(withoutYED theshortrun(ths f uctuatonof economjc activty s
beingconnanD; Eng€lcurve2 whichgoesthroughthe knownasthe 'trade'or 'busness'cyc€), salesin th€
orign0hasanncome €lasticryof d€mand equalto constructon, the carandthefurntureindusiries are
onethroughout itslengthiastly,Engecurve3 wh ch s gnficaniy.ffect€dwhereas salesin thefoodindustry
hasa horizontalnterceptat pointH s ncomeinelanic arcnot affectedasmuch.TheJormerindustries are
'cycica'whereds the latteris'acyclical'.
lhrolghoutits ength(withoutYEDb€inqconstdnt).
. 'lo ) )h.heprobdbee"el.ori,ngtr.on€e/eh
on the demandfor a products shown:starting fror.

Fl9ure2,'12 In.ora eldrLkiLyof deTd-d: t-gel (utue(

(b)
. Thedegreeof 'nec€ssity' of the good maysubntute basmdtirce andmLrltgra
n br€ad for
lr a d€veloped counlrythe d€rnand for llxurygoodsand ow'qualtyrce or wh te slicedbrcadAsthe r in(omes
servicesexpands rapdlyaspeople3 incomes rseturther, '. e J u - . l e . o t i l e , o e n o u . F o - l o o o n d y e v e i r L r e a A
whereas the dernand for bascgoods,suchasbreadand but t takesa decin ngproporrlolr oftheirincome.
most{oodproducts in gen€ral,rsesdow y. Engel'slaw . The livingstandafdsofthe economy
statesthatasincomes increas€,a declining propo,'tlbt Wheiher marketdemand for a goodis ncomeeasicor
s spenton foodbecause of ihe'fixedcapacty'oithe incom€neastc is notwith n ts 'naiure,but isa function
hLrrnanstomach. Demand forfood s therefore of the livnq standardsof the marketpa(cipanh.The
nel.stic.Furth€rmore,certainbasc foodstLrffs 'icorre
may samegoodmaybehave asan nfedorgoodw rh negative
beh.veas nferiorgoods,meaning thattheir ncome YEDin a hiqhlydeveloped counrryandasa highly
eancitesarcfeqative.Thus,asincomes peope
increase, ncome-eastc one n a leastdev€loped country

. Frmswo! d keto knowwhetherd€mandfor rher . A government mayalsobe interened in knowng income

product s hghy ncome €lastrc
or ratherincomeneastc
to hep thembetterplantheirinvestments. tf an economy
rsgrowingand ncomes are noeasingfastthenf rms
producng h qh y income-elastic
products mdyhavero
nvestnowrnexpandng theircapacityto be ableio meet
'he rrLea.aoderc o..o,lvFrcp!, . -e " 9ro\^'r9..d).
potatoes mayth nk of swtchingro kiwifrut lthisexpains
whyin Ethiopiacoffe€grow€6areswtchng to chat,a
^arcoLi rorroaqo oJr .- \^f ch h. e d l. qf'a . ,o.re
e astcityof demand.
elastictyof dernandn v.rioussectoKin ordertopan
aheadtra ningfor displacedworkers: the€conornc
sgnficanceandviabiltyof incomeinelastic sectorsw
ghrinkn th€ ongrunsosomeworkersin thesesec@rs
may osetheirjobsandw needr€trainng.Inth s sense,
a growingeconomy maysufJer ffomincreas€d(structura)
un€mployrnent andmov€awayfromful €mptoym€ft.
Aho,assecroEproducing h gh y income-etastic
products
(e.9.servcet willgrowf.st,enrployment needsw ta so
growTastsogovernm€nrs shoud pldnaheadchanges
n schoolcurri.!a andvocatonalschook.Empoyment
botiefeckswillthusbe avoid€d.

Crossprir

De{inition:Theresponsveness of demandfof onegood(x) moreexpensv€ andthuspeoplebuy i less,theyw lt a so

to a chanqein the priceof anothergood(y). buylessofth€ othefone
SymbolXPEor CPE l XPE= 0, thenthe two goodsx andy areunrelated.
Measure: Thepercentage It io owsthatthefurth€rawayfromzeroXpEs, the
changen thequanttydemand-ad
ot qood. d videdbv ,h- o".ilr-aoe c d 96 In ha pr, F oi srronoe/ oe.we6rI p oood<.
lLo redlor"'r.o Co-\e-e,/.
goo0y: the coser(absolutey)to zeroXPEis,rheweakerthe
relationship betweenthetwo goods.
XPE= %AQ"/%APY Figure 2.13allustratesthe caseof substirutes
in which
lje'" .l e sor de-"rTtre- \o!1 wa i--o.oretcro$ p i,e crosspnceelastciiyof demands postive.tf the prce
e ancityof demandfor a product: of coffeencreases fromP] to P2thenwe expectrh.t
. if XPE>0,thenthetwo goodsx andy aresubstitutes the qlantty demanded perperodof teaw increase
meaning thattheyarein comperitve demand:Tone ircm Q] to Q2assomew I switchawayfromthe now
becomes moreexpensve thenconsumerw llswitchto To'e e o- li\e .os-F to -eao n\ rg. \o-o rl-a-r'ris
is not a demandcurveason theon€axiswehavelne
. lf XPE<0,thenthetwo goodsx andy arecompern€nts prce perunitof onegoodandon the othertheqLrantty
meanng thattheyarejointlydemandedf onebecomes denranded perperiodof another
Cross
. Figure2.13billustrates
the caseof compemenls in which Alternatvely crosspriceeastcity.anbe ustrated through
'oscpri.p"d, Liryo der cnd s _eoat/e.L_lle or:c. thesetof d agraras below:
fromP1to P2thenwe expectthat
of cotreeincrcas€s . In Fi9.2.14 the prlceof cofieeisshownon the eil to r se
thequanttyof sugardemanded perperlodwil decrease fromP] to P2perun1,leadng consumeB to switchto
fromQ1to Q2assomew ll quitor decrcas€ coffee tea,a substtute.Demand for teaisshownto shft to th€
cofsumplonleadingto esssugardemanded perperiod r ght fromD to D'.
A gair. iL c \ ro . d Fr dnd . L v e as or I l p o e d\ is t p
"
havethe prceperunt of onegoodandon th€ otherthe Figure
2.14Case
ofsubstitutes
quantitydemanded perperiodof another.
. ll instead
of a posiuvelyor negatvey soped newe had
the cas€of tlvo totally
a verticalne it wou d lustrate
unreatedproducts whereXPEiszero.fthe priceof
cheesecake riseswe expectthedemandfor iPhones lo
remainunaffecred
(cPE<0)
Figlre2.13 S!bstitutes(cPE>0)and complements

!
g

Q2 Q1

Q2 !
I

Q2

Q2 o1
 Cross

Figure2,15 Caseof complement!

I
E
I

a2 Q1
perperiod
ofCoflee
Quantity Qu6ntity perp€ od
ol Sugar

n Fg.2 15theprlceof coffee isshownonth€ efrro rse Usesof closspriceelasticityofdemand

tromPl to P2peruf t, eadingconsunreB to cui down
on sugar, a complement. Demand for sugars shownro
shit io rhe eft fromD] to D2
. Crosspriceeastcity o{ demandis usedby poticymakers
to d€lrneatema*e1s t helpsto know the s ze of cross
pfice
-aastcitesro decde whethermuf{ ns and egqs
' ho- o oe Lo i oorpooeo' gi .g t-e.an" ma." ra s
K el l oggS
cerea.
. Firmscan usecrcssprce elastictyto guidethe r p, qrg

Price

Definition:The responsveness
of quaniiB,supptedwhen Figure2.l6 Pri.e-elasticsupplycurue
the prceof the goodchanges.
PES
Measure:The percent.gechangein qlantitysupp€d
d videdbythe perc€ntagechangein prce:
PES = %AQ5/%AP, = (Aas/a1y(Ap/p1)
thLrsPES
= (^Qs/ P)*(P,/Qr)
Thesignof PESs postives ncesuppycurves typicdrynavea
postiveslope(firmsofiermoreperpe od.r a higherprice).

Ranges
of priceelasticity
ofsupply PEs> 1 ar all poinrs(b!i not.onttano
. Suppyispficeelastic Linearthroushthe vertkal(prjce)aris
(fofsm.lchangesaroufdrhe
nital pric€)fthe percentage
changen quanritysupplied
s larqerthan thepercentag€chanqein prce(pES >1)
(Fig.2 16).Alternrtively
w€ cansaythatf a changen
prceleadsto a propo,.T/onatetqreat€rchangein qlantty
supped thensupplyfor the prodlct s priceeastc
Priceela
Infi ni tel y(perfedl y)el atti csuppl v.urue
thatcutthe Paxsareprceelastrc: Fi gure2.19
Al inearsupplyfunctons
. Supplys priceinelastic(forsmaLl changes aroundthe
iniiialprlc€)ifthe percentagechangeln quantitysuppLied
issmaler ihanth€percentage chang€nprice(0<PES<l)
'I g /l,.Alterdrvey^"'dn-dv-l'd rra'no,lgFi'
pdceleadsto a proportonatetsmaller changeln quantity
supplled thensupply{or the product
is prce ineastic

curve
Figure2.17 Pricelnelasti.suPply

Inllnitely(Perfectly)
ElatticSuppLy

in prce
. Supplyis perfectlyinelasticif a smallchange
leadsto no changein the quantitysuppied(PES = 0)
(Fig.2.20).ftce changeshaveno effecton the amount
offeredperperiodAsuppycufr'eof zeropric-"elasticty
horizonial(quantity)axs isa verricalinepara€lto the pice axrs

Fi9ure2.20 prke-inelasti(5upplycurve
Pedectly
Q/Pe r iod

All linearslrpplyfunctonsthatcutthe Q axsarepnce

inelanic:
. Supplyis unit elasticf the percentagechangeln quantity
slrpplled s equaltothe percentagecnang€n pn'e
(PEs = 1)(Fg 2.18).
curve
2,18Unitaryelatticsupply
Figure

.=
Tips
: ::.
Llrearthrolghthe or glr Rememberthat (price) (of supply)and
elasticiq? slopeare
]rorth€samething.Whatmatterc iswhethet slrpply
ihe
curvecutstheverticalaxis, the odglnorthe horlzontal
axis.lf askedto draw the (short-run)supplycurue1or
Q/Pe i od
a larm prodrct(e.g wheat or coffee),draw i ase
vertcal ne(PES = 0)asproduction of suchptoducts
A li-"". -.pp ,1 .n(.rorsl'rorgo .l' ouontheorgir are
!nitary€lastic: s charactefizedby org umelags.f askedto descrbe
mafketconditions for a hotelor say,a tenniscoud,draw
. Supplyis perfectlyelasti(if a smallchange in prce
quantty suppled the supplycuruevertic.astherels limited,f any,ability
leadsto an nfinitelyarg€change in
rm iswl Ling to change'quantity'off€red 6eats,rooms,etc.)per
(PES -) -) (Fiq.
2.19).Thrsmeans that the f
periodfo lowinga chang€ln demandcondtions
lo offeras much asthe market demands at the current
p,-.Asuo olv L1eot nf i, lilep. e€los i' I \ \ oli _ D
parale to the quantiq/
axs.
 Thetime period . Extento{ €xc€ss capa(ity.Thefurrherbelowfurl
In€conomcs,t meisdistinguished intothe momentary capacitya frm isop€ratinq the greateftheplce eastcity
(ormarketperiod), the shonrLrnandthe longrun.The ofsuppyisexpecred to be.
distnctioni5basedon the extenttowhichadjustments . Whetherthef rm €mploys mostlyskilledor unskilled
canbe made.Inthe mornentary (ormarker) perodno labour.Expanding output n a productionprocessthat
adjustments arepossb e n the shortrunsom€,bui predominanty re eson highlysk ledlabolrmaybe more
notall,adlLrstments arepossibenthe ongruna difficutthan f monly!nskilledwork€r wererequred.
adjustments arepossble. . Whetherlong or sho( time lagscharacterze the
Concerning morethetheoryof producUon theabove productonprocess. The ongerthetime aqsinvoved,
dei n_tt
ofs be.omemorespecific. Themomentary (or thelongert iakesforsuppyto adjustto newdemand
markei)period iswhena factoEof productonar€ condtions Aqrcuturalprodlrcls arecharacterzed by ong
consderedfxed,thefirmlsoperating in the short timelagssosupplyisoftenconsidered perf€crlyneastc
runwhensome, butnoia, factors of producton are
consdered fxed whilein the longrunai factorsof . Thespeedby which costsrke asoutputexpande. Firms
production areconsdered variable(nofixedfactorsexist). w ll b. e.r'oLraoeo
.o e.o"10or-o-. bvrore p-. pe.iod
tfollowsthatin the mom€ntary run,supplys perf€ciy thelowerth€ addtional(margna)costof doingso
ineiasUc (vertcal).lf demandfor the productincreases
quantitysupped rcrnains unchanged. The ncreased lmportan(€
of pric€elasticity
of sopply
der.andw be expressed onlyasa h gherprice.Supply . Piceeastcityof suppydetermtnes
is notat allresponsve In theshortrun,rhe ncreasecr theextenrto which
anincrease
n d€mand wllaffecttheprceand/ofqlanrty
demandwl be partialy expressed asan ncrease in
quanttysupplied oftheqoodin a market.
Themoreprce-ineanic suppty
andpartiay asan ncrease in prrce
r , . l l _ o 9 p d t p . l r r e 'l . p d s F i r p r c e g v e , l d , l , pd,e n
wh e n the ongr!n, whenallfactorsarevarabe (and
demand; the more€lastic
suppyis,the qreaterihe mpact
thusthet rm canevenincrease itsscaleof operations (15
ol an ncrease
in demdndon quanrty.
sze),outputcoud expandevenmoreThrsinthe onq
run,slrppyistypca y expected 10be moreprceelastic
thanin theshortruf.

Pricecontrols
Prcecontrosref€rto cases wherefor somereasonthe governmentconsdersth€
market-determined (eqLrilibrium)
priceunsatisJacrory
andasa resultntervenes
andsets
the priceertherbeow or aboveit.

Maximum

. An authorty,usuay thegovernmenr, setsa maxrnum Figure2.21 Maxlmumpdce(p ceceiling)

pricela so referrcd
to asa prcece ng)if it conscters
themarkeldetermined prceas toohlgh ltthusams
to protectthebuyers of the product. As suchit s seton
'senstive'prodLrcts
that mony ower nconrehous€hotds
buy A maximlmprce s a prlc€serbeowthe mark€t
prceas t makesno sense to setit above.
n Fg.2.21atth€pricePmaxfirmsw I bewilllngto offer
Q1 Lrnts p€rperodurhereds consumers w llbe wii ng
andabe io purchase Q2irnitspefperiod.A shortage thus
resLilts
equalgeometrically to Q1Q2unts perperocl
(orHF).
5 ncea shortage exstssomeconsumeBwillend up not
6 .ovi-o lr p good ov6r ho-91- hF/ drp bo-h *illirq a-d
abe io pdythe pfice.lhis mednsthat the priceme.hansm
; - o pedo _i r ' o ro n r_ g L -c i o 1 , ;.F . d i . -o o o..l e
the good to who€veriswillingand abe to payfor lt.
Therelorean a ternativeratoning mechanisrn is requrcd.
 Allocaton on a'{ rstcome, fi6t served'basis.
Thiss lkely Policiesto
reduce ther€sultingshortages
lo ledd-o oueJei'ire. of oaope)de.eoprg d. ppopo
. Tominm zetheseprobemsgoverriments mayattempt
wll rushto buybeforcsuppiesareexhausted)orf ms
adoptingwaitng ists. io reduc€the shortagesbyencouraging suppy (.e.
se'"'s p e e e,r(e,1a! oecroe attempringto shiftsupplyto the riqht), for example by
v\ho9e.,.,regoo..
The product dfawing on nocks, by directgovemment producton or
maythusbeallocated on the basisof who
the cLrstomer by grantingiubs/diesortax re ief 10f rrns Alternarlveiy,
is.k hea reguar?ls heattractve?k she
':r oo-d_rI -ferrdrLer\rotonqer th€ymayattemptto r€duce demandbyencourag ng the
-lp€',ordl'd mdjo productionof more and cheapersLrbsttutes.
advantage)but becomes'persona', sod sclmlnatonmay

Theproductcouldbe a ocatedon a randombass(for nps

example, by ballot).
Coupons couldb€ usedto faton the qood.This Rernembef, thatev€nthoughseemingly countenruitve,
a ternativehasbeenusedn t rne!of wa. a maximum pricemustbedrawnbeowth€equlibrum
A majorprobemwith maximum pdcesisthe likely leve.Toavoidconfusion asio wh€thera maxmumprc€
ern€rgence of b ack(paralle) mark€ts
wherecustorler5, shoLld be dfawnaboveor belowthe market-d€term ned
unable io bry enouqh in egalmarkets, maywellbe prc-Athinkof thealternaUve term'priceceiling':the
prepared to paya muchhigherprce.In Fiq.2.21ther€ qova'lrre - b nld-d'ce'lirs o otove'rr.hep ce 'on
areconsumers w lingto payPbto acquireunt Qb The risng towardsthe equ ibriumlevel.Also,theshortage
willngness to p.y,measured bytheverticaldistancefrom cr€ated rsnotan areabutthedistance between the
the horzontaaxsto the demandcurve,ls greaterthan ouo'rlrLydendrdeoard rreqLdnr-y rrpphed d. .re ,e
ihe maxmumprice,for allavaableunts up to lnit Ql. price.L neardemandandsupplycurves arepreferable
Inthe longrunadditonalcosts mayemergeTheqLralty to use Lasiy, lent controls'are
analys€d n thesame
or certarnproductsmaywors€n asproducersmaybe waywtrr rentp€runt on th€v€rtcal,apartment units
-.moredo .4(t^Faper rp_._.aso. .o.hFrror_prrp_ perperiodon the horizontal, the shoar,run
supplyof
control€dproducts canbeproduced usingthesame apartment unitsdmwnperfecty nelastic ard the
nputsthensupplym.y shrinkfurth€r,makng shortages ong runsupplyof apartments moreprice€lastlc.

Minimumpi
.riiiit

An authority, Lrsuallythe qovernment, setsa minirnum Fiqure2.22 Minimumprke (prke floor)

price(referred to alsoasa pdcefloo, (rg.2.22) fii
consideB the market-determ nedpdceas'too ow'.A
minmumprices setabovethe market-determrned prce
and t armsat protecting producerc (mostoftenf.rnrers).
In orderfor a pdcefloorto beeffective it mlst beset
abovethe equlibriumprice.
Settinga m nimLim priceisako knownaspricesupport.
h Fig.2.22at the prcePmn flms arew lingto offer
Q2uniisperperiodwhereas buyers arew lingandabe
to buyonlyQ1 unts perperod.Assumng competitve
markets, a su|pusrcsLrlts eqlal to Q1Q2unis p€rperod
(orHF).
Thegovernment s forcedto buythissurplus. il it doesnt
Lhe Ie'ndr."rorcew d b"owr'"pqLlib.iLTpce
assellerswillwantto r d themseves ofthe extraunhs
not boughtat PminlThissurplus mustbe boughtat tlre
 '::-.;
Minimum

Theqovernmentthusspends area(Q1Q2HF) whichsthe

prcet paysPmn trr.esthequanttyt muslbuy,QlQ2 Tips
Consumers(blyert areworseoff asthey€nloyessoTthe
p o o-cl a r I q her oer J r " p D odl q\ d e b p - o Thercsulting is nol an areabut a d stance(a ne
surplLrs
'.
"
areh gherGovernment €xpendrtur€s segrnent)at the setprice.Drawthesupplycutuerather
off dsthelrrcvenu€s
steep sothat the resLr
ting surpus s not 'unreastjcally
rise(orqovernment spendng n otherarcashasto
lf spendnq r6€sthentaxpayers eventually beaf large Preferaby Lrse near demandandsupplycurves
decrease).
Remember, thrt even though 5eemingly counterlntu1ive,
the blrrdenof thispo icy,asth€ypayforit in thefom ot _11'1pri.o !o rilbiLa
ro ,-. . l pnt p o o, e. p- ooLr e s . ' o d t F d . a Trr 111 . oeo a^1ooo'e LLre
1 C.6a ,od
res!ting n resource
^n
misallocaton. ToomuchIand,for lev€l:theqovernment buildsa 'f oor' sothatthe prce
doesnot dropbeowthe desired level.Thesame
example, w lbe a locatedin the productonof th s f:rm
.na y,tical
framework can be employ€d to dessbe
theeffectsof mlnimum wagelegisationr thevertica
measLre in thiscaseisthe nroneywage rate(W)per
worker;the horizontal depctsthe numberof workers(t)
_r
.1d -l'p 'p . rpo.edep'esp.\ -ne_oor-F'rl

lndirecttaxationandsubsidies
Actions

Governments a soaffectresource allocatonby mponng Subridiesarepayments bythegovernment to nrms,

nd recttaxesandby granlng subsldies whichainrat
typicaly on a p€runI of outputbasis,
. Indire.t(orexcise)taxes caneitherbe imposed on a per loweringproductoncostsandthusthemarketprce,
(knownas'speclflc' for exdmple,€0 80 per wh € raisn9outpLlandconsumpton aswelasfirm
unt basis taxes;
or asa percentaqe
packof c garettes) oTtheprce(known revenues. subsidesaregrantedto s!pportcertan groupt
of producers (farmeB)orto enco!rage the producton
as'advaorem'lax;for example a 19%valueaddedtax).
conslrmptron oi andtheconsLrmption of ceftan goodsthdt createpostL\€
ndir€cttaxesareimposed to discoumge
yon externalites (malaria
vacc net. Theyare a so a formoi
de"n"rigoods a^dro - oelera ooodsildL{redle
protecUon sma5theycon{€rto dom€ncprcducers of a
negativeext€rnates.Theyarealsomposed to rase
.c\e ,lro, o 'le gov . r - Fr \ oLe r d d' r t J . olo e, producta competilve edg€thatleadsto lewerLmports
goods"andservicesto discourdge or evento expoG D agrammatically, s ncea sLrbsidy
mpos€d on imported
caLy,s ncean ndirecttax decreases productoncons t increas€ssuppy,shiftng
thel consumption. Diagramrnat
prodlrcton
increases coststdecreas€s supply,shftingthe thesupplycurueto the rlght.Th€vertca distance
supplyc!rvetothe Left.Theverticadstancebetlveen the between thetwo supplycurvesisih,"perunitsubsidy
(se€Fq.2.2s,page28).
istheperLrnt tax(seeFg 2 23,beow)
i\rvosupplyclrrves

i Indirecttaxation

In Fig.2.23a marketis llunrarcdwth a demandc!rve Figure2.23 Effectsof€ specificindiredtax

D anda suppycutue 5.Demand andsupply condltons
deteminean in tia equilbfiLrmat polntEw th ma*et
prceeqlaltoPoperunt andaneq! librium quantlty
of
QoLrnits perperiod
Theunttax maybeconsidered asanadditonalcosr of
producton. lt'sa5lfproductoncosts rcseby the amount
of thetaxsothe sLrppy curv€shiftsverucalyLrpward
bv
the amountof thetaxABto stax.Thevertca distanceAB
in Fig 2.23isthls equaltothe perunt tdx (Notethatin
cornpetitivemarkets the supplycuruebth€ marginalcosl
curue.50an nd recttaxeffectvey in.reases the marginaL
costof prodLrcingeachunit,shftifg the MCcurueup at
eachLev€l of output.)
r&ft d. indirecttax Thegov€rnm€nt taxrevenues
collects equaltotheshaded
- area(PpHFPm). Thisareaisfoundby mutiplyinqthetax
=. : :l :he marketpficer s€slromPoto Pmp€runt
- r perunt (FH)bythe nunrbelof unts sold(PpH)(whichis
- -liE.:i fromQoto Qmper
.'i!m quantitydecreases equa!to Qrn)
Frc :-ip!t andconsumpion of thegoodthusshrink. Resources arernsa ocated(unlessthe
good s a demert
- +:,:rr-:arn onlyPp(= HQm)perunt astheyhaveto qoodor a goodwh ch creates negativ€
externalltetas
3ai -ir Ther newaverag€ revenue isthlrslessthan t".- 1r... €,o-d /opinatarour.o tpgoodi(now
:rE -: -al, pre-taxprceandaverage revenue Po prodlcedandconsumed.
-:
W€lfarelosss eqlalto arcaFHE.

. -ar n.dencerefe6to who payswhatproportion of a tax. will haveto tendto nfinitysothe denomlnalor mun tend
. F g.2.23 rev€a s that the rnarketprice d d not to zero. tfollowsthatthe ncden.eon produc€Gw be
--€..inq
-c--:e byth€fullamountofthe nd r€cttar imposed. 0% andsoit w lbe 100%for cofsumers Notethat f
-_--tze of thetaxi5FH(thevedcaldistance between ihe PES = PEDthenconsumeE andproduce|sshar€equaly
:---.x.nd the post-tax supplycurve, wh e marketprce (s0% each)a tax.
1-.ied onlyby Fl
. : 3wsthatthe incid€nc€ ofthistaxison bolh . Equlbr umqlantitywi de.reaseess,th€ esseiastic are
:..i!mers
- and producet9. consurners andprodLrcers demandandsupply. lor the
lt fo owsthattaxrcvenLr€
i:? ihe tax.Taxincidence on consumers is FJ(= PoPrn) government w! be greater
.1-€ieastax lncid€nceon produceBslH (=PoPp).
N/larketprc€wi risemoreandhencethe consumerc'
. ;, :rcidence dependsof the priceelasticiq/ofdemand
share ofthetaxw belarger, the esseastcs demand
:.1l.e prce elastictyof supply.The fo owng holds:
andthemorceasicissuppy.
q of t ax in( ; d e n c eo n (o n s u me rs N/larketpic€ wil riselessandhencethe producers' share
^ --,^ -..
\ ot ta'( Incrdenceon ploou(ers will b€ arger,th€ morcelastlcisdemandandthe less
F5_9 n mindthat the two percentages on the eft e anc s suppy.
:. jd up o 0 0 o o .l -" - e ' o red l o r o ' .h ea b o vpi
. ll isafguedthata taxistypically fuly paidbythe
:1en prcee asticty of supply,thenthe moreprc€-elastc consumels. Howcanthatbethe casefthe aw of
::Tdnd is,the qreaterthe tax ncdenceon produc€rs. demandhasalmostuniversa applcablity?Theanswer
-"is s sensbleasdemandwi be morepice-easlicthe s lhatsuchcases arca resultof f ffis veryoftenbelng
j.e.t€r the numberandclosen€ss subntuies
of available ablelo supplyncreased qudnttiesperp€fiodatthe same
ic consumers. consur.erswillhavealternativ€s
to resod prlcebecaus€ o{ constant returnstoscaler thelraverage
:o folow nq a taxon somegood. andmarqna costsdo not changeastheyexpandoutpLrt.
n fie e"rrcme Ldre\ here.l'ere.'4 o,Jb5.ilrp' . Doconsumer expend turesincrease or decreasefo owing
.vaiable afd d€mand isperfectly
prce neanLc(PED=0) an indrecttax?Theanswers that t depends on tlre prrce
andvetica thentaxincidence on prcducersmustbe 0% elasticty of demand.Focus ng on Fiq.2.23t shouldlre
(thedenominator on the eft-handsideof the equatlon) , er. .fa. ,-reo. gl a, .l.et'ralpo lib'L-ooi (
consurners areburdened "ld
soit is 100%on consumers. EandFar€on the demandcurue. Thus,whethefar€a
bythefull amountof thetax.fhe sameholdsif supplys OQmFPm isbrqgeror smallerthan areaOQoEPo depends
perfect y eastc(PEStendsto aslhe fractionon the eft O NP E D .
-)
 . What fthe tax s a percentage1ax?Sucha tax s anaysed n Fg.2.24d percentag€ tax s i unmted. n l al y ma r kei
n the sameway as a per un t tax exceptthat the sh ft of demandand marketsupplyarc at D and 5 r€sp-activey
E
E suppy is not pafa €l but the 'wedge' {= vefiica d stance) with Poth€ nit al mark€tpr ce and Qo the nit al quantir
tr wdens at h gherpdces.TheefJectsare identca tothose bought and sold per pe od. Let a percentaqe t.x (e.q.a
D
D 19% VAT)be mposed.
p The do ar (or yuan)amountof the tax at eachpossibe
Figufe 2.24 Effectsof a percentage i.directtai {VAT) pric€is no longerconnant Thisis why the vertca
E distanceUR s greaterthatthe vertcaldistanceAB. The
i. new suppycurveS taxs no ongerparal el tothe ori gna
supplycLrveS.The 'wedge at eachoutput level,wh ch ,!
i p dn oLl o h- o. bF o^ ol b qqer..l d b qqo.

Tips
Todrawa specifclndrecttaxdiagrama waysusea
r!ler andstafioff by drawnq two parael supply€urves.
Labelihemproperly andthendrawthedemandcurve
Fromthe int€K€ctonof the 'rew' suppy (Stax)and the
demandcurve(pointF n Fgs2 23 and2 24)dropd Ine
to findthe neweq! libriumqLrantity (Qm)Reazingthat
the newprcePmis€qlalto ne FQmyo! nust subtracl
th€ tax(thevearicaldisrance)to f nd the newnetof tax
prce(average r€venue) the producer earnsperunitof
output(HQm= oPp).

subsidie5

A subsidy isdefned.s a pefunt payment to f rmsby Figure2.25Effectsof a per unit subsidy

the governmenr a m nq at owerng ther costsandthls
thema*etpdceand ncreasng production, consumpton
andfirm revenuests anayssissymraetcato thatof
an nd rccltaxasnowthe qovernment s paying(and
not gettlngpaid)a pefLrnitar.ountof moneyto l rrns
Product on costsare ow€rbytheamountof thesubsidy
sosupplyshfts verticallydownwardbythatamount(the
marglnal costof producing eachunt of outputs now
ower).
n Fg. 2.25the nlia demand ands!ppyconditlons
represented bycurvesD andS ledto anequi brunrprce
oi Poperunt andan €quilibdLrm qu.ntly Qo perperiod
Thenewsupplyfo owingthe gfaftingofth€ subsidy is
dI ssLbsdy.-i e /ed " di. dr," AB \ ,hFpF' I
subsidy andrepres€nte thedecrease ln costs€achfrm
nowenjoys. Thenewequillbrium s at pointFwherc
marketprce s owerat Pmand€qLribr umqLranlty oaoa.
biqger at Qm. Q / period
Nowyouneedto b€ extracarcfuin the nextstep.lhe
newmark€tpric€s Pmwhlchis equato lineFQm.The . Boththe prodrcerand the consumerof a productbene'.
producer thoughearnsfromeachLrnitnorjustwhatthe lrom a subsdy.Howthe subsdy 5 split betweenthe t\r':
' o r\L_ 1e o cv.bL Ld, or h- J b. idl9dr pdby hFtd F . part es aga n dep€ndson the pr ce elastictyof demanc
Theproducer
thusearnsQmFlwherc
FHs the subsidy andthe prce el asti cty Thesam€reatonshp
of suppl y.
holdsas in the caseof an nd recttax (seepage27), on'l
Theqovernment spends (FHPpPm)which
in totalarea is r ov t F r:..o or hp t-r i I p "d-ioof -ho pol e -dgF
the productof the perunt subsdyFHtimeetheqlantty benefitfrom th€ subsidyconsumersenjoyoverthe
producedandconsumed oQm(= FPm). p" ' e be €r f 01 .re,Lo.a/ p oo ,- p1j o,
" a"
 _h's.
givenPES,
'?r example, the producersben€fitmore,
:€ -:.e price-eastc demandforthe good s Tip
a]lsa €: dreoftengrantedto far.ergto ncrcase th€ir
lrcr€ a5wellasto protectthemfrom mports(mporied Todlawa subsdy diagram alwaysusea ruer andstart
automatcay becomerelativelymore off bydr.wingtwo para€lsupplycurves. Labeth€m
-?*:roducts
:rce-:]e). The owerpriceof dornestcfarm prodlrcts properyandthendrawthedemandcurve.Fromthe
rre, -:i onlyblockmportsbut nrayleadto the creation inte6ecton of the'new'suppy andihedemand curve
f:- .riif cia conrparative
advantage andthlrsp-"nelrate (poinlFabove) go veirically
up io ihe in tia suppy curve
(i.e.dfawllneHF)to fnd the newaverage revenuefof
r"-<::3s maya so begrantedto encourage production the producers(oPp= HQm).Faiureto do soleadsto
tt-- :-.iJr prio,lorqoods\^itrr
poetveco,,.'"rp-io'r
o' most€rrorsn thisdiagram.
3:'r-.ion extern.tiesandof co!rsein the caseof mert
;ro- servces suchasheath andeducairon.
-nd

lgriculture policy
andagricultural
Ihy do g

ErFirnents often ntervenen aqrcu turalmarkets. Fisure2.26 Relativepricesof farm prodlctsthroughtime

. l'€rthe long run therearefactorsthai leadro ihe

r.ic ne n the reatv€ pficeofsuch productsand thus of
-=e ihare of natonalincomeenjoyedby the farmer. .:E
. r ie short run (fromy€arto yeaf)pficesof suchproducts
=-ciuate a ot and thus {armersface high lncefta nty over
:-. €ve of the r expectedncome(pricesand ncomes
. L i g J re)..1 6i r J ,r,d re .rh e )e
b i rs ho r . . r ot d. iti ,y
-.'
. a per od of n yearspr cesfrom p€rlodto perod
=-1,er
jduate but overthe long run the trend is typca y
::,lnward asthe trend line FHshows.

lbE is a long'rundownward
trendin relativepri(es Figure2.27 The ong run downwardtrendof relativefarm

. Srpplyof agrculuralproducts hasdEmatcay jncreased

:!e to the mechanizaton of producton,the useof
ihe advafces
'€,iilize|s, in biotechnology,
dise.secontrol,
-.:c wh ch haveraisedand prcductivity.
However,
iemandfor suchproducts hasnot keptpacebecause
Ji ts low ncomeelastcity.A3percapitaincom€eves
'ncrease demandfor foodandagricult!raproducts may
n.'FasebLrby p opo'rio1"-ely n .chlp.s ( ofee pri(e,
:rc an example. Overaperiodof manyyea|swondsuppy
Jf coffeehas ncreased fromsays to sn but demand
-houqhhaslncreased onlyfromD to Dnleadlngto a
iowerword pricefor cofiee,Pn,as lunratedin Fig.2.27.
But
. Lalely, therehasbeena sgnficantupwardtrend n world
foodpdcesOnthesuppysde,g oba warmingis b aried
lorshrnk nq cropyeldsdndrecoddroughts, adversey
affectifgmanyfoodproducers suchasAustralia.On
the otherhand,worlddemandfor grainshasbeen
ri, 19'd,- becd,seof .heq o$ 19 -urber o peoolen
Why do

emerglng countr€s,
suchasChna,who havereached . Notethatthesetwo characteristcsalsoatfect
levesof incomethdtp€rrntthem to consume
mor-" expoarrevenuesof deveopng countriessincemany
rneat.Toproducemor€meat,moregrainsarene€d€d to pre'iominantly
exportpr marycommodiies(farmand
fFe d cd le.Ar l p. p r l6onFl/ o\ ^ F. p. o i, o - 1 a . nonJarmprodLrcts) ihe r expoftrevenues
fluctuate
trom
demandforfood products maybe ratherlncomeeastc yearto y€arand nlh€ ongrunther termsof trade
tor sorn€t rneto come.Demand isalsors ng because
rnoregrain(mostycorn)s beng d vert€dawayfrom
hunranconsumption intothe productionof bofues. tigure2,28Thesho.t{unfluctuations
of fam product
prices
Whetherths trendcanbeconsider€d shortrunor long
rLrniemains to beseen.

Ther€is a sholt-run
downward
trendbecause:
Shofirunsupplyfor agdcutLrralproduc1s s q?picaly
perfecty inelasric(vertcal)due to the associatedlong
producUon i melaqs.Suppy is alsosublect to shocks
(shiftsleftor r ght to S1or s2)typically
asa resut oi the
effectof weatherandotherrandomfactols
Ontheotherhand,demand for agr.uturalgoods s
relativelyprce neastcs ncespending on suchproductss
a smallproportonof consu mersp€nding (at eastin h gh-
ircoa e e.o .ro-r , p. dnd o . o' r A. 04 ho wL olF, t h p F
goodshavefew substitutes.
Theshiftsof suppythusleadto thesharpprce
fllctlatonsshownnFg 2.28

. Governments often ntervene in agrc! turalmarkets Q*Ql (= FH)Lrnt5of coffeeat P* (bufierstockscanthls

aimingat protecting producers aganstthese be usedonlywth foodproducts thatcanbestorcd).
characteristcs.Therearevarious formsof gov€rnment Rev€nues of produc€rsarcgivenbyarea(0Q1HP-)
ini€rventon. Oneof themis gEntingsLrbsdies or settng . t neil perodoutputs dt Q2Lnitsthenprc€wouldrise
^ rin J n p'. F\ 'e a-1r-.de. e l Bullersto(k5dre abovePi, as€xcess dernand equato lF unts resuh at
€mployed ln an an€mptto stabilzethe price. paceP* Authorites wilise fromstocksQ2Q*unts (= lFr
. BliJ€rnocksareako a subsetof so-caled.ommodity of coffeeat P*, mantaningthe prceat P* Rev€nu€sof
agreements that.ounlriesproducing pr nraryprod!ctr producers ar€area{0Q2lP*)
haveemploy€d in ordefto stabizetheirexportearnnqs
Commodities areprimary prodLrcts(aqricultura
or non-
aqricutura)usedas nputsn manufacturing andtraded
n worldmarketscoff€e,coco.,.otton,lute,r n and Figure2.29Theoperationof a bufferrtock
copperareexamples of prmaryproducts. commodity 52 Sr 51
o ri rL d d . e o p F rr-o . o , " ,p o - q j o-d.

^' . c ' dedgeene -,v h .h p ro d J 1 9 ,o rr' i p rry o

enforce to limit the amountof, say,cofieeor copp€rthat
reachesworld rnark€ts.

Theoperationof a bufferstork
. T heoper at onof a b L rffenro c k s l u n ra te d n F i q 229
t s assumedthat the goalis to stab ze, say,coifee prces

. t output s at Q* ihere is no needfor anyactionas

mdrketdemandand supplyconditonsare suchthat th-o
t ar getpr c ewil b e a c h i e v e d .lofu tp !t i s a t Q 1 th enthe
bulf€r nock authortiesn€edto take acton as otherwEe
the prce w dropto P] as a rcsLrtof the excesssLrppy
FHat P*. Authoriteswi hav€to buy and nock th€
. Theprcemaynab lizebut lncomes do not:theyvary
direcdywth the evelofoutput. | | r 's l o r a w l u i r a o e n d r o . I n , ea 0 1 1 0 ( ] \ F ' e r d i 9 e
. Af incentveto overproduce resuts asth,egovernment in prce.Nexldrawthesuppyclrveforwhlchno
!
essence guarantees that twill buywhatever amounti5 : byth€ bufferstockmanagef
intetuertion is needed
produced andnot boughtby consurneB. | (drawth€supplycurves vertcal,a sensblechoice
. lt s costy s ncestorage
costsandfinancng costsexst especiay fyourexamples an aqrlcultura commodity
:
whichcouldbe recouped if goodandbadharvests :I suchascofi€e).Lastydrawtwomoresuppycurves, one
dli€rnate andthe pricehasbeensetat a truelonq-run to i-a q o _ i l ^ e - ' d l , J D o l vL r r , e o e to I e p1
",lo
av€rage. l _9: L'.__- ___- ________
. Commodity agreementsusually collapse(historica
y they
a haveco apsed) because of financng problems that
result.

of production
Theory

Theshortrun s definedasthatpe od durng whichat A fewpointsto remember

leastonefadrorof productions consdered Jxed.
lf we assunetwo factorsof production, capita(K)
and abour(L),it s typically
capital(K)thaiisassumed
constant rnthe shortrun.
Totaproduct(output)canchangebyvaryingthe evelol
labourgiverthe levelofcapltal.
ln the shortrunthe behavourof outputls determlnedby
thelaw of diminishing marginalr€turns.
Thebehavourandshapeof shortruncostss d direct
cons€quence of the behaviour
of outputandof the law
of d m nishingrnarginareturns.
. t is a short-runaw lt assumesthe existenceoJat least
(Lrsually
onefixedfactorof production capita)
. Technology s assumed constant
. Thevariable factorusuallylabour,s assumed
Thus,anyd ff€rences in returns(ouipui)asmoreabour
s employedarenot because of difier€ncesin workerc'
db irp,burd'psr,r.of l-etonrruou,y,h"9 9,ap "
to labourratio.That'swhythe aw isalsoknownasthe
lawof variableproportions.
lfcapia andlabourwereperfecrly sLbsitutabe factorsn
the prcductonprocess thenthe lawwor d fot hod.
Th€marginal product(of labour)s definedasihe change
ir o.1o. be""r(eo i' tbo. ,oil 5lh-.lope
",hdnge
of thetota productcurve

As moreandmoreunitsof a varabiefadror(abour)are workerthen2i unitswill be produced. Butsincethercis

addedto a f xedfdctor(capta), th€res a pointbeyond
whichtotal productw contnueto rise,but at a
d minshnq rate,or equvalenty,thatmarginalproduct
w I startto decline.
Vsuaizea pizzeraequipped with ov€ns, tabes,etc.
Withzeroworkers, outputperperiodwll bezerc.lt one
worker isempoyed thensomelev€lofoutputw lbe
produc€d perpeiod,sayx unitsThisworkerwillhaveto
do - erfh .q: -at'roo ders.p eoa ng fe prl/as, se'.iro
th€foodandgettingpad froma tables.
It nowtwoworkersareemployed then t shoLr
d be
reaLizedthatif thesecondworkersirnply'coples'the fist
somuchcaptalcornpared to abourthercsa ot of room
for specializaon to takepace.Theiwo workersmay
agreethatonew I be in chargeof the wholekitchen, the
othefof a the servng.Outputwi asa resuitmor€than
. OLroL-./ | rrru,be rr .t y , r"d.i I iD rFd,,ng
" "'r
rrte up untilsomeunt of labour, sayL] in Fig.2.30a.
\o i .ro .ld ror ce .l-". t.re dr9,"r poir b 5 ,.eppe
"
lhanat pointa. Sincemargnalproductistheslopeof
totalproduct andth s sope s increasing, t fo owsthat
iheMPcurve in Fiq2.30bs is ng up until11.
The

f igur e2, 3oP r od u c ti oi n th e 5 h o rtru n(a

r )T P a n d
nps :' ll
DrawtheTPcurvein three'steps': in tia lywith a risng
posi/e sope.t'orretoIo I I'. l'€rw-nddecreaci g
positive sope (frcmLl to L2)andthen wth a neqative
slope(pastL2).At each'switch',dropa rnetowards
the quant!yaxesof bothdiagrams. Youwi thushave
deterrnined pointsL1andL2in the bottorndiagram.
Finilhit off by drawngthe MPcurv€,makingsuf€lhat
it slartslo decreaserightaboveLl andthat at L2 t is
zeroandcrossesth€ horzonia axis

. AveraSeproductof labour s definedasthetotal

product(i.e output)overthe n!mberolworkers
employed (AP= Q/L).
It isthusoutputperworkerempoyed, alsoreferedto as
the productivity
o{ labour.
E o ,J ', l q o r F i g l . l . a D . L d _ v p o i r r 0 1 t 1 " l P ( Jr vp i ,
equato the slopeof a nra ght linedrawnfromthe oagin
to that polnton theTPcurve.Forexarnple, APat L' i5
equaltooutput(L'H)divdedbythenumbefof workers
€rnployed {0t') Thisrato isthe sopeof the siralght
line0H.
. lt folowsthatto determine the behaviourot average
productoneneedstoexamine the b€haviourof theslope
of thestraightinefrcmthe orign to success ve po ntson
thetota prcdlrctcurue
Theslopeof this ineisthe neepestat L'soAPhasa
At thlspo nt though,addingworkersw lstj//help
maxmurnat thatlevelofwofke|s.
;ncreare totalproduct(theTPcuruein Fig.2 30a s sti// productof laboutncreases up
ln Fig.2.:1b the average
gairy W) but naw it will tiseat a s/owelrate (it lrecomes
the to L' andthen decteases
fatter andflatter).Eachextraworkercontributesto
produciion o{ pzzasbutnot asmuchastheprevtaus Figurc2.3l Produdionin the shortrun:(a)TPand
one.Thebeneftsof moreandmor€specalizaton are
sowly exhauned.Thetotal ptodu.t cutuestill risesbut at
a de$easingrate Marginalproductis thus positivebut
decreasing fron L1 ta 12.
Youshouldnotethaitheslopeat pointc is f atterthan
at pointb andthatatworkerL2the slopeof TPi5zero
(pointd) somarginal productiszeroin Fig 2 30b.
Afterworker12,labouristoo muchfor the amountol
capitalavalabe (ihesizeandequipment ofthepizz€ia)
sotota productwill startdeclning.Workers are50many
ihattheygei in €achother'sway.Thecontribution of
each€xtraworker (her marginalprod uct) is,egative altef
L2worke6areemployed.
. Thelawholdsbet\rveen L] unitsof labourandL2units
of labour:After workerL] tota productcontinues to rise
but at a decreasing rate,n otherwordsmargrnal prooucl
is decreasing Nofirmw ll everemploymorethanl2
worke6asthereistoo muchabollfcornpared to captal
norwillii everemployfewerthanLl worke6asih-"re
woud betoo muchcapta compared to laboLrfDistance
LiL2is knownasthe economic reqion ol producton.
. i:- :re MPandtheAPcurves areshapedkean Inverse . Reiurning
to ourAPandMPcurves, ir mustberh.r
- :-i car€mustbetakenwhenonedrawsbothcurves whenthe averageproducts rsingthenMPmustexceed
| :ie d agramasihe relatonsh
p betlveen
marginaldnd APwhilewhenthe av€rageproductisfa ng thenMP
:F,zge products veryspecific.
1ngenerathefo lowing mLrst
b€ essthanAPAt the maxmumof theAPcurue
margnalandav€rage mustbeequal.
= \!r > AP then AP wil rise
= r . l?< A Pt henAP w i l d ro p . Figute2.32 Marginalandaverageproductcuruesin on€
= uP = AP then APwill be at a r.ax mLrm.
-_€ brsic ded behindtheserulesthat governth€
:.raviour of marginalandavefageproductis simpleafd E
: . olds f or anym a rgn a l a n da v e ra q rn
e a q n i t!d e.
-- nk of a studenttakinga seresof tests n her
:(onomicscourse.lf in her sixthtest (her marginaltest)
;.e earnsa h gher qradethan her averagegradeto that
30 nt (in otherwords,if her M > A)th€n her averagewil
-:te. lf sheearnsa ower gradethan her averagegradeto
:rat po nt (n otherwords,lf hef M < A)ihen her average
jfade w ll iall And lf she earns n her sixthtest exactiythe
rameqradea5 her av€rageto rhat point,then her av€rage
.villnot chanqe.

Costtheory
Short-runco5t5

rnentoned ear er,the shoftrun s a periodof tim€durng Figure2.33 Fixedand averagefixedcosts

-5
,rhichat leastonefactorof production isfixed.Asa resut
':rns n ihe shortrunfacebothfixed andvariablecosts
. Fixedcostsarecoststhatdo notvarywhenthe levelof
production v.ries.Theyexst(andtheyhaveto b€ paid)
evenI outputiszero Exampestypca y includerent,
inter€sion loans,insurancecosts,fixedcontractcons,

. Fiqur€ fixedcostsasa ineparael to the

2 33a ustrat€s

. Fiqur€2.33b ustfat€s averaqe flxedcostsSnceaverage

firedcostsaredefnedasJxedcostsd videdby outputt
folowsthatihe averag€ fxed costscontnuousydecrease
asoutputrises,but neverbecome zero.Notethatthe
arersbeneath theAFCcurv€areallequaltoth€ fxed
con the { rm faces.
. Variablerostr ncudecoststhatvarywth the leveloi
output,e.g.rawmateria s, components, abourAverage
variableconsareihusdefnedasaverage costsoverthe
evelofoutput.Theaveragetotalcost of producng
some€velof outputs thenthesumof average variable
andaveraqe fixedcostsof prodLcing that evelof output:
ATC= AFC+ AVC.
. llarginal costisdel nedasth€ addtiona costof
producing .n extraunitof output.lt s thusthe change
(totalorvarabe)result
in costs ngfroma changenthe
leveof oLrlput: lvlc = AC/ Q. lt s the sopeofthe tota
cost(orof thevariable con)curveai each€velof output
. Theshapeof con curves in the shortrun s a reflectlon Figure2.34 Variableand marginalcosts
ofthe aw of diminshnq m.rginalreturnsOutput(TP)
n theshortrunin tialy rsesat an ncreasng rate!p Llnt
that unlto{ labolrrat whichdiminshng r.afg na retufns

. Th!s,asmores produced, varabecosts rs€but nilaly

rate.Producrng
theyrseat a decreasing rnoreandmore
outputs'easy'slncewth doublethe !nits of labolrf,
morelhandoubletheoutplt I it
the f rm canproduce
wishedto produc€lustdoLrbieth€ outputitwouldneed
lessthandoubelabour:varabe costsrisebuttheydo not

vd rdDp .o.t5 In ig. 2. 34. a ed. r o' d l F

"dt ado
^ll'
up uniilthatunt of outputQ] atwhchdimn shlng
that levelof
margnd r€tunrsset n prodlction.Beyond
o.p JrOIv/db e(o -t s ^. ll- ed 1 Fd. - ' o' r lF
"n
Marginalcons wllbe decreas ng n Fiq2 34bun1
outputleveQ1.
Sincein tia y vadablecostsr seat a de.reaslrg rateand
alieroutputQ] theyincrease at an increasng ratpir
followsthat Mc (th€sopeof VC)lnitallywl decrease
andth€nat Q1wl startto ncrease leadlngto a 'NLke

IVCfallswhenin plodlrction rsesandN,4C

l\,4P rises
when n producuon MPdecteases (i.e whend m nishrng
margna returnsnart in Producton)

andlixedcostsin onediaglam
Toral,variable figure2.35 Total,variableandfixedcosts

. \o{ rl_dr'ne snapeof .l'e\a abe,o,. c-1e l'dsbee_

to ncudein on€diagramthe tota
expain€dit is posslble
costscurve,thevariablecostscurveandthefixedcons

. In Flg 2.35thetot. costcurveisshaped justlikethe

varabe costcutue except that it hasb€en shfted up by
the amount of the fixedcons.
. Thus,thevertlcal disiance bet\,veenthetotalcostcLrrve
andthevariable con curveisthesameD stances .b, fh,
lk and uv areallequallo the fxed costdisiance 0c
 4r€.n_:etota cost s the sum oJ averagevarabe cost . Figve2 37a llustrat€s
the generalpo nt n a simpe setlip
arc :,:rage fix€dcost.Ihrs the avefagetota costcurv€ wiih MCandanAC curyewhercas Fig.2.37bI ustrates
|e 33ve1h€ averag€variablecost curve The fv€rtca thesamepo nt usng ATCandAVCclrves.n bothcas€s,
riE_{e is equalto av€fagefixedcosts. notethatthe Mc curvecutsthe averagecostcurves at
; . ! - r v " r " g"f p d -o 1 . 0 1 ( -r,o u s yd .. o a c ea . o.-p-- ther respective
minma.
rc=res (seeFg. 2.33b) tfollows that this vertical
rs-"ce (ab in FiS.2.36)becomessma €r and sma er but Figure2.37
Marginaland
average
costin thesamediagram
f€:r.o U shap€dcurvesnevertouclr
n.::he averdg€tota and the avefagevarab e cost
: r ' - dF U ho p -db F o .eo f -l ' p l a ^ o ' d r ,l i .hi rS E
na returnsand the behavioufand shapeof the
-al
:'e=le produ.t curve(seeFg 2.31b).
- ' E . v er agev a ra b ec o n c L rrvies th e m rro r ma geofthe
r'* age prodlct curve.

fi+E 2,36 Theaveragetotaand the averagevariable

cost

(b)

0a
Q/p e od

Howto drawmarginaland
av€rag€
costcurv€5
in the

. Theruesthathaveto befol owedareexacty the sameas

ihoseexpainedn Fig.2.32.
. Averagecostscurues(ATCand AVc)are U-shapedand
MC is ke the 'N ke-swoosh'.li tolows that f average
costsarefa ling then margna r.ust be l€ssthan avefag€
wh € f averagecostsarc fsing then margna must
exceedaveraqe.Lastly,marginalcoston ts way up mun
cutan averag€
costcurveat ts minmumpo nt.
f MC< ACth€nACw lldrop. i lf youwanttodrawanATc andanAVccurveon
i thes.med agram,filst drawthe ATCcurve.Notethe
f MC> ACth€nACwll rse. i m nimumof yourATCcurve.Th€ndrawtheAVc be/ow
f MC= ACth€nAPw I be at a m nimurn. i (, makingsurcthatitsm nimum6 to the/eftof theATC
i m nirnumandalsothatiheyget daserandclasetlb'-)t
i do no. tou,rr a. -o -.re o rr
'or- -ove
Productionand'

Remember, the longrunisdeflnedasthatt meperioddurinq Figurc2.3aThe long{un averagecostcurve:economies

and
whicha adlustments arepossible. lt folowsthat n the ong diseconomies
of sale
run. firmconsdersallfactorsof production variable.lt can
thuschanqeitsscaleof producton. lt cangrowor t can
shrinkin size
I
In the lonqruntherear€threepo$tble€ffectson oltput
froman ncrease in the leveof useof a//facto6.
Increasing relufnsto scale:the percentag€ ncrease
in outputs greatefthan the percentage ncrease in a
lnpurs.For€xample, doub ng al factorsof producton
morethandolblesthe eve ol outputQ. Stated
ditrerenty, an ncrease in all nputsbyl%will€adtoa
grcaterthan1% ncrease in outpLrtAsa result,average
rJr - . on. o' p'oriL,-ionoe 'Fd,F.The r n eljo\s
OQ
Q/Pe od
constanrrerurnsto scale:.hppe Le .ca€ -r. ea("ir
ouipuiis€qualto ihe percentage Increasen all nputs.
For€xample, doubinga fadorsof producuon doubes Forexampe,cutueSAC2is the shoft-r!n averageiota
the lev€lof outputQ. Statedd fferently,
an increase in aLl costcurvewhen a firrn er.ploys,say,K2 capta (imagne
nputsby 1% will eadto a 1% incr€as€ n output.Asa a lirm wiih a size'2' factory) The SAC: cutueis the
r€sult,average (unt)costsof productionreman constant averagetotalcost.utue when a firm empoys K3 capital
Deceasingreturn, to s€al€:the percentaqe ncrease rn wh ch s g reater than K2 (im agirc a f tn having gravn
oltput ls lessthanth€ p€rcentage ncreasein al inputs. to a factory size '3' whi.h is larger than the factory size
Forexampe, doublinga lfactorsof prodLrcton lessthan 2' ) l f i hi sfi rm n Fg 2 38 now w oul dl i keto produce'Q '
doub€sthe lev€lofoutputQ. Statedd fierently, an Lrnts i t co!/d do so w th ei thera' sze 2' faci oryor wt h
increase na inputs by 1% €adstoasmalerlhanl% a larger'sze3'factory But it paysto grow n sze as t
increase (unit)costsot
n output.As a resut, average co!ld produceth€seQ un ts of output at an averagecosi
productonrse.Thef rm sufi€rsfromdiseconomies of ot Qb ratherthan Qa.
tfollows that the ong'run aveEgevafiablecost curve
Fgure2 38 llustrates
economesandd seconom esof /LA (\dei r oe l ^an n nL1 ov. dqF o I o' prodr , ' 9
to ncreasing
scaiecorrespondinq anddecr€asing reiurns €achoutput lev€l(Q)whenthe fnn is able to atljustall
to scalerespectively. returnsto sca€ (andthus
Constant tnputsoptimally, .€ when ihe firm is ableio adjust ts
constantong-runaveraqecostt areiqnoredto s mpit

nitaliy.lheong-runaverage costc!rve(LAc)slopes Tip

downward. asthe szeof a firm
Average
andoutputlncreases
costsdecrease
Thedownwadsecrlon of an LAC
-l
Drawthe U shapedtACcurveraihershallowmaking
curuellLrnrateseconomesof scale(EoS).
sLrrcthaton ts decr€as ng r€gon the SACcuvesare
Aftersom€polnt,the long-runavefage cosicurve(LAC)
tangentto t or rhe/eftof ther lowestpo ntswh le
slopesupwad Average costsdseasthe szeol a lirm and
on itsis ng sectiontheSACcurves aretang€ntto t
oLrtput increases.
Theupward-sloping s€ctonof an LAC
on the rght of theirminimaAlsonotethatthesize
clrrveillustrates
d seconomlesof scae (DOS) correspondlng to shoar-run avefag€costcurveSAC*is
Noteat eachleveof output(Q)thecorresponding
the opt ma scaleas t iswth th s scale(siz€)lhat
the
r pa- r c r r " r i7 prd n dt J , d \p E ' l . .h o r ' u ' d verdge
f rm canachieve m nimumlongrunaverage costs
costcuwe,SAC)withwhich the J rm can achevethe
ln /a <i n ^ << h a :!p,;np.^< t<
r.n esof scae (EOS)are d€fin€dascon savlngs du€to FinancialEosarisebecause:
rce€d scaleo{ productionTheycanbedistnguished into . A arS€firmoftencanborrowfrombanksat ower
|Ie-;l Eosandexrernal EOS nternalEOSarecostsavinqs
n-€ -r actionsofthe i rm itself.Ext€rnaEOSarccostsavinqs ManagemenlEOSarisebecause:
rg..i nqirom dev€lopments outsrdethefirm,for example
re=-;e the indunryn wh ch t operates qrows. . Larserf rmscanemployspecalists n eachdepartnrent
(alarqesuperm.rket to managets
h rcsf nancalexpears
sorresof €conomies
of scale cashflow on a daiy basis;
a arg€department norehiles
specidst buy€rs,eic.)
of sca€ canresutfrom technca,
-:-aleconornies RiskrelatedEOSarisebecause:
-..<:tinq, f nancalor rsk relatedreasons
nranagement,
. A argerf rm isoflenmored versifled,
se ng not onebut
_.(hnical r d r r ' p o d L L . , . , r 1 o o e b J t a c 'r ) - . 1 dt p l o r F / " i
EOSarisebecause:
rnanycountrier.Risks, andthe associated costs,arethus
' : argerf rm mayb€ abieto adopitechnologies of betterspr€ad andm nirnzed
:.oductionnot avaabe for smalerfirms.Capiial
3u pments ofrenindivsib€(eq. the assembyne). External economies of scale
' Largerflrms ofiermoreposslb litesfor speciaization
. ts a resLrt of ih€ 'contanerpr ncple'{orthe ' aw of Sometmes,asan ndustrygrows,unitcostsofthefrms in it
oimensons'). cosrsavngsmdydrisebecause vo umes maydecrease. Typicallyth s isa resut of similarfirms locatng
nselasterthansurfaces. Forexampe,a storage tankihat together in one area (alsor€ferred to as agglomeraton
canstorcdoube thevo umeof somethng costs€ssthan econorn €t. why?Because:
doubleto manufacture. Thisapp esto blastfurndces, A specidzed abourforcernaydevelop (technlcalschoos,
oipe...rL,L drd o -oL seshrporq rd \po o io ' cater ng to their needs, may a so be estab shedn th€
Mark€tingEOSarisebecause:
. on the inputslde,a arqerf m bLrysnputsn bu k and Cornplementary f rmsmayalsobe established.
Bettertransportation andtelecomrnun catorsnetlvorks
thusmaysecure betterprcesfromsuppliers.
. on th€ outputside,distribLrtion costsareusuay owerfor
Marketing oJby-products maybe possble.
l:rqertirms.

-ihesear€defnedasincreases costsdu€to
in averag€ . Motvatonmayd€crease.
increasedscae ol produ.ton.Theycanorqinatewthln a . Interdependencieswthin a hlrgef rm may eadto
firm(/rternalDOS)or oLtsid€thef nr (external
DOS). probemsif therearehold-ups or bottlenecks
in any
paricuar paftof thef rnr.
Intemaldiseconomies
of scale
External
diseonomies
of srale
Alter a po nt, sizemay becomed problem.When frms grow
. Aitera pont,cong€ston costsnanareamaydeveop.
o e yo loa pr ldr r' i- p I p r J r o s l . c d y s .a _i . r." .i r g
. Asan ndustrygrows,factorpices(formaterak,for
Possble reasonsifclude:
. Managementproblemsol coordination,controland speci.izedlabour,etc.)maya sostartincreasing
asa
res!ltofthehiqher factordemand.
com m lr nic at on as s o c i a tewdth h u g es z e .

Goalsof firms
Maximizingprofits

Theworkng assumpton in €conomics isthatf ms a m at maxml2e profitsor revenues

b!tthey on y nrivetc
maximizng economic profts.Ths s not thoughth€ only acheveat /eastiomeprcdefined eve (of profitsor
available
behavioral Frrnsmayhaveothergoals
assumption.
. lt maybethattheya m at maxm zingrev€nues or long ABa,nanagetialthearies of theftrn (Baumol,
W lliamson
r!n prcfirsor longrunrevenue andmarketshare andothe6)sLrqgest thatmanagers mays€ekto nraximize
. Therearealso'saf6tcn9'theor,er. Thetem was ther own 'Lrtility'
wh ch mayincludesalarysecurty,
lntroduced by HerbertSnron('satsfyandsuffice'): powerand/orprestiqe.
because of informationaimtatonsfirmscannot
 Economc profitsare definedas ihe difiercncebetween
tolal revenuesand totalecofomic costsof producton.
n(q)= rR(q)- rc(q)
Thekeyto !nd€rstanding the termeconomicpro{its
isto realzethat fromar e.onamist's paintaf viewI|e
termeconomiccostsreJ€6io ihe vaueof a//resources
thataresaclfceddurng the productonproc€ss. Thiss
because in economcsthe drivng forc€s th€fundamentai
econorn c prob€mof scarcityt imp esthateconom c
costsinclud€not on ythe so calledexplicitcostsof a
firm(theexplcit payments t mak€sfor the useof tacto6
knownalsoas'out of pocket'costs) but a so implicit
costs.Thes€ref€rto thevaueof f rm ownedresources
forwh ch thefrm ls notforcedto rnakeanypayment
but,fromthe economists pointofvew represent
saarf cedScarce resources
lmp cit costsalsoincludethe rnnirnunrewardthatthe
factor'entrep.eneu6hip'r€quiresto remainin that ne
of busne5slhis s knownasnormalprofit and s an
eement or economc co51s.
. The idea s that, to securen a businessactivly the s.arce
factor'entrepreneurship', sonrem n mLrmrewad !s
necessary for the rsk rhai rJurdertakpr.lh s min mum
s equa to what could be earnedby entrepreneurship
ihe next b€staiternatveavail.ble.lf th s m nimum reward
doesnot m alera l i z e ,l h eth
n e fl rm w l c o s e d o w nsothat
the financialcapita tjed up n i1w I be fre€dand moved
nto the n€xt bestaltemativeprcjectthat commandsthe
profitsin a marketeconomy
Roleofeconomic
. Profts arethe rewardfor €ntrepreneurship.
Theyd I{er
iromwaqesn that proftsarenol contracted,
aswages
are,blt arca residuaandmaythusevenbe negatve
. Supernormal profts attractrcsources ntoan indunry
w\ - pd, o, . p. .p -J p ,e \o J r F \ p -.- i rg r e L)e
in other ndustries. Relailveprice changescoupled wth
supernarnai profits and lassesdrive resourceallocatian in
a narket economy.
. SlrivnS to acheve profiisresultsin lesswast€and thus n
greater(technical) efficiency.
. S uper nor mpr a o ftsp ro v i d e
th € n c e n tv € a n d fundnqfor
firmsto financeexpansion(investm€nt)
Remembef, for a frrn to secure
thescarce factor'labour',
wageshaveto be paldwhich,of course, arean €lement
oi cost.Inthe sarneway,to seclrrethe scarcefador
'entr€preneurship', a nrnimumrewardwoud. so be
reqLriredwhich,symmetrically,sho! d alsobe incllrdedn
tfollowsrhat ftota revenues
areequaltoeconorn c
consihuscreflred, theneconomc profitsarezerobutthe
film is makng money/t /snakingthemininun rcquned
to renainin thisbusinessW€saythatit s making
normalprofits Zefoeconomicprofitsthusimp,
nomalprofilssothereis no reasonfor theentreprcneur
to ext andmoveon to the nextbestbusinessopportunity
lf totalrev€nuesexceed tota econom c coststhusdefnec
th€nthefirm s makng morethanthe minmum t
requires to reman ln th s busness(.e. morethannormal
profits).t is makingsupernormalpro{its.
Tips
Bedr1 Trrd thdtd((ountingpro{itsd " dr ow.
in scopethaneconomic proftsastheyreferto the
in d ff€rencebetween totalrevenues collected
and
accountingcostsThe atler ncudeonlyexplictcosts
Aso,the leveof outputat whichtota revenues equal
tota productioncostsis knowndsthe breakevenlevel
ol output.Theterr. is lsed bothin the accountnq sense
and n the broadereconom c sense.
. Sup€rnormal
profihcanbe usedto financeresearch
and
dev€lopment
programmes andmaythus eadto producl
(to dynamc effciency).
andprocess
lnnovatons
Conditionfor profitmaximization
. t canbeshownthat f a firmwishesto maximze protits
t munchoose anoutputleveqatwhich[,1R=lvlcand
the MCcurveis rising.
. ManyerroneousLy thinkthdith s meansthatproftsare
zero,torgettng thatthet€rmmarglnal ref€rsto onemde
un(, theextraunt.
. Torca zewhyprofitsaremaxmumwhenMR= MCone
rnustconsid€r thea/iernatives.
Th€a ternativesaretwo.
Ivlargna revenues couldbe€ithergreateror lessthan
margna cost.
 M R> M C Case2: lVlR< MC
r"sumethatatthe chosenlevelofoutputq, niargna . lf theftrmhadchosenan outputrateq at whichMR<
=--;€nre is qreater thanmarqlnal cost(MR> MC) Readng MC,then,by producng oneunit/e$ itwolld not co ect
:;; carefultmeans thalthe exra revenue Tronr
collected the assoclated revenues but it wouldnot incurthe greater
ng ore moreun t of output exceeds the extracostoi associated cost.tfollows,thatwhatever wdsthe eveot
-
..oduc ng thatextraunLt. proft, it wou d hcreaseprcfilby producng one essunt
::rt, l thatisthe case,then,whaleverth€ leveof prcfts,
Thus,profitscannotbeat a maximum lf MR> MC(casel)
-ae f rm would be ab e io ncreasethese by producng or f lvlc > MR(case2).
-'dl extrd un t lt fo owsthai f MR > lvlc then pronts . lf N,4R > l,4Cthenthe profitrnaxmizng f rm should
.da, or oe dL a Ta/ - . r d9 hp/ "n be 1c ' "d\ ed lncreaJe rateto acheveitsgoalwhere.s
itsolrtpLrt f
\ote thatev€nfthefrmwas nclrlng ossesatthat MC> lVlRlt shoud decrease l1soutput rateto achreve
.nosenq, t wouldb€ ableto decrease theselosses bv ts goa
oroducing ihatexlraunt, sothe chosenq couLd not have
itsoutplrt
(1he A f rm shouLd thlrsneitherncrease nord€€rease
oeenthe riqht best, the optimum)
cholce.
ratelMR=Mc.

lty sho'rldMc be rising? firmd€cdedto produce onemorcunilof output Proiits

wou d furtherncrcas€
as the eftrareven!ewouldexceed
Tounderstandwhyat the chosenevelof outputq at theextfacostincurred.tfollowsthatat the chos€n
whichmarginarevenues equaltornarginaL costt must outplt q notonLymustMRequalMCbut a sothe NIC
the
,/sobethatthemargifalconcufr'eis risng,consid€r
(rhatIVCwasdecllnng)andassume
altefnatve thalthe

alocationandeffic€ncy
li turnsoutthat resource (wheth€rtheyhaveprcingpower)andconsequ€ntly ther
.onsidefatons aregreatly
affectedby marketstructLr-" performance,i.e whethereff ciencyisaclrevedn resource
Thestructure of a market(wh€thertherearemany,fewor Thismodew llbe conlrasted
a ocation. laterwiththe theory
oneflrnr)ismportantasit determnesth€ condlrctoffinns markets
of contestable in wh ch structurci5not reevant

f o. nd rre. s.r-(IL 'F.dr e I . d r r o, ld i d t 10' ed: Ma*et nructures arcdistnguish€don the basisol rhe
nLrmber of firms n the mafket(v€rymany,few one),the
typeof th€ product(homogeneous or differentiated)and
competit
on whether€ntrybarfersexEtor not.
Monopolistic
Oligopoly

Perfectco
] ll;

characteristics . Noentryb.rriersexist(i.e perf€ctmobiltyoffacto6of

. Verymanysma firms. Perf€ct to all marketpafticpants
informatonavarlable
. Homogeneous product,meaning thatthe prcdLr.ts
consderedbyconsumers se erc'Exampe!
/derrtalacross
arelew andmonlyfoundin the pnmary
of suchproducts
sector(farmproducts,
metas).
ls the

veryfew markets
in the rea worldw sharethese
. F|5tof all,scd€ economies, especiay in the
mairutacturing sector,areverycommon. veryolten afger
f rns cdnproduce at a owerunitconthansmallerfirrns
can Fjrmsthushavean incentive to groweitherntemally
(throLrqhinvestment n physicalcapital)
or throuqh
mergers andacquistions. Ths explanswhy afgefirms
aretypcalyfoundin mostindustries.
. Firmsa so havethe ncentveto different atetheirproduct
(by mprovng quality, changng characterstcs, etc.)
in orderto acquresomedegree of monopoypower
Molopo/pov\e ,de' edds.hedbrry.o'ar_.p'i'F
abovemarqna costTheLerner;ndex of monopoly
powerisgivenbythe rato (P- McyPA firmrhar
manages to produce andse evena 5lghtlydifferentated
productwllface a negatvelysoped demand c!rvefor
irsp odL'- i1d -hL.l-a.p-l^pablirrro ir. rada pri'p
w thout osng allcunomers.
. Frmsa sotry to createentrybarrerssothaltheycan
mantan anysupernormal profitsin the lonqrun.ln
addtion,exit barriersin theformof'sunkcosis'asoare
comrnon. sunkcostsarecoststhata firmcannotrecover
uponexitng an ndustry
. nformaUon n the realword s not iree.Uncetainry and
riskssurro!nda b!sines5 andconsurnption de.sions.
Search cosBexistandmaybesignifcant
. Lanly,p€rfectmobil1yseldorn character zesfactorsof
production.Labour,for exampe,oftensutrers trom
occupatonaandgeograph ca immobilty.
Whythenis perfedcompetition
stillusefultostudy?
. Desptethese nrtatons,perfectcompetiUon retans ts
us€fulness.
tissimp€andt iscapable of successfuy
predicting
chanqeNlostimportantly,itsefficiency
propearles
areconsdereddesrabeanditthusserves asa
modelaqanstwhichrea worldrnark€ts canbe cornpared

short-run
equilib
Assume a perfeciycompetitlv€ mark€tlllrstratedin in (a)the
Figurc2.39Pedect.ompetition:short{un analysis
-iq.2.Jqb.N/drLFr for.e. dFre.-re -hordrlp piFa typicalfirm(b) the market
P td.\ fi r pere'U, o-rpprit
- " ve1"'l p. isd'prne (.)
taker'meaning thaithe market-detemined priceP s
a q venfor eachfrrm Sincethereareso manyother
fnmsofferng an denilcalprcductto perfectlynforned
cons!mers it cafnotincrease the prceabovethe nrarket-
delermined eve dsno onewoud purchase evena single

It alsohasno incentiveto lowerthe pricebelowthe

marketdetermnedlevelast is,byassumpton, sosmal
compared to the marketthatit cansel a itwantsat
Il_Fqorrgndr'e pri(eD lrr€"5"ro) bed-\v\.1€dch
qrainof sandbeinqa firm.Evenif t doubles itssizeand
becomes asbigastwo gransof sandit wouldmakeno
d fference. Ths mp esthata perfectly competitve f rm
'a.lrell10 F a hF .o-Fp 16 <oi if rs dcrno
".
. oere-lyela,i( de 'ra.o o' . prodJct dt .heoo'r'o
(b)
5inceit cansela it wantsat Pperunitit means thatthe
exlrarevenLre {Tomse ng an extraunt is Pandthat,on
averaqe, it €arnsP perunit Priceisthusequaltomarginal
revenu€ for a p€rfectly
compettivefirmandis,of co!rse,
equaito average revenues:
P = MR= AR,in perfectcompetition
Thisperfectly f m (th nk of a farmernamed
competitiv€
Joey)hason y to decld€howmuchoutputto offerin the
marketperpeiod giventhe pr€vailing marketprceP
Sinc€we assume thatloeyisa prcfitmaximizer,we know
ihe answer. Hewi choosethat evelof outputfor which:
MR= MCandtheMCcutueir rising
TheMCcurvein Fig.2.39alntersects the MRcurveat
polniH whichis riqhtaboveoutputq*. lt fo owsthat
Joeywlchooseto sel q* ufits p€rperiodat P perunt
short-run in
equilibrium

Theaveraqe costof producing e.chof theq* units Figure2,40 Perfectcompetition:rhort run analysis:
caseof
s q venbytheaveraqe costcurve.Gong up fromq* in (a)the typica firm (b)the markei
losses
towardtheAC curvewe f nd po nt Fandfromth€re
we turn leftandf nd that t costsloeyC on average to
produc€ eachof the q unts.
Totalrevenues collected areequato the numbero{ units
sodt mesthepriceperuntor q* timesP Ths sthearea
of reclangle(0q*HP).
TotacostsareeqLral io the numbefprcduced t meshow
muchit costson avefag€ to produceeachor (0q*)t mes
(q*F).Thiss ihe ar€aof rcclangle (0q"FC)
Economic profitsarethedifference bet\,veentota
revenLiescollectedandtotalcostsof production, so
geometically on Fig.2.39atheyareequato the p nk
ar€a(cFHP).
Economic proftsfor Jo€y, thetypicalJrm,arepositve
Ths meansthatfirms n thisma*et aremakng morc
thanlhe m nimumtheyrcqurc to compensat€ tor the
f€sources employed andthe rsk taken(defined asnorma
profits)loeyis m.kingsupemorma profis.
(b)

Tips
A typ ca m stakenudents mak€ s when they'shade'
the profit area.Makesureyou coff€ctlydentifyon your
d aqrarnthe av€ragecost associated wth the chosen
l ev elofout pui.A s o , l i n eF Co n F g .2 .3 9 ac a n n o tb e
tangentto your U shapedaveragecurvein the shortrun
as MC s shaped ke the 'Nikeswoosh'.

Short-run in perfedcompetition:
equilibrium
caseo{ €conomic losses
. lt s not necessary
forthe typicalperfectycornpetitivef rm
to be makingsupernorma or normalprofitsin the short
run. t couldbe makinqosses. FigLrre
2 40 i ustrates

. n Fq.2.40bmarket demand issuchthattheequlibrum

prices determined at P Thefifm n Fg.240aseects
ts opt mallevelof outpuiat the inters€ctionof MRand
MCat q*. Average consarcequ. to q*Fwh e averaqe
revenue (price)ison y qt H.Ths f rrnis makingosses
eqLralto.rea (HFCP).

Long-runequilibrium in perf€ctcompetition Assunre, as ustrated in Fg. 2.41,a pefi€cty compettive

. R€sources ndustryn whichthetyprcalfirm is makng supernorma
areattrdctedntoan nduslryn whichf ms
protls.As mentioned on paqe38,thiswillinduce €ntry
earnsupernorma proftsasihisimpliesthatthesefirms
oi fewl rms ntothe industryAs newfirmsenter,rnarket
earnmorethanin th€ nextbestalternatve use.on th€
supplyincreases, shiftingthe rnarket suppyc!rveto the
otherhand,econornic oss€swil nduceext off rms
rght andpushing the marketpriceowerThisprocess
fromthe industry asthe resourcesiheyemploycoud (theenlryof f rmt w nop whenthereis no lncentvefor
earnmoren thelrnextbesta t€rnative. it fo or,Ethat if
morei rmsto enier,i.e.wheneconomic profitsaredriven
econom c profitsin an indunryarezeronetherentrynor
to zero.Fiqure 2.41I ustrates exacty thissituation.
The
extwill beobserved asf rmsin suchan industry make
justasmuchmoneyastheywoud ir theirnextbest marketprcein Fig.241bhasbeendrivento P Th€typica
f rrn n Fig.2.41aproduces q* unts At th s l€veof output
a lernatve.Whyenteror exitsuchan ndustry?
totdlrevenues andtotalcosts areequaltoarea(0q*FP).
 Short-runequilibrium

Figure2.4l Periectcompetition: ong{!n equilibri!m in . Noteh€retheroe of profits andossesna ocatng

ll (a) the typkalfirm (b) the market
E andrealocatnq scarce resourcesin a marketeconomy
o Profts attraclscarcer€sourcesdsnewf rmsent€rthe
o ndunry(a5surning no entrybarrlers)wh le osses force
qJ t rmsto exit,freeingup scarceresources. Bankruptcy tfi
perlorms a most mporrdntrole n a rnark€teconomy
as t makesscarce resourcesavailable againfor us€
= n oth€r,moreproductve dreas.Of course, whether
lreedup resources rnayor maynot be channeledinic
moreproductve uses asodepends uponther mob :.
rr ddd (r1 he,ff-4pdpdr1".//orlF."rdo\r- ..
capita)mayfaces gnficantadtunrnent cons.
. In the.aseof shortruf oss€s, ilustrated in Fg 2 4C
lirmsw ext, decrea5 nq andshiftnq to the leltthe
nrarket supply andthuspushnq up mdrket prceanc
thLrsaverage revenue. Theprocess (theext off rms
stopswir€naverage revenue becomes equato aver:;-E
cost,n otherwords whenthetypcaf rmismakin_c::1
economc profits, .e. as mlrchas t wou d earnin lf:
bestat-"rnatve(nornra) Thereis no reasonfor r.o.:
i i rmsto €xt. F g!re 2.41 l l | nratesexactythi ssi t!.::-

nps
To llustrateofg-run equilibriumn perfectcompet::,_
start by dfawinga U-shapedav€ragecost curvefor:_:
l rm and then draw, lirng always a ruler, a honzan-:'
tanqentat ls min m!m. Th s I n,cwi be the dema.:
land MR and AR curues)ths flrm fa.es :nd thus
determi n€s the prce.Makesurethe MC cl rrves dr... -
in suchd way ihat it cutsth€ AC curv€ t its m nimL-
a 1oi F," o. orl avR a-d.LoN / cJ..o -
a ne to determineth€ eqlr libr um output of the 1'"
W hc- . e gl Idnoradp-oaga' rr,.l -e" 0" ..
makesurethe markeldemandand rLppy cutues
OQ i r Ff.1d. ,6p..6)o l ato-
oFr6.^.Foo .
Q / pei o d
d agramYoucouldof course
starttheotherway.'---r
b r i '- d e . F r 1 q 1-^ol- aqL o|r p 'd
Longrunequilbriumthusrequresthatat the chosen
extendinq lt a the way to the eJt-hand d agram
outputrateq th€typca frmismaximiznqproJrsard
thdttheseeconom c profltsarezero(norma) so no entry

MR= MC(andMCis risinS)

IJr||4 -r.: Figure2.42 Shutdownrulefora perfe.uycompetitivetirm:
ir_r- l be clearthatin the longruna oss-nrakng
- _r-
r,' shutdownand€xt the markei.In the lonqrun
h.vebeenmadeandtheiirm
il :i::ible adtustments
ra -,: ;ixedfactoEandthusfacesno fxed (andthus
ra,c dable)costs

. rE shortrunthoughsom€factorsof production are

=.;.ered flxed.Thismpliesthatthefnmfacesfixed
=s=, coststhatareunavoidab€ in thattheyhaveto be
:ac Ft.n rrof.n p'odLLe.1€ o 'r' .sot oLroL
:!-'e 2 42 il[]strates a perfeciycompetitve f rm
:crralinq n theshortrun.Thisshutdownd agram
=.Ji.esthatboththeATCandthe AVc cLrrves are
:r:sent Themarkeiprce s d€termnedat Pwh ch
r.; flrmmusttakeanddetermnethe opt ma, prolrt
levelof output.Marginal revenue and . So,anyloss-making {irmin ihe shortrunshouldshui
-3ximizing
-narginalcosts areequalexacty above outputlev€|q1. downonly f average revenue (theprc€)doesnot cover
Thisf rm is makinglosses. Average r€venLre (price)s equal avefage variable cost.At anyprcebelowthe mLnlmum
io qll whileavefage (total)consar€equaltoql Fso per AVCthefirmshouldshutdown
unr losEes areequato distance lF.Muhiplying thisby Pl Shutdownin the shortrun if P (=AR)< minimum
(equalto output0q1)givesth€ lossarea(IFCP), thered AVCi.e. if TR< VC
rectangle.
. Shouldthisloss-making firmshutdown?lf lt shuts
downltwillstillfaceandhaveto payltsflxedcosts(for
examp\e,rronth\ palments{or an ouisiandinqbank
loan).lf theseunavoidable fixedcostsarebiggerthan , In' s,(ot..,r/ddql drn o ct' ar1/ ard reeds-one
Ii
the lo e. facedb/ p oduc;ng, ,Te1,L,hor,d,endn 1 i praciice Staftoftbydrawing theU-shaped ATCand
business asitwill be losingess i
I AVC c-ftA pr J. n9 n" r1":. vF i. d, o.s,dn,p ...re i
Notethatthevenicaldisrance at eachoutputevel i o v o - a g Fr , , F d , o s , i o e . o T e , \ n d l 'e . o , l d " l r a l t p , i
oetween the average tota andth€ averag€ variablecost as output increas€s. Make sure th€ MC (th€
.i\ad ' curve i
crftp s equo io ' e cos ,. Fo. o.dn p.F or i N.e-\,oo.a,Jr.o,(ur\r.roLgl-
"ve.agp hp-1o,r .^ai i
output€velq2the corrcsponding av€rage fixedcoslsare i ,p.Loo\oap ele,eloeh^een.1"-rndo-AIC i
d stancedb,the difference betweenaverage totalcosi! j andAVCanddenorerhelineMRandAR.Fnd the i
q2aandaverag€ varabecostsq2b. i nteEection ofth€ Mc andMRcurues andbrinsa ne i
Geom€trcacomparson berwe€n fixedcostsandthe i downto the Q axisro f nd the profifmaximiz n; ourpur i
losses incurredat outputq] s fac tdt€d f we caculate rate.Makesurethdt po nt Fis not arrhesametevetas i
thetxed costar€ausng the dverage '
fixedcostsatrne I minmumATC.ThevericaL d st:nceFHisrheAFCso
chosenoutputlevelq1. MLrltiplying i
outputC'H(= 0q1)by i multpliedby cF (= oql) w I g veyouarea(HFCC,), rhe i
FH(theAFCat ql) is area(HFCC,), theirm's fixed(os's, i fxed costsand oss€sncurred if rheffm decdesto shut i
the rhlckblackoutlner€ctangl€. i down.TofindtheATCwhenq1 unitsareproduc€d you i
t fo lowsthdtin the shortrunthisfrm shoud remarnn i oo up roT o .nl por I roa.led.ro., p"r f L.if i
busness t w ll oselessnroneyby pfoducng than f it i 'h " l o . - 1 1 d L, l g 'i . - 1 c o r . r . " , - o o r o o J F . . . I L i
shutsdown Byproduclnqt not onlycoversitsvaaabte - - - - - - - - -- - - - - - - -- - - - - ____i
costsbLrta so pafiofthe unavoidabe fxed costs.
Thesupply

ln theshortrunthe supplycurueol a perfectly Figurc2.43Short{unsuppiyofa pedectlycompetitivefirm

competitve frm isthatportonof ts marglnaicost curve
thatles abovethe m nimumoJitsaveraqe varabecost.
n Fig.2 43,thesuppycurveisthusihe redsegment ol
the lVlCcu&e Why?
Rememberthat a supplycurveshowshow manyunts
a f mr w bew llingto ofierperperiodai eachprce,
LFrarrroi'|b-. Perer19 o-ig./.4J.if 1--dlF
prlc€wasat Pl thenthe proft maxm zinqperfecty
competitve f rm w llofferql unts perperiodasitsMR
curventersects the lvlc curveat pointf. Simlarly,if
the marketpricewasat P2thenthe profitmaxlmiz ng
pef€ctlycompetitive i rm w ofierq2 unts perperod
as ts newMRcurveinters€cls the MCcurveat po nt
h Lasty, if the marketpricewasat P3th€nthe protit q/ peiiod

maximzifg perfectycompettive firmwi offerq3unts

perperiodasitsnewMRcurventersects the MCcurveat
However, n theshortrunit wil beon y thatsegmentabove
the mrnmumAVCasat any owerpriceit wasesrabish€d
Pojntsf, h andj thusshowhow manyunts thisfirmwrl thatthefrm willnotofferanyunts butwil shutdown.In
offerat differcntprces.!t folowsthatthe IVCcurvelsthe the ongrun, t w lbe thats ectionofthe MCclrruethat €s
aboveth€ATCcurveas t w ll notofieranyunitsandshlt
downil pric€s lessthanATC

Givenrharthefundamental prob€mof anyeconomys Allocative elficiency in p€rfectcompetition

scarcty,it s lmpefatveto consider efficencyssues.Severa .
ln Fiq.2.44ba unilsthatarewo(h morcto consumers
typesof eficiencyare distinguished in econor.cs.
ihanwhatli coststo produce th€mareproduced.
. Allocativeefiiciencyexistsif 'junthe r qht amoLrnt'oi
a lhsisaful versionofFg 2.5wltha th€necessary
good is produc€dtom sociely'spoint af view A oca\1re backqround knowedqe preseni. Unt Q1 sworthQla
ettcencyisachiev€d if all!nitsof a goodthatarevau-cd andthemarginalcost of produc ng it s Q1b.lt should
by consumermorcthanthe costto produce eachare be produced andin a perfectycompelitive mark€ttwill
i-deedprodJFd rpJr- | rraLrr . for ch pnces
'^h b p o 'o d i . F o A L - 1 ( 9 w o 1 l o r o d u L , r g r o . rl,o p.)1
equaltomargna cost.lf, for the lan Lrnitproduced, po nt ol vew areindeedproducedForthe lastunitQ*
P= N,4C thena locatv€ eff c €ncyisachiev€d. producedn a perfectly compettvemarket,P= MC.
. Te(hnical{or productive)efficien.yexsts f prcducton . Focus
ng on Fig.2.zl4b it canbe seenthatsocalw€lfar€,
takespacewth minimalresource waste,ewit deJnedasthe sumof consLrmer andproducer surpus,
minmumaverage costs. s maxmized.Consurner surplus iseqLralto area(FP*E)
lf marketsar€ perfectlycompetitivethen both andproducer surplus isarea(HEP*). Therrsunr,area(HEF)
allocativeand productiveefficiencyare achieved. s maxmumsinceallocatve efficencyis achieved. lf any
otherquanttywasproduced, socialwelfare woud b€
Efficien(y

Figure2.44Efficiency
in perfectcompetRion(a)theJirm(b)the market
raj (b)

(orproductive)
Technical efiiciency
in pe ectcompetition consq*2.l\,4in ma resourcewaneisthusacheved.Af rrn
. Inthe iongrun,f ms if perfectly ncun ng higherthanqiz unftconswou d beforcedto
competitve ma*ets
dretechnicay efficentastheyareforcedto produce ext the industryasitwo!ld be makinglosses
. t followsthatperfecty compet tivemarketsnoronly ead
wth mlnimum average coslsnFg.2.44aong-run
equilbrjunr to the opt malproduct mixbLtta soscarc€
resour.esare
outputq* isachieved wth minmumaverag€

Evaluationof perfectlycom

Th€res no guarantee thatthegoodsproduced w Perfect y competit veindustresproduce undlfferentiai€d

be d strbutedto the membeBof society
in thefairen
proportions.
Theremaybeconsiderab e inequaty of
Remember thatmarketdemandisdefnedasthe
wil ngnessbrt a/sofheabllityto buya goodat each
priceAb ty reflectsthe lev€lof ncomeeachrnemDer or
socetyfaces.Poofhouseholds maynot be'counted'n
the marketdem.ndfor a 'basic'productif theydo not
haveenough'€uros'to casttheir'vot€1.Ther-6 isthusno
guaranteethai pedectcompelitioneadsto a ||utsocally
optimumcombination of goodsproduced
Perlectly
competitvefirmsdo not havean ncentve
to nnovate.Notonlyr.aytheynot be ableto afford
spendng on rcsearch anddevelopm€nr bLrtthey
alsoknowthattheI nnovaton(a newproductor a
betterproc€ss)wllb€ copedbythe otherfirms.5lch
nvestmentsp€nding wo!ld be a wasieof money.
ptodLrcts. Thislackofvarietymightbe seenasa
drsadvantage to the consumer.
Pricein competitve markeiichanges g venanychange
in demdndor costGupply).ond tionsThesef uctuations
increase unce(ainty andmaydeterlong-termnvesrm€nt
In an IndustryIncontrast,the prcestabiltyoftenfound
in ollgopolisticmarketsmayse€mdesrablefor investment
piannnq conslderations.
Theperfectly compettivemodelisnorcompatblewiih
1- ed\-I ptL .l ro scale.r e. r\ tr Frorlo.]eso ), dle.
Tecofomesof scae werepresentthen th s woud mean
lhatther€wouldbea costadvanrag€ in bggersizesothe
ndustry woud endup wth few largefrms.Theabsence
oTscaleeconomes n perfectcompetitonmayimpythat
p iLedfierdll .l-gr.rr'la-ir$orloha/Fo""i .her€
werelew largefirms nvolved

45
 Mon ;;il:j:lii
Charactefttics Theconceptof monopolys reatves ncelt cruc.llydep€nds
. Onefirmpfoduc on how naffowlyor broadlythe prodlct.nd the market
nqa qoodwthoulcosesubsttutes;the
aredelined.Notealsothe mpo(anceof th€ geogrdph ca
ndustrycoincides
withthefirm.
. LJnqueproduct(aslhereis byde{n tiononlyonefirm n lador,i.e. ocaion n reatonto trdnsportation
cons.

points(oncerning
someinter€sting themonopolyfirm Equilibfium(short-run andlonq-run) of a monopolyfim
A monopolist canchoose €itherthe leveof outputor . A monopoy,beng the onlyfirm n the market,fac€s
ihe prc€but not both,s nc-"the rnonopoly f rm isst the n€gatively slopedrnarketdemandcuw€.f t s a
connrained by a negativey sopeddemandcuwe. protitmaximiz nq frrmit w choose thatrateof output
A rnonopoly f ffn doe5not necessarily makehugeprolts. at whLch MR= VICandMCisrisnq.In Fiq.2.35th s is
t mayevenmakelosses; rememb€r thatprofitsarea the cas-aat olrtputQ*. Havinqdetermlned the profit
iunction ofthereatvepostion ofthed€mand (theAR) maxmizngoutputtw ld€termnetheprceatwhch
curveanorneaverage coslcurve. th s quantltywillbeabsorb€d byconsumers. Ths
A monopoly f rm (moreqenerally, anyfirmfacinga ifformaton isgivenbythe demdndcurve.lt wl thuss€t
n€gatlvely slopeddenrand cutue)doe5 norhavea supply the priceal P*.lt cannotset t anyh qh€rbecaus€ at any
curve:ihemafgna costcurveisnofa suppy cLrrve lor priceaboveP* fewerthanthe proft maxirniz ng eve ol
suchfirms;eachoutp!t f.te corresponds 10mor-"than outputQ* w be bought.
oneposslble priceasan infn te numberof MRcurvesmay . Focus ng on Fg.2 45, at Q* unts of outputperperiod,
go throughanypoift on the MCcufr'e protitsare€quato area(cFP*C). Th€differenc€ betw€en
t canb€ shownthatlf the demandc!fr'e{theARcurve) the average revenLre Q*F and the averag€ cost Q*G s the
s lin€ar,
the rnafgna revenue cutueisahoI near,hasthe profitperunitwh ch,if mutip ed bythe numberof unts
sarn€vertcalntercept anddoubletheslop€. cG (equalto Q*),g vesusthe profitare, (GFP*C)
A monopoly f rm cans€tthe prce(it s a prc€'setter and . Thisf rrnis makingsupernorma proftsblt s nce,by
-otd p ip l: lh" deg'F"of ^1o1opo y po,^pr" q /" assumpton, baneu €xst,no newf rmsw llenterthe
"le
bythedifierence between the pric€charged andmafgina industryf demandcondtions,con condtionsandthe
cost€xpress€d asa prcportonof prce. -"ntrybdrrierspersist thenthisequilibrium (P*,Q*)will not
A profitmaximizlng monopoyfirmwi nev€rchoose. change so t isa so. long-rLin equilbiunr condton.
rateof outputQ thatcorresponds to the price-in€l.stjc . Notethat f the monopolist a msat maxirnizinq ,eyerues
segment ofthe demandcurveit fac€s.ltwi always instead of profltsthenit w choos€ th.t leveof output
ocatebelowtheelastic segment. Ths is becalrse lor profr al whrchN/lR = 0 (r€ferto Fg. 2.11a).In Fiq.2.45th s i5
max.nzatonMRmunequaMCbutsince marginal th€ caseat Qr
costis necessariy a posiUve numberit fo owsthat IVR
musta so bea postivenumberat ihe proft maximzing Figure2,45Monopoly: short-runand ongiunequilibrium
output.lvlargna rev€nues poslive(i.e.llesabovethe Q
axis)only for thatsetof outputratesthatcorrespond io
theelasticregon of the demandcurve.
Theproft-maxm zingoutputevelis necessa r ly /essthan
the revenLre-max miznq lev€lof output{where[?]R= 0)
andthusthecorresponding pricecharg€dis higher.n
otherwords,revenue rnaximization eadsto moreunts
b€inqproduced at a lowerprce.

46
A ocativeefficiencyis not achievedLrnder
monopolyWhy? FiguE 2,46 Monopoly and perfed competition
. At the leveof outputQ* chos€nbythe monopoyfrms/
prceexceeds rnarginalcost.Societywouldvaue more
unts to beproduced. Soc€tywou d ketoenjoyalllnits
up unt| lnit Qsocn Fig2.45,wh ch s vallredasmuchas
twoLrdcostsociety io produce(dstancelQsoc)Unlts
Q*Qsoc arenot produced and thussocetydoesnot enloy
wefareeqLralto area(HlF).Area(HJF)is the resultng
wefare ossrefeffed to asd-"adweghtlossasll is net
valuethat is ost.
This s a casewhere mdrketforc€s ead to inefficient
a locaton of scarceresourc€s.
lt s a marketfailLrre
Produclv€neffciency a soresultsundermonopoly
Why?Themonopoyfirms not forcedto produce wth
m n mumaveraqe costs.At Q* averagecostsareQ*G
whicharchgherthan rnnimum
L.s1..!d1Fvrp be-lrtern Lor€d he rFrr X-inefticiency
for a differcnttypeof netficiencythatsom€v€ry
prot€ct€d monopoy post onsmayl-aad to 'X-neffcienry'
r€lersto ihe /rterrals/ackestthai .haracterzessome fthat s ihe casethenthe monopoywillhav€a new
monopoes.Ths s the casewh€n,on a diagram, th€ marginal costcurvethatcoud be aslow asMC,.MC,
ACcurveisnot as ow asit coud be,giventheavailable ref€c1sthe deaofscaleeconomes f this s the case
lechnoogy.
thenthe monopoly mayendup producng evenmore
(Q*")thanthe perfectly competit
ve ndustryat an ev€f
ls therea casein favouro{monopoly
and,moregenelally,
in
favourof largefimswithmonopoly power?
Perhaps,€venmoreimportantly, a drqefm with
. Theanswers yes.Issurnea p€rfectly compelitiveindlstry monopoypowermayleadto a fasterrateof
wth a marketsupplyat S(alsoth€ Mc curve)and market technoogicaadvancenrent. Innovations, definedasn€w
demand at D.s in F9 2 46.Equibrumpricew lbe at products or newproc€ss€s, nrayresut ai a lasterratein
Pcandequ ibrum quaitityat Qc.We haveshowntlrat suchmarkets. Why?Because, assuming the monopoy
th s outcomeis€fficient.lssumenowthatsom€howth s Jrm is nol enfrerche4meaning that t is not protected
perlectlycompetitvendustrys monopoizedbutthat by nate-created barr€rssLrch a5 cen€es, ihenin oroer
the productiontechnoogyremansunchanged. Thus,the to maintan iis poston it maybeforcedto innovate. In
mdrgna con curveforthe monopolyfirm remains at MC. addiion,the sup€rnormal profitsit enjoysactasbaitihat
Themonopoistw I choose Q* unts andseI at a priceP*. luresoth€rfrms io nnovate in an att€mptto displac€
We havealsoestabshedthatth s outcomes in€f{icient. the monopolst. Perfecty cornpetiUve flrmswoud not
Thernonopost rcstdcts oltput andrasesprce.Wefare havethe incentiveto innovate becalsefreeentrywoutd
e n natethe possibty of a prcfitabe return.These
. Howev€r,
th s resullrenson the ratherun ikey ideasareoftenreferr€d to asdynamicefficiencyand
oc(.-o.io .r tL dr d dr oar 10- opoly r . 1e- pt o/ 5 t\e aredssocated withtheAustdanecononr st losephA.
sanretechnoogythat thesmallperfectly
competitve Schumpeter
f rnrs('loey')employ.t isveryprobabe thatthe
monopoly t rm w llenloyeconomiesof scale.

47
 Batriersto

Barretsaredefnedasantthingthatdeteuentry nto an Figure2.47 Naturalmonopoly

I dL r) o h" p'F/"1rs",( ro"1 an 10 i r./. A oo_re
rasesth€ unitcon ol a pot€niiaentrantaboveihe lev€l
enjoy€d bythe incumbent firm
Barretscanbe classfedirto natLrr.,statecreatedandfirm

Naturalbarders
. Naturalmonopoly
Often,pfoductontechnology s suchthatv€rysgnfcant
economies of scalearepresent. Asa resut, givenmarket
sze,of ly fewor evenony onef rm canprofilabycoexst.
Whenonyonef rrncanprofitaby eristnamark€tt s
the caseof naturalmonopoly. Fg!re2.47illustrates th€
point n thisdiagrams gf fcant economesof sca€ arc
present at lhe LACcurveslopes downward throughout
the engthof the demandcurvethatdefines the reevant a at2 a
market.Assume that nitl. ly thereison y onefirm n thLs Q / P€riod
mdrketandthatthe profit-m.xirn zingoutputisat Q
wh ethep ceatwhichtheseQunitswl beabsotued th€ pricew I reman at P Ea€hfirmnow is makinga Loss
s P - - rn i\ prcrr"oleanaiTAr_oyp'o . pqJoro equdto hf perunit.ft s muchtoo expensve to produc-o
ab p€runt. f nowth s ma*et s equaly sharedbytwo Q/2 units,as Fg.2.47I unrates
{ nns,eachproducing andsel ng Q/2units,thenthe . Exclusive ownership ofsor.evtal nputcoudasolead
tota amount enterngthema*€twilsti beQuntsand rc a monopory positon.

Statecreated
. Patent!.e 9 dr .edbygover ne drd d e r9ht5Lo
"
produce exclusivelyior a fixedperiodofUme.Patents
airnat protectng the incentiveto spendon research
and . Advertisingand brandname mag€cr€.tion:The
. Licences areexcusve permits thatoneor few f rmshave.
ry andradiobroadcasting firmsrequire
a lic€nce.
. Tarifft ". LLoap€t. o- ro-1fore9r rn
-.'ld .'ed.e
Frrilshave€veryncentve10try to erectbarriersn orderto
enjoyrnonopoly powerandlong-rLrn supernorma profts.
strong€rthe brandnamein a marketthe moredifficut it
rsroTa newcomerto enter
. Productdifferentialion Firmstryto d fferentatetheI
prodLrctor producernanyvadet esof tto rnakeentry
morediffcut
. lnc!mbentfirmsmaydelib€ratey rnaintan excess
producfivecapacityPotental entrantsknowthat
the ncumbentfrm canthuseasilyncrease output,
deprcss ng prceto unprofitabelevels.

charactedstic slopeddem.ndfor the prodr.rct prce

t sels.lf t increases
. verymanysmallfrms(eachfirm hasa verysnal shareof twillnot osea lof itsclstomers.
Typca €xamples of monopoistcaly compettive industries
. D fferentiated ncudehairdressers, restaLrrantsandDVDrentastores.
product(differentaton
canbe a ong
Notethatoft€n,especia y in rnanlfactur ng,the
qualty,dLrrab
lity,desgnor productserr'ice
andcanbe
exnenceof manybrands for consur.ers doesnot
rea or imagnary).
necessary jmpy monopolinica ly competitjve markes.
. lt s thesecondcharacteristc Forexample, in the detergentndusrryth€re mayb€very
thatconferssuchf nnswth
manybrands to choos€ frombut behindthesebfands
a verysma degree ofmonopoy powerSnceth€product
thereareonlytwo orthrcef rms.
ls not hornoqeneols
theneachf rm facesa negatively

48
Short.run
andlong+unequilibrium
in monopolistic . Entrywlcontnueuntthercsnolongeranncentive for
(ompetition it to takep ace.Thiswi bethe casewhensup€rnormal
Theillunration of short-r!nequ ibriumin monopolrstc proiits arecompeted awayandihetypcaharsalonis
compettion isidentcato themonopoy d agram(Fq. m.kingnormalprofts, .e.zeroeconomic profts Lofg-
2.45).A monopostcalycompettive firm mayenjoy rLrnequilibri!mwi beachiev€d whenthetypicalfrm
supernormal profitsn the shodrun.Supernorr.alprofrts n sucha marketis maximzingprofitsandiheseprofits
rnthlscasewil induceentryasno bafiiersareassurned arczero,.e.normalFgur€2.48illustrates long-run
n thlsrnode.f haI salonsn . marketarcenjoying equ ibrum asat Q* thefifi equates MRandMCand
supernormalprofih, othersuchfirrnsw lbe attracted. thusnraximizes prcfits(Q* s the opt ma outputrate)but
Sooner or lat€roth€rhaI saonsw ll open!p andlure ARandAC are€quato Q*Fsoeconom c profiharezerc

As€ntrytakesplace,thedemandthatthetyplcal Evaluation
of monopolisric
competition
ncumbent f rm fac€swi 'shrinkandtilt'. Demand will A locativeinefficiency
resuts. Prceexceeds marginacost
'9r'ir L bedJ,F rorpIrr,-npydsnale -r'ate. at the equlbr um lev€lof outputfor eachf m.
sharefor each.At eachpr cethe qLrantity demanded Technica inefficiency
andexcess capacityahoresult.Each
perperiodw ll decrease D€mand will 'tilt' andbeconre li - orodJ.e. e- oL.pL. . dr .l.p o-F , orp\po1o 1q o
fatter because the res!klngb ggerchoiceavail.bleto rnn mum.veraqe typca y havernany
costs.Restaurants
' o_sL1p - l ea'L h" dFr ",ld w bp.o1p ror" pice emptytables andonedoesnot haveto wat in lineto r-cnt
elastic.
Remember thatpriceel.sticq/ncreases
when a DVD
consumerstacernor€andclos€rsubsttutes Theqreatervaretyof producis avaableisconsidered
an advantage ior consumers.Frmsthoughareforced
Fi gur e2. 48
M onop oi s ti cc o mp e ti ti o n :l o nrug ne q u i i b ri um to adv€rlseandto resortto othermethods of non-prce
competiton. Thehiqherthdnminmumunt costsin such
mafketscanbe interpreted asth€ 'con' of vadety.

Tips
Fiqure 2.48isverytr ckyto draw FirndrawaU shaped
ACcurveThendrawa lineardemandcurv€at a tangent
to the ACcurve.Automatcay,the profit'maxirniz ng
outputfateisdetermined beowthetanqency poift
dsat a otherlev€ls of ouiputAC > ARandthe f rrnLs
mdkLng a oss.Nextdrawthe MRcutueas ts posiUons
nrictlydetermnedat doubLe theslopeof the demand
curveDrawtheMC('Nike-swoosh')curve lan, mdkng
sur€thaion itswayup r cutsthe MRriqhtabovethe
prolifmaximiz ng evelof outputQ* andthat t a socuts
the minmunrof the U shaped AC curue.

O l i g;;;,,,i

Characteristi(s produci(ahon dny ndunralproduct,e.g cars

. Few nterdepend€nt detergents,
applanc€s,aircrafi,bankng,insurance)
fims. . Sgnlicantentrybarrier.
. Homoseneous(o , sleeor cement)ord fferentated
Oligopolycontinued '
lllustratinginterdepend€nc€ Tocomp€t€
or to collud€?
. The del n ng charactersticof oligopolyis . Thed emmacharacteriz nq ntedependent c
oliqopolist
ntedep€ndence. Firmsareconsidered in1€rdependent f firmss whethertoconipete or to.o ude.
theolrtcome of anyactionof onef rm depends on th€ . Through competitontheymayincrease th€irown market
reaction ofthe rva firms.Forexample, the success ol share and iheir profts at the expense of rvas
anadvertisng gn
campa of frm A depends on whether . Colusion, on the other hand, decreases uncertanty
iival {km B decreases iG priceat the sametrmeor not andfrms maymaximize jointprofitsasif theywerea
ifterdependence canbe illustrated in a diagfamln
Fg 2 49 a marketwth two firms,A andB,isassumed (a
collusion
Assume that{ m A iscurrcntly selinqQo Lrnits at prce . Collusive oligopolyexistswhen two or moref rm
Po. ncreas ng ihe prceto Pl mayleadeiiherio a aqreeio fx pdcesorto engagein otherdntcompetiUv€
reat vey sharpdecrease n lh salesor to a reat vey m ld behdvour. Agrcement canbeeith€rformaor nlorrnal.
one.it depends uponhowr valf m Bw react.lf f rm B . lf theagre€menr isformaw€ havethe caseof a cartel.
dp. oe lo fo,o\^lae plce I Crease -l'e1| n A v .ee
Cartesareg€neraly egal.n mostcountriesfrrns
quanttydemanded decrease on yto Qlf (f:follow)as cannotsignl-pqay enforceable contracts. Frmsthat have
bothI tmswillbemoreexpensive nth€market.lfthouqh madeformalagreements tryto rnakesurethatth-ar
fivalfm B doesnot folow the prce ncrease thenA3 agreernents r€man secret. oPEcisa caseof a formal
sa€swi shrinkto Qlnf (nf:notfollow)asmany01 ts aqreement betwe€n oil €xporting countriesin whLch
customers wil swtchto trrmB. debed' on.drdoe' o d p p rb Lr.ed as - ooardle
Symmetrica ly,by d€(easingthe priceto P2salesrnay abovendtonal aws
expandsiqniflcantly to Q2nf fthe rva doesnotfo ow . Lfthe agreementis nforrnalthen we havethe caseof
wh € theymay ncrease but not assubstantia y I the rva 'tacit co uson. To illustratethe co llisve behaviourwhere
f rm doesfolow andalsodecreas€s ts pric€. firms behaveds d monopoy firm, one can employthe
. Not€that interdependence is m|ch broader thanthe case n orooo) drdgr" .]l - 9. 2 r5\ r.pqL.b' J-no..p" s
descrbedhereasrivakybetween firmsmayextendin th€ loint profit maximzing output and th€ proflB mun
manyotherdimensions, e q. the decsionto invenorto somenowDesnar€0.

Howlik€lyis itfora collusive

agfe€m€ntto
collaps€?
Figure
2.49Interdependence
in a duopoly
Co usvestructLrrcs areunstabebecause ofthe inherent
ncentveto cheat.Eachmemberwou d preferotheKto
abde bythe outputrestrcting agreement wh le t doesn't
andexce€ds it. Suchagreements aremoreikeyto coll.pse,
. the greaterthenumberof memberfirms;
. the smaer the propoirion of tota ndustryolrtput
members of the agreement contro'
. lf the goodisdiffer€ntiated andnranyvariet€sexistl
. f production costsd ffer;
. f marketdemands shrinking
---'.li fonveBey,whenthe rnarkets domnatedbyveryfewarge
firms,producng a ratherhomogeneoLrs prcductwth s rn ar
p-odLrio'rcostsd'rdderard s l's ng.rl^ardry 're
"gree '.
w I b€ morelikelyto ast.

Non-collusive
oligopoly
arnf a1f ao a2f Q2nf
Thetermrefe6to the casewhereoliqopolistic f ms have
no agreement concernng theirbehaviour andtactcs.
sti , repeated eadso igopostc firmsto avoid
interaction
changnq outputevenif costcondtionschange.
Thek nkeddemand cutuemodel(Fig.2.s0)illustrates
th s point.lt waslntroducedby P sweezyin 1939and
il din"dat e p" 1rno.l'" obcprvpdp'i F ,r,I re"5i'
o gopostc markets evenwhen cost
condtionschanged.
It istypicalyconsdereda modelofnon-cousve
 Th€behavoraassumptior, n the k nkeddemand Thernodelisusef! asit ustrates theobserved stcklness
curvemodelis simpe:given thecurrent prc€,f a firm n pricesn o iqopoiesin a 5mpe way
increasesprcethenrva frmswil norfollowwh€, f a t hasbeencritlcized qrounds
tholgh on theoretica as
firmdecrcasesprice,thenrva fims wi fo ow andcut ttaik to expalnhowtheorginalpriceP* isformed
pricestoo.lhus a k nk w form n thedemandcurvethe anda so because the rangeof possibestrateq
esand
indvdlalfm faces atthecLrrrenlprce. rcspons€s n suchsetupss rnuchmorecompcated.

Figue 2,50 The linled demand

Tip
Sta.rdrawingthis diagrambyf rst (hoos ng the k nk
somewhereln th€ !pper eft cornerof the graphspace;
then drawth€ demandcurvemak ng surethat the
sectionret€ctingth€ resut of a pdcedecreases not
too steep.Nextdraw f rst th€ MR secton coffesponding
to the felativelyelanicsegmentof the demandcury€,
maintainnq the doube-the sloperule.The MR wh ch
corr€sponds to the lower right segmenthg of the
demandcurveshouldstari at sucha po nt b (seeFg.
2.s0)thatdb = bc and a so ma ntan the doube-th €'

(ompetition
Non-pric€
Oligopoistc f rmsavodcompetng throughpricecLrtssuch
a strategy coud €adto a competitve downward spral n
pices(apricewar)wh ch colld eav€a lf ms worseoff.
In Fig.2.50,the k nk isat pointh corrcsponding io th-" Non-prcecompetiton.antakeseveraforms,suchas:
intia prceP*andthenitialquantiiy Q* Segment . heavry advertsing andbrandnamecr€aton (e.9.Pepsi
fh o{ the demandcurveis reatveymoreprlceelastic andCocaCoa);
thansegment hg asa consequence of the behavioral qiftsandcoupons (€g. newspapers andmagaznes);
assumption. Notethai demandb€lowthe kinkdoesnot continuolsproductdifferentaton(.ars,c€l phones, DVD
haveto be prce neastc but ony lesspricee astc thant playels,TVsets,TVstations, €tc.);
isaboveit, asthe exstence of a postivesegm€ntforMR exceEs ve productproiferaton to covera I maginable
ma*et n ches(eg. icecfeam,breakfast cereal);
Thekinkleadsto a d/sconrrurlyn the margnd revenue €xiended guarantees(typca y n eectricaapp ancer,
curyewhlchhasto bedoublethe sopeof eachsectonof computer hardware devces);
alietsaesservic€(custorn€rplansof carmakers)l
5 ncethe fmr isassum€d to b€a profitmaximzer vo umed s.ounts(oftenn products suchasshampoo and
t fo lowsthatmarqna costmun haveint€rsected
the margna revenue curverightabovethe chosen
outpLrt ll a pricewarocc!rsn the realworld,someparticpants
Q*. (typically
Ths couidbethe caseeitherwth the MC,eFcurveor thosew th 'deeppockets')ookfoM/ardto w€aker
tirmsbeng forcedto qo oul of business or b€acqurred.
withthe MCft,ercurve. Byinf€rence, anychangein costs
withinth s ranqew ll alsoeadto Q* unts chosen and
thlrsto tlr€sanrepriceP*.ftce rsstickyat P* in a
o gopoyevenf costcondtionschanqe.
non-collLrsive
tnce otscnmtnalton .r.'.rtiti: Price i

. Pricedkcrimination{PD)isa pricng polcythatceara n n p€*eclPDth€ entlreconsur.ef

surpusisapproprated Third-d
ilrmsadopttof!rther ncrease theirprcfits.Formaly,prce bythe producerwho enjoysa sue us€quato ar€a(bea).
This
nationexstswhena f rm selsthe sameproduct
trlscrirn Aso,allocatveefficiency
s achevedasa unitsforwhich
:i two or mored fferentpricesn two or moremarkets prceexceeds marginalcostareproducedandsod up
.rovidedthdtthe prcedifferences do nol refectcost unit(Qnin thed aqranr)forwhich
untilthat priceisequa
to margna cosi
. The closestr€d world appfoxirnation
' L\anrples
incud€. rlln€t ckets,tra n andbusfar€s, of ihis highly
andc nematickets,phoneservces,awy€r/doctor/ th€oreticalconstr!.t maybe open-ar marketswh€re
aheatre
' hagql l ng's common.
. n inlernatonaltrade,dumpings a soconsidered
a torm
priced scrm natonas t lnvoves
of internalionai seling Second-degreepdcedisrrimination(or blockprice
.broadat a owerprcethanin the protected domenc discrimination)
Eit h
n s€cond-degree PD'b ocks'ofoutp!tare50dat
dfferentprices to the sameconsumer Forexample, ln th
conditions
permitting
a firmto pri(€discriminate nranyparkng garages in cty centrespriceth€f |st hour
. Ihe firm mustenjoysomedegreeof monopoypow€r. at,say€10.00, the next2 hoursareat€6.00perhoLrl
ji mlst fdcea negativeyslopeddemandcurve.Thu5 a_d"nJdddirord. LoL'sac a-\'00 pFr'oL lr vdy
. pe.fecty cornpeitive
firmcannotpractseprc€ they extract a greater portionof the corsumer surplus
compared to charging a singleprceperhour
No resaleof the goodk€ferredto as'seepage')fromthe n the s mplifl€ddiagram, Fiq 2 52,the prcfil-maximizng
cheaper to the prciermarketshouldbe possible.The f ffn in tia y s assumed to chargea singlepr(e q sel ng
rvo markets mun be somehow separable,otherur'ise Q Lrnits perperodandrnaknq maximum proftsequa The
'arbitraqe(buying ow andsellinghiqh)wllguarantee to somen t nowdecides to adoptseconddeqreeprce
ihal eventuay oneprcewilldominate in bothmarkets. discdmination andchafges a prceP'forthef rstQ'units
Priceeastcitesof demandbetw€enrnarkets must wh le r charges d prjcePfof unitsQ'Q.
differSomeconsumers mustbe prepared to paymore, Totalcostshaveremanedthe sameasit s stillproducng
:iiher because areavailable
f€w€rsubstitutes to themor Q unrs (0Q'+ Q'Q= 0Q)bLrtitsrevenles arehigherby hr gh
3ecause theyenjoya hiqherlevelof ncome. area(PhfP'). lt fo owsthal it hasmanaged to incr€as€
profitsabovethe even achiev€d w th a s nqe prce.
rirn-degree (orperfectpri(€
pricediscrimination
diroimination) seconddegree(blo<kPD)
Fi9ure2.52 Pri(ed iscrimination:
. A h qh y th€oreticalcasewherethese er s assLrmed to Consl
beluly awareof theconsumer's wil nqness to payand
.harqes herthemdximum prcesheiswii nqtopayfor
In gen
:acn!nrt consumed
. r ihesimplfed dlaqrdm, in the e
Fig.2.s1,thef rstunt Ql s
sod.tthe maxmumpricepossib e,P] Thenextunit,
Q2, s alsosoldat the maximum prce t canfetch,P2,dnd

firstdegree(perfect
Figue2.51Pricedisdmination: PD)

ii

I Useth s claqramto showthatpriced scrmlnation i

i can ncreasef rm proftsabovethe s nqe-price i
i Drofllmax..zinqleve. i
Third-d€gr€e
pri(ediscrimination Figure2,5! Pricedlscrimination:third
degree
. Ths isthe common€n rypewheremarkets aresegm€nted
across somecharacterlsticthattakesadvdntage oi
differing priceeastcites and that doesnot permit rcsae.
Forexarnple, a rinetcketsboughta dayin advance con
morethanif theywerepurchas€d a monthn advance
of a f iqht Sincelhe nameison thetick€tthecompany
tl esto takeadvantageof thefactthat f onedecides to
travea few daysbeforea f ght ethershehasimportant
busnessto conducior sheiswealthyandlhe tcket
expense isa sm. l proporton of h€r ncome
Eitherway,the higherpr ceiecharged ln the market
ch.racterzed bythemorepic€ neastcdemand
n thesimplfedd agram, Fq.2.53,thetwonrarkets are
drawnsde bys de.Da,on the riqhthandsde,rcfects
rhedemandcondtionspr€vailing n nark€t'a' assum€d
to be morcpric€inelastic (e.g busnesstravellers). Db,
on th€ eft-hands de,refechthe morepfice-elastc
condtionsprevailng n market'b'(for examp e,iourst
travellert.Margnalcostsar€dssumed, for simplcity,lo i WhendrawinSthetwo demandcurr'es rnakes!rc thelr i
i slopesdlffersubnantiay sothatthe resultng prces i
. Thefirmwill choose th€ profit-maxlmizng outputln ea€h i diaer on L"nt, i
marketby equatng tvlcwitl-rMR n market'a' th s oc€lrs --------i
at outputQar€sultnq n pice Pa. n rnark€t'b' wlth the
-ore p'i e e d.r, dendrdI'e p o'i-f a -lil'r9o-.p-.
isat Qbandthe priceis ower,asexpected, at Pb The
h qherpriceischarqedn the marketcharacterized by the
rnoreneastcd€rnand condtions.

Consumersand orice discrimination

In gefer., . pr ce-discriminating
f rm appropriatespart(or
in the€xlremecaseof filst-degree PD,all)of theconsumel
surplus.sincethe prc€discriminating finn s ableto charge
cosertowhatconsumers ar€at th€ mostwillingto pay,lt
foLlowsthatthispolcy n g€nerarunsagannthe interesG
theremaybe stuationswherecertaingroupsdo benelt
Ye1,
. Thegroupthatpaysthe lowerprce,if t is lowerthanthe
pric€charged
in the s nge-prcecase.
Thispricng policymaypermita I rm to se a gr€at€r
vollrmeof outputandasa result€njoyeconomies of
scae f thesecostsavngsarepassed a ongin thelormol
ovefallowerprcesthenconsumers beneft.
f otr€rnq the qoodwaslnprofitabe at anys ng€ pr ce,
thenpficed scrm naion maymakethe prcvsionot a
ooodoror.cbleo d g ouoof ro-r(-1"' rho'orh-1\i.p
woud haveto do wthout t.
 Theoryof co

-rcorfdr..o .l'eo{'odo l€of o ratel.rr.rrr.r. FiguE2,54 Contestable

markets
thetheoryof contestable doesnotfocLrs
mdrkets on ihe
numbefdndsizeof thefirmspresent in a markel.lnstead
tfocuseson €ntryand,especiay,ext conditions.
Theidedof marketcontestability
renson the absence of
sunkcostsdefinedasentrycoststhatarenot recoverabe
uponexit.Examples of sunkcons ncudeprodlct
development costs(whichareh gh n the pharmaceutcal
or thecarinduniet, advedsing costs,specalzed

lf lhereareno sunkcostsnvovedthena contestab€

niarkets subjectto 'hit andrun'.Firmscanenter,reap
the profitsfor aslongaspossibedndthenexitwthout
incurring anyexitcosts.
Thispossibiryfor.es n.umbentfirmsto seta pfice
r. rhe|osr\ o' p.odL(.io1.
I' dr.e'1", W rl-oL,b" riF.
to entryafd sunkcosts,it s potentialcompettionthat
w ll ensur€'competit ve' pedorma nceevenn highly
concentfated markels with few larqefirmspres€ntFms
\ ll b"'orcpdro par,rTproecolo-ni.pro'L drd p ; F
will beclos€to marginal cost,ensurng in equilibriuma thusthedegr€eof contenablity Contenablityincr€as€s,
socially€ffici€ntoutcom€ the lowerthe szeof sunkcosts,
the lowerthesizeof
ln Fg 2.s4a proft-maxirn zingmonopolist w lchoose barriers
to entryandthe hiqherth€szeof supernorma
to ofi€rQ unitsal a p ce Pmakingsupernorma prolrts
equaltoarea(P*hfP). lf nowthismarketwas perfectly Themainpolicyimp catonof contestable markeltheory
conknab€th€nth s monopoly frm woud be torced isthatif on yfew firmsexistin a marketit shouldrot
io setihe pric€at P* sellngQ* unts,asatthai lev€lol necessailynpy nefflciency. Thusmarkets with iew large
outputthe resultng €conomic profitsarenormaland needgovernment
lirmsdo not necessarily interventon
no'hi andrun'entry wi beinduc€d. Outputs at the andthescaleeconomies oftenassocated mayevenbean
socally effcientevelas at Q* prces equaltomarginal addtonal reason to makethemdesirabe.
Contestabq/ theoryhasforcedpolicymakeE ro foclrs
Perfect
contestabilty
doesnot existin the realwordas moreon pot€ntiacompetitonandreduce theiremphass
perfectcompettiondoesnot existeitherWhatmatte6is on t rrnsizeandmarketconcentraton.

Allinone Fi gurc2.55
A l l i n one
Figure2.55lustrates a monopoly or mperfecty competitive
firm,i.e.anyf rm facng a negativelyslopeddemand
clrr'efor itsgoodor sevice n th s diagramd rnalor
d agrarnmaticalpoints ar€I ustrated.

Q1:maximizdtion of profitsisach€ved,asMR= MC{poin1

a)andMCis risng
Q2:technca (productive)efficlency asMC= AC
G achieved, !h
(pointh)andthusAc ismininrLrm
Q3:alocativeefficienctj
isacheved,asP(=AR)= MC(pointf)
Q4:maximization of revefues isacheved,asMR= 0
asr nomal(zero€conomc) profitsareacheved,asP(=AR)=
AC;a firm n a concentrated perfectyconi€siabe
marketwould beforc€dto priceatthat €vel

54
Marketfailures

. Thefundamentaleconomic probem thatallsoc€tes existence

face of externalities andth€ caseof publicgoods A
s scarcty:imted resolrcesversus un imtedwantsThis mdrketfaiureexistsf market{orces fa lto reachefficeft
necessitateschoices,.e.decLslonsaboutwhichgoods outcomes. In sucha c.seeithertoo muchor notenoughs
w lb€ produced and n whatquantites. Howwi scarceproduced or consLrmed soscarce resolrrcesarenot a ocated
resourcesbeallocated? n the socallyoptimaway.
. In a marketeconomy, theanswers g venbyth€ market . OneshoLrdnotetholgh thattheund€rlying income
(theprce)mechan sm.Theinteracton of demandand distributonof the popuationmaybeveryLrnfair And
supply,with conslr.ersa m ng to maximze ut ityand sincethe marketdemandfor anygoodrefectsnot
f rmstryingto rnaxmlzeprcfits,det€rmnes'lhewayth€ jlstwillngn€ss to consume ii butalsoabiltytodo so,
otde ol d pdi ol s ssos ac..1o\^nL' 1o ed- qood households w th severcncomeconstraints, Livnq,say,
w be produced andconsumed. Relalveprcechanqes b€lowtheabsolute pov€rtylln€,wil not'exist'inthe
coordnateeconom c actvtyasif an invisible
hand mark€texprcssion of rhedemandfor perhaps even
ex/stsRelatveprcech.ngesprcvdethesignas andthe the mostbascproducts suchasfood Par.phrasng
r-ce_.he9lor prooJ. Fr,ono. o1. r er..oLLraloerr! r Samueson's famousexpression, theseholsehodsdo not
havednydo arsto votewith lt fo owsthatthe resultng
lf ma*etsarefreeandcomp€ttive thenwe hav€shownthat oltput m x mayrefectalocativeefficiency but maynil
theoutcomes socally€fficientBut,in the rea word besociay Lndeslrabe
. markers arcoftennot compeitivedslirmsr.ay possess
signif
icantmonopoly power; Monopoly powerar a source of market{ailure
. he of e onom.rar'sa'to_." e o "
-o!Gdndbenelits Thismarketfalurehasbeenestablished €arlierin the
pad of enjoyedbyth rd part€soutsideth€ market; pr€sentarion of rnonopoly ando gopolyFrmswith
. tr!€ prcferencesarenot revealed monopoly powefareabe to restct outputbeow the
Theabovethreepointsreferto threeimpodanttypesol competitv€ dealand charge a higher prce,eading to a
marketfailure:theexstenceof monopoy power,the

Possible
solutions power
to monopoly In additon,contesta
bilitytheorystrongly
suggests
that
. Thegovernment ev€nhiqhlyconcentrated indlstresmaybe capable
shouldensure thatcompettiv€
of approximatecompettveoltcomes.Theregulator
conditonspreva in markets.ltshould€nsure that no
shoud th!s makesurethatsLrch s.ae economies
are
mer9e6or acquistions materi.izethatexcessvey
northepotentalrateof nnovation
notsacrificed
increase the monopoy powerof anyf rm.
. lt shouldmontor f rm practcesthatseernanl
A mostetfectvewayto r€ducedomestcmonopoy
comp€ttive; it couldtaxor fne firmsfoundguiltyof such poweristhroughllberaliz
nq nternatonatrade.Fre€
praclces;t shoud evenbreakup suchf rmsintosrnaler
tradeautornatcay incr€ases
competiton,l,"adng to
independent pieces.
. However, efficen.yandlowerpr(es.
incrcased
theremaybeverysgnficanldynamic beneits
arisng fromthe exist€nce of suchlargemonopoyirmsin
theformoffasterratesof innovatonandtechnooqca!
chanqeandeconomles of scale.

Exter

ls present
An externallty if an economc activty produced or consumedMarketforcesalonelal to €ad
(productionor consumption)cr€ates ben€ftsor mposes to anefficientresource
allocaton.
costson thirdpaftiesforwhichthe atterdo not payor . Externa ites mayarse n the productonprocess in which
do not getcompensdted resp€ct vey. Equivalently,
an casetheyareknownasproductionexternalitiesor In
€xt€rnaty existswhenever thereis a divergenc€b€tlveen the consumption process in whichcasetheyareknown
prvat€dndsocalcosts of productonor betweenprvate asconsumptionexternalities. Theymayinposecosts
andsocalb€nefitsof consumption. on thirdpaftes n whichcasetheyareconsderedas
leadsto marketfalureasif t is
An externality negativeexternalities, or cr€at€benelitsin whrchc.se
presentthene thermore(overprovision)or less theyareconsderedpositiveerrernalities.
(underprovision) thanthe socially opi malamountis
 Figure2.56Negativeproductionexternality
. Marginalprivatecosts0vtPC)
Thecostsof production thatthefirmrakesinto
.o']sderd io'r, it_decrsor -",irq prc(es<. l^ey,lcroe
wages,rawmalerals, etc.lt fo owsthatthe NIPCcurves
thesuppycurveof a (competit v€)firm
. Marginalsocialcosts0\45C)
Thecostsof prcductonthatarebornebysocety These
refectthevalueofa//resourc€s thataresacdflced in the
specficprcduction processTheythusinclud€notjustthe
labourandoth€rrcsources thataresacfificed andwhich
compnse th€ coststhataretaken nto consderationby
thef rm,but a soanyexternal cosrsihararenottaken
intoconsideraton in theformof, say,polltion. nlhis
casethe marginalsocal co5lsof producionexceed the
margnalprvatecosisandrhoud bedrawnabovethe D, (MPB MSB)
-
MPC(thesupply) curueThiswouldbethe caseof a OQ'Q
negatveproducton€xternalty. lf thougha productlo, Q / Period
process creat€sbenefts for a thirdparty(say,anoiher
flrm)thenthe IVSCcurveiesbeowthe MPC(suppy) or owerthanthe privatebeneftssothe demandcurve
curveastheres an externalproductionbenefit reflectsbothprivateandsociabenefts.
invovedin the process 5ocetywouldwantony Qi unts of steeproduced and
Marginalpr:vatebenefits(MPB) consuned. At unitQ* theM5CislustequaliotheMSB
Thebenefits the individualenjoys fromthe consumpton Forall uniisbeyondunt Q* the marginalsocal con
ot an exifaunlt.Prvdtebenefits determnethew lingness exceeds the marginalsocia benefit.TheldstuniiQ that
to payandthusthe demandc!rveisalwaysbasedon and is producedn a freemark€ts worthto society on y Qf
rellecrs
the margnd prvaiebenefits cufr'e. (= 0P),slnceth s is how muchconsumers arew lling
Marginalsocialbenefits(MsB) at rhemostto payfor it, but socjeq/
sacrficesfor rs
Thebeneftslhatsociety enjoysfrorneachextraunt production more,nameyQh.Theproduction of unitQ
consumed. Theyth!s includethe prv.te benefitenjoyed by marketforcesleadsto a welfar€ossequalto fh Sinc€
bythe ndvidlal but in additionanybenefts othe6may Toral unts Q*Qrhe MSCexceeds MsB,rhewetfare
enjoyasa resut. Thesociaben€firsncudethe private oi i, poLdl o -hp or-t d ed ref )refa.-ng.ferndrrel
beneftsenloyed plusanyexternal benefits.
ll fo lowsthat neffciency.
the MSBcurveiesabovethe MPB(anddemano/ (urve. Themarketfals because (Q*e)
t leadsro overproduction
li thoughthe consurnpton actvityof individuals mposes oTth€ good gnoringthe external po uton costseadsto
a coston oth€rsthenthe MB curvewil liebeowthe too muchneelal too low a pricefor society.
MPB(anddemand) c!rueasthercisan exr€rnacostof
consumpion generated bythe process.

Analysis
of a negative
production
externality
Tof nd thew€lfareosstriang€ takeanyunitof outpui
. Fgure2.56illlrstrates a steemarketnwhichirmsare betweenQ andQ* andcompare the nrargnd socia
polluting the envronment. Ther.arketoutcomes found costto themafgna sociabeneft.TherdfferenceErne
at the inteK€cton of the ma*et demandcurv€D andihe w€lfarcossfor that unit.Doingthe sanrefor all unjts
marketsupplycurueS.Themarkelw ll eadto Q unts of QQ*w g veyouthe resultng welfareloss
steelat a prceof Pper!nit.
Production externalities ariseon ihe productonside
sowe locuson the nrarketsupplyn thediagram. The Analysis
of a positiveconsumption ext€rnatity
supplycurvereflects the privai€cosisthatf rmstakeinto . Fgure2.57 lustrates the marketforhybridcars.
consideraiion so it s a sothe MPCcurue.ThepollLrtion Owners of suchcarscrcatebenefits to sociery
asthey
costsareth€ externalcosts whichfirr.sareassumed to hep d€crease pollutionin a city.Alternatively,
youcan
rgnoreSocal costsof prodLrction (whatsocetysacrifces) th nkofthemarketfofflu vaccnations. f anindivdual
arethusbiggerthanthe prvatecostsof production and getsva€cnatedit s not h€ralonewho benefits asrhe
th€ N,4SC curvelies.boveth€ MPCcurvefor a lleves of prcbabirythatotherssufieffromtheflu somewhar
ste€loutput.lt fo owsthal MSC= MPC+ extemalcos1s. decrea5es n bothcases the marketoutcomes rourroar
Thedemandcurverefectsthe b€nefits enjoyedby the ntersectlonof the marketdenrand curueD ario(ie
consumers ar eachlevelof outputso it s a sothe MPB marketsupplycuf/eS.Themarketwill eddto Q unts of
curve.Sincein thisexanrple thereareno consumpton hybrdcatsor vaccin€s at a prceof Pperunit.
externatiesinvolv€d, afenot h gher
the socialbenefits
Exter
Figure2.57 Marketfor hybid cau All unitsbetw€enQ andQ" shouldhavebeenproduc-"d
fromsociety3 po nt of v €w asfor eachthesociabene{t
enloyed is biggerthan the costof producton(NISC).
Thus,the marketfalsas t leadsto underconsumptlon of
t (MPC= MsC) vaccines andhybridca|sandthe resultng wefareLoss !s
eqlaltothepinkarea(efh).
Nolethatlor the lastunitsocierywou d keconsumed
(Q*)themarqinalsocal benefits equathe marqinal
socalcosts Butsincendvidua s do notconsiderthe
MSB= MSC
external benefltsther consumptlon creates
andbase
.hF dec5ro . on ,h- dFr d1o . - v o . h p r d r l e r p ,i . e
mustsom€how besetlowerat P" for thesociay opt ma
amountolvaccnesandhybridcarsto be consumed.Ih s
couldbeachieved
througha subsidy.

Q / period
Consumpton externatiesarseon the consur.ption
sdesowe focuson marketdemandin the d agrarn.
Thedemandcurv€refectsthe prvatebeneftsthat
th€ ndvidual€nloysandtakesintoconsideration n
rnakng buyingdecsions, so t isahoth€ MPBcurue. The
external
benefits fromd v ng a hybfidcaror fromgeftlng
vaccnatedare gnoredbythe indivdlal. Thus,thesocia
benefits
of.onsumption arebggerthanth€ pdvate
b€nefits
of consumprion andthe MsBcury€ esabovethe
MPBcurve for d levekofoutput. tfolowsihatMSB=
MPB+ external benefits
Snceth€ productonof thecarsof the vaccinationsdo-"s
not crcat€any€xternaty t followsthatthesupplycuve
refectsbothprivateandsociacosts.
Themarketfa lsasatthe astunt prodlcedand
consumed Q the IMSB(= Qh)exceedsthe MSCof
producton(= Qfl.Thesocialy opl malamountprodLced
andconsumed perperods moreat Q*.
ini - *',"'
fth€ external benefitsfromtheconsumption ofthe
goodof servceareverysignifcantin slz€thenw€ have
thecaseof a merit good.Vaccnatonsandhealth
caree1,.e.as d-ed-c..o .re ypc" e dn ples
oi mert goods.^elTheyarea soa caseof marketfailure.
Analyssof rnertqoodsi5identcato theon€abov€.
Notethatoth€rdefn t onsof rnertgoodsstress:
. Thefactthatindivduas ar€oftennot {uly aware
ol ihe trlrebenefitsderivedfromthe consurnption
ol a goodsothal thegovernm€nt hasto stepn
andensure that peopledo indeedconsume thes€
goodsn adeqlatearnolrntsThusn manycountres
chidrenhaveto attendsomeschooinq,theyhaveto
Devaccrnated, etc.
. lhe lactthatlow-ncomeindivduas oftencannot
affordto consurne suchgoodssothe governm-"nt
hasto €nsure that.l, rchandpooralke,consume
sufflcient amounts of theseqoods.

Analysis
oI a n€gative
consumption
externality Figure2,58 Marketfor.igarettes

Fqure2.58illustrates the marketfor cigarettes.Smokinq

s presumdbly enjoyable to thesmokerbui it cr€ates
.osLs to ro-iey "s " v hoF.Th- F " p e' e|r" os,ir
theformofthe leff€ctsof passvesmokinq aswe as
the probabeheath{elatedcarecoststhatsmokers often
mposeon society asther habitmayresut in lessheath
relaledresources avaiabe to others
sincethisisan externdlty generated n theconsumption
of thegoodwe focusn thediaqramon marketdemand.
Thedernand curvereflects the prvatebenefits
thatthe
ndviduaenloysandtakesintoconsider.tion n maknq
buyngdecisons so it s a sothe IVIPB
curve
. Theexternacostsof consuming thegood,i e. oT
smokng,are gforedbylhe iidiv dLral. Thus,thesocia
ben€ftsfronrsmoknq are essthanthe prvatebenefils
of conslrmpton andthe MSBcurveles belowthe |\lPB
curvefor all evelsof output.lt fo owsthat MSB=
MPB- externa.ostsol consumption

57
 EXte

5 ncethe prodLrclon of ciqdrettes

doesnot creat€any Figure2.59 Thedeckronto drive
externality it folowsthatthesuppy curverefl€cts both
privateandsociacostsof producng cigar€tles.
Themarkei fa s.s atthelan unt Q produced and
consumed rheMSB(= Qh) s lessiharthe Msc ol
production (= Qf)inFg 2 58
Thesociayoptinralamount of cqarclt€sproduced and
consumed perperodis essat Q*. A uf ts betw€enQ*
andQ shouldhavenot beenproduced frcmsociety'spoint
ol viewdsfor eachthesocalbenefits enloyed are ess
thanthe sociacostof producton(MSC)Thus,the market
lais as t leadslo overconsumpton of cgarettesandthe
resut ng wefare osssequato the pinkarea(efh)
Not€lhai for the lastuntsocietywouldkeconsumed
(Q*)themarqinalsocal benefitsequathemarginalsocral
cons.Butsincendviduas do not consider theexterna
consthalther consumpton of ciqarettescreatesand
basetheirdecisons on theirdemandcurve,the market 0a'a
KilometEs ddven per weel
pricemun somehow b€ sethiqherat P* ior thesociay
opt ma amountof cigarcttes to be consumed Thiscould
b€achevedthrougha tax. Altehativediagrammati(approaches: thedecision to €ducat€
a child
lnragnea poorChinese farmerfacng the decsion
Tip wheth€ror notto sendhisdaught€r to the nearby
pr maryschool.Hew w€ighthe b€n€fits h€ expedsto
ll theextefnacostsfromthe consumpton of some enloyfromsendng hisddughteroff to schooagainstthe
goodor s-arviceareverysignficant,asisthecas€with costshewill ncurfrorndo ng so.
smokng ard drinkinga cohollcbeverages, thenwe have i he is not capable
of r€azingthetruefuturebeneftshis
the caseof a demeritgood. D€m€rtgoodsarea so
ch d may€nloyin ifefromschooling, he mayconsder
d, d.F ol r".le- iaJ - e And i. \ o oF- Fit gooo i,
the prvatebenefits derived v€rylow asMPBin Fig.2.60
ide nt calto the one. bov e.
. Ontheoth€rhand,the costshe incurs(private cosrs)
frcm
Altetnative
diagrammati(
approach€sr
thed€cision
to drive eachextrayearof schoolnq ncudethe lost abourand
lncome(ash s childcouldhavehepedhimon hisfarrn)
p usanytranspod andothercosts.n F9.2.60theMPC
. Onecananaysethe effectsof d negdtveexlernary
aretor s mpictyasslmed constantandequatoc.
ol consumpion d fferently.
Fqure2.59illustrates
th€ . Hewillthusdecderotsendheroff to school. burur€
ndvidud3 decsionto drive.Howmlch shouldonedrlve soclabenefits fromeducatnq a childfarexceed ihe
ther carlrornsocieiy's po nt ofvew? privalebenefih.Therearesgn fcant external ben€fits
. Ihe indivdualwill drlv€moreandmorekilonreres per arising
fromprmaryedlrcaton TheMSBcurvethus es
perodaslongasthe €xtrabenefits enjoyedfromdrivng abovethe MPBcurve.Fromsociety3 po nt ofvew the
exceed th€ extracostshe ncu6fromdrivnq. childshouldaltendQ* ye.|sof schooling. Theres thus
. Theseextrab€nefits he enloysfrommoreandmore reasonlortfr€ governmentto ntetuene.
drivnq become smallerandsmalerandthis s shown
ihroughthe negatively slopedmargna benefts of drivnq Figure
2,60Thede<ision
to educate
a child
curveMBwh ch canbethoughtof asa demandtor
drivnq schedule. As no on€esebeneJts fromh s drivnq
i fo lowsthatIVPB= [,4S8.
. Theextfaprivate costs(MPC)frcmdrivlngncude
gasoinecostsaswe las thevalueoft meandany
d scomfo(the drvingperperodof tim€cals€s.Theyare
assumed for s mpicty constant.tc poundsfor eachextra MPC(=MSC)

. Drivingonescar mposes costson otheEln th€ formof

increasedpo luton andconqestion Thes€ar€external
consandfor s mplictyareassumed constant andequa
to cc' Thusthe MSCcurvewhichlnclldesbothprvate
andextefnalcosts of drivlngs constant at c'.
It lolowsthatihe ndivlduaw I choose ro drv€ioo much,
spectca y Q k om€tres perweek,whereas socjery would
havewantedh m to d ve essatQ*kilometres perweek.
Ther€s thusrcason for the qovernment to ntervene.

58
It s lsuallytoo costy forth€ aflect€dpddiesto negotiate to po ut ng f rmsthataretradablen theopenmdrket
andanveat a rnutlalybenefcalsoluton Asaresult An incentive synems thuscreated ascleanerfrrnswhich
gov€rnmenl usuay intervenesandtres to correct find t cheaper to Lower their €ve of pollulon w I have
the ext€rna ity€itherusnq the marketmechanism or dn incentive to sellunusedperrnts to oldefanddirter
clrcumventinq it throuqhcommand dndcontrolpo cres. { rnrsthat f nd it costlyto reducepo luton evek.Poluton
permltsarescarce ard a markets created torthe n9htto
solutions
Ma*et-based po ute Aftera ltrad ng ecompleted, a newa Locaton ot
pernrts wi emergewithth€follownq propert€s:
Externallt esaremark-"lfalureswhereethertoomuchor . the larg€teve of tota po uton isacheved;
not enolrghof a goodis produced andconsumed. The . the ossol oLrtputs smalerlhanif the government
r€ason isthatpr ceslor sonrereason maynot exsior may
hadassigned for a firmsthe samenraximum leveot
fa lto r€fectthetruebeneflts or th€lrueconsol an actvrty.
li followsthatonetypeof solulioncouldtry rnakng sure
thata prceexistsandthat t i5thecorr€cione probemsof slch a mark€t-based
Potential sout on ncude:
. Assisninsand enfor.ing propertyrightsovef . the nildlallocalon
of permts maybedificut fofthe
assetsAssets mayinclldea panurethatotherws€ governrn€nrro oerermne;
the fightsto a ceanlakethdt . monitorng compianc€s expensiv€.
wou d be overqrazed,
otherwsewouldbe polllrt€dor the rightto driveones
vehcledowntownIn th s waylhe ownerw ll n€edto Command-and-control
solutions
.onsld€rthe costsandbenefits of hisactions.f propedy Oftent is not possbleor not effectveto rey on changnq
rlghtsexst thenpri.escanbes€tandthe benefits .nd market sgnals.Governments thusreso todirectreguaton.
costsof an activtycanbeen matedForexampe,ta Governments outplrt,prices,ocation,
cand recty regulate
qovernnent setsa prcefor the ight to driv€downtown operating hours of prcducton aswe aswhohdstherght
thena drverw haveto incudethisprlceto h s private to dr nk or smok€andwh€re.n manycases d r€ctregLrlatron
consof drivng in Fig.2.59.A too oftenii s mpossb e maybethe onlyreast c and cost-effect vesolutionbut t
to assiqnprvat€prcpertyrlghts,asin the caseot the maya so €ddto costlyand neffcientoutcom€s.
almospnerc or rnesea
lmposingtaxesequato anyextern,costsol prodrr.non (orbanning
Advertising of),moralsuasion,
education
or anyexternacostof consumption. Greentaxeson
Thiss a d fierentsetof soluiions
whereby the government
po Jl 'rg 1 '1. d no oar p"" ; \ 4. 1' 1t Li.
"c , o_. attempts to changethe prcferences andpractces of
consumers andof f rmsby ncreasinq theI awarenessol the
cranting subsidieswhen the fu lbenefitsof an activty
€xternacostsor ben€flts actvitestheyundertake.
of cert.Ln
ar€ not capturedbythe nd vidlalor ihe lrrm creatng
Bymakng schoochldren awdreof the beneftsol recycling
them.Th s is the case n manyheath-calerclated
products.The prce s effectivelylowercdso consumption todayth€governnrent a msat creatng citz€nsmakng
increases to the socaly deslrableleve.
Tradeable pollution permits. Theseare licencesto
polllte a specficarnountthatth€ governmentallocat€s
 '--------"-::,
Public tB
A good s considered a pub c qoodif consLrmption rsnon Pubic goodsarea caseof marketfa lue becalrse sL
€xcludabe andnon-rival. consumers havethe ncentveto concealtheir trLr€
. consumpion isnon-excludable if oncethegood preferences,
hopnq to ben€fitasfreerldels.As a result,
s available
to evenoneconsumer it automatcaly prvateprofitorentedfrrmswill (normally)
not havethe 'tb
becomes avalabeto a , sono onecanbeexclLrded from ncentveto produceandoffersuchgoodsandserr'ces
consum ng t. Consequent y, ndviduas havethe ifcentive throuqhthe market.Themark€tfa s. Cornpusory
taxationandprovsion(butnot necessarily
produclion) by 2a
to concealihe ftrue prefer€nces
andbehave as'free
ridets'(people whoclingto th€busandgeta freerde theqov€rnm€nt isrhetypicalsoluton.
2b
wthout payingthefarc)becaus€ theyknowthatthey
canenjoythegoodwithouthavlngto payfor it onceit Tips
becomes avaiable for others. 3a
. Consumptons non-rivalf consumpton of thegoodby Whethera qood s cofsidered a pub c goodor not
onedoesnot decrease th€ amountavailab e for a otheE; depends on whethefit satsfies thetwo crtera above.
ths mp esthatthemarginalcost of an extrauseris . A commofm stak€s for studenhto believ€ thatany
goodthata government orthe staieproduces isa 3b
Examples pub c qood
. Fewexamp€s of purepublicqoodsexst.A ighthous€, Furth€r,the prob€mof po luton exceeds natonal
dro1. dpe " "-^ple,. borde,s C ob" vdrnirgi ob,io-.1) globdrp'obl"T 4a
"e"nd ""r-'rqh6areLyp "
J a ghthouse becomes in someslandno
avdilable Polution s in th s sensea'publcbad':if t exstsfor
Jsherrnan canbe excluded fiom ls benefits whileil t is one,it exstsfor alland,l onesuffers the restwil h
'used'byonethe amountof services.va ab€ to the rest sufferthesarne.t isan internatonal probemrequirng
arethesame(themarqna costof onemorefishlngboat nternatonalcooperation. Unfortunatey, no
usng theservices iszero). 5a
supra-n.tional bodyexistslhat canimposesolutions
. 'Lawandordei and'pdcestab ty' aresomewhat on sovere gn nations. Treaties
area movement in that
d ffer€fl examples but theysatisfy
bothcrtera andtheir 5b
d eclon/h/oo red).1 eBdl )Lnn.\brte/pn -
implicatons areinteresl ng.Lawandord€rcanevenbe a'rato_ (on..rr_]oy" llLhoo"e 10.to abdebvr.
extended to implya fLrnctiona institutionaframewofk, Worse,sornecountresar€not wil nq to siqnsuch 6a
which s especay impodantfor a deveopng economy treates.Af interening solutonproposed by Nobe
andon y a qovernm€nt canprcvdet. aureate Jos€ph Stigtz sto consderthefirmsof such 5b
. A ldstexampe is lv andrado broadcaning Bothcrtera natons(asthe US)asreclpients of natesubsdiesNot
aresatlsfed.f Fr'erdrs broadcan for oneholsehold, payingthefull costsof productions equvalentto
no househod with a TVs€t(aseparate privateqood)can receving a statesubsidy. Sincesubsid€swithintheWTO
opp uoooard it e Jolr'p .'ro\^ youLd e_.o.r a tradesystem areillegd, othernationswouldhavethe
rnuch.These servlces thoughareoft€nprvatelyprovrded rightto mposetradesdnctonson thesenations, forcng
asthe broadcast ng firmdoesnot selltheshowsbut themto cooperate dndreduce ernssions. 7b
advertsing t me,whichisbothexcudable andrva.

HI

2l

3l

4l

n
 1 and2
Sections
lB Questions:
5LLongEssays Expaln how prclt s determjnedin p€rf€ctconrpetilon.
(10mafkt
n thes qial nq and ncentive
1a Expla oi pr.esif
tLrnction 'Whaleverthetype of marketnr!d!re, proit
d marketeconomy (10ma&s) po-t r,|..
o^o\op qodto o
-'
th€ proposiionthatgovernment
1b EvalLrate nter/entonn D sc!s5 (l 5 narkt
themarketfortobrccosllstf€d (l5mdrks) o
oul i nethe w aysi n w h.h monopoypow erml qht l
2a Expainwhy !nderprovsion of mer;iqoodsin a market
economys consder€dro bea mark€tta ur€ (10marks) Evauatethe ext€ntlo wh ch qovernnrent5 shouldseek
3
thata government
2b Evau.te the possb e rnearures m tht E'
to.ontro the qfow l hol monopol ypow er(15 mar ks)
u5eto coffectqlcha marketfd ure.
What fo e do pricesp ay n the allocaton o1 r€soulces
c proberns oneof scar.:lly
3a Thebasc e,:onom of l n d markele.ofomy?(10 m.rks)
prodLrct!e
resoLrrces.
Expldn howresourcesar€a ocat-"d FvdLratethe oplons availableto governments10
bo po .q i b o-ord 6 .o o r .
overcom€the fa ure of markehin the producton and
( 10^ o 6 , . o .
m ar k s ) consLmplon of demerigood5.
t (15marks)
3b Di!.u5sth€ v€w that therersstrcnqlustf catlonfor
governmentinterventionin the nrarketfor heakhcdre 8a Whyar€envronmeftdprobemsconsider€d to bean
115 (10marks)
exanpleof marketfd Lrre?
' nar k l 8b Towhai€xlentcangovernrnent nter,/enton
rorrect
4a Evallatethe impoft.nceof prce n a Locatng sc.rce fa ure?(15markt
thrsqovernment
resources. (10 rnarks)
4b Evduateth€ possLb of mpLemeitinq
e cons€qlence5 9a c arelullyexpldn what t isthatpr.e, inromeandcross
mdxmum dnd rn n mlrm pficecontrols.(15 nafks) prlceea5tcite5of demand arem€antio rne.sure
{10m.rks)
5a Expaln how a buffer slockmay be usedto stab ze 9b D !c!ssthe pr.cti.alimportance of pr.e €ldstrcty
ol
aqr cLriLrralprices.(10 marks) dernand for ftrmsandfor the government. (15nrarks)
5 b D s ( us st he v ew th a t n i e ru e n to nn a g r.u tL rra l markeh
c dus es th a nl l s o v e s (1
r nor epr o b l e ms . 5 ma fk s ) in the
10a Whaldo€san e.onornn meanby ef{clency
operationof a firm?(10marks)
6a What are posiive external es dnd how do lhey arrs€? 10b D 5cuqswh€therthe achievementof effcrenc\,
Lislrat€your answerwith examples(10 marks) '
possb e anddesrable. (15rnarks)
6b EvaLral€the oplons dva .ble to governm€nts to
overcomethe Ia ure of markehto take acco!nt ol
HI ShortEssays
postv€ externallt€s.Referto reirlworld exampes Ln
. o i 6p.o\ j
your answer (l s marks) o."b".\-pn ol pod..n,d
of healthcare unrdtesthe problemof'oppodLrnlty
7a What fa.tors d€terrnne the pr ce;nd n.ome €ldnicities cosi . Expl.n the ndtureof the problemlsifg a
of dem andlor a p ro d u c t? (1 0 m rrk s )
produdon posslblii es cutue
7b Why m ght firms dnd qovernmentsb€ rftelened to
k nowt he pr lc ea n d rn .o m €e a s 1 .i e so t d e m.n dtof 2 'NofmallytwoLrtdbe exp€cledthat morewouid be
v ar ouspr oduc ts(1 ? 5 n ' a rk s ) detemLfedat ow€r pricesas oppos-"dto at h gher
pr,:ei ,al otherth nqsbei ngequ., but thi smayfot
Ht tong Essays a waysb€ the care' Expaln th s natement

lo entrymayaffectmarket
]a Expa n how barriers 3 ' A s pr cEfa s, ql antty suppl l ed
{.l l s.A s suppy
nructur€.(10markt noease!,pr cefa s U sesl ppy.nddenrandanayss
1b Evallatelhevlewthatrnonopoys rn Lrndesrabe io exp.in why lhesetlvo stat€n€nlsdo not contradict
mark€lnrLrctLre(l5 markt
condtionsfor prcedLscrim
2a Expainthe necessary n.tion 4 U snq demandafd suppyanaysi s€xpl an how
to t:kep !re.110mdrks) ocatedln a marketeconomy.
2 l) Di . . - l a , d o .o ,,a o - o p 6
" o. " rl " J F 5 H ow m !hl the pr ceel astl .tyof demdnd.fi ectth e
dilcriminationfor consume6and producers(l5 mdrks) shapeof a frm's totil revenLre curvo?
3a Caref! ly drstnquishbet$reenm€rt, d€m€il and pub c 6 E xpai nw hy the pi .e e ai l .l i e5 of bothdenranda nd
qoods( 10 nr .rk 5 ) supplyof pflmarycommoditlestend to be rclativey o!!
3b EvajLrntethe vew lhat governmentssho! d a way!
ntervenern r.arketsfor s!.h goodt a5ciqarelt€sand
. c oho ( 15nr a rk s ) 7 D efne cros5prc€ eastci tyol demandand Lrsi n!
d agramsoxplan what determne5whethercross
4d .1," .L.d oora b 4 .- - lo poLi
eastrty Eposti veor negatve.
competiton ando gopoy(10rnarks)
4b D sclrss
th€differencei
b€t\'veen
co usveand 8 li nany countriesthe pfl.e of housesha! r len n€ddily
non'coluslv€o sopoy.(15marks) overrecentyearswh e moreand morepeope lrave
 IBQ

d
"s;9

'14 Explj

rurt.ri

62