Section 2 - Microeconomics - Table of Contents

Section 2 - Microeconomics - Table of Contents 7/5/10 10:17 AM
Section 2 - Microeconomics
Markets - introduction
Introduction
Resources are allocated in competitive (free) markets
through the workings of the price mechanism. Price
changes give signals to suppliers who are able to
respond to the demands of consumers. If the price of
houses rise, for instance, more builders will want to build
(supply) houses. Also, if more people want to buy
houses (demand) in an area, say as a result of a
government department relocating there, prices will rise.
Two key terms have been mentioned, supply and

demand. Write down now, before you go any further, what you think these terms mean. Put
your descriptions to one side. We will return to them later.
The free market price mechanism, operating under certain specific conditions (more of this
later) is also the base against which the workings of real markets and economies are
measured by economists.
This unit examines the concepts of demand and supply in detail, then goes on to examine
the operation of a competitive market. It is an extremely important unit, not only in its
own right, but also because it links in with other units, such as units 4 and 5.
In this section we consider the following topics in detail:
Markets
Market structure
The importance of price as a signal
Demand
Supply
Interaction of demand and supply
Price controls
To start looking at these topics, click on the right arrow at the top or bottom of the page. To
get back to the table of contents at any stage, simply click on the 'home' icon at the top or
bottom of the page.
Markets
So what is a market?
A market is any effective arrangement for bringing buyers and sellers together, not
necessarily face to face.
The forces of supply and demand meet and react in a market. Prices are established and
buyers and sellers alike give signals. Markets can involve face-to-face dealings between buyers
and sellers, or may be postal or even electronic.
The market mechanism brings together two different forces, the power of the consumer and
the interests of the supplier. Both want 'the best' from the market, but their 'bests' are
different.
Objectives of consumers
Rational consumers want to get the most from their money and a RATIONAL CONSUMER wants
the highest quality at the lowest price.
Objectives of producers
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Firms want to get the maximum from the resources that they use. In financial terms they
want to maximise profit. This means that they may want to sell as low a quality product as
they can for as high a price as possible.
The general assumption of economics is that the main objective of private businesses is profit
maximisation.
Types of markets
There are several different types of market. Markets may be local, national or international.
Here are some examples:
Consumer markets
There are two main types of these:
1. Markets for consumer goods
Consumer goods are goods bought by individuals rather than businesses. Consumer goods are
often divided into durable goods and non-durable goods. These are often traded on a national
basis.
2. Markets for consumer services
The provision of a service involves the seller 'doing something' for the buyers in return for
money. This includes financial services, travel and tourism, all types of leisure services etc.
Services are part of the tertiary sector of an economy, and it is this sector which tends to
grow most rapidly when living standards rise.
Commodity markets
A commodity can be defined as a raw material or a semi-raw material, e.g. rubber, coffee,
copper orgold. Such markets are often characterised by large fluctuations in price, mainly
because of the instability of supply due to seasonal factors, the weather natural disasters etc.
Major commodity markets exist in large cities such as London, Tokyo and Chicago.
Capital goods markets
The capital goods markets is where items bought by industries and business are traded, e.g.
machinery and equipment. Capital goods are also known as producer goods as they are used
in the production process to make other goods and services.
Stock markets
These are markets where the stocks and shares of public limited companies are traded, as well
as other financial securities.
Market structure
In a competitive market, firms are expected
to compete. We have assumed so far in our
market model that firms compete on price
only. This is not the case in the real world.
Firms may compete on the basis of:
Quality
Service
Reputation
as well as on price.
The world of competition is dynamic. Firms

try to improve, to produce better products,
to increase their market share etc. They

want to increase their profit. They will look at their production processes and try to reduce
costs and to increase revenues.
They will only do this if they can get something from it, and that something is profit. Unless
there is a financial return they will not invest in any improvements. Why should they?
Spectrum of competition
However, the way in which competition manifests itself in a market depends on what is called
the market structure. The market structure is the degree of competition in the market and
the way in which the market is organised. As consumers, we would all like markets to be as
competitive as possible to ensure a wide variety of goods and low prices, but firms would
rather have less competition to make the market more profitable and to minimise the costs
associated with competition for them.
Economists argue that competition is beneficial for a variety of reasons. They therefore set up
what they consider to be the ideal form of competition - known as perfect competition. This
is a market structure at one end of the spectrum. At the other end is obviously little or no
competition - this is called monopoly. In between is a range of market structures and we look
at each of these below.
Market structures - monopoly to perfect competition
Perfect competition
This type of market has many competitors, who produce the same product and the market
sets the price. So, firms in this type of market are price takers (they have little market power)
and have to be aware of all possible efficiencies, the lack of opportunities to use modern
marketing techniques, the ease with which new entrants can join the market and the
probability of low profit margins. In fact, perfect competition should be considered as an ideal
or a benchmark. It does not exist in practice, although some markets may approximate it. The
key assumptions of perfect competition can be summarised as:
Firms are all too small to influence the market and are therefore 'price-takers' (they simply 'take' or
charge the market price)
There is a large number of firms and buyers
Products are all homogenous (identical)
There is complete freedom of entry and exit
There is perfect knowledge
Monopoly
This comprises of just one producer in a particular market, although a firm is often considered
as a potential monopolist if it has 25% or more of the market share of a particular market.
The producer has the power to 'make' the price and profits will normally be high. To maintain
the high profits the producer will build as many barriers to entry as possible and try to keep
the monopoly status by not allowing others to enter the market.
Monopolistic competition
This type of market is a cross between perfect competition and monopoly, having
characteristics of both. Firms have many competitors, but this time producing a different (or
differentiated) product. They have some influence on prices within the market, but again have
to concentrate on cost efficiencies and accept low profit margins. However, they can use
marketing to promote their product but need to be aware that others can easily enter the
market.
Oligopoly
This type of market has just a few competitors, and there is interdependence between the
firms that comprise the market. The market relies a lot on non-price competition, e.g. after-
sales service or guarantees, and normally spends large sums on advertising and promotion. If
successful in this type of market, the firm can earn large profits. To protect their market share
they use marketing techniques to build brand loyalty via such features as unique selling points.
These are designed to build barriers to entry, so reducing potential competition. Some

participants collude, or join together to make it even more difficult for new entrants to gain a
place in their market.
You may also like to see a table summarising each of these key market structures with
examples.
Summary of market types
Market structures - self-test questions
Market structures
1
Match the following descriptions with the appropriate market structure?
a) An industry with significant barriers to entry and a single Choose...

supplier
b) A highly concentrated market with just a few interdependent Choose...
firms
c) A highly competitive market with slightly differentiated Choose...
products
d) A highly competitive market where firms are price takers Choose...
Market structures
2
Which of the following is the most competitive market structure?
a) Perfect competition
b) Monopolistic competition
c) Oligopoly
d) Monopoly
Market structures
3
Which of the following is the least competitive market structure?
a) Perfect competition
b) Monopolistic competition
c) Oligopoly
d) Monopoly
Market structures
4
Which of the following is NOT a feature of monopolistic competition?
a) Numerous sellers
b) Product differentiation
c) Numerous buyers

d) Homogenous products
Market structures
5
In which form of market structure would price be the key factor when competing?
a) Monopoly
b) Oligopoly
c) Monopolistic competition
d) Perfect competition
The importance of price as a signal

This section requires knowledge of the way in which demand and supply interact. You may
therefore wish to return to it after you have studied demand and supply analysis. Click on the
relevant link in the table of contents on the left to switch to demand and supply (or click the
'home' icon at the top or bottom of the page.
The process of resource allocation
As we have seen in Unit 1, the central problem of

economics is one of scarcity of productive resources
relative to the unlimited potential demand which could be
made upon them. It therefore follows that every society,
be it centrally planned or based upon markets, has to
have some mechanism by which its resources, that is its
land, labour and capital , are allocated amongst all the
numerous uses to which they could be put. So, by what
process are resources deployed so as to ensure that
consumers obtain exactly the right amounts of frying
pans, ice-creams, jeans etc. that they require? Well, under a system of central planning the
answer is not too difficult to ascertain - the state planning authority decides upon its priorities
and directs resources to those lines of production which are deemed to be most important;
but, in the absence of a central planning authority, how do consumers magically obtain those
goods that they want in just the right quantities? Here the answer is slightly less obvious -
essentially, it is through the interaction of demand and supply. But, how exactly does this
interaction perform the allocative function?
The short answer to the above question is that it is through movements in prices which act as
a link between demand and supply. These changes in price indicate and motivate - the so-
called signalling function. Changes in price indicate the relative strength of consumer
demand and signal to producers changing consumer tastes; they also indicate changes in
supply which enable producers to signal to consumers what is available on the market and on
what terms. Rising prices of goods, which in turn increase profitability, motivate producers to
respond to increases in demand by increasing supply; producers will decrease supply when
demand, prices and thus profits all fall. Likewise, labour will be motivated to supply more
factor services as its price, that is the wage rate, rises, and vice versa. This process can be
illustrated in the diagram below:

The process of resource allocation
In the diagram, consumers, who are assumed to be rational, knowledgeable and sovereign,
decide, perhaps because of more inclement weather, to switch part of their demand from
sandals to wellington boots. The increased desire for wellington boots means that consumers
would be willing to pay more for them at each and every price, and the demand curve would
therefore shift out to the right. This would cause the equilibrium price of boots to rise and
boot producers, spurred on by the prospect of greater revenues and greater profits, to
increase their output of boots, indicated by a movement along the supply curve from point X
to Y. The fall in demand for sandals has the exact opposite effect, with the demand curve
shifting to the left, the equilibrium price falling and producers receiving this as a signal to cut
back their output of sandals in the light of less potential revenue and profit. At the same time
the derived demand for labour would mean that the wages of workers in the wellington boot
industry would rise and those of workers in the sandals industry would fall.
Through this mechanism, prices act as a link between consumers and scarce resources. Those
sectors of the economy in which demand, prices and profits are rising will be able to
commandeer resources away from declining sectors of the economy by paying more for labour,
land and capital. The resources of the economy, which are assumed to be perfectly mobile, are
therefore allocated to those sectors where consumers want them to be employed, in our
example, to the wellington boots industry. Here, the consumer is said to have 'called the
tune', to be 'king' or 'sovereign' - despite having no direct command over resources,
consumers have determined how they should be used and have ensured their optimal
allocation: hence the case for feely operating markets and the argument that government
intervention, beyond a minimal level, is both unnecessary and undesirable.
Demand
A detailed understanding of demand theory
is essential for success in economics.
Demand is defined as 'that quantity of a

good or service that would be bought at each
and every price over a period of time'. This
means that demand combines:
The desire for a product

A willingness to pay for it
The ability to pay for it
This definition is important. You have to pass

all three tests for it to be demand.
Look at these questions:
Would you like to own a Ferrari? Probably, yes. Test 1 OK

Would you be prepared to pay for one? Yes. Test 2 OK.
Have you got the money? Probably not. Test 3 failed. Not counted as part of the demand for a
Ferrari.
In other words to count as demand, the demand for something has to be what is known as
effective demand. This means that the demand has to be backed by a willingness AND ability
to pay (tests 2 and 3 above).
The law of demand

This assumes that consumers act in a rational manner, so that, other things being equal, the
lower the price of a good, the greater the quantity demanded and the higher the price, the
less the quantity demanded. Thus, in the diagram below (Figure 1), as the price falls from OP1
to OP2, the quantity demanded increases from OQ1 to OQ2. If price were to rise from OP2 to
OP1, the quantity demanded would fall from OQ2 to OQ1.
Figure 1 Demand curve
It is quite important to distinguish between individual and market demand. The difference is
hopefully clear. Individual demand is demand from an individual - like you or me! This will be
affected by all the factors we identified in section 2.1. However, a whole market is made up of
hundreds, thousands and sometimes millions of individuals and so to get market demand we
need to add together all the individual demand curves. This will give us market demand.
To add the demand curves, we need to add the individual demand curves at each price. We
can see this in Figure 2 below, where we assume that the market is made up of just two
individuals - Posh and Becks.
Figure 2 Individual and market demand
Determinants of demand
The demand curve shows that demand depends on price. However, price is only one of the
factors which influence demand, or is one of the determinants of demand, as economists call
them. The full list of the determinants, including price, is:
Price
PRICE OF OTHER GOODS (SUBSTITUTES and COMPLEMENTS)

REAL DISPOSABLE INCOME

THE AVAILABILITY OF CREDIT
EXPECTATIONS OF PRICE CHANGES
TASTE
ADVERTISING
SEASON AND THE WEATHER
POPULATION
If you understand how all these factors influence price, fine. If not, try to explain them
yourself, then click as usual.
Shifts of the demand curve and movements along the demand curve
A change in price will produce a movement along an existing demand curve, but a change in
one or more of the 'ceteris paribus' factors will shift the demand curve to a new position.
N.B. The demand curve is drawn on the assumption that only price has changed and
everything else has remained the same. This is an important assumption to note. In reality
many factors are changing at the same time, but if we are to analyse the factors causing a
change in the market, we first need to isolate each of the factors. This assumption, known
as 'ceteris paribus' or 'other things being equal' enables us to do this. See Unit 1 for more
detail on this assumption.
Movements along the demand curve
When the price of the good, and only the price, changes there is a movement along the
demand curve. A movement up a demand curve, to the left, is known as a contraction of
demand. The price rises and quantity demanded falls. A movement down the demand curve is
known as an expansion of demand. Both of these are shown in the diagrams below:
Figure 3 Expansion of demand
Figure 4 Contraction of demand
Shifts of the demand curve
These will occur as a result of any factor, apart from price, changing. A shift of a demand
curve to the right will mean that more will be demanded at each and every price. A shift to
the left will reduce the quantity demanded at each and every price. These possibilities are
shown below.

Figure 5 Increase in demand
A shift to the right, an increase in demand at each and every price, will come from one or
more of the following;
A rise in the price of a competitor's products

An effective advertising campaign by the manufacturer
A rise in the real income of the purchasers
Can you think of any more? Jot them down, then click SHIFT 1.
Figure 6 Decrease in demand
Think about what might cause this type of shift, then click SHIFT 2.
Summary
Having completed this session you should know and understand that:
1. Effective demand is the quantity of a good that would be bought at each and every price
over a period of time.
2. It combines the desire for the good with an ability and willingness to pay for it.
3. Demand has several determinants, e.g. own price, price of other goods, real income,
changes in tastes and fashion, season and population.
4. A change in price results in a movement along an existing demand curve.
5. A change in any other factor apart from price will cause the demand curve to shift.
Example - shifts and movements along a demand curve

You must be absolutely certain about what causes shifts and movements along a demand
curve. Work carefully through the following example.
Example 1 - Movements along and shifts of demand curve
The diagram below, Figure 1, represents the demand for a product at a point in time. The price
then was P*.

Figure 1 Demand curve
Copy this onto another piece of paper, then sketch on this new diagram the effect of the
following changes. Treat each change as a separate change - in other words start each time
from Figure 1. Once you have had a go at each one then follow the link below to check you
got the change right.
(a) The firm launches a new, effective advertising campaign.
Answer - change (a)
(b) The market price of the product rises to P2.
Answer - change (b)
(c) The price of a substitute good is reduced.
Answer - part (c)
(d) As result of a glut in the supply of the product price falls to P4.
Answer - part (d)
(e) The real incomes of the buyers of this desirable product increase significantly.
Answer - part (e)
(f) There is an increase in the population size and the size of the potential market.
Answer - part (f)
These should not be difficult if you keep calm. Ask yourself three questions:
Has a 'ceteris paribus' factor (other determinant of demand) changed? If the answer is yes, then there
is a shift.
Will demand increase or decrease? This will determine if the shift is to the right or left?
If the price has changed, will there be an extension or contraction of demand?
PlotIT - Build a demand curve

Consider the (imaginary) data in the following table. This shows the annual demand for tennis
shoes in three sections of the market. Calculate the total (annual) market demand. Jot this
down on a piece of paper. You may like to check your answer.
Price (£) Tennis club Players, but not Non-tennis Total market
members club members players ('000s) ('000s)
('000s) ('000s)
100 6 1 0
80 7 3 0
60 8 6 2
40 9 10 8

20 10 18 20
From the table, plot each of the figures for total market demand on the following diagram. To
do this, click your mouse on the graph axes for the position of each of the plots. When you
have done this, the demand curve will automatically be drawn.
You may like to check your answer to see if it matches the correct curve.
Expansion/contraction of demand
1
If the price of tennis shoes falls, there will be an extension in demand.
a) True
b) False
Demand for tennis shoes

2
A higher rate of economic growth will lead to an expansion in demand.
a) True
b) False
Demand - self-test questions

Demand
1
Which of the following would be likely to decrease the demand for a product?
a) An increase in advertising for the product

b) An increase in the price of a substitute good
c) An increase in the price of a complementary good
d) An increase in income
Shift in demand curve

2
Which of the following may lead to a shift in the demand curve?
a) An increase in the costs of producing the good

b) An increase in income
c) A decrease in income
d) An increase in the price of the good
e) An increase in the price of a substitute good
f) An improvement in productivity
Demand
3
Which of the following would be likely to shift the supply curve for Mars Bars to the left?
a) An increase in cocoa prices

b) A decrease in cocoa prices
c) An improvement in productivity for the production of Mars Bars
d) An increase in price of Mars Bars
Demand
4
Which of the following would be likely to lead to an extension in demand for iPods?
a) The launch by Sony of a cheaper hard-drive player

b) An increase in consumer income
c) An improvement in productivity for the production of iPods
d) An increase in the cost of production of iPods
Exceptions to the normal law of demand

We have assumed so far that demand curves slope downwards from left to right, and most of
the time this is true. However, there are a few circumstances where it is possible for the
demand curve to slope upwards to the right. This may be for the whole curve or, more likely,
it may be over a certain price range, as shown in Figure 1. This is often termed a perverse or
upward sloping demand curve.

Figure 1 Perverse demand curve
There are two particular types of goods where this may occur and they are called Giffen goods
and Veblen goods. Let's look at the definitions of these.
Giffen good
A Giffen good is a good for which an increase in price results in an increase in demand for
the good. It is an extreme inferior good and will have a perverse (i.e. upward sloping)
demand curve.
Veblen good
A Veblen good (named after an American economist - Thorstein Bunde Veblen) is a good
that has an upward-sloping demand curve. People buy more of the good because it is
more expensive and therefore demand is higher when the price is higher.
Giffen goods
In some poor countries, the people often live on a basic diet of rice which is very cheap plus a
few more expensive vegetables or some much more expensive meat. In such societies, if the
price of rice rises then the people may well decide to buy more in order to substitute it for the
more expensive vegetables and meat. There has been an increase in demand in response to
an increase in price. Sir Robert Giffen fist noticed this phenomenon. In the 19th century, he
saw that the demand for potatoes increased in response to the rises in the price of potatoes
caused by the great potato famines in Ireland. Hence products of this kind are known as
Giffen goods. Examples of Giffen goods are difficult to find in richer countries.
Veblen goods
Products such as perfumes, expensive cars and designer clothes maybe regarded as Veblen
goods.With these products, a rise in price is often interpreted by the consumer as an increase
in quality and so they may decide to buy more, thinking that they are buying a superior
product. There may be psychological factors at work. The economist Veblen carried out
research into this and concluded that the price of a product conveyed more than just value
information for the consumer; it also represented status and exclusivity. These products which
appear to experience rising demand with rising price are known as Veblen goods.
Price expectations
It is also possible for goods where price expectations are critical to have perverse demand
curves. This is because if people expect prices to increase further, then they may buy more
now. In this case it appears that an increase in price has increased demand, but in reality this
has come about because people expect prices to rise even further in the future.
Supply
Supply
That quantity of goods and services that will be supplied to the market at various prices
over a given period of time.

The law of supply

Other things being equal, the higher the price, the greater will be the quantity supplied and
the lower the price, the less will be the quantity supplied. The supply function slopes upwards
from left to right. As the price increases, the more firms will be willing to supply. Higher prices
mean higher profits for those already producing. Those who were at the margin can now make
a profit, and some less efficient firms will now be able to supply and remain profitable. Look at
the illustration in Figure 1.
Figure 1 The supply curve
The diagram illustrates the law of supply - at a price of OP, OQ will be supplied. As price
increases to OP1, the quantity supplied increases to OQ1. More is supplied at higher prices.
Determinants of supply
Like demand, there is a set of determinants of supply. These include the following:
Price
COSTS OF PRODUCTION
PRICES OF OTHER PRODUCTS
TAXES AND SUBSIDIES
TECHNOLOGICAL PROGRESS
WEATHER
If you understand how all these factors influence price, fine. If not, try to explain them
yourself, then click as usual.
A change in price will produce a movement along an existing supply curve, whilst a change in
one or more of the 'ceteris paribus' factors will result in a shift of the supply curve.
Summary
1. Supply is the quantity of a good that would be provided for a market at each and every price over
a given time period.
2. Supply has various determinants, e.g. own price, price of other goods that could be made, taxes
and subsidy levels, technology and weather.
3. A change in price results in a movement along an existing supply curve.
4. A change in any other factor will cause the supply curve to shift.
Example - shifts and moves of supply curve

You must be absolutely certain about what causes shifts along or movements of a supply
curve. Work carefully through the following example.
Example 1
The diagram below, Figure 1, represents the supply of a product (X) at a point in time. The
price then was P* and the quantity supplied Q*.

Figure 1 The supply of Product X
Copy this onto another piece of paper, then sketch on this new diagram the effect of the
following changes. Treat each change as a separate change - in other words start each time
from Figure 1. Once you have had a go at each one then follow the link below to check you
got the change right.
(a) Market price of the product falls to P1.
Answer - part (a)
(b) The government passes new minimum wage legislation, which will have the effect
of increasing the cost of labour to the firm.
Answer - part (b)
(c) The government places a tax on the sale of the product.
Answer - part (c)
(d) The Research and Development department of the firm invent a new, highly
efficient production process for the product. It is well protected by patents, and will
give the company a significant cost advantage.
Answer - part (d)
(e) The firm makes another product in the same factory, and can switch production
easily and quickly from one to another. The market for this other product collapses
and its price falls significantly.
Answer - part (e)
This should not be too difficult if you keep calm. Ask yourself three questions:
Has a ceteris paribus factor changed - in which case the curve will shift?
Will supply increase or decrease?
If price has changed will there be an extension or contraction of demand?
Interaction of demand and supply

We have studied demand and supply separately. Now we put them together to get the whole
market. The operation of demand and supply in a market is known as the market mechanism.
We are familiar with the upward sloping supply curve and the downward sloping demand
curve. Combine the two on one diagram and we have a model of a market (Figure 1).

Figure 1 The demand and supply model of a market
The market will be in equilibrium at price P, when quantity Q will be bought and sold. In figure
1 OP* is the equilibrium or market clearing price at which the amount demanded exactly
matches the amount supplied.
Changes in demand and supply
We can now see how shifts of supply and demand curves cause changes in prices and
quantities bought and sold. In the next two sections, there are two example markets with a
series of changes to each. Try working through each one and check that you understand how
the curves shift. Click on the right arrow at the top or bottom of the page to look at the first
example.
Summary
Having worked through this unit you should be able to:
1. Define a market
2. Show how it responds to changes in supply and demand
3. Demonstrate that movements along a demand curve come as a result of a shift in the
supply curve, and movements along a supply curve from a shift of the demand curve.
AnimateIT - Markets and prices

In this section we look at animated versions of the supply and demand diagrams. It is worth
going through these to see how the changes in supply and demand build up.
Demand curve - shift left
Demand curve - shift right

Supply curve - shift left
Supply curve - shift right
Example 1 - the market for DVD players

Try copying out Figure 1 below, but label it as the market for DVD players.
Figure 1 The demand and supply model of a market
Now work through the following changes, and adjust the diagram as you go. After you have
had a go at each change, follow the answer link below and see if you made the right changes.
Treat each change as a separate change - in other words start with Figure 1 each time.
Change 1. The development of a new microchip enables manufacturers to reduce the

price of their products.

Change 1 - answer
Change 2. The firm mounts a major successful advertising campaign for DVD's.
Change 2 - answer
Change 3. The government applies VAT to all home entertainment equipment.
Change 3 - answer
Example 2 - the market for fish

Let's look at another example, and make sure
that you understand how the shifts and
movements occur and interact. Now work through the following
changes, and adjust the diagram as you go. After you have had
a go at each change, follow the answer link below and see if
you made the right changes.
Figure 1 represents the market for fish at the start of a week.

Assume that all demand and supply changes occur without delay, i.e. they react instantly. The
changes given are all sequential. In other words use the diagram you end up with as the
starting point for the next change.
Figure 1 The Market for fish
Change 1. There are very rough seas, and small boats cannot fish.
Change 1 - answer
Change 2. It is Thursday, a day where the demand for fish is very high. Seas become
even rougher.
Change 2 - answer
Change 3. It is Friday, when demand for fish is even higher. Storms weaken, though,
and fishing becomes easier.
Change 3 - answer
In this example, we have seen price rises accompanied by an increase in sales. This does not
mean that the rules of price and demand are wrong, just that in such cases there will have
been changes in supply and demand. Be careful to separate shifts from movements. Notice
that movements along a demand schedule come as the result of movements of supply
PlotIT - Build a demand and supply diagram

The demand and supply schedules for organically grown wheat are shown in the following
table. From it we can see that at a price of £200, farmers will produce (or plan to plant and
produce) 220 tonnes per annum (p.a.); likewise consumers will buy 220 tonnes p.a. at this
price. However, the price of non-organic wheat falls dramatically and is considerably cheaper

than organic wheat. As a result the demand for organically grown wheat changes by 80 tonnes
at all prices. Calculate the new level of demand at each price level. Jot this down on a piece of
paper. You may like to check your answer.
Price per tonne (£) 50 100 150 200 250 300 350
Tonnes supplied 100 140 180 220 260 300 340

p.a.
Tonnes demanded 400 320 260 220 180 140 120

p.a.
New tonnes 8 6 2
demanded p.a
In the diagram below plot the original supply and demand curves and the new demand curve
given this change in the price of non-organic wheat.
You may like to check your answer to see if it matches the correct demand and supply curves.
Market for organic wheat

1
What will be the shortage/surplus at the original price of £200 per tonne?
a) A surplus of 80 tonnes
b) A shortage of 80 tonnes
c) A shortage of 50 tonnes
d) A surplus of 50 tonnes
Equilibrium
2
2
What will be the new equilibrium price and quantity?
DragIT - Demand and supply

The following diagram shows the demand and supply of good X. For each of the following, click
on either the demand or supply curve (or first one and then the other) and drag the curve(s)
to a position that illustrates the question to help you match the events to the particular
change.
Shifts in demand and supply

1
Match the following changes to the shifts that will take place.
a) An increase in the level of income Choose...
b) An decrease in the price of a substitute Choose...
c) An increase in cost Choose...
d) An improvement in productivity Choose...
Diagram toolkit

In the diagram toolkit you get given a panel showing possible curves and labels and you then
drag these curves onto targets on the diagram to try to build an appropriate diagram.
There are a number of sections. Follow the links below to access the different sections or use
the table of contents on the left.
The market for air travel (1)

The market for iPods (1)
Why not try the one below as some practice? Drag curves and labels onto the targets on the
diagram to build a demand and supply diagram showing a market in equilibrium. Once you
think the diagram is right, click 'Check answer'. To see the correct answer, click the
'Feedback' button.
Click on the right arrow to start trying out the diagram toolkit.
Air travel (1)

On the diagrams below, drag curves and labels from the panel on the right to build the
appropriate diagram. Once you think the diagram is right, click 'Check answer'. To see the
correct answer, click the 'Feedback' button.
Number 1

Number 2
Number 3

Number 4
Click on the right arrow try some further examples.
Air travel (2)

Number 1
Number 2

Number 3
Air travel (3)

Number 1
Number 2

Number 3
iPods (1)

Number 1
Number 2

Number 3
Number 4

iPods (2)
Number 1

Number 2
Number 3

iPods (3)
Number 1

Number 2
Number 3

Markets and prices - self-test questions
Market changes
1
The diagram below shows the market for 3G mobile phones. Which of the following events might
have caused the shift in the demand curve?
a) 3G phone suppliers take advantage of economies of scale

b) An increase in advertising expenditure by phone companies
c) An increase in interest rates
d) The entry into the market of a major new 3G supplier
Market changes
2
The diagram below shows the market for coffee. Which of the following events might have caused

the shift in the supply curve?
a) Starbucks expand significantly in Eastern European countries

b) Coffee substitutes like green tea become more popular
c) An increase in income
d) Subsidies are offered to coffee producers in developing countries
Market changes
3
The diagram below shows the market for olive oil. Which of the following events might have caused
the shift in the supply curve?
a) Improved pesticides enhance crop yields

b) A cut in the price of vegetable oils
c) An increase in income
d) A severe drought in Spain
Market changes
4
The diagram below shows the market for hard disk music players. Which of the following events
might have caused the shift in the demand curve?

a) Entry into the market of a major new supplier

b) A reduction in the price of the chips used in hard drive players
c) An increase in the rate of economic growth
d) The introduction of new phones and PDAs with built in flash music players
Shifts in demand and supply curves

5
Consider the market for Mars Bars. Match the changes below with the shifts in supply and demand
that they are likely to lead to.
a) An increase in cocoa prices Choose...
b) Health concerns over obesity Choose...
c) An increase in price of other chocolate bars Choose...
d) An improvement in productivity Choose...
Subsidy payments
6
Farmers are paid subsidies for the production of wheat. On a separate sheet of paper, draw a
supply and demand diagram to show the impact of a subsidy and type an explanation of the
diagram in the box below.

Shifts in demand
7
Choose appropriate phrases from the drop down boxes below to complete the explanation of shifts
of a demand curve and movements along demand curves.
When the price of a good changes there will a Choose... the demand curve. If the price
increases, there will be a movement upwards and to the left on the demand curve and this is called
a Choose... in demand or a Choose... in quantity demanded. If there is a
decrease in price, then there will be a movement downwards to the right and this is called an
Choose... in demand or an Choose... in quantity demanded. However, if one
of the determinants other than price changes then the whole demand curve will shift, either to the
right or to the left. For example, if income increases, then the demand curve will shift to the
Choose... . If, however, the price of a substitute falls, then the demand curve will shift to
the Choose... .
The impact of taxation

We looked briefly under supply at the impact of a tax and you should be clear now that a tax
will shift the supply curve to the left. In fact, it shifts the supply curve vertically upwards by
the amount of the tax.
However, we need to look at this in a little more detail as there are different types of taxes.
So, first some definitions.
Specific (or per unit) tax
A specific tax is a fixed amount of tax charged on each unit. A specific tax will shift the
supply curve vertically upwards by the amount of the tax. Examples include cigarette,
petrol and alcohol taxes.
Ad-valorem tax
A tax that is levied as a percentage of the selling price. An example of an ad valorem tax
would be VAT.
These two taxes will have different effects on the supply curve. First the specific tax. We know
that this is a fixed amount (which is why Chancellors / Treasury Ministers tend to increase
these each year - if they did not they would be losing out). Since it is a fixed amount whatever
the price of the good, it will shift the supply curve parallel upwards as shown in Figure 1.
Figure 1 Specific (or unit) tax
However, the ad-valorem tax is a percentage of the selling price. This means that at low prices

the tax will be relatively little (10% of $1 is just 10c), but at higher prices the tax levied will
be higher (10% of $10 is $1). This means that the supply curve shifts to the left and
outwards as price increases. This is shown in Figure 2.
Figure 2 Ad-valorem tax
Tax revenue
We can also use supply and demand diagrams to show the amount of tax revenue that the
government will receive when they tax a good. We know from above that the tax per unit is
the gap between the supply curves. So to calculate the full tax revenue we simply take the tax
per unit and multiply by the number of units being bought and sold in the market. See if you
can draw this and then click on TAX REVENUE.
Tax revenue
DragIT - Tax revenue

The following interaction illustrates the effects of a change in tax rates on the revenue received
by the government. Remember that the effect of a tax is to shift the supply curve upwards by
the amount of the tax per unit.
Click on the "S2" label and drag the supply curve S2 to the left and back to see the impact of
a change in the level of taxation on the tax revenue.

Tax revenue
1
As the tax per unit rises the equilibrium quantity will fall.
a) True
b) False
The impact of subsidies

A subsidy is a payment made to firms or consumers designed to encourage an increase in
output. A subsidy will shift the supply curve to the right and therefore lower the equilibrium
price in a market.
The aim of the subsidy is to encourage production of the good and it has the effect of shifting
the supply curve to the right (shifting it vertically downwards by the amount of the subsidy).
This is shown in Figure 1 below.
Figure 1 Impact of a subsidy
The amount of the subsidy is shown by the gap between the supply curves. This subsidy will
cost the government money and we can use the diagram to show the amount they have to
spend. Total subsidy expenditure will be the subsidy per unit (the vertical gap between the
supply curves) multiplied by the number of units that are traded on the market. This gives the
area shown in Figure 2 below.
Figure 2 Subsidy expenditure
As with a tax (see the previous section - click on the left arrow at the top or bottom of the
page), some of the subsidy will benefit the consumer (the amount of the price decrease) and
some will benefit the firm. This effect can be seen in Figure 3 below.

Figure 3 Subsidy shares - producer and consumer
Price controls
Price controls are controls that governments
(or other authorities) put in place to try to
influence the outcome of a market. For
example, a government may feel that a price
is too high and so set a maximum price for
the good or service. An example of this may
be rent controls - limits on the maximum
rent that a landlord can charge for the use of
a property. We look at this in the next
section maximum prices - click on the right
arrow at the top or bottom of the page to
look at this.
Alternatively, a government may feel that

the market results in a price that is too low and set a minimum price. An example of this
occurs with labour markets where equilibrium wages can be very low and governments set a
minimum wage. We look at this case in the section - minimum prices.
Markets can also be very unstable and this may persuade governments to try to intervene to
stabilise the markets. This is particularly true with agricultural markets and we look at this
situation in the section - intervention in agricultural markets.
Maximum - prices-set below the equilibrium

A maximum price may be set where the government feels that the price is too high. For
example, rent controls in the rented housing market could be used to prevent rents from rising
to the equilibrium market level. Maximum prices are designed to benefit consumers. The effect
of a maximum price is shown in Figure 1 below.
Figure 1 Maximum price
The maximum price means that demand now exceeds supply (excess demand) and this means
a shortage. This is shown in Figure 1 as the distance QsQd. For this reason, a maximum price
will mean that some form of rationing will have to be applied as too little is being supplied. It
is also likely that a black market (illegal market) may develop in the good or service.
N.B. There would be little point in the government setting a maximum that was above the
equilibrium as the price is below that anyway!

DragIT Maximum prices

Government may set a ceiling for prices below the market equilibrium in order to benefit
consumers. This is referred to as a 'maximum' price because suppliers are not allowed to
charge a higher price. In the UK, the price of a standard loaf of bread was set by the
government right up to the early 1970s. Low maximum prices are often used in developing
countries as a means of helping the large numbers of urban poor.
Assume that the domestic market price for wheat is £5 (which is also the world price of
wheat). In the diagram below drag the 'low maximum price' line to a level that reduces this
country's market price of wheat by 20 per cent.
Maximum prices
1
In the above situation which of the following will be true?
a) There would be a shortage of 5,000 tonnes of wheat per annum.

b) Producers' incomes will fall by 36 per cent.
c) Consumption would increase by 20 per cent.
d) Supply of wheat would fall by 1/5.
e) Future supplies of wheat will be less because farmers will have less incentive to plant
wheat.
Maximum prices
2
In the above situation, which of the following will be true?
a) Over time, fewer people will be engaged in wheat farming, choosing instead to seek work
in more profitable occupations - probably in the local town.
b) Rationing may have to occur, which can be unfair on those in the most need.

c) A black market in wheat could evolve. The black market price could reach £6.00 per tonne.
d) If the world price is £5.00 and the black market price reaches £6.00, there is every reason
to believe that smuggling might occur!
e) Policing the policy (i.e. stopping the black market and smuggling) would ultimately have to
be paid for by the taxpayer.
Minimum prices - above the equilibrium

We saw in the previous section that governments may sometimes think that the equilibrium
price is too high and set a maximum. Alternatively, if the government feel that the equilibrium
price of a good or service is too low then they may choose to set a minimum price. A
minimum price is designed to benefit producers. This is shown in Figure 1 below.
Figure 1 Minimum price
The impact of this policy is the opposite to a maximum price. This time the minimum price will
create a surplus in the market (QsQd in Figure 1). Normally the price would fall as a result,
but it is not allowed to fall below the minimum and so the surplus remains. Something
therefore has to be done to store or destroy this surplus. An example of minimum prices at
work is the Common Agricultural Policy (CAP) of the European Union and we look at this in a
little more detail in the next couple of sections (click on the right arrow at the top or bottom of
the page to access this).
Minimum wage
Many countries have now set a minimum wage. For example, a minimum wage was
established in the UK in April 1999. It is a form of minimum price that sets a floor for wages
which employers cannot pay below. From October 2003, the minimum wage in the UK was set
at £4.50 per hour. The effect of a minimum wage will be very similar to that of a minimum
price.
Assuming that the minimum wage is above the equilibrium level, wages will rise to the
minimum wage level, but the number of employees will fall (to Qd in Figure 2), at least in the
short run.
Figure 2 Impact of a minimum wage
However, the extent of the unemployment will depend on the elasticity of demand for labour
and the elasticity of supply. If both are very inelastic then there may be very little

unemployment.
If the substitutability of labour is very low (in other words employers cannot substitute capital
(machines) for labour), then this should help minimise the impact on unemployment.
Task
Use the web to find out if there is a minimum wage in your country. If there is, try to
answer the following questions.
1. What is the level of the minimum wage?

2. What age does it start at?
3. Are there any exceptions where employers are allowed to pay below the minimum wage?
4. How much has it increased in real terms (compared to inflation) in the last five years?
Intervention in agricultural markets

One area where national governments and the EU
intervene extensively is in agricultural markets. The aim of
this intervention is normally to guarantee farmers a stable
and secure income as agricultural markets can fluctuate
significantly. One of the largest intervention schemes is
the Common Agricultural Policy (CAP) run by the
European Union (EU).
Commodity agreements
These may take the form of attempts to stabilise prices,
through the operation of a buffer stock scheme or
attempts to raise prices by forming a producers' cartel and
restricting supply through the use of quotas.
Buffer stock schemes

Firstly, we will consider the operation of buffer stock
schemes which have existed on and off since the 1920s for a range of commodities including
wheat, tin, rubber, coffee, sugar and cocoa. All of these have eventually failed for one reason
or another, so there are no prominent examples to consider.
So what is a buffer stock scheme?
Buffer stock schemes are operated by a central authority and aim to stabilise prices and
protect producers from sudden shifts in demand and supply (often supply in the case of
agriculture). This is done by 'leaning into the wind', i.e. if there is too much supply, forcing the
price down, the buffer stock agency will increase demand by buying up stocks. If there is a
shortage of supply, forcing the price up, the agency will release stocks onto the market forcing
the price down.
A buffer stock makes use of a price band. Figure 1 below shows the effect of setting up a
buffer stock scheme for coffee. If the market is within the two boundaries set by the agency,
no action is taken. However, if the market price moves outside the boundaries, the buffer
stock operators will intervene.

Figure 1 Buffer stock for coffee
If there is a very good harvest of coffee, the supply curve will shift to the right and the price
would fall below the boundary. The buffer stock operators would then step in to increase
demand to keep the price within the boundary. This is shown in Figure 2 below.
Figure 2 Buffer stock - good harvest
The bumper harvest causes the supply curve to shift to S1. This would initially cause the price
to fall below the lower boundary to OP1. By buying up stocks, the agency shifts the demand
curve to D1 and brings price back within the upper and lower boundaries to OP2.
If there is a poor harvest of coffee, the supply curve will shift to the left and the price would
increase above the upper boundary. The buffer stock operators would then step in to increase
supply by selling stocks and this would push price down below the upper boundary. This is
shown in Figure 3 below:
Figure 3 Buffer stock - poor harvest
Problems of a buffer stock scheme
There are a number of possible problems related to buffer stock schemes and these may
include:
Problems of storage, storage and administration costs and perishability, particularly if there are
too many years of bumper harvests.
Difficulty of setting appropriate floor and ceiling prices. If buffer stock managers have to
consistently intervene at the floor price, they will have to keep buying and may run out of finance. If
they have to keep intervening at the ceiling price, they will run out of stocks to put on the market.
Problems of inadequate supplies if there are too many years of bad harvests.
Problems of financing the buffer stock if there are too many years of good harvest - funds have to
be contributed by the members.
Problems of keeping prices artificially high if there are close substitutes available, e.g.
rubber/rubber substitutes
Difficulties in maintaining the agreement on prices in that some producers may be underproducing
and could improve their individual position by cutting price and raising output. This is particularly the
case where producers are scattered in different countries.
Cartel arrangements
Such schemes have been attempted in the case of rubber, tin, coffee and sugar, and involve
the formation of a single selling organisation, i.e. a cartel, to restrict output of individual

members through the issuing of quotas. Thus, when prices need to be increased, members
would be ordered to reduce their output in accordance with their quota allocation. This is
illustrated in Figure 3 below.
Figure 3 Cartel - use of quotas to restrict output
The supply of primary commodities tends to be perfectly inelastic in the short run, so the cartel
requiring a reduction in output would shift the supply curve to the left from S to S1 and raise
the price from OP to OP1.
Such schemes have suffered from some of the same problems that have beset buffer stock
schemes, i.e. problems of maintaining the cartel and the switch towards substitute goods if
prices are kept too high.
Common Agricultural Policy
The Common Agricultural Policy swallows almost half of the entire EU budget (though at one
stage it was nearly three-quarters). The total subsidy budget of nearly 45bn euros amounts to
nearly $140 per head of the EU population. With the enlargement of the EU and 10 new
countries joining in 2004, reform of the system was vital and was partly agreed in June 2003.
The Common Agricultural Policy relies a lot on offering minimum prices and guaranteed prices
to farmers to try to maintain consistent and reasonable levels of income for farmers. However,
this policy means considerable surpluses being accumulated and the EU has, at various times,
had a wheat mountain, a beef mountain, a butter mountain and a wine lake. All this conjures
up a range of interesting visions!
The CAP has been criticised for a number of reasons, including:
Surpluses are a waste of scarce resources

The high prices prevent fair trade and make it difficult for farmers in the developing world to compete
in EU agricultural markets
Inequalities in agriculture can be increased
High food prices will penalise the poorer members of society
The policy has had damaging effects on the environment as it encourages as much production as
possible at the guaranteed price regardless of environmental impacts
Many of the surpluses generated have been 'dumped' on world markets and this has distorted
those markets - opening up the divide between rich and poor nations further
A range of reforms have been proposed to the CAP to try to address some of
these concerns, and the aim is to shift the emphasis from encouraging
production by paying farmers to produce, to paying farmers to protect the land that they use.
For further details on the changes proposed in June 2003, why not have a look at the BBC
article 'EU farm reform'. There is also a useful short summary of the CAP in the BBC A-Z of
Europe.
DragIT - Intervention in agricultural markets

Added to the problems of price fluctuations and relative declining income that they have faced,
most European farmers have also suffered from growing competition from other food-exporting
nations around the world (e.g. USA, Canada, Australia and parts of Africa). One solution to
this specific problem would be to set a tariff on all imported products that compete directly
with domestic producers.
The following diagram shows the domestic demand and supply for wheat in a given country.

The world price of wheat is £3 per tonne (shown by the horizontal red line).
Import tariff
1
What will be the level of domestic production at a world price of £3 per tonne?
a) 5,000 tonnes per annum

b) 15,000 tonnes per annum
c) 25,000 tonnes per annum
d) 35,000 tonnes per annum
Import tariff
2
What will be the level of imports at a world price of £3 per tonne?

Import tariff
3
What will be the level of imports at a world price of £4 per tonne?



DragIT - Intervention in agricultural markets (2)

The Common Agricultural Policy (CAP) has traditionally used high minimum prices as the
means of supporting the European farming community.
The following diagram is the same as the one we had before. It shows the demand and supply
for wheat in a given country. The world price of wheat is £3 per tonne (shown by the
horizontal red line). Given this low price for wheat, domestic production is 15,000 tonnes per
annum, yet demand is 35,000 tonnes per annum. As a result this country imports 20,000
tonnes of wheat per annum.
Drag the horizontal red line upwards to represent the setting of a high minimum price that
would result in the country now having a surplus of 10,000 tonnes of wheat per annum (a
surplus that is then exported).
Import tariff
1
What will be the revenue of domestic wheat farmers before the policy change?
a) £45,000
b) £60,000
c) £105,000
d) £75,000
Import tariff

Import tariff
2
What will be the price charged after the policy change?
a) £4
b) £5
c) £6
d) £7
Import tariff
3
What will be the revenue of domestic wheat farmers after the policy change?
a) £120,000
b) £60,000
c) £125,000
d) £180,000
Import tariff
4
How much has consumer expenditure on wheat risen by?
a) £180,000
b) £125,000
c) £120,000
d) £15,000
Import tariff
5
Assume that as a result of the policy, the world price of wheat has fallen to £2 per tonne, and that
the government buys any surplus and then exports it at the world price. What will be the taxpayers
contribution to this policy?
a) £180,000
b) £60,000
c) £20,000
d) £40,000
Web links - supply and demand

There are a range of web materials out there that may help you with this area
of the course. On this page we look at a sample of them.
1. Biz/ed presentations
There are some excellent presentations on Biz/ed that help you to see how markets and
supply and demand work. The main one is one on supply and demand analysis but there is
also an excellent one on elasticity as well. You could look at the different ways in which

governments can intervene in agricultural markets. There is also a good presentation on the
impact of tax on the market equilibrium and who pays the market price.
2. Biz/ed questions
The Biz/ed question bank has a range of questions that you ought to have a go at to practice
all the principles of supply and demand that you have learnt in this unit. The tests to look at
are:
Markets - demand and supply (1) (http://www.bized.co.uk/stafsup/options/qbank/page2.htm)

Markets - applications of demand and supply
(http://www.bized.co.uk/stafsup/options/qbank/page3.htm)
Markets - elasticity (http://www.bized.co.uk/stafsup/options/qbank/page4.htm)
3. Biz/ed Virtual Learning Arcade
This section on Biz/ed has a range of interactive simulations that you can use to try different
values and see the impact this has. For demand and supply, you should really be looking at
the following simulations:
Cross price elasticity of demand (http://www.bized.co.uk/virtual/vla/the_cped/index.htm)

Price elasticity of demand (http://www.bized.co.uk/virtual/vla/the_ped/index.htm)
Determining the price of a house (http://www.bized.co.uk/virtual/vla/house_prices/index.htm)
The interrelationship between markets (http://www.bized.co.uk/virtual/vla/inter_market/index.htm)
4. Biz/ed - between the sheets section
This section has some spreadsheets for you to try out supply and demand and see the effect
on a market equilibrium in changes in either supply or demand. The ones in particular to look
at are:
Market equilibrium spreadsheet (http://www.bized.co.uk/stafsup/options/sheets/market_equil.xls)

Market with tax spreadsheet (http://www.bized.co.uk/stafsup/options/sheets/mkt_tax.xls)
Demand and supply (http://www.bized.co.uk/stafsup/options/sheets/demand_supply.xls)
Elasticity (http://www.bized.co.uk/stafsup/options/sheets/Elasticity2.xls)
The main index for this section also has links to some worksheets to go with these files that
you may like to have a look at.
5. Biz/ed supply and demand theory trail
Biz/ed also has in their diagram bank a theory trail for supply and demand. This is a good way
to work through all the principles of supply and demand through diagrams and see how the
market model builds up.
6. Other odds and sods
Biz/ed also has a useful factsheet about markets and supply and demand, and there are some
excellent worksheets to try out to see how well you understand supply and demand:
Worksheet 1 - Markets, supply and demand

(http://www.bized.co.uk/stafsup/options/phws/prenhallw01.htm)
Worksheet 2 - Markets in action (http://www.bized.co.uk/stafsup/options/phws/prenhallw02.htm)
Elasticity worksheet (http://www.bized.co.uk/stafsup/options/elas.htm)
Worksheet on the housing market (http://www.bized.co.uk/stafsup/options/housing.htm)
Elasticity questions (http://www.bized.co.uk/stafsup/exams/elasques.htm)
There is also a set of basic notes on supply and demand and for the really sad amongst you
out there, you can download a Biz/ed screensaver on supply and demand!!
Keeping up to date
It is always useful to keep up to date with what is going on in the economy, and an excellent
way to do this is through the Biz/ed 'In the News' section. This is a searchable and browsable
database of news articles written especially for students of economics and business.

Why not try some searches in the window below? Try search terms like:
Supply and demand

Demand
Supply
Price
Demand and supply
Elasticity
You should find useful up to date examples that you can use to illustrate your answers in
exams.
In the News
In the News is a database of topical news stories that are considered from a business and economics point of view.
Stories are added on a daily basis during UK term time.
We've designed In the News so that you can access and interact with the stories in a number of ways. You can search
and browse the database to find stories dating back to 1997. If you want to learn on the move, you can subscribe to
our podcasts, and if you want more interaction, you can try the interactive questions.
There are also RSS feeds for In the News, and pages of key facts from 1945 onwards.
Search In the News
Search for:
Restrict search to between

Jan 1997 and Dec 2010 (inclusive)
Match whole words only?

Match your phrase exactly?
Match all keywords?
Search
Browse UK archive by year

Browse UK archive by quarter
Browse international archive by year
Browse international archive by quarter
List of all In the News stories - this is a very long list. You are advised to use the search facility above instead
Elasticities - introduction
This unit, with its numbers, will scare some
students. Be positive, the maths is easy; the
key is to understand what the words mean.
It is language, not numbers, that is usually
the problem.
In the last unit we saw what demand is, and

what its determinants are. We know that
demand is sensitive to changes into these
determinants; it is important to know how
sensitive. Economists do this by measuring
elasticity. In particular, they study price,
income and cross price elasticity of demand.
This is new language, so some definitions
are needed.

Elasticity is simply the economist's word for responsiveness. For example, price elasticity
shows how responsive demand is to changes in price. In this section we consider the following
topics in detail:
Price elasticity of demand (PED)

Cross elasticity of demand (XED)
Income elasticity of demand (YED)
Price elasticity of supply (PES)
Applications of concepts of elasticity
PED and taxation
Other applications of elasticity
bottom of the page.
Price elasticity of demand
Price elasticity of demand (PED)
A measure of the resposniveness of the demand for a product to changes in its own price.
PED - formula
Price elasticity of demand is calculated and defined as:
Price elasticity of demand = % change in Qd / % change in P
Where Qd = Quantity demanded

and P = Price
Some students find it difficult to remember which way up this equation is. The following 'aide
memoire' may be of use. You usually put your dinner (demand) on your plate (price). Demand
is over price, D over P!
Price elasticity is negative because price and quantity demanded usually vary inversely with
each other. This is so common that the sign is ignored. Do not forget, when price increases,
demand falls and vice versa.
Elasticity values
Elasticity ranges from zero to infinity and the value is given different names over different
numerical ranges as summarised in the table below.
Value Description Explanation

O PERFECTLY Price has no effect on demand at all
INELASTIC
Under 1 INELASTIC Price has a small effect on demand. The % change in price is
larger than the % change in demand
Exactly 1 UNITARY % Change in price and % change in demand are the same.
Remember, though, the signs are different.
Over 1 ELASTIC Demand is very sensitive to price. The % change in price is less
than the % change in demand.
Infinity PERFECTLY An infinite amount is demanded at one price but nothing at all at
ELASTIC a slightly higher price.
Elasticity along a straight line demand curve

Because of the way that it is calculated, price elasticity will vary along a straight - line demand
curve. Examine Figure 1 carefully.

Figure 1 Elasticity along a straight-line demand curve
It is usual to represent the degree of elasticity graphically. The common shapes for demand
curves and their elasticity values are given in the diagrams below.
Figure 2 Perfectly inelastic demand curve
Figure 3 Inelastic demand curve
Figure 4 Elastic demand curve

Figure 5 Perfectly elastic demand curve
The special shape that represents a price elasticity of 1 is known as a rectangular hyperbola!
This is shown below.
Figure 6 Unit elastic demand curve
Determinants of price elasticity
Price elasticity of a good or service depends on a range of factors:
The availability of close substitutes in the market. The more substitutes available the greater the
elasticity.
Is the good a luxury or necessity? Luxuries are more elastic in demand than necessities.
Proportion of income spent on them. Cheap items tend to have an inelastic demand.
Are they addictive? These obviously become price inelastic.
The time period. Elasticity tends to increase with time.
Number of uses
For more detail on any of these factors, follow the links above.
You will be expected to calculate and use elasticity, and to interpret given data. This may
happen in any of the papers that are taken. Some examples follow (click on the example
links) and there are a series of practice questions which are accessible from the questions
section (click on questions - module 2 in the left-hand menu bar).
Example 1 - price elasticity of demand
Example 2 - price elasticity of demand
Elasticity and revenue
Remember that if demand for a good or service is price inelastic then an increase in price will
decrease sales but increase sales revenue. However, a price cut will increase both sales but
decrease sales revenue.
Firms like the demand for their product if possible to be inelastic. This means that any
increase in price that they put in place will have proportionately less of an effect on demand
and their total revenue will rise.
If price elasticity is 1, then revenue is the same all the time, even if prices are increased or
decreased.

The changes in revenue for different elasticity values are summarised in the table below.
Price elasticity Price change Impact on firm's Explanation

value revenue
Elastic Increase Fall Elastic demand will mean that when price
increases, demand will fall by a greater
percentage than the price increased. This
means a fall in revenue.
Elastic Decrease Increase Elastic demand will mean that when price
falls, demand will increase by a greater
percentage than the price decreased. This
means an increase in revenue.
Inelastic Increase Fall Inelastic demand will mean that when price
increases, demand will fall by a smaller
percentage than the price increased. This
means an increase in revenue.
Inelastic Decrease Increase Inelastic demand will mean that when price
falls, demand will increase by a smaller
percentage than the price decreased. This
means a fall in revenue.
Cross elasticity of demand
The cross elasticity is a measure of the responsiveness of the demand for one product to
changes in the price of another product.
Cross elasticity - formula
Cross elasticity is calculated and defined as:
Cross elasticity of demand = % change in Qdx / % change in Py
Where Qdx = Quantity demanded of Good X

and Py = Price of Good Y
Cross price elasticity varies from 0 to infinity. As before, the now familiar descriptions are
used:
Value Description
0 Perfectly inelastic
Under 1 Inelastic
1 Unitary
Over 1 Elastic
Infinity Perfectly elastic
Significance of XED sign
The sign is as important as the numerical value, however.
Some products tend to be bought together, others are purchased in competition to each other.
Products bought together are called complementary goods. Products which are in competition
with each other are called substitute goods.
Examples of complements are strawberries and cream, fish and chips, cars and
petrol, and televisions and TV licences. Complementary goods have negative
cross price elasticities. Perfect complements will have a cross price elasticity of - infinity.

Example - complements
Examples of substitutes are beef and lamb, gas and heating oil, petrol and
diesel fuel. (Note that the substitution may not be possible at once). Substitutes
have positive cross price elasticities.
Example - substitutes
Cross price elasticity can change with time, therefore.
Again, here are some examples of calculations.
Example 1 - cross price elasticity
Example 2 - cross price elasticity
Income elasticity of demand
Income elasticity of demand (YED)
The income elasticity of demand is a measure of the responsiveness of the quantity

demanded to changes in real income.
YED - formula
Income elasticity of demand is calculated and defined as:
Income elasticity of demand = % change in Qd / % change in Y
Where Y = real income

and Qd is the quantity demanded
Normal and inferior goods

Elasticity can be calculated and a range of values found. What do they show? What do they tell
an economist?
Income elasticity may be positive or negative. If income elasticity is negative, demand falls as
real income rises. Goods or services with such elasticity are called inferior goods. Write down
some examples of inferior goods.
If the income elasticity is positive, demand increases with real income. These goods are known
as normal goods. Write down some examples of normal goods.
The sign reveals whether the good is inferior or normal.
Elasticity is given different names over different numerical ranges. Learn these, and the
related diagrams.
Some examples of calculations:
Example 1 - income elasticity of demand
Example 2 - income elasticity of demand
Price, income and cross elasticity - self-test questions
Price elasticity
1
A cut in price from $1.50 to $1.20 sees demand for a product rise by 10%. What would the price
elasticity of demand be for this product?

a) 2
b) 1
c) 0.5
d) 3
Price elasticity
2
A firm increases its price from $8 to $12 and sees demand for the product fall by 20%. What would
the price elasticity of demand be for this product?
a) 0.4
b) 1
c) 2.5
d) 1.5
Income elasticity
3
What type of good would you expected to have a negative income elasticity of demand?
a) Normal good
b) Inferior good
c) Luxury good
d) Giffen good
Income elasticity
4
If disposable incomes rise by 5% and the income elasticity of demand is known to be 0.5, what
change in demand would we expect to see?
a) 10%
b) 5%
c) -5%
d) 2.5%
Price elasticity
5
If a price cut does not lead to an increase in revenue, we might infer that the demand for this
product is?
a) Price inelastic
b) Income inelastic
c) Price elastic
d) Income elastic

Price elasticity
6
If the price elasticity of demand for a product is known to be (-) 2.5 and the firm cuts the price of
this product by 5%, what change would we expect to see in the demand for this product?
a) Increase of 2%
b) Increase of 12.5%
c) Increase of 0.5%
d) Increase of 10%
Price elasticity
7
If the price elasticity of demand for a product is known to be (-) 0.5 and the firm increases the price
of this product by 10%, what change would we expect to see in the demand for this product?
a) Increase of 20%
b) Increase of 5%
c) Decrease of 10%
d) Decrease of 5%
Price elasticity
8
If the price elasticity of demand for a product is known to be (-) 2.5 and the firm increases the price
of this product by 5%, what change would we expect to see in the demand for this product?
a) Decrease of 50%
b) Increase of 2%
c) Decrease of 2%
d) Decrease of 12.5%
Sales in a recession
9
In a recession, which sort of good would we expect to see a rise in sales for?
a) Luxury
b) Necessity
c) Inferior
d) Normal
Price elasticity
10
A cut in price from $75 to $60 sees demand for a product rise by from 1,200 units to 1,500 units.
What would the price elasticity of demand be for this product?
a) 0.8

b) 1
c) 1.25
d) 2
Income elasticity
11
If disposable incomes rise by 2% and the income elasticity of demand is known to be 1.5, what
change in demand would we expected to see?
a) 3%
b) 1.33%
c) 0.75%
d) -3%
Price elasticity
12
The image below shows a medium size yacht. What would you expect the value of the price
elasticity of demand for yachts to be?
a) Relatively price elastic

b) Unit elastic
c) Relatively price inelastic
d) Zero
Price elasticity
13
The image below shows cigarettes. What would you expect the value of the price elasticity of
demand for cigarettes to be?


b) Unit elastic
d) Zero
Price elasticity
14
The image below shows wheat being harvested. What would you expect the value of the price
elasticity of demand for wheat to be?

b) Unit elastic
d) Zero
DragIT - Calculating elasticity

In the diagram below, shift the demand curve to the right by 15 units. Do this by clicking on
the 'D1' label and, keeping the mouse pressed, drag it to the right. Note that the slope
remains the same (i.e. -5). Once you have done this, try the questions below.

Price elasticity
1
What is the value of the price elasticity on demand curve D1 when the price rises from £5 to £7?
Price elasticity
2
What is the value of the price elasticity on demand curve D2 (once dragged to its new position)
when the price rises from £5 to £7?
Price elasticity of supply
Price elasticity of supply (PES)
The responsiveness of the quantity of a good supplied to changes in its price.

PES - formula
The value for price elasticity of supply is calculated and defined as:
Price elasticity of supply = % change in quantity supplied / % change in price
Possible PES values

The familiar descriptors are applied to the value that you get from this formula (known as the
coefficients), namely:
Value Description Diagram
0 Perfectly inelastic
Between 0 and 1 Inelastic
1 Unitary
Between 1 and infinity Elastic
Infinity Perfectly elastic
Follow the links below to see some sample calculations if you are not sure about
how to calculate the value of price elasticity of supply.
Example 1 - price elasticity of supply
Example 2 - price elasticity of supply
Price elasticity of supply measures the ability of a firm to increase or decrease its output in
response to a change in price. This sensitivity changes with time, or rather with economic time
and the degree of substitutability between factors of production.
Unitary elasticity of supply
Any straight-line supply function that passes through the origin has a coefficient of 1. Look at
Figure 1. All the supply functions have an elasticity of 1.

Figure 1 Supply schedules with unitary elasticity
Determinants of PES
Supply elasticity depends on a number of factors:
The time period

The substitutability of factors of production available to the firm
Level of spare capacity within the firm
Level of stocks available
Effect of time on supply elasticity

Firms use factors of production to manufacture their goods. Consider a farmer growing wheat.
There is the farm and its equipment, silos and the farm workers. The owner farmer makes all
the decisions.
Very short run - no changes possible other than the use of stocks
This is the position after the planting season. The yield is fixed. Excess grain may go into
stock, or stocks may be sold to satisfy a shortage. Supply elasticity is very low, and may even
be perfectly inelastic.
Short run - at least one factor fixed
The farmer may be able to increase or decrease the area used for wheat. The potential here
will depend on the efficiency of the farm, the choices open to it, and its production possibility
frontier. Look at Figure 2.
Figure 2 PPF between wheat (good A) and barley (good B)
If the farm was at point Y it can only increase wheat production at the cost of barley. On the
other hand, if it is at X it has much more flexibility.
Supply will have become more elastic. The farmer will be able to respond to the signals that
the market is sending out.
Long run - all factors are now variable
The farmer could buy more land, invest more capital and significantly increase production.

Supply will now be very responsive to demand; it will have become elastic.
Very long run
This is where technology comes in. A new process or procedure, such as genetic modification,
can revolutionise an industry and radically change its potential. Such changes are few and
come after much research and other investment.
Effect of substitutability on supply elasticity
The easier it is to increase or substitute factors of production the quicker that a firm will be
able to respond and produce more. Consider a number of factors:
Labour. The more skilled and specialised the labour being employed the lower will be the supply
elasticity. The longer the training period, the lower the elasticity.
Materials. If a process uses materials, which are in short supply on long delivery periods and which
are very specialised, then the supply elasticity will be low.
Capacity factors
Firms working below their maximum capacity can respond quicker to changes in demand than
those working flat out. The greater the spare capacity, the greater the elasticity of supply.
Stocks
The availability of stocks can increase the ability of a firm to respond quickly so will increase
the supply elasticity, at least for a short time.
Summary
1. The responsiveness of supply to changes in price is known as supply elasticity.

2. Elasticity of supply is normally positive.
3. Supply is perfectly inelastic if its coefficient is 0, inelastic if it is between 0 and 1,
unitary if it is exactly 1, elastic if it is between 1 and infinity and perfectly elastic if it is
infinity.
4. Price elasticity of supply of a product varies with time, economic time (i.e. very short
run, short run, long run, very long run). It also depends on the substitutability of the
factors of production used in its manufacture.
DragIT - Elasticity
In this section you can check that you know all the elasticity formulae. In the
exercises below, you need to drag the blue buttons on the right onto the orange
target areas to build the relevant elasticity formula. Have a go at each in turn. Try to get them
right straight away, rather than by trial and error!
Price elasticity of supply

Price elasticity of demand
N.B. A way of remembering this formula is to think of 'dinner (D) on your plate (P)'. In other
words demand divided by price.
Income elasticity of demand

Price elasticity of demand for exports

Income elasticity of demand for exports
Applications of demand and supply

Markets rarely react fast, so it takes time for the market to regain equilibrium after it has
experienced a change or a shock. Examine Figure 1, which shows the effect of an increase in
demand on the market for new houses in an area. Assume that a major, large government
department has just announced that it is to relocate to this area.

Figure 1 The market for new houses
The initial market was defined by demand curve D and supply curve S. The market was in
equilibrium at price P1 when Q1 new houses were bought and sold. The entry of the
government department will increase demand and shift the demand curve to D1. Supply will
take time to react so price will rise initially to P2, then fall back slowly to P3 as the supply of
houses increases. It will move from one equilibrium position, P1Q1, to another, P3Q2, over a
period of time. It will pass through P2Q1 on the way.
A further example, the market for drugs or alcohol. Suppose the police were to really crack
down on drug dealing, with considerable but not perfect effect. What would happen?
The US Government once tried to ban the sale, and hence consumption of alcohol in America,
but with only partial success. What happened here? Look at Figure 2.
Figure 2 The drug or alcohol market
In both cases the measures had no effect on demand, but reduced supply. So price would go
up but the quantity available would fall.
For the drugs, the street price would be an indication of the success of the police. The greater
the rise, the greater the degree of success.
The real supply curve?

The supply curve is usually drawn as an upwards (left to right) sloping curve. This implies that
as price rises, so will the supply. This further supposes that the response time for the supplier
is zero. In many cases this is far from the case. (If it was, then supermarket shelves would
never be out of stock of the item you want!) Consider the market for houses in a region
illustrated in Figure 1 below.

Figure 1 Supply of houses
Builders are constructing and selling 'Q' houses per month at present at price 'P'. Suddenly
demand increases significantly, as a government department is moving a London office there.
What can be done? Not much, at least in the next few months.
Supply is essentially fixed at Q1, regardless of demand. The supply curve is a vertical line.
Prices will be put up by the developers if they think it worthwhile - in our diagram prices have
risen to P1.
Supply will take time to react to the new situation. They

need land and planning permission and this can take
months or years to organise. It will then take anything
from 6 months to a year to build the house itself.
Once adjusted, the builders will actually be operating on

another vertical supply curve. They will now be building
Q2 houses per month and the pressure on prices is
eased (though the exact impact will depend on national
effects as well). Let's hope the government does not
change its mind!
Figure 2 Increase in supply
Now think about the supply of things like CIVIL AIRCRAFT, AGRICULTURAL PRODUCTS and
FOREIGN HOLIDAYS.
SUPPLY CHANGES SLOWLY, MUCH SLOWER THAN DEMAND.
Applications of concepts of elasticity

Measuring elasticity
Price elasticity is based on the demand curve. In fact, the elasticity is the gradient of the
demand curve at a particular point. (Mathematicians will note that it is the differential of the
demand function, in fact.) This means it is a static measure, since it is based on static, or
equilibrium data.
In the real world elasticity, is very difficult to measure. There are far too many variables, and
these change all the time. Quantitative data is rare, but qualitative data can be useful.
It is useful to remember that essentials tend to be price inelastic, as are addictive products.
This is one of the reasons behind the taxing of alcohol and tobacco. More on this later in the
course.
PED and taxation

The imposition of a tax will mean that the price goes up (as supply shifts to the left).
However, the amount of the price increase will depend on the elasticity of demand. Compare
Figures 1 and 2 to see the difference.

Figure 1 Tax imposed on a good with elastic demand
Figure 2 Tax imposed on a good with inelastic demand
Tax revenue
1
If you aimed as a government solely to reduce the consumption of the good, which type of good
would you be taxing?
a) Elastic demand
b) Inelastic demand
Tax revenue (2)

2
If you aimed as a government to tax goods simply to raise tax revenue, which type of good would
you tax?
a) Elastic demand
b) Inelastic demand
So we can see that if we tax a good with elastic demand, then the price will rise very little and
the tax will fall mainly on the producer (as they are not able to pass on the tax as a price
increase). If, however, the good is inelastic in demand the producer will be able to increase
the price more and therefore pass on more of the tax as a price increase. In this situation the
burden of the tax falls mainly on the consumer. You can see this in Figure 3 below - the price
increase is borne by consumers and the rest of the tax (the gap between the supply curves) is
borne by the producer.

Figure 3 Tax burden - consumer and producer
The burden of the tax depends overall on the elasticity of the demand curve. The more
inelastic the demand curve, the more of the tax will be borne by the consumer.
DragIT - Incidence of tax

In this interaction, drag the end of the demand curve up and down to see the impact of a
change in the elasticity of demand on the tax revenue received by the government and the
incidence of the tax on the firm and on the consumer. The tax revenue is the sum of the two
areas - consumer share and firm share.
In this next interaction, drag the end of the supply curve up and down to see the impact of a
change in the elasticity of supply on the tax revenue received by the government and the
incidence of the tax on the firm and on the consumer. Again, the tax revenue is the sum of
the two areas - firm and consumer.

Incidence of tax
1
The more elastic the demand curve the lower the consumers share of the tax will be.
a) True
b) False
Incidence of tax
2
The more inelastic the supply curve the lower the producer share of the tax will be.
a) True
b) False
Incidence of tax
3
The more inelastic the demand curve the higher the producer share of the tax will be.
a) True
b) False
Other applications of elasticity

PED values are important to firms for a number of reasons and in this section, we look at the
relevance of the price, cross and income elasticities for business decision making.
Click on the right arrow at the top or bottom of the page to start with a look at the relevance
of the price elasticity of demand.
PED and business decisions

PED and business decisions - the effect of price changes on revenue
PED is important for business decision making as it determines the effect of price changes on
total revenue. When a business is considering increasing or decreasing price, it is important to
know what will be the resulting impact on its sales revenue.
Consider the following demand curves:
Unit elastic demand
Figure 1 Unit elasticity of demand
Here the curve is a rectangular hyperbola. Thus all rectangles under the curve are equal in
area and each rectangle equals total revenue (for example, the blue and red rectangles are
equal). Thus, total revenue remains unchanged as price changes.
In this case it might not be worthwhile for a business to lower price as the extra demand
would not bring forth any extra revenue (MR = 0), but it is highly likely that extra costs would
be incurred in producing the additional output.
Elastic demand
Figure 2 Elastic demand (PED greater than 1 but less than infinity)
Here a decision to reduce price would lead to an increase in total revenue. As price falls from
OP1 to OP2, there is a more than proportionate rise in the quantity demanded from OQ1 to
OQ2 and total revenue rises from OP1 x OQ1 to OP2 x OQ2. The fall in revenue from the lower
price (the red area) is more than compensated by the rise in revenue from the extra sales (the
blue area). The decision to lower price may well be sound in this case as total revenue will rise
which may lead to higher profits, depending on the relationship between costs and revenue.
Conversely, a decision to raise price would lead to a fall in total revenue. A rise in price from
OP2 to OP1 would cause a more than proportionate fall in demand and so reduce total
revenue.

Where demand is elastic:
as price increases, total revenue falls
as price decreases, total revenue rises
Inelastic demand
Figure 3 Inelastic demand (PED greater than 0, but less than one)
Here a decision to lower price would lead to a decrease in sales revenue. As price decreases
from OP1 to OP2, there is a less than proportionate increase in demand from OQ1 to OQ2 and
total revenue falls. We can see from figure 3 that the loss in revenue from the lower price (the
red area) is less than the gain in revenue from the higher sales (the blue area) and so total
revenue will fall.
Conversely, a decision to raise price from OP2 to OP1 would lead to a less than proportionate
fall in demand from OQ2 to OQ1 and sales revenue would rise.
Where demand is inelastic:
as price increases, total revenue increases
as price decreases, total revenue decreases
Thus knowledge of the PED facing a firm's product or service enables rational pricing decisions
to be made.
XED and business decisions

Cross elasticity of demand: relevance for firms
Cross elasticity of demand (CED) is the responsiveness of demand for one good (good X) to a
change in the price of another (good Y). Can you write down the FORMULA? Follow the link to
check your answer.
The numerical value of the XED will depend on the relationship between the goods in question.
If the goods are substitutes or complements, the numerical value of the XED will be much
larger than if the two goods bear little relation to each other; i.e. a change in the price of one
good will have a significant impact on the demand for the other good. This will be important
for business decision making.
For example, consider two manufacturers of different brands of beer (perhaps your teachers
will take you on a field trip to test this?) Brand X and Brand Y, which are close substitutes for
each other. The decision by the manufacturer of Brand X to lower price will, other things being
equal, lead to an increase in the consumption of Brand X beer. If the manufacturer of Brand Y
beer leaves the price unchanged, he is likely to experience a decrease in demand as Brand X
will become relatively, and possibly absolutely, more expensive than Brand Y. The
manufacturer of Brand X is faced with an important pricing decision in order to compete
effectively with the rival.
Conversely, consider the case of two goods which are complements, strawberries and cream. A
good harvest will increase the supply of strawberries and lower their price. There will be a
movement along the demand curve for strawberries, an extension of demand. Given that
people like to pour cream on their strawberries to give extra taste, manufacturers of cream

will have to make important output decisions if they are to meet the potential increase in
demand for cream arising from higher consumption of strawberries.
YED and business decisions

Significance of YED for sectoral change (primary - secondary -
tertiary) as economy grows
Income elasticity of demand (YED) is the responsiveness of demand to changes in income. Can
you write down the FORMULA? Follow the link to check your answer.
Economic growth is the increase in productive capacity of the economy and is best measured
by the increase in real GDP (output) over a period of time.
Typically, as economic growth occurs and real incomes and living standards rise over time, the
primary sector tends to become relatively less important, while the secondary and tertiary
sectors tend to become relatively more important. Fundamentally, this is because of the
importance if YED.
In general, the products of the primary sector e.g. fruit, vegetables, raw materials and so on
tend to have a low YED i.e. as real incomes rise, there tends to be a less than proportionate
rise in demand for these products. No matter how rich you are, there is a limit to how much
fruit and vegetables you can eat, so an increase in income may not stimulate a large increase
in consumption of these goods. Consequently, the primary sector is likely to grow only slowly
as living standards rise.
The demand for manufactured goods and the services of the tertiary sector, however, tend to
have a very high YED. As we become better off, there tends to be a more than proportionate
increase in demand for electrical equipment, furniture, banking, travel and tourism etc. Hence
the secondary and tertiary sectors grow much more rapidly than the primary sector as living
standards rise.
In the more developed countries, the tendency is for the tertiary sector to grow the most
rapidly in response to rising real incomes. This is not because people in rich countries fail to
buy more manufactured goods as they become better off. Rather, it is often the case that
these goods are imported from other countries, often newly industrialised countries, which may
be able to produce the manufactured goods with a comparative advantage, i.e. relatively more
cheaply.
Thus YED has an important effect on resource allocation within an economy and the speed and
nature of sectoral change as countries develop.
Theory of the firm

In this section of the module, we start
to look at the basis of supply. We know
that consumers create demand and that
firms create supply, but we need to look
at the behaviour of firms in more detail
if we are to understand supply fully.
The first stage of this is to look at the

costs of production. This may seem an
odd place to start, but costs are
fundamental to supply. Firms exist to
make a profit - that is their key
objective. If their costs rise, then they
will be more reluctant to supply and so
we need to understand the costs they
face.
Cost theory
Short-run
Long-run
Revenues
Profit maximisation

Perfect competition
Monopoly and oligopoly - introduction
Oligopoly
Contestable markets
Price discrimination
bottom of the page.
Cost theory
You need to be able to define and explain the following terms:
Fixed and variable costs

Fixed costs (FC) - costs that do not change as production is increased or decreased. They have to
be paid in advance of production. They exist even if output is zero.
Variable costs (VC) - costs that vary with output.
Total, average and marginal cost

Total costs (TC) - the sum of fixed costs and variable costs at a particular level of output. So TC =
TFC + TVC.
Marginal costs (MC) - the cost of one more unit of output. In other words the increase in total cost
from producing one more unit of output.
Average costs (AC) - total costs divided by the level of output. There are three aspects of average
cost: average total cost (ATC) which is total cost divided by the level of output, average fixed cost
(AFC) which is total fixed cost divided by the level of output and average variable cost (AVC) which
is total variable cost divided by the level of output.
These costs all relate to operations at a point in time, but they can all vary with time.
Fixed costs
These costs are those that remain unchanged as the output level of the firm changes. It does
not matter what level of output the firm produces (even zero output makes no difference), any
cost which is a fixed cost will remain the same. Common examples of fixed costs are as
follows:
Examples of fixed costs
Rent
Interest on loans
Insurance
Depreciation
Fixed costs can be represented graphically and this would appear as follows:
Figure 1 Total fixed costs
Variable costs

Any cost which varies directly with the level of output would be classified as a variable cost.
Varying directly means that the total variable cost will be dependent on the level of output.
Common examples of variable costs are as follows:
Example of variable costs
Direct labour
Raw materials and components
Packaging costs
Heating and lighting
Variable costs can be represented on a graph and this would appear as follows:
Figure 2 Total variable cost
We could also classify costs as semi-variable costs. Have a think about what these might be
and then follow the link below.
Semi-variable costs
Calculating costs
You also need to be able to calculate a firm's costs from given data, be able to draw cost
curves and then interpret what they mean. We come to that skill later.
You will also need to identify and explain short-run and long-run cost curves. Look carefully at
the following examples.
Figure 3 Short-run average cost curve

Figure 4 Long-run average cost curve
In the short-run, at least one factor input is fixed. In the long-run all inputs are variable. This
means that short-run curves are models of what is happening. Long-run curves are planning
data. A firm cannot operate with all inputs variable. Having decided what it wants from an
examination of the long-run curves, the firm makes a decision to fix a factor, usually capital,
and this gives rise to a new short-run situation.
Now, the calculations and the drawing!
You could be presented with data in the form of a table, like the one below
Output 0 1 2 3 4 5 6 7 8 9 10
(units
Total 100 110 125 145 170 200 235 275 320 370 425
cost
($k)
Plot this with output on the horizontal axis and total cost on the vertical axis and look at it.
There is also a static version of this graph available.
What do you know now?
The firm has fixed costs of $100,000, the cost of 'output zero'.
The total variable cost is increasing with increasing output
Now, some more sums. Work out the average cost (TC / output), the total
variable cost (TC - FC), the variable cost (TVC / output), the average fixed
cost (FC / Output) and the marginal cost (TC (Qx) - TC (Qx-1)).
Once you have had a go at calculating all these, follow the answer link below to compare how
you got on.
Answer - cost calculations
Now plot this data on two separate graphs as follows, and see what it shows.
Graph 1 - Total cost, total variable costs and total fixed costs
Graph 2 - Marginal cost, average cost, average fixed cost and average variable cost
You should get the following:

Graph 1 Total cost, total variable costs and total fixed costs
Graph 2 - Marginal cost, average cost, average fixed cost and average variable cost
Average cost (AC) falls initially, then turns and starts to rise.
AFC + AVC = AC.
MC follows the same pattern, but at a more exaggerated rate.
Marginal cost and average cost cross at the minimum average cost.
See Figure 6 below for the standard representation of these curves.
Why do average and marginal cost cross at the minimum point of average cost?
Well think of this in terms of cricket scores. Your last innings is your 'marginal' innings,
whereas your batting average is your 'average'. Say your average is 50 and in your next
innings you get 20 runs. What happens to your average? It will fall. However, if in your next
innings you get 80 runs. In this case your average will rise.
So, if the marginal is below the average, the average will fall and if the marginal is above the
average, the average will rise.
There are many questions for you to work on in the questions section (click on the questions -
module 2 link in the left hand navigation bar). It may also be worth having a look at the
Diggin' diagrams sections (accessible from the course homepage) to check how well you
understand your diagrams.

Interactive spreadsheet
To see how changes in cost affect the cost curves, why not have a look at our interactive
spreadsheet. On this, you can make changes in the values of costs and instantly see the effect
on the diagram of cost curves. Follow the link below to view the spreadsheet.
Total cost curves - interactive spreadsheets
Summary
Remember, a standard marginal and average cost curve diagram should look like this:
Figure 5 Marginal and average cost
Add in the average fixed and average variable cost curves and it should look like this:
Figure 6 Marginal cost, average cost, average fixed cost and average variable cost
Short-run
It is important to know the difference between the short run and the long run. The law of
diminishing returns is a short run law. Economies and diseconomies of scale occur in the long
run.
Short run
The short run is the period of time in which at least one factor of production is fixed. Over
this time period the firm can only expand production by using more of the variable factor.
Long run
The long run is the period of time when all factor inputs, including capital, can be changed.
You need to remember these as the time period makes a big difference to how the firm can
react to changes in circumstances. In the short-run their capacity is fixed and so all they can
do is employ more variable factors. They cannot expand the scale or size of the firm. In the
long-run though they can. We put the word scale in bold just now because it is important -
economies of scale will only arise in the long-run. In the short-run we get diminishing returns
to a factor (because the firm can only change the variable factor).

In theory, in the short-run, the average costs of a firm should decrease as the output of the
firm increases. Fixed costs are constant, so become spread over more and more product. In
reality, however, average costs may fall initially, but at a decreasing rate. A minimum will be
reached, and average costs will then start to rise. This is the background to the law of
diminishing returns.
Law of diminishing returns - as more and more of a variable factor is added to a fixed factor, output
will rise initially but will eventually fall. This is shown in Figure 1 below. Output (total product) initially
rises at an increasing rate (up to A), but marginal output then starts to diminish. This means that total
output still increases, but at a decreasing rate (the slope of the curve tails off). There may eventually
be a point where returns become negative (output level B) and output falls.
Figure 1 Illustration of law of diminishing returns
Initially, in region 0 - A, there are increasing returns. In the zone A - B there are decreasing
returns, and beyond B there are negative returns.
This theory supports the shape of the marginal and average cost curves. Both of these curves
will be u-shaped as eventually diminishing returns will lead to costs increasing. Initially
increasing returns mean that both AC and MC will fall, but once diminishing returns set in both
curves start to rise again. The MC and AC curves are shown in Figures 2 and 3, although we
will return to these in more detail in the next section.
Figure 2 Marginal cost curve
Figure 3 Average cost curve
The marginal cost curve will intersect the average cost curve at its minimum point.
The actual position of the AC curve will vary with a number of factors.

Costs of factor inputs (labour, materials, services etc). The cheaper the inputs the lower the
average cost will be at any given output.
Productivity - productivity can be defined as output per unit input. The more productive the firm, the
more output it gets from its inputs and the lower the average cost at any output.
Productivity is measured in a number of ways:
Marginal product (MP) - the change in total output resulting from the adding of one extra unit of a
variable factor, often labour.
Average product (AP) - total output / units of variable factor being used.
The choice of factor inputs will be driven by their costs, productivity and effect on product
cost. An efficient firm will make its choices so as to minimise its average cost at the production
rate being worked. Look at the following example.
Example
Student Computers make DVD drives. Its average cost curve is shown in figure 4 below.
Figure 4 Average cost curve for Student Computers on 1st May 2002
The following then takes place:
Business rates increase (fixed costs (FC))

Insurance premiums rise (FC)
Wage rates (variable costs (VC)?) and salaries (FC) increase
This will change the cost curves. The curve will move upwards due to the increase in fixed
costs. The average cost of production at the present output will rise from C1 to C2. Unless
something is done about it, the profits will fall.
Figure 5 Average cost curves for Student Computers on 1st July 2002
In response to these changes the research and development department introduces new
materials that are cheaper to buy than the old ones. They also introduce new working
practices and procedures that increase productivity considerably. The savings are shared
between the firm and its employees. This all reduces variable costs and the AC curve falls
again. Now the production average cost, at C3, is lower than before.

Figure 6 Average cost curves for Student Computers on 1st November 2002
The firm has responded to rises in certain costs by taking steps to reduce others.
Costs and cost curves - self-test questions
Cost calculation
1
A firm produces 200 units and the total cost of production is $4000. When they increase output to
220, the cost rises to $4200. What is the marginal cost?
a) $200
b) $20
c) $10
d) $1
Cost calculation
2
220, the cost rises to $4200. What is the average cost of producing 220 units?
a) $4200
b) $20
c) $21
d) $19.10
Cost calculation
3
A firm producing in the short run produces 200 units and the total cost of production is $4000.
When they increase output to 220, the cost rises to $4200. When output rises to 240, the cost rises
to $4100. The firm is experiencing:
a) Increasing returns to the variable factor

b) Increasing returns to scale
c) Diminishing returns to scale
d) Diminishing returns to the variable factor

Cost calculation
4
220, the cost rises to $4200. When the firm produces zero output, the cost is $1000. What is the
fixed cost per unit when they produce 200 units?
a) $1000
b) $500
c) $15
d) $5
Cost calculation
5
220, the cost rises to $4200. When the firm produces zero output, the cost is $1000. What is the
variable cost per unit when they produce 200 units?
a) $3200
b) $14.54
c) $16
d) $5
Types of costs
6
Match the following cost definitions to their type.
a) The increase in total cost from producing one more unit Choose...
b) Total cost less total variable cost Choose...
c) Total fixed cost divided by the level of output Choose...
d) Total cost less total fixed cost divided by the level of output Choose...
e) Total cost divided by the level of output Choose...
AnimateIT - Short-run total cost curve

In this section we look at an animated version of the short-run total cost curves. It is worth
going through this to see how the diagram is built up.
Total cost curves

Long-run
First let's remind ourselves of the definitions and what type of economies of scale there are. It
is important to remember that economies/diseconomies of scale occur in the long run, with all
factors variable.
Economies of scale
Economies of scale are the advantages that an organisation gains due to an increase in
size. These will lead to a decrease in the average costs of production.
Diseconomies of scale
Diseconomies of scale are the disadvantages that an organisation experiences due to an

increase in size. They will increase the average costs per unit.
Both economies and diseconomies of scale apply at all levels of output, but economies
predominate at low outputs and diseconomies at high outputs. This is summed up,
diagrammatically, in Figure 1 below.
Figure 1 Economies and diseconomies of scale
This behaviour can explain the movement towards monopoly in some industries. The lower
costs can be passed on, at least in part, to the customer in lower prices, and demand will rise.
Market share will grow, and the firm will gain monopoly power.
So what actually causes AC to fall or rise?
Both economies and diseconomies of scale can be internal or external. External factors relate
to the industry itself, and are open to all firms within the industry. Typical examples are the
availability of suppliers and specialist labour in a region, and the establishment of a better local
infrastructure. However, as the concentration of an industry in a region grows, there will be
excessive pressures on these facilities, so an advantage may change into a disadvantage.
Internal factors relate to the firm itself, and are particular to it.
Economies of scale
Typical examples of internal economies are:

Technical - the bigger something is, the lower is its unit cost. Big is beautiful! E.g. one large oil
tanker may require the same staff as a smaller tanker but will be able to transport much more oil.
Specialisation - use of specialist staff on a full time, efficient basis
Purchasing - bulk buying. Larger firms are able to get better purchasing deals.
Financial - the bigger the firm the cheaper and easier it is to borrow money. Banks will offer better
deals to Unilever or ICI than the corner shop.
Risk spreading - large firms are able to diversify and spread the risks of their activities. With
globalisation a large firm will be less vulnerable to changes in a particular economy.
Diseconomies of scale
These are mainly people related. They can be summarised as:
Poor communication - as a firm grows bigger it becomes harder and harder to communicate.
Language can become a problem as firms go multi-national. Modern technology has reduced this
problem, but the main approach is to reduce the need for much of the communication. Delegation of
authority is a great help
Slow decision making - seeking authority can take a long time, especially in large, international
companies. Planning, pre-authorisation and delegation can reduce this problem.
Growth of bureaucracy - bureaucracy and paper work can build excessively as firms grow. This is
largely a matter of management style and trust.
All of these can combine and interact to cause a fall in morale and motivation of the staff
operating the business.
The point at which diseconomies of scale become dominant depends on the effectiveness of
steps taken to suppress them. The more that firms trust their staff, delegate authority and
reduce paper work, the longer that the diseconomies can be held at bay.
Long run cost curves
The long run cost curve of a firm is sometimes called an 'envelope' curve as it envelopes all
the short run average cost curves. Consider the different ways that capital intensive and
labour intensive industries develop. First, some definitions:
Capital-intensive firm - firm where its cost structure is dominated by fixed costs.
Labour intensive firm - firm where its cost structure is dominated by variable costs (this may be, but
does not have to be labour).
Cost structure - the relationship between fixed and variable costs for a firm.
Capital-intensive activities have long, deep long-run average cost curves. Small firms cannot
compete against large ones; the difference in average cost is too great. A few large firms, with
perhaps a few small but very specialist businesses, will dominate industries. Look at Figure 2.
Figure 2 Long-run AC curve for capital-intensive business
Labour intensive activities have short and relatively flat long-run average cost curves. There is
little advantage in being large, so the industry develops with many small firms. Look at Figure
3.

Figure 3 Long-run AC curve for labour intensive business
This means that it is very expensive to try to enter a capital-intensive industry. The minimum
scale of operation will be high and will require a large investment of capital. The risk will be
high, and the capital will be hard to raise. The cost becomes a real barrier to entry. The
potential reward, however, will be large.
On the other hand, it is much easier to enter a labour intensive industry. The minimum scale
of operation will be low, as will be the initial capital investment. The risk will be low, and not
much capital will need to be raised. Cost will not be a barrier to entry, but the potential
rewards are also smaller.
Economies of scale
1
Match the following examples of economies of scale with their classification.
a) A large company negotiates a loan at a preferential Choose...

interest rate
b) The introduction of larger oil tankers makes oil transport Choose...
cheaper
c) Growth in demand enables a firm to negotiate a better Choose...
deal with its suppliers for ordering more
d) A firm with very seasonal demand diversifies into other Choose...
areas to make demand more consistent all year round
e) Growth of the firm allows them to employs a financial Choose...
controller for the first time
Capital and labour intensive

2
Which of the following industries would you expect to be capital intensive?
a) Glass production
b) Computer game development
c) Steel production
d) Aircraft production
e) Fruit growing
The very long run

So far we have looked at the short-run and the long-run. We now meet the very long run.

Very long run
Where changes in technology make major changes in costs possible.
Invention, innovation and technological change gives some firms a huge cost advantage in
some industries, and brings into existence new industries in their own right.
A new invention, protected by patent, obviously gives its inventor a huge advantage. This is
the way that the pharmaceutical industry works.
Patent
A document granting monopoly powers to the inventor of something for a period of time
(up to 20 years) to allow it to recover its investment and make a reasonable return on it.
Within existing industries a smallish firm making a technological breakthrough can gain a cost
advantage and become dominant. Look at the diagram below.
Figure 1 Effect of technical breakthrough on competitive position of a firm
Innovation and invention has to be paid for, and research and development is an expensive
exercise with no guarantee of success. Investing firms aim to protect and exploit their
inventions, whilst others aim to obtain and use this research.
Major breakthroughs are few and far between, but yield big gains. They are costly.
Revenues
Revenue is the income a firm obtains from the sales of its goods or services. Three terms must
be understood:
Total revenue (TR) - all the revenue earned by the business. Total revenue = price x quantity
demanded.
Average revenue (AR) - total revenue divided by number sold.
Marginal revenue (MR) - the increase in total revenue as the result of one more sale. This is not
necessarily the same as the price. It is only the same as price, if price remains constant.
Revenue curves vary depending on whether price is constant at all levels of output (as in the
case of a firm which is a price-taker), or falls as output increases (as in the case of a firm who
is a price-setter). Look at Figures 1 and 2 below to see the difference this makes to the shape
of the average / marginal revenue and total revenue curves:

Figure 1 Revenue curves - constant price (price-taker)
Figure 2 Revenue curves - falling price (price-setter)
You have to be able to calculate revenue, in any form, from data, then draw and interpret
curves. Time for an example, and for you to do some work again!
Output 0 1 2 3 4 5 6 7 8 9 10
(units)
Total 0 100 180 240 280 300 300 280 240 180 100
revenue
($ 000)
Plot this with output on the horizontal axis and revenue on the vertical axis. Look at it and
then we will do some more calculations.
Total revenue rose at first, reached a maximum, and then declined.
From the total revenue curve data above, now calculate the figures for marginal
revenue and average revenue. Once you have had a go, click on the answer link
below to check your calculations.
Answer - revenue calculations
Now, plot the marginal and average revenue curves from this data as well. Examine it. What
does it tell you?

Observation of the graph shows:
Both AR and MR fall as output increases.

AR and MR start at the same point on the Y-axis, at the same level of revenue.
MR can and does become negative.
Using the first graph as well, when MR is zero, TR is at its maximum. Output is 5.5 units.
Profit
Within economics you will meet:
Normal profit - is that level of profit which is just sufficient to keep the firm in its present use. Normal
profit is assumed to be an element of the ATC curve.
Supernormal profit (or abnormal profit)- this is any profit made in excess of normal profit.
The definitions of supernormal and normal profit mean that profit on a diagram drawn by an
economist shows supernormal profit only. Normal profit is included as an element of the ATC
curve and arises where ATC = AR. Examine the following diagrams (we'll look at how to build
these diagrams in more detail later on):
Figure 3 Firm in perfect competition - supernormal profit

Figure 4 Monopoly - supernormal profit
This has to be compared with the accountant's definition of profit.
Accounting profit
The difference between revenue from sales and the costs incurred in making these sales,
regardless of any credits given or taken.
Accountants deal in facts. They do not get involved with concepts such as normal profit.
Governments tax accounting profit, not normal profit.
Why do firms try to make a profit?
Profit has many uses:
It is the return to the entrepreneur.

It is a source of funds for development
It is a motivator.
Profit is a driving force within business. It is an incentive to invest for investors. It lies behind
all cost reduction exercises, as the aim of cost reduction is profit maximisation.
DragIT - Revenue curves (1)

The demand curve for product Z is drawn below. Drag the orange dot, (located at the origin)
to where you think is the correct price and quantity combination that would return maximum
total revenue (TR) (as you do this the corresponding marginal revenue curve will appear).
Revenue curves
1
What is the price charged by the firm to generate maximum revenue?

Revenue curves
2
What will be the value of the total revenue received by the firm if they choose to maximise
revenue?
DragIT - Revenue curves (2)

A change in the firm's output represents a movement along the demand curve (AR) and a
movement along the TR curve. A shift in the demand curve would cause the total revenue
curve to shift too.
The diagram below shows the current demand curve and marginal revenue curve (AR1and MR1
respectively) for product Z. Demand for this product falls by two units at all prices.
(a) Click on the points where the demand curve crosses the two axes in order to construct the
new demand curve.
(b) Now click on the two points where the MR curve crosses the two axes in order to construct
the new MR curve.
You may like to check your answer.

Revenue curves
1
What is the new price charged by the firm to generate maximum revenue? (For the AR2 and MR2
curves)
Revenue curves
2
What will be the value of the total revenue received by the firm following the shift of the demand
curve to AR2 if they choose to maximise revenue?
Profit maximisation
Combining revenue and cost curves

Now, some diagrammatical work. Let's combine the two examples developed in this section
and the figures from the previous notes on costs. This gives us the data below.
Output 0 1 2 3 4 5 6 7 8 9 10
(units)
Total cost 100 110 125 145 170 200 235 275 320 370 425
($ 000)
Total 0 100 180 240 280 300 300 280 240 180 100
revenue ($
000)
Profit ($ -100 -10 55 90 110 100 65 15 -80 -190 -
000) 325
Marginal 100 80 60 40 20 0 -20 -40 -60 -80
revenue ($
000)
Marginal 10 15 20 25 30 35 40 45 50 55
cost ($ 000)
Now let's plot yet another graph. From the table above plot the marginal cost, marginal
revenue and profit figures. You should get a graph looking like the figure below.

There is also a static version of the graph available.
See clearly that the profit is maximised when MC = MR. You can see this from the graph, but
can confirm from the data that this is the case as well.
Profit maximisation
The traditional model of the firm assumes that the objective of all firms is profit maximisation.
This is particularly applied to private firms. Publicly owned firms are treated differently.
As we have seen above, profit maximisation occurs where marginal cost is equal to marginal
revenue. So, the first condition that you need to commit to memory is:
Profit maximisation occurs when MC = MR (Marginal cost = marginal revenue)
Below in figures 1 and 2 are the usual diagrams that show firms maximising profits:
Figure 1 Small firm in perfect competition (price taker)
Figure 2 Large firm in imperfect market (price setter)
We'll come back to these diagrams and look at them in more detail later on in this module, but
the key difference between the two diagrams is in the shape of the revenue curves. The firm
in perfect competition is a 'price-taker' - they are too small to influence price and so they

simply charge the price given by the market. The firm in imperfect competition on the other
hand has a degree of market power. This makes them a 'price setter'. They can set their
price (subject to the constraints of the demand curve) and find the profit maximising level of
output.
Why does profit maximisation occur where MC = MR?
1. Profit = revenue - cost

2. As you sell more, profit will grow as long as the extra revenue obtained is greater than the extra cost
incurred (extra revenue = MR, extra cost = MC).
3. MR is constant or falls, and MC may fall initially but quickly rises.
4. This means that they will soon cross if plotted on the same graph.
5. Before they cross MR is greater than MC and each extra unit will increase total revenue. However,
once they have crossed MC is greater than MR and then each unit will reduce total profit (as more is
being added to cost than revenue).
6. Therefore maximum profit is where MR and MC cross.
Therefore if MR is greater than MC, increasing output is worthwhile as it will add more to
revenue than to cost. If the MC is greater than MR, however, increasing output will not be
worthwhile as more will be added to cost than to revenue. Thus the best place to produce is
where MC =MR.
PlotIT - Profit maximisation

As we saw earlier, profit maximisation will occur for a firm where MC=MR. The following
diagram shows the costs and revenues for a product Y over a range of output from zero to 80
units per week. Product Y is one of many products produced by the firm. The fixed costs
associated with producing Y are £120 per week, £60 of which is normal profit.
What happens when the demand for a firm's product changes? How will this affect the profit
maximising price and output? The following diagram is the same as the one above. It shows
the cost and revenue curves for firm X in the production of good Y.
Now assume that a close competitor of product Y has dropped the price of its product. As a
result demand for product Y changes by 15 units per week.
In the diagram below, click on the two points in turn where the new AR curve strikes the axes.
Then do the same for the MR curve.

You may like to check your answer.
Shift in demand
1
Given the drop in demand faced by the firm, what is the new equilibrium profit maximising output
and price? How much profit is the firm making at this equilibrium?
Revenue and profit - self-test questions
Revenue definitions
1
Match the following definitions to the appropriate type of revenue.
a) Price multiplied by output Choose...
b) Total revenue divided by price Choose...
c) The increase in total revenue from selling one more unit Choose...

Revenue calculation
2
A firm is selling 100 units at a price of $25. However, to sell 110 units they need to cut the price to
$24. What is the level of marginal revenue at this higher level of sales?
a) $140
b) $2640
c) $14
d) -$1
Revenue calculation
3
A firm is selling 100 units at a price of $25. However, to sell 110 units they need to cut the price to
$24. What is the average revenue at 110 units?
a) $25
b) $2640
c) $14
d) $24
Other objectives
Profit maximisation is not the only objective of private firms. Other objectives include:
Survival
To make enough profit to satisfy the needs of the owners (satisficing)
To break-even
To maximise revenue
Growth
Improving market share
Objectives may be short-term as well as long-term. Short-term objectives, which are more
tactical than strategic, might include:
Penetrating a market
Eliminating a competitor
Dumping unwanted products
State owned companies are often thought to be good because they are not profit maximisers.
It is argued that they act 'in the public interest', avoid externalities, and minimise wasteful
activities. However, this may not always be seen on examination of real nationalised
corporations.
Perfect competition
Assumptions of the model
Perfect competition is considered as the ideal
or the standard against which everything is
judged. Perfect competition is
characterised as having:
Many buyers and sellers. Nobody has

power over the market.
Perfect knowledge by all parties. Customers are aware of all the products on offer and their prices.
Firms can sell as much as they want, but only at the price ruling. Thus sellers have no control over
market price. They are price takers, not price makers.
All firms produce the same product, and all products are perfect substitutes for each other, i.e.

goods produced are homogenous.

There is no advertising.
There is freedom of entry and exit from the market. Sunk costs are few, if any. Firms can, and will
come and go as they wish.
Companies in perfect competition in the long-run are both productively and allocatively efficient.
Equilibrium under perfect competition

In perfect competition, the market is the sum of all of the individual firms. The market is
modelled by the standard market diagram (demand and supply) and the firm is modelled by
the cost model (standard average and marginal cost curves). The firm as a price taker simply
'takes' and charges the market price (P* in Figure 1 below). This price represents their
average and marginal revenue curve. Onto this we superimpose the marginal and average cost
curves and this gives us the equilibrium of the firm.
Figure 1 Equilibrium of the firm and industry in perfect competition
Firms in equilibrium in perfect competition will make just normal profit. This level of profit is
just enough to keep them in the industry and since profits are adequate they have no
incentive to leave.
Normal profits
Normal profit is the level of profit that is required for a firm to keep the resources they
are using in their current use. In other words it is enough profit to keep them in the
industry. Anything in excess of normal profits is called abnormal or supernormal profits.
Any profit above normal profit is a 'bonus' for the firms, as it is more than they need to keep
them in the industry. We call this supernormal (or abnormal) profit. However, this
supernormal profit will be a signal to other firms and will attract more firms into the industry.
If firms are making consistently below normal profits then they will choose to leave the
industry.
What does this mean for prices and competition? Consider the following case.
A firm enters a perfectly competitive market with a product. It sells Q1 units of its product at
price P1. It is able to make supernormal profits at this stage. It sells at P1 but has a cost of
only C. It makes SNP's of P1 to C per unit sold. This is shown below.
Figure 2 Firm in perfect competition making supernormal profit
Competition is perfect. New firms enter the market. Supply increases (the supply curve shifts
to the right - S2 in Figure 3 below) and prices fall. The original firm has to lower its price or it

will sell nothing. It charges P2 (the same as the market price) and so now sells Q2. The
market size expands from Q1 to Q2. Look at the modified diagram below.
Figure 3 The impact on a market of supernormal profit
The presence of SNP's has attracted more firms to the market and this has led to the price
falling. The supernormal profits were competed away and equilibrium was reached where only
normal profit was earned. Each of the firms will now be in long run equilibrium earning only
normal profit. The long run equilibrium is where MC = MR = AC = AR. This can be seen in
Figure 4 below.
Figure 4 Long run equilibrium in perfect competition
The falling prices put pressure on the less efficient firms. They may be forced to close and
transfer their assets elsewhere.
Short-run losses
A firm with high costs may face a short-term loss-making situation. It is not at risk in the
short-run provided price at least covers its variable cost, i.e. its day-to-day running costs, so
that a contribution is made towards the fixed costs. This is shown below. The price, P*, covers
variable costs and some fixed costs. A loss of C - P* is made.
Figure 5 Short-run losses
The firm will have to become more efficient. If it does not, it will be forced to leave the
industry. As a number of firms leave the industry, the market supply curve will shift to the
left, and price will rise until losses are eliminated and normal profits are again being made.
The long run equilibrium will occur where no firms are making losses and no firms are making
SNP's. It will be in equilibrium, as shown earlier. Look at the diagram again. You must know it
and be able to explain its development.

Figure 6 Long-run equilibrium of firm and industry in perfect competition
So, perfect competition is a model of an efficient form of competition. Efficient firms face well
informed consumers. Only normal profits are made, so prices are not excessive. Resources are
used effectively and efficiently. Sounds too good to be true.
Shut down price, break-even price
The break-even price in perfect competition is where normal profits are made and AR = P =
ATC = MC = MR. This is shown in Figure 7 below.
Figure 7 Perfect competition - break-even price
Shut down price
A firm may make a loss in the short run, providing AVC is being covered and some
contribution is being made to the fixed costs. If a firm is unable to cover its AVC's, i.e. its
day-to-day running costs, it will shut down immediately. This is illustrated in figure 8 below.
Figure 8 Shut down point
Here output is OQ*, where MC = MR. A loss of PBCE is being made, as ATC is greater than
AR. The fixed costs are given by the area ABCD.
Thus if the firm receives a price of OP it will not cover all its costs but will contribute the area
APED towards its fixed costs which have to be met even if output is zero. It will therefore be
worth remaining in the business at least in the short run.
However, if the price were to fall to OP1 (the lowest point on the AVC curve, where AVC =
MC), the firm would shut down immediately as it would be covering neither its fixed nor its
variable costs.

Do perfectly competitively industries exist?
No 'perfect' perfectly competitive industries exist. Ironically, one of the closest today is
probably the market for shares. However, as we mentioned before, it is still an important
model as it provides a benchmark against which other markets can be judged. It can help in
formulating appropriate policies to improve uncompetitive markets.
DragIT - Perfect competition

It should now be clear that the amount of profit or loss that the firm makes will depend on the
market price.
In the diagram below drag the price up and down to see the impact of these price changes.
Note that the vertical dotted line represents the profit-maximising or loss-minimising output,
where MC = MR.
Perfect competition - equilibrium

1
When the firm in perfect competition is making supernormal profits, they are in long-run equilibrium.
a) True
b) False
Perfect competition - shut-down point

2
If the price falls below the level of AVC the firm in perfect competition will cease production.
a) True
b) False

Perfect competition - self-test questions
Assumptions of perfect competition

1
Which of the following are assumptions we make about perfect competition?
a) A large number of industries

b) A large number of firms
c) Each firm is a price-taker
d) No government intervention
e) Identical products
f) Information on the activities of other firms is generally available
Long-run equilibrium - perfect competition

2
Which of the following will be true when a firm is in long-run equilibrium in perfect competition?
a) MC=MR
b) AC=AR
c) The firm is making supernormal profit
d) MC=AR
e) The average cost curve will be tangential to the marginal revenue curve
f) The marginal cost curve will be horizontal
Long-run equilibrium - perfect competition

3
Which of the following will be true when a firm is in short-run equilibrium in perfect competition?
a) MC=MR
b) AC=AR
c) The firm is making supernormal profit
d) MC=AR
e) The average cost curve will be tangential to the marginal revenue curve
f) The marginal cost curve will be horizontal
Shut down price

4
Select appropriate options in the paragraph below to make up a suitable description of the shut-
down price.
A firm may make a Choose... in the short run, providing Choose... is

being covered and some contribution is being made to the fixed cost. If a firm is at least unable to
cover its Choose... in the Choose... i.e. its day-to-day running costs,
it will shut down immediately. In the Choose... the firm will need to at least break-
even or make a Choose... if it is to survive.

AnimateIT - Perfect competition

In this section we look at animated versions of the perfect competition diagrams. It is worth
going through this to see how the diagrams are built up.
Perfect competition - short run supernormal profits
Perfect competition - short run losses
Perfect competition - firm and industry
Efficient allocation of resources

Economists are concerned about the efficiency of markets, and ensuring that resources are
allocated efficiently.
Perfect competition is considered to be efficient because:
Supernormal profits are not made by any firm in perfect competition in the long-run.
MC = price, so both parties, suppliers and customers, get exactly what they want.
No wasteful advertising.
Firms are allocatively and productively efficient.

The major assumption behind this analysis and evaluation is that firms cannot produce
products cheaper if they were bigger. It assumes that there are no economies of scale
available in the market.
Allocative efficiency
Allocative efficiency occurs when the value consumers put on the good or service equals
the cost of producing the product or service. In other words, when price = marginal cost.
Productive efficiency
Productive efficiency occurs when output is achieved at the minimum average cost.
We can see from Figure 1 below that when it is in long-run equilibrium, perfect competition
achieves allocative and productive efficiency as MC = MR = AC = AR. This means that they are
maximising profits (MC = MR) but only making normal profit (AC = AR).
Figure 1 Long-run equilibrium - perfect competition
So, perfect competition looks good, but is it always so? Problems with perfect competition are:
There are no reasons to do anything better, or research new products. As soon as you do,
everybody else would step in and copy. Wait and let somebody else do it.
Consumer has no choice. There is just one unbranded product on the market.
Some economies of scale always exist.
Perfect competition is not competitive in the fullest sense of the word!
Barriers to entry will always exist.
Look at economies of scale. Some are always likely to exist. Financial economies apply - the
better your reputation the cheaper the loans, bulk-buying economies are there as well.
Economies of scale are there, like gravity. It is up to the firm to take advantage of them.
Competition encourages their application and exploitation.
Perfect competition may well operate efficiently, as far as economists are concerned. The
consumer, however, may get an ordinary product or service at a high price. Is it worth it?
1
At what point will the firm be productively efficient?
a) MC=MR
b) AC=AR
c) MC=AC
d) MC=price

2
At what point will the firm be allocatively efficient?
a) MC=MR
b) AC=AR
c) MC=AC
d) MC=price
Monopoly and oligopoly - introduction

Concentrated markets, ones where there are only a limited number of suppliers, behave
differently to competitive markets. You are required to know about monopoly and oligopoly.
Monopoly
One or occasionally a few firms dominate the market. The others have to accept the
market as established by the others. A perfect monopoly is when there is a single supplier.
However, a firm gets monopoly powers as its market share edges above 25%. Some
industries are natural monopolies, such as water supply and basic power generation.
Oligopoly
Oligopoly is when a few suppliers who provide the same product dominate a market. Petrol
companies and the soap and detergent industry are good examples. Each firm has to be
concerned about what the others in the industry will do.
Governments are concerned about both of these types of competition. Economic theory
suggests that as markets become more concentrated (the number of firms in the industry
falls) they become controlled by the suppliers at the expense of the consumer. As we shall
see, this is not always the case. They try to regulate, or control these industries.
As was seen earlier, the very size of the firms makes it difficult for others to enter the
industry (the size of the firms acts as a barrier to entry). Sunk costs are high so potential
losses are high. There is no great encouragement to enter the market however good a product
the firm has.
Why do some markets become concentrated and others do not?
The simple answer is growth and economies of scale. Some firms are more efficient than
others, and in some industries there are much greater economies of scale than others. This
has led to the formation of a number of highly concentrated industries. Examples are the oil
and petrochemical industry, the aircraft manufacturing industry, airlines, soft drinks and
banking to name just a few. Follow the links below to see how each industry fits the
characteristics of monopoly and oligopoly.
Oil and petrochemicals
Aircraft manufacture
Airlines
Soft drinks
Banking
All the above are examples of oligopoly. Examples of monopoly are few and far between. Many
natural monopolies, often state owned, have been broken up (privatised) and artificial
competition (usually with regulators to control the market) introduced. Examples are electrical
power, gas and the telephone service.

More examples - web links
It is worth being aware of recent examples of monopoly and oligopoly and government policy
towards them. The best bet is probably to do a search in the Biz/ed In the News archive. You
can do this in the window below:
Try searching on terms like:
Monopoly
Oligopoly
Competition
N.B. When you are searching on more than one word, it is best to check the 'match exact
phrase' box.
Growth and power

Why do firms want to grow?
As they get larger they get stronger. They start to eliminate competition, and start to gain
control of the market. They move from being a 'price taker' in a situation of perfect
competition towards being a 'price setter' (or price maker) in a monopoly situation.
Price taker
A price taker is a firm which cannot influence the price of the product on the market. If it
puts its price above the one ruling in the market it sells little or none. Firms in perfect
competition are price takers.

Price setter
A price setter (or price maker) is a firm that can determine or fix the price of the product
on the market. It sets the price, but the quantity sold is determined by the demand curve.
Firms start to develop monopoly power as they grow and increase their market share.
Monopoly power
The power, or ability to influence a market, influence the survival of others, and establish
the price. It enables it to increase profits.
Sources of monopoly power
One of the features of monopoly is that, unlike perfect competition, supernormal profits may
be made in the long run. If there were free entry to the market this could not of course
happen as the arrival of new firms would have the effect of shifting the market supply curve
to the right and lowering the market price until the supernormal profits were eliminated. The
existence of long run supernormal profits therefore implies the presence of barriers which
prevent the entry of new firms into the industry. Indeed the basis of monopoly power is the
ability to prevent entry of new firms. So what are the barriers to entry that exist? They may
include:
Legal restrictions
Capital costs
Limited sources of supply
Agreements between producers to limit competition
Non-price competition as a barrier to entry
Tariffs and quotas
For more detail on any of these, follow the links.
Examples - web links
It is worth being aware of recent examples of monopoly and oligopoly and government policy
towards them. The best bet is probably to do a search in the Biz/ed In the News archive. You
can do this in the window below:

Monopoly
Economies of scale
Competition
Branding
Advertising
N.B. When you are searching on more than one word, it is best to check the 'match exact
phrase' box.
The model of monopoly

Monopoly, as a market form, is at the
opposite end of the spectrum to perfect
competition. In the literal sense, a monopoly
exists when one single firm or a small group
of firms acting together controls the entire
market supply of a good or service for which
there are no close substitutes. This is a
situation of pure monopoly, which like the
case of perfect competition, is rarely easy to
identify in reality. Moreover, whether an
industry can be classed as a monopoly will
depend on how narrowly the industry is
defined; for example, a city underground often has a monopoly on the supply of underground
travel within the city, but does not have a monopoly on all forms of public transport within the
city: people can also travel by bus or overground trains.
Thus in practice, less stringent definitions than 'single producer' tend to be used and

economists focus instead on the degree of monopoly power which exists rather than absolute
monopoly power. A firm may be regarded as being a monopolist if it controls 25 per cent or
more of the total market supply of a particular good or service.
A market concentration ratio is used to measure the degree of concentration within a

particular industry or group of industries. A commonly used ratio is the five firm
concentration ratio which indicates the proportion of the industry's output produced by the
five largest firms.
Theory of monopoly
The monopolist's demand curve
In our analysis of perfect competition, we showed how there is a distinction between the
demand curve of the individual firm and that of the market as a whole - the existence of many
firms each competing against each other means that each one has no influence over price, and
has to take the price that is determined in the market through the intersection of the demand
and supply curves. The demand curve for each firm is therefore horizontal: an infinite amount
is demanded at one price, with nothing at all being demanded at a higher price and with the
charging of a lower price being inconsistent with the goal of profit maximisation.
However, under monopoly there is only one firm in the industry; thus there is no difference
between the demand curve for the industryand the demand curve for the firm. As the
monopolist is subject to the normal law of demand, the monopolist's demand curve will be
downward sloping so that to sell more, price would have to be lowered (see figure 1). In
comparison to other types of market, the monopolist's demand curve is likely to be relatively
inelastic as close substitutes may not be available if price is raised. Indeed, the availability or
non-availability of close substitutes is one of the key factors determining the monopolist's
power in the market.
Figure 1 Monopolist's demand curve
The demand curve shown in Figure 1 presents the monopolist with a choice. The monopolist
can either choose to make the price or the quantity, but cannot do both; for example, if
the monopolist chooses to set a price of OP1, the market dictates that only a quantity of OQ1
could be sold; however, if the monopolist chooses to set a quantity of OQ2 to be sold, clearly
the demand curve tells us that this could only be achieved at a price of OP2.
Marginal revenue and average revenue under monopoly
The table below assumes that the monopolist faces a normal demand schedule,
and from this the revenue curves are derived. Try calculating the figures for
total, average and marginal revenue and once you have had a go, follow the link to check
your answers.
Output Price Total revenue Marginal revenue Average revenue

1 20
2 18
3 16
4 14

Total, average and marginal revenue answers
From the table two points can be seen:
a) As price has to be lowered to increase sales, marginal revenue is not equal to price as in
perfect competition: the additional revenue gained from each extra sale is always less than
price or average revenue, and thus the MR curve will always be below the AR curve in
monopoly.
b) As price is identical to average revenue, the demand curve is also the curve relating
average revenue to the quantity produced.
The information in this table can now be shown in diagrammatic form to show the relationship
between the average and marginal revenue curves (figure 2).
Figure 2 Marginal and average revenue curves
Monopoly equilibrium
Like the firm in perfect competition, the monopolist will maximise profits where marginal cost
= marginal revenue (MC=MR). This indicates the best or profit maximising level of output.
When the average cost and average revenue curves are related to each other, they indicate
the level of profit.
Figure 3 Equating MC with MR in monopoly
Figure 3 shows that there is no level of output better than OQ for the monopolist; for
example, if the monopolist decides to stop producing at OQ1, then MR would be greater than
MC by the distance AB, and output could be expanded with more being added to revenue than
to cost; if the monopolist decides to produce beyond OQ, say to OQ2, then MC would be
greater than MR by the distance CD, with more being added to cost than to revenue, and
clearly this would not be worthwhile. The best output would therefore be where MC=MR.
In Figure 4, we add the average cost and average revenue curves to the previous diagram to
show the monopolist's best output and level of profit at that output.

Figure 4 Monopoly equilibrium
As in figure 3, the best level of output is at OQ where MC=MR. To find the price or average
revenue, a vertical line is taken from OQ to the demand curve (the monopolist 'charges what
the market will bear'), and a horizontal line is drawn across to the revenue/cost axis. The price
is therefore OP or QR. The level of profit is indicated by the amount by which AR exceeds AC:
AR=QR; AC=QS; so RS is the profit per unit of output, and the total supernormal profit is
given by the area CPRS.
Under perfect competition, supernormal profits can only exist in the short run, as in the long
run new firms are attracted into the industry and the abnormal profits are competed away as
the market supply curve shifts to the right and the market price falls. However, under
monopoly new firms are unable to enter the market as there are various barriers to entry
which are the very source of monopoly power. Thus a single firm may remain the only
supplier, and supernormal profits may persist in both the short and long run; in monopoly,
there is therefore no distinction between short and long run equilibrium.
Although the existence of such long run abnormal profits implies a considerable degree of
market power, the fact that the monopolist cannot control both the supply of the good and its
demand means that complete control does not exist. Corporations devote an enormous
amount of time, money and effort trying to mould our demand to fit in with their long term
corporate plans: a situation which might be described as producer sovereignty; however,
providing the demand curve is not completely inelastic, some element of consumer sovereignty
will still remain.
You should note that a monopolist will always produce at a point where demand is elastic, and
will achieve this by restricting output to keep price in the upper price ranges (the elasticity of
demand on a straight line demand curve varies from infinity at the top left section of the curve
to nought at its bottom right section).Figure 4 shows that the marginal revenue curve falls
continuously as price falls, eventually becoming negative. It can be seen, however, that
although the marginal cost curve falls and rises, it is always positive as there will always be
some cost involved in producing any economic good. It would therefore follow that where
MC=MR and the firm is in profit maximising equilibrium, MR will be positive, and where this
occurs demand is always elastic.
DragIT - Monopoly (1)

The amount of profit that the firm under monopoly makes depends on (a) demand, and hence
the position of the AR and MR curves; (b) costs, and hence the position of the AC and MC
curves.
In the diagram below, drag the average and marginal cost curves to see the impact that
changes in cost will have on the firm's profitability.

1
If AC is greater than AR where MC=MR, then the monopolist will be making a loss.
a) True
b) False
Monopoly - equilibrium
2
Where the AC is tangential to the AR curve the monopolist will be making supernormal profit.
a) True
b) False
DragIT - Monopoly (2)

The diagram below shows the profit-maximising price and output of a firm facing a downward-
sloping demand curve. Show the effect on price and output of a rise in demand by dragging
the AR and MR curves. Do this by clicking on the 'MR1' label and dragging it vertically up and
down.
Now click on the top of the MC curve and, by making it steeper or flatter, show the effect on
Q and P after the AR curve has been dragged to the right.

The model of monopoly - self-test questions
Monopoly
1
Choose appropriate options below to make up an appropriate paragraph describing the
characteristics of monopoly.
Under Choose... , Choose... can only exist in the

Choose... , as in the Choose... new firms are attracted into the industry
and the abnormal profits are competed away as the market supply curve shifts to the right and the
market price falls. However, under Choose... new firms are unable to enter the
market as there are various Choose... which are the very source of monopoly power.
Thus a single firm may remain the only supplier, and supernormal profits may persist in both the
short and long run; in monopoly, there is therefore no distinction between short and long run
equilibrium.
Monopoly
2
Which of the following are true in monopoly?
a) The monopolist can set price and output

b) The monopolist can make supernormal profits in the short run and long run
c) The demand curve for the firm and the market are the same
d) The monopolist will always make supernormal profits
e) The monopolist protect their position through barriers to entry
f) A monopolist will always produce where the demand curve is inelastic

Output levels - Monopoly

3
At which output level in the diagram below will the monopolist produce to maximise profits?
a) Output level 1
b) Output level 2
c) Output level 3
d) Output level 4
e) Output level 5

4
At which output level in the diagram below will the monopolist produce to maximise revenue?
a) Output level 1
b) Output level 2
c) Output level 3
d) Output level 4
e) Output level 5
AnimateIT - Monopoly
In this section we look at animated version of the monopoly diagram. It is worth going
through this to see how the diagram is built up.

Monopoly v. perfect competition

Monopoly compared with perfect competition
In the discussion that follows, we shall draw extensively upon several concepts that have been
introduced earlier; that is, the perfect competition model and the various types of economic
efficiency, static, dynamic, productive and allocative. If you are unsure about the meaning of
any of these concepts, it would be advisable at this stage to refer to the relevant sections
before proceeding.
Consumer and producer sovereignty
Because of the conditions of perfect competition - many buyers and sellers, perfect knowledge
and freedom of entry - firms would be forced to produce those goods and services which
consumers most wanted. Any firm or even group of firms not behaving in this way would be
unable to survive for very long as the competitive pressures from those firms who were
responding to consumers' wishes would soon drive them into extinction. From this point of
view it could be argued that consumers are sovereign in as much that it is they who 'call all
the shots'. However, as described previously, monopoly producers may well decide on which
types of goods they are going to supply and at what prices, and then set about manipulating
and moulding consumers' tastes, via their marketing activities, to match their pre-determined
output plans - a situation in which the producer and not the consumer is sovereign.
Under monopoly price is likely to be higher and output lower as compared with
perfect competition.
Figure 1 can be used to predict the effect of a monopoly taking over a perfectly competitive
industry, making the assumption that costs would be unchanged in the process of
monopolisation.
Figure 1 Perfect competition compared with monopoly
Arm(Dp) is the monopolist's demand curve and the market demand curve under perfect
competition. MC is the combined marginal cost curve of all the firms in the perfectly
competitive industry. As the competitive firm's marginal cost curve is also its supply curve, this
combined marginal cost curve must also represent the industry's supply curve. Equilibrium
occurs where demand equals supply, and therefore in perfect competition OPc would be the
equilibrium price and OQc the equilibrium output of the industry. If the industry is monopolised
and costs are unchanged the monopolist would produce where MC=MR, giving an equilibrium
price of OPm, higher than OPc, and an equilibrium quantity of OQm, lower than OQc.

However, if monopolisation of a perfectly competitive industry leads to the reaping of

economies of scale, as may well be the case when several small producers are replaced by
one large producer, then lower prices and a greater output might result - the opposite of what
we originally predicted. In this case, it is possible to predict a social gain from monopolisation.
In Figure 1, the gaining of economies of scale is indicated by a downward shift of the marginal
cost curve from MC to MC1, and where MC1 intersects with the marginal revenue curve a new
and greater equilibrium output is obtained at OQ1, with a price of OP1, which is lower than the
perfectly competitive price of OPc. However, the monopolist has still not achieved full allocative
efficiency as price is still above marginal cost; neither has it achieved full productive efficiency
as it will not be operating on the bottom point of its new average cost curve.

1
At which output level in the diagram below will the monopolist produce to ensure productive
efficiency?
a) Output level 1
b) Output level 2
c) Output level 3
d) Output level 4
e) Output level 5

2
At which output level in the diagram below will the firm produce to ensure allocative efficiency?
a) Output level 1
b) Output level 2
c) Output level 3
d) Output level 4
e) Output level 5

Monopolist - productive and allocative efficiency

3
A monopolist will be productively and allocatively efficient in long run equilibrium.
a) True
b) False
Perfect competition - productive and allocative efficiency

4
A firm in perfect competition will be both productively and allocatively efficient in long-run
equilibrium.
a) True
b) False
Economic efficiency in perfect competition and monopoly
Productive efficiency refers to a situation in which output is being produced at the lowest
possible cost, i.e. where the firm is producing on the bottom point of its average total cost
curve. Since the marginal cost curve always passes through the lowest point of the average
cost curve, it follows that productive efficiency is achieved where MC= AC.
Figure 1 Equilibrium in perfect competition and monopoly
The diagrams in Figure 1 show the long run equilibrium positions of the firm in perfect
competition and the monopolist. We can clearly see that for the perfectly competitive firm,
productive efficiency automatically arises as in long run equilibrium MC=AC at point X.
However, in the case of monopoly, the firm is not operating on the lowest point of its AC curve
(point X ) but is instead operating on some higher point (point S). We can therefore conclude
that in contrast to perfect competition, and assuming an absence of economies of scale, the
monopolist will be productively inefficient.
Allocative efficiency occurs where price equals marginal cost in all parts of the economy.
Again, with reference to Figure 1, it can be seen that in perfect competition, MR = MC, and MR
= price. MC therefore equals price (at point Y), and allocative efficiency occurs. However, the
monopolist produces where MC = MR, but price does not equal MR. It can be seen that at the
equilibrium output of OQ, price is greater than MC by the distance RZ, and the monopolist
could thus be said to be allocatively inefficient.

Dynamic efficiency
Both productive and allocative efficiency are examples of static efficiency in that they are
concerned with how well resources are being used at a particular point in time. However, it
is also important to consider how efficiently resources are being allocated over a period of
time, when, for example, there may be technological advances, and this is the concern of
dynamic efficiency.
Monopoly has been justified on the grounds that it may lead to dynamic efficiency. This is
because the supernormal profits made will not only enable the monopolist to finance expensive
research and development programmes but may also provide the necessary inducement to
undertake such programmes in the first place. In contrast to this, firms operating in a perfectly
competitive environment may lack the incentive to finance expensive research and
development programmes, as open access to the market would mean that their competitors
would immediately be able to share in the fruits of any success. The greater certainty of being
able to earn supernormal profits in the long run also explains why levels of investment in
capital projects may be greater in more monopolistic markets.
So can you now summarise the advantages and disadvantages of monopoly? Have a think
about them, jot them down and then follow the link to compare your notes with ours.
Efficiency and market structure
We are concerned here with concentrated (monopoly and oligopoly) and competitive markets.
Competitive markets are considered to be statically efficient - both allocatively and

productively. Dynamic efficiency is another matter. Because firms are all small, no one firm
can afford R&D; it would have to be done on a collective or industrial basis. This has been
done, but a number of problems arise over funding levies and charges.
Concentrated markets, on the other hand, are considered to be inefficient in the short-run.
They are statically inefficient, even though their AC may be significantly lower than their
smaller 'perfectly competitive' equivalent. The profit motive makes them strive to be more
efficient, so they may invest in R&D and may be dynamically efficient
Monopoly vs perfect competition

1
In the diagram below, which area represents the level of consumer surplus under perfect
competition?
a) Area 1
b) Area 3
c) Area 1+2+3
d) Area 4+5+6
e) Area 7


2
In the diagram below, which area represents the level of consumer surplus under monopoly?
a) Area 1
b) Area 3
c) Area 1+2+3
d) Area 4+5+6
e) Area 7

3
In the diagram below, which area represents the welfare loss if a monopolist takes over a perfectly
competitive industry?
a) Area 1
b) Area 3
c) Area 1+2+3
d) Area 4+6
e) Area 3+5
DragIT - Welfare loss under monopoly

Deadweight welfare loss depends on the degree of monopoly power, which in turn depends on
the price elasticity of demand for the monopoly's product.
To see how the deadweight welfare loss changes as the price elasticity of demand changes,
drag the handle at the end of the AR curve (i.e. the demand curve) in the diagram below. The
deadweight welfare loss is represented by the shaded area. As demand becomes more elastic,
so the deadweight welfare loss decreases.

An industry in monopolistic competition is one made up of a large number of small firms

who produce goods which are only slightly different from that of all other sellers. It is
similar to perfect competition with freedom of entry and exit for firms and any
supernormal profits earned in the short-run will be competed away in the long-run as new
firms enter the industry and compete away the profits.
Assumptions of monopolistic competition

In monopolistic competition, as with perfect competition, we make a number of assumptions.
However, do not get muddled by the word monopolistic in the title. As a form of competition,
this is closest to perfect competition and nowhere near the monopoly end of the scale. The
reason for the name is that in monopolistic competition we drop the assumption from perfect
competition of homogeneity of products and so each firm can develop their own 'brand' of
product. This means that each firm has a 'monopoly' over their brand, but there is still a large
number of firms.
The main assumptions are:
Large number of firms - each firm has an insignificantly small share of the market.
Independence - as a result of a large number of firms in the market, each firm is unlikely to affect its
rivals to any great extent. In making decisions it does not have to think about how its rivals will react.
Freedom of entry - any firm can set up business in this market.
Product differentiation - each firm produces a different product or service from its rivals. Therefore
each firm faces a downward sloping demand curve. This is the key difference from perfect
competition. Product differentiation involves creating differences between products, either real or
imagined, in consumers minds and is likely to involve various forms of non-price competition such as
branding and advertising.
Examples of monopolistic competition
Petrol stations, restaurants, hairdressers and builders are all examples of monopolistic
competition. Monopolistic competition is a common form of competition in many areas. A
typical feature is that there is only one firm in a particular location. There may be many chip

shops in town but only one in a particular street. People may be prepared to pay higher prices
than go elsewhere, or they may simply prefer this 'brand' of fish and chips.
Monopolistic competition in the short-run
As with other market structures, profits are maximized in monopolistic competition where MC
= MR. The AR and MR curves are more elastic than for a monopolist as there are more
substitutes available. The profits depend on the strength of demand, the position and elasticity
of the demand curve. In the short run therefore firms may be able to make supernormal
profits. This situation is shown in the diagram below.
Figure 1 Equilibrium in monopolistic competition in the short-run
Monopolistic competition in the long run

In the long run firms will enter the industry attracted by the supernormal profits. This will
mean that demand for the product of each firm will fall and the AR (demand curve) will shift
to the left. Long run equilibrium occurs where only normal profits are being made as new firms
will keep entering as long as there are supernormal profits to be made. In equilibrium, the
demand curve (AR) will be tangential to the firm's long run average cost curve as shown in the
diagram below.
Figure 2 Equilibrium in monopolistic competition in the long run
We can see this change between the short-run and long run clearly if we combine Figures 1
and 2 together. Figure 3 shows the changes taking place as new firms enter the market.
Figure 3 Changes in equilibrium in monopolistic competition short-run to long run

Limitations of model
The monopolistic competition model has various limitations and these include:
Imperfect information
Difficulties in deriving the demand curve for the industry as a whole
Size and cost structure mean that normal and supernormal profits can be made in the long run by
firms in the same industry
The simple model concentrates on price and output. However, in practice, the firm will need to decide
the variety of the product and advertising
Efficiency in monopolistic competition
Monopolistically competitive firms may have higher costs than perfectly competitive firms, but
consumers gain from greater diversity
Monopolistically competitive firms may have fewer economies of scale and conduct less research and
development, but competition may keep prices lower than under monopoly
Neither productive nor allocative efficiency is achieved. AC is not at its minimum in the long run
(productive inefficiency) and price is greater than marginal cost (allocative efficiency).
AnimateIT - Monopolistic competition

In this section we look at animated versions of the monopolistic competition diagrams. It is
worth going through these to see how the diagrams are built up.
Monopolistic competition - short run supernormal profits
Monopolistic competition - short run to long run
Oligopoly
The nature of oligopoly / assumptions of the model
Oligopoly is a market form in which there are only a few firms in the industry with many
buyers; so market supply will be concentrated in the hands of relatively few producers,
although an industry might still be said to be oligopolistic where several smaller firms existed
alongside the few large firms that dominate; the wholesale petrol market provides a suitable
example of the latter. The markets for cigarettes, records, confectionery, motor vehicles, fizzy
drinks, high street banks, airline carriers, domestic appliances, soap powders and supermarket
chains all provide good examples of oligopoly in the UK and elsewhere.

Where the few firms produce an identical product, this is known as perfect oligopoly, and
where, more commonly, the products are differentiated, this is referred to as imperfect
oligopoly. The case of duopoly, where there are only two firms in the industry, is a special
case of oligopoly.
However, the absolute number of firms in the market is less significant than the way in which
they behave and the relationship between the firms that comprise the industry. In the case
of the monopolist, for example, independent price and output decisions can be made, with the
only consideration being the customer's reaction to the change in price. However, in oligopoly,
where there is competition amongst the relatively few, each firm has to also try to assess the
reaction of its rivals to a change in price, as each firm will occupy a sufficiently important
position within the industry for its particular price and output decisions to have a significant
impact on its competitors. Thus if an oligopolist is thinking of raising the price of its product, it
has to assess whether its rivals will do likewise or keep price down in order to gain more
custom. Oligopoly is therefore characterised by interdependence between the firms that
comprise the industry, and by reactive market behaviour.
Oligopoly has emerged as the most prevalent market form in the industrialised world. This can
partly be explained by the existence of economies of scale, especially in manufacturing,
encouraging the growth of large scale production; inevitably, as firms grow in size, the number
of firms supplying the market falls, and hence the tendency towards oligopoly power.
Moreover, once established, this power may be sustained by various barriers to entry, similar
to those that exist under monopoly.
The importance of non-price competition
As we shall see from our forthcoming discussion of oligopoly, an important feature of

oligopolistic markets, i.e. ones dominated by a few large firms, is the tendency towards relative
price stability. Lack of price movement will occur most obviously where firms collude with
each other to collectively fix their prices, but it may also occur in a situation of, what is known
as, non-collusive oligopoly, where no such price agreements exist; inderdependent firms may
well come to the conclusion that there is no point in 'cutting each others throats' by engaging
in price warfare in the longer term as this could be disastrous for all the combatants, although
there may be a tendency towards occasional short bursts of price cutting. However, this
absence of price competition does not necessarily mean an absence of competition:
oligopolistic firms are likely to compete in a variety of non-price forms.
Non- price competition occurs where firms attempt to win a competitive advantage
over their rivals by strategies other than reducing prices. Non-price competition inevitably
involves product differentiation. Here, oligopolistic competitors try to carve out separate
markets in which they can command consumer loyalty through the creation of actual or
imagined differences in the goods or services they offer, which are essentially the same as
their rivals. This is in contrast to perfect competition where the good on offer, perhaps an
agricultural one, is homogeneous, and product differentiation is difficult e.g. one carrot is
pretty much the same as another.
Product differentiation is extremely widespread amongst the whole variety of consumer goods
and services that we buy e.g. washing machines, television sets, home computers, motor cars,
washing powders, soft drinks, packaged holidays and financial services, to name but a few.
These are all differentiated one from another in a variety of ways, including shape, size, quality
and image.
Non-price competition may take a variety of forms, including:
Advertising
Branding
Product innovation
Packaging
The provision of after sales services e.g. product guarantees
Free samples and gift offers.
We shall examine the first three of the above i.e. advertising, branding and product innovation
in greater detail.
2.3.9.1 Advertising
Advertisements are usually classified according to

whether they are informative or persuasive.
Informative advertising
As the name implies, this type of advertising is

concerned with the dissemination of information
about products or services, e.g. as regards
availability, price or performance, and such
information would be of a factual type. For
instance, an advertisement for a car could focus on
such things as its fuel consumption, its safety
features, the time it takes to reach certain speeds,
its price, the names and addresses of main dealers
etc.
Persuasive advertising
The main feature of persuasive advertising is that it
provides consumers with little, if any, meaningful information about the products being
advertised; rather it seeks to persuade consumers to buy one particular brand of a product
rather than another through a combination of 'catchy' jingles and appealing images.
If the advertising is successful, the images and jingles register into our consciousness and
create strong brand loyalty, e.g. the lines, 'A Mars a day helps you work, rest and play', and
'Coke, the real thing' are extremely widely known, but provide consumers with absolutely no
information on the sugar, fat and chemical contents of the products in question.
Often the images are sexual and are intended to lead consumers to believe that their relative
attractiveness to the opposite sex will be enhanced by the consumption of the good. Many
advertisements for such things as cigarettes, alcohol, cosmetics, sports cars and even ice-
cream fall into this category.
Task
The next time you watch commercial television, make a note and brief summary of the
advertisements which appear during your first hour of viewing.
Classify these advertisements into informative and persuasive. Which type of advertising
predominates?
The following table provides a summary of the potential advantages and disadvantages of
advertising to consumers, firms and the economy as a whole, although its overall impact on
such factors as prices, costs, competition and resource allocation is, as with many aspects of
economics, very much a matter of judgement.
Advantages Disadvantages
For consumers Acts as a medium of communication Persuasive advertising may render
between buyers and sellers, provides consumer choice irrational and destroy
information on product availability and consumer sovereignty
facilitates wider choice
May lead to lower prices if (a) larger Through its portrayal of a fantasy, largely
sales and production levels result in affluent world, it creates unnecessary wants
economies of scale and lower unit by generating feelings of inadequacy and
costs and (b) the advertising is based greed
on price competition
May lead to higher prices because (a) there
may be higher costs, particularly if
economies of scale are not achieved and (b)
advertising may act as a barrier to entry of
new firms and thus increase monopoly
power, particularly where established firms
engage in saturation advertising which
cannot be matched by smaller firms
For firms If successful, advertising will (a) shift Lower profits if costs of production are
the demand curve to the right and (b) increased without raising sufficient extra
make the demand curve more inelastic. revenue, or without shifting the demand

curve making demand more inelastic

It may enable firms to maintain their
monopoly power through the creation
of brand loyalty and barriers to entry
Greater profits may be earned if higher
sales and output levels lead to
economies of scale and lower costs
For the economy A greater level of employment if the Advertising may lead to a misallocation of
as a whole level of sales and production increase society's scarce resources as the pattern of
production may reflect the skill of the
advertisers in manipulating consumers'
tastes, rather than what consumers actually
want / need.
Certain sectors of the economy only The generation of negative externalities

survive because of the revenue which through tasteless or unsightly advertising
advertising earns, e.g. commercial
radio, newspapers and magazines
Task
As a group task, in a formal debate, discuss the following motion:
"This house believes that goods which have to be advertised ought not to be produced at
all."
Select two main speakers to support the motion and two speakers to oppose it. Other class
members should prepare points either for or against the motion so that they can contribute
to the proceedings when the discussion is thrown open to the 'floor of the house'.
Branding
The creation of consumer loyalty to particular
brands is mainly achieved through
advertising, and it is in oligopolistic markets
where branding, backed by extensive product
promotion, is most prevalent. The markets
for soap-powders, cereals, cars,
confectionery and cosmetics provide a few
notable examples.
The main aim of branding is to make

particular goods, produced by particular
firms, appear as if they have unique features
which the products of competing firms do
not possess. On occasions these features
may be real, e.g. the distinctive quality of a BMW car or a Sony camcorder. However, often
the 'uniqueness' may only exist in consumers' minds, but a difference, real or imagined, in
how consumers perceive branded products, may be sufficient to allow goods to be sold at very
different prices e.g. well known brands of soft drinks, sports-wear, bars of soap and shaving
creams are all sold at higher prices than their 'own brand', or lesser-known, equivalents.
Thus, if successful, branding will reduce the degree of substitutability for the good, make its
demand more inelastic, allow for higher prices and profits to be earned and enable the brand
to become unassailable.
Moreover, the practice of multiple branding serves as a very effective barrier to entry of
new firms e.g. go to any supermarket and you will see several brands of soap powders on the
shelves, but these are mainly produced by just two firms, Unilever and Procter and Gamble -
the costs of breaking into such a market would be formidable as any new entrant would have
to compete against numerous brands of soap powder, requiring an enormous outlay on
advertising; obviously if Unilever and Procter and Gamble only produced one brand each, the
task of contesting the market would be made considerably easier.
Product innovation

Non-price competition in oligopoly may also take

the form of product innovation whereby rival
firms attempt to gain a larger slice of the market
by constantly seeking to improve the quality
and/or style of their existing products, or by
developing entirely new products. This innovation
usually has to be backed by extensive research
and development (R&D), and has the effect of
causing rapid obsolescence of consumer durable
goods, a renewable source of demand and certain
decline for those firms unwilling or unable to
engage in such innovation. Most car
manufacturers, for example, are constantly in the process of changing the design and other
features of particular models so as to generate new demand, and the few large firms that
dominate the pharmaceuticals industry are locked into a perpetual struggle to develop new and
better drugs.
This process fits well with the writings of Joseph Schumpeter (1883-1950) who took a long-
run, dynamic view of monopoly to argue that over time it would be far more efficient than
perfect competition. He argued that the static method i.e. taking a point in time approach, of
comparing perfect competition with monopoly, overlooked the likelihood of technical advances
which may lower costs and prices as output expands. Although Schumpeter's analysis relates
specifically to monopoly, it is appropriate to apply it to contemporary oligopolistic markets.
Schumpeter identified two main reasons why monopolies would be more innovative than
competitive industries: firstly, because of the earning of long term supernormal profits, the
monopolist would have greater access to the funds necessary to finance inevitably expensive
research and development programmes which are the basis of most innovation; and secondly,
the monopolist would have a far greater inducement to undertake R&D in the first place - in
highly competitive markets, any technical advantage gained by one firm would only permit the
earning of high profits to be made for a relatively short period of time, as new entrants and
existing firms copy the innovation and bid any abnormal profits away; the monopolist however
would be the sole beneficiary of technical advance and would thus be able to reap the benefits
of lower costs and higher profits indefinitely.
However, empirical evidence on the subject suggests that whilst smaller firms, i.e. those not
possessing substantial monopoly power, tend to undertake little R&D, no clear, positive
relationship between the amount of R&D spending and company size exists beyond a certain
minimum size of enterprise.
Theories of oligopoly
A central aim of market theory is to formulate predictions about firms' price and output
decisions in different situations, and, under such market forms as perfect competition and
monopoly, economists can be fairly certain about likely outcomes: in the case of the former,
price is set in the market through the free interaction of demand and supply, and individual
firms passively take this price and equate marginal cost with marginal revenue to determine
the best output; in the case of the latter, the firm will still equate MC with MR, but can restrict
output and raise price in so doing.
However, under oligopoly no such certainty exists - where the number of firms in the industry
is small and much interdependence exists between these firms, there will be a whole variety of
ways in which individual oligopolists may respond to rivals' price and output decisions.
Consequently, several different models of oligopoly have been developed, underpinned by
different analytical approaches and assumptions about the nature of oligopolistic, reactive
market behaviour.
Unfortunately, therefore, for students of economics, there is no single, general and all-
embracing theory of oligopoly to explain the nature of the business world around us! Particular
theories of price and output determination under oligopoly should therefore be seen as
illustrative of what might happen under certain sets of assumptions about the reactions of rival
oligopolists.
The various models of oligopoly can be classified under two main headings: non-collusive or
competitive oligopoly and collusive oligopoly. We shall consider each in turn:

Non-collusive or competitive oligopoly
In this case, each firm will embark upon a particular strategy without colluding with its rivals,
although there will of course still exist a state of interdependence, as possible reactions of
rivals will have to be considered.
There are three broad approaches that might be adopted by firms in a situation of competitive
oligopoly:
Observe the behaviour of rival firms but make no attempt to predict their possible strategies on the
basis that they will not develop counter strategies. This was the essence of the earliest model of
oligopoly developed by Cournot as far back as 1838: each firm acts independently on the assumption
that its decision will not provoke any response from rivals; this is not generally accepted nowadays as
providing a useful framework in which to analyse contemporary oligopoly behaviour.
Make the assumption that a given strategy will provoke a response from competitor firms, and assess
the nature of the response using past experience. This is the basis of the kinked demand curve
model, described below, in which it is assumed that any price cut by one oligopolist will induce all
others to do likewise, whilst a similar price increase would not be matched.
Formulate a strategy and try to anticipate how rivals are most likely to react, and be prepared with
suitable counter measures.
This is the basis of game theory in which competition under oligopoly is seen as being similar
to a game of chess in which every potential move must be regarded as a strategy, and
possible reactive moves by opponents and subsequent counter-moves must all be carefully
considered. The application of the theory of games to economics was first introduced in 1944
by J. von Neuman and O. Morgenstern. Games theory involves the study of optimal strategies
to maximise payoffs, taking into account the risks involved in estimating reactions of
opponents, and also the conditions under which there is a unique solution, such that an
optimum strategy for two opponents is feasible and not inconsistent. A zero-sum game is one
in which one player's gain is another's loss, and a non-zero-sum game is one in which a
decision adopted by one player may be to the benefit of all.
In this discussion of non-collusive oligopoly, we shall focus our attention on the second of the
three broad approaches identified above.
The kinked demand curve theory
This theory of oligopoly was first developed in 1939 by Paul Sweezy in the U.S.A, and by R.
Hall and C. Hitch in the U.K, to explain why oligopolistic markets would be characterised by
relatively rigid prices, even when costs increase.
As mentioned previously, the kinked demand curve model makes the assumption of an
asymmetrical reaction to a change in price by one firm: a decrease in price by one firm will
cause a similar reduction of price by other firms eager to protect their market share, whilst a
price increase by one firm will not be matched and its market share will be eroded. This is
shown in Figure 1 below.
Figure 1 Kinked demand curve
Price is initially set at OP1, at the kink of the demand curve, and the oligopolist sells an output
of OQ1. If the firm tries to reduce price to OP2 in order to sell more, other firms would match
this reduction so that sales would increase only slightly, or more technically, by a less than
proportionate amount, to OQ2. The demand curve would be inelastic and the reduction in price
would not represent a sound strategy as total sales revenue, and probably profit levels, would
both fall; clearly the area OP1 x OQ1, representing initial revenue, is greater than OP2 x OQ2,

the producer's revenue after the reduction in price. The alternative ploy of raising price to OP3
would also be unsound as none of the other oligopolists would follow suit, and a large or more
than proportionate fall in demand would follow.
Here, the demand curve would be elastic and the change in price would again cause total
revenue to fall - OP3 x OQ3 is smaller than OP x OQ. The logical conclusion from this analysis
would therefore be that oligopolists would benefit from keeping prices stable so long as all
could enjoy reasonable profits at the established price.
The kinked demand curve theory also has other implications. A normal demand curve becomes
less elastic as price falls, but the oligopolist's demand curve becomes less elastic suddenly at
the kink. Mathematically, this causes the MR curve to suddenly change to a different position,
as can be seen in Figure 2, so that a discontinuity exists along the vertical line YZ above
output OQ1.
Figure 2 The oligopolist's absorption of a rise in costs
This implies that the MC curve can increase or decrease between this discontiuity, without
necessitating a change in the profit maximising output OQ1 or price OP1 - the oligopolist will
absorb the higher costs. According to normal demand and supply analysis, an increase in costs
would cause a fall in output and an increase in price. An example of cost absorption in practice
is when the price of crude oil rises and petrol companies wish to increase price, but do not as
no company wants to be the first to do so.
Criticisms of the kinked demand curve theory
The theory assumes that oligoplists perceive a kink at the current market price i.e. at point X, but it
does not explain how or why the original price was chosen. As a theory, it is therefore incomplete as
it does not deal with price determination.
Price stickiness or rigidity in oligopolistic markets might, in practice, be more apparent than real; for
example, in the market for new cars, published catalogue prices may remain constant over relatively
long periods, but the common practices of offering discounts, and items such as free insurance, cash-
back deals and interest -free credit all amount to ways of reducing price. In fact, the theory takes no
account of the various forms of non-price competition which characterise most oligopolistic markets.
There is little empirical evidence from firms operating in oligopolistic markets to substantiate the
kinked demand curve hypothesis that a change in price by one firm will always evoke a predictable
and uniform response from its rivals. In practice, a very wide range of possible reactions is probable.
Any perceived stability in prices in oligopolistic markets may not be due to the existence of a kinked
demand curve, but may occur for other reasons such as the administrative expense and
inconvenience of altering prices too regularly.
Cut-price competition (predatory pricing)
Although oligopolistic markets tend to be characterised by relative price stability in the longer
term, occasionally short bursts of price warfare break out. This typically occurs when the
dominant players attempt to defend and/or raise their market shares because the total level of
demand in the market is insufficient to enable all to achieve their intended level of sales, and
overcapacity results. The price cutting has the effect of reducing the profits of all the
combatants in the short run, with consumers gaining the temporary benefit of lower prices.
However, the likely outcome is that the weakest firms, i.e. those with the highest costs, will be
driven into bankruptcy, with a new era of relative price stability eventually emerging. If too
many casualties are caused, consumers are likely to face greater monopoly power and possibly
higher prices. There have been numerous examples of price wars in recent years with the

most notable battles occurring on the petrol forecourts and in the retail grocery and travel
businesses.
Collusive oligopoly
A central feature of competitive or non-collusive oligopoly is the existence of uncertainty

amongst the interdependent firms. Although these firms may utilise informed guesswork and
calculation to cope with such uncertainty, they can never be entirely sure as to how their
competitors will react to any given marketing strategy. Thus instead of living with uncertainty,
firms may adopt a policy of reducing, or even eliminating, it by some form of central co-
ordination, co-operation or collusion. Such collusion may occur where firms attempt to
maximise their joint profits, by reaching agreement on their price, output and other policies,
or where firms seek to prevent the entry of new firms into the industry so as to protect
their longer run profits.
In the next section we consider the forms that such collusion may take. Click on the right
arrow at the top or bottom of the page to have a look at this section.
Forms of collusion
Formal collusion
The most common type of formal collusion is through the cartel; where a small number of
rival firms, selling a similar product, come to the conclusion that it is in their joint interests to
formally collude rather than compete, they may establish a cartel arrangement in which they
agree to set an industry price and output which enables them to achieve a common objective.
This is likely to involve the setting of agreed output quotas for each member in order to
maintain the agreed price.
A successful cartel arrangement, from the point of view of the participating firms, would be
one in which the cartel acts like a single monopolist to maximise profits of individual members.
This is illustrated in figure 1 below.
Figure 1 Profit maximisation for the cartel
This is the familiar monopoly diagram, with each curve representing the aggregated situation
for all the firms in the cartel. In order to maximise profits, MC is equated with MR and a price
of OP is set, with an output of OQ, which represents the potential level of sales. The allocation
of this market quota between members could be decided by such criteria as geography,
productive capacity or pre-cartel market share, or cartel members, having set a price of OP,
could engage in non-price competition to each gain as large a slice of OQ as they can.
In practice, cartels may tend to be rather fragile and may not last for very long. This is
because individual members may have an incentive to renege on the agreement by secretly
undercutting the cartel price. The almost inevitable necessity to limit output to keep price high
will tend to leave individual firms with spare productive capacity, and provide the temptation
to increase profits by expanding output. Such an expansion would not only generate profit on
the additional sales, but would also increase the profits on existing sales, as average fixed
costs would fall as output expanded.
As the end result of successful collusion will be to create a situation similar to monopoly, with
its consequent drawbacks and loss of economic efficiency, cartels are illegal in many countries,
including the UK and the USA. Various cartels do, however, operate internationally, the most
famous of which is OPEC. Another example of an international cartel is IATA (The International
Air Transport Association) which has sought to set prices for international airline routes.

However, the experience of both these cartels has been one of price cutting amongst its
members, particularly during periods of declining product demand and competition from non-
members.
Informal or tacit collusion
The most usual method of tacit collusion is priceleadership which occurs where one firm sets
a price which is subsequently accepted as the market price by the other producers. There need
be no formal or written agreement for this to happen; it is sufficient that firms believe this to
be the best way of maintaining or increasing their profits. Price leadership may take various
forms:
Dominant firm price leadership
This type of price leadership occurs where a firm, probably by virtue of its size comes to
dominate an industry in terms of its power to influence market supply. The dominant firm sets
a price to suit its own needs and the smaller firms then adjust their planned output in line with
the market price that has been set for them. An example of such price leadership is provided
by Ford Motor Company, who have often been the first to raise prices in the car industry.
Barometric price leadership
A barometric price leader need not necessarily be the dominant firm in the industry; rather it
will be a firm, possibly small in size, which is acknowledged by others in the industry as having
an informed insight into current market conditions, perhaps because it employs the best team
of accountants and market analysts. The firm's reputation will therefore enable it to act as a
'barometer' to others in the industry, and its price movements will be closely followed.
Collusive price leadership
This involves a form of tacit group collusion in which prices within an industry change almost
simultaneously and is linked to price parallelism where there are identical prices and price
movements in a given market. In practice collusive price leadership might be difficult to
distinguish from dominant firm leadership, especially in circumstances where the price leader is
quickly followed.
Tacit collusion may also occur where firms in the industry follow a set of 'rules of thumb'
instead of a price leader. Such rules may be designed to prevent destructive competition and
thus maintain longer term profitability, although some short run profitability may be sacrificed
as the rules do not require MC and MR to be equated. One such rule of thumb is cost-plus
pricing.
Cost-plus pricing
This is also known as average cost pricing, mark-up pricing and full-cost pricing, and empirical
evidence suggests that it is the most common pricing procedure adopted by firms. It involves
firms setting price by adding a standard percentage profit margin to average costs, so that:
Price = AFC+ AVC + profit margin
Cost-plus pricing is consistent with the idea of relatively stable oligopoly prices as, providing
costs are stable, prices will also remain stable in the short run, even though demand might be
changing. Conversely, if costs rise on average by 5%, then prices in the industry will also be
rising by a similar percentage.
Coursework task
Choose a particular market to study, e.g. the market for soap powders, chocolate bars,
computers or any other of your choice.
Investigate the degree and nature of competition in your chosen market and the
implications of this for producers and consumers.
Contestable markets

This theory was first developed by the American economist W.J.Baumol in the early 1980s. The
theory argues that what really matters in determining an industry's price and output is not, in
reality, whether the industry is perfectly competitive or a monopoly, but the potential of new
firms to enter or leave the market. The theory is based on the idea that a firm may enjoy a
monopoly position within a market, but if there existed the real threat of competition from
other firms, this would force the firm to behave as if it actually faced competition; that is, the
firm would not pursue a policy of charging exorbitant prices to make excessive profits.
What is a contestable market?
The term 'contestability' has nothing to do with the number of firms currently in the industry,
but refers instead to the ease with which firms are able to enter or leave a market; a perfectly
contestable market is one in which there are no barriers or costs to entry or exit: the greater
these are, the less contestable is the market, and thus the greater is the monopoly power of
existing firms; so for a market to be contestable, a barrier to entry, such as a patent
protecting technical knowledge, must be absent.
We previously discussed the various restrictions to entry, the idea of barriers to exit needs
further explanation. A firm will incur substantial costs of leaving an industry of its capital
equipment cannot be transferred to other uses. In this case these costs are known as sunk
costs or irrecoverable costs, and are costs which cannot be recovered in the event of exit from
the market. For example, the air travel industry is often cited as an example of a contestable
market as an established airline operating on a particular route would easily be able to gain
entry to another route, and, just as importantly, would be able to withdraw from that route if
it so desired. Should operations on the new route prove unprofitable, the airline could transfer
its operations without incurring high sunk costs because aircraft can easily be switched from
one particular route which is loss making to another which is more profitable. Thus, so long as
a firm is able to redeploy its capital or sell it when it wishes to leave a market, then the sunk
costs would be low and relatively costless exit would be ensured.
One feature of markets which are contestable, that is where entry and exit costs are low, is
that it may encourage hit-and-run competition - because entry to the industry is easy, firms
may enter that industry to share in the fruits of temporarily high profits, and then withdraw as
soon as the abnormal profits have been whittled away. However, the threat of such
competition may be sufficient to force firms to price as competitively as possible.
Implications of the theory
The theory implies that, given easy entry to and exit from an industry, monopoly or oligopoly
firms will behave as if they actually existed in perfect competition; that is they will:
Equate MC with MR to maximise profits

Only earn normal profits (AR = ATC) in the long run, because if supernormal profits were made,
new firms would enter the industry increasing supply and driving down price to a level where only
normal profits are made; and if losses are made, some firms will be forced to leave the industry,
causing supply to fall and price to rise back to a level consistent with the making of normal profits.
Operate with productive efficiency on the lowest point of the ATC curve where AC = MC; if this
were not the case, new firms could enter the industry, produce at the most efficient level, price their
goods more competitively and force existing firms out.
Operate with allocative efficiency where P = MC; this will occur because the earning of long run
normal profits requires that AR or price should equal AC, and as AC = MC (see above point), the MC
should equal the price.
It would appear from the theory that the 'best of both worlds' can be enjoyed; that is, so long
as there exists the threat of entry into an industry, consumers will be protected from the
worst abuses of monopoly power, whilst at the same time firms will be able to reap the
advantages of large scale production in the form of greater economies of scale, and will
operate in accordance with the criteria for economic efficiency.
The theory has been 'taken to heart' by right-wing politicians and economists who argue the
case for non-intervention by the government and a policy of deregulation. The theory, it is
argued, implies that providing there is sufficient potential for competition, there is no need for
the government to interfere with the pricing and output policies of firms, but should instead
confine itself to ensuring contestability through the use of deregulatory policies designed to
remove barriers to entry and exit. Such policies have had a major influence on government's
monopoly policies in recent years.

It has been argued that the theory represents an improvement on the simple perfect
competition and monopoly models:
Like perfect competition, the perfectly contestable market may exist only rarely in practice and
could be said to represent a model or abstraction of the real world rather than the real world
itself. However, advocates of the theory of contestable markets argue that it is a more useful
model than that of perfect competition as it provides a more effective means of making
predictions about firms' price and output behaviour than does the number of sellers in a
market.
The theory of monopoly only considers the markets in terms of the number of firms operating
in it or in terms of concentration ratios, but does not make any allowance for the impact that
potential competition might have.
Criticisms of the theory

The extent to which the theory of contestable markets may be applied in practice is limited.
Two pre-requisites may not be met:
1. Firstly, firms' sunk costs must be low so that they can easily leave the market. However, in reality
sunk costs may be extremely high, even when capital is transferable. For example, if the Ford Motor
Company decided to switch its operations from Dagenham (UK) to Delhi (India), it could not do so
without substantial costs, despite the possibility of taking much fixed capital to India with it.
2. Secondly, the specific technical knowledge necessary to operate in the industry must be freely
available. However, sole possession of technical knowledge, often protected by patent, is a common
and powerful barrier to entry to monopolistic markets where production is of a highly sophisticated
nature, and is underpinned by extensive R&D - for example, the case of the drugs industry.
The theory ignores the possible aggressive actions of existing firms to potential entrants. In a
market where cost barriers to entry and exit are low, existing firms may behave like
monopolists by charging high prices and making supernormal profits, but might frighten off
potential entrants by making it quite clear that any firm attempting to enter their 'patch' would
face 'big trouble' in the form of all-out, to-the-death competition.
Those on the political right view the theory in terms of a justification of free markets and non-
government intervention as both consumers and producers appear to benefit. However, this
standpoint may be criticised on the grounds that even if perfect contestability exists, which is
in itself by no means common in practice, government intervention in the free market may be
warranted for a whole variety of other reasons.
Price discrimination is the practice of charging different prices for the same or similar
product/service to different consumers where the price differences do not reflect the
differences in cost of supply.
Reasons for price discrimination
Price discrimination is carried out primarily to increase the profits of the discriminating firms.
It occurs where different consumers are charged different prices in different markets for the
same product or service, or where the same consumer is charged different prices for the same
product, where the different prices are not due to differences in supply costs.
Necessary conditions for price discrimination
Condition 1
There must be some imperfection of the market. If there were perfect competition, price
discrimination would be impossible since the individual producer could have no influence on
price. At least some degree of monopoly power is therefore necessary so that producers have
some ability to make rather than take the market price.
Condition 2

The discriminating supplier must be able to split the market into separate sections and keep
them separate, such that it is difficult to transfer the seller's product from one sector to
another i.e. there must be no 'seepage' between markets in the sense that goods can be
bought in the cheaper market and re-sold in the dearer.
Barriers between markets may be:
Geographical in that customers are separated by distance e.g. the international dumping of cheap
goods, where goods are sold overseas at prices below those in the home market, and often below the
cost of production e.g. the East European Communist block countries used to sell their exports to the
West at lower prices than those prevailing in domestic markets to earn hard foreign currency.
Temporal in that customers are separated by time e.g. it may be cheaper to travel by train after
9.30am than before 9.30 am, and the two markets can be kept separate as ticket office staff will not
sell the cheaper tickets until after this time
According to customer type so that customers are separated according to some easily identified
feature of the customers themselves e.g. age, sex, income or occupation; examples of this would
include cheaper theatre tickets for children, old age pensioners and the unemployed, reduced price
rail travel for students and higher private physician consultation fees for those who are perceived as
being able to pay more.
The two conditions discussed so far would make price discrimination possible, but for it to also
be profitable a third condition must also be satisfied:
Condition 3
Price elasticity of demand in each market must be different; if this were the case , the
discriminating supplier would increase price in the market with an inelastic demand curve, and
reduce price where demand is elastic in order to increase total revenue and profits. If the
elasticity of demand in each market was the same at each and every price, a common price
would be charged in both markets as this price would represent the profit maximising price in
each market where MC = MR. You might wish to refer back at this stage to where we
discussed the relationship between price elasticity of demand and total revenue.
Equilibrium of the discriminating monopolist
Figure 1 Equilibrium of the discriminating monopolist
The profit gain from price discrimination is (x + y) - z
In figure 1 there are two distinct markets, Market A and Market B. A third market, Market C,
which is the combined market, is obtained by the horizontal summation of the individual AR
and MR curves from A and B. Market A has an inelastic demand curve, whilst Market B has a
more elastic demand curve. The gradient of the combined market demand curve will lie
between that of A and B.
In the combined market, MC is equated with MR to give a single profit maximising price of OPc
with an output of OQc, and a total profit equal to the shaded area z is earned. With a single
price, this is the maximum profit that could be earned as the charging of a higher price would
reduce demand and the area of profit, z.
However, total profits can be increased through price discrimination, with the total output OQc
being sold at different prices in markets A and B. Price will always be higher in the market
with a more inelastic demand as consumers will be less responsive to price changes.
As price discrimination only occurs where the differences in price are not associated with any
cost differences, the combined market MC curve will also apply to markets A and B, and the

output of each sub-market is therefore determined by equating MR in each market with the
marginal cost of producing OQc units of output. Thus in figure 1, it can be seen that the
marginal cost of production, OM, is projected back from the combined market as a horizontal
line to enable the monopolist to find the equilibrium points Ea and Eb where MC = MR in each
of the individual markets, A and B. Similarly the average cost of production, OC, is projected
back from the combined market to determine the area of profit in markets A and B. As the
level of profit is denoted by the amount by which AR exceeds AC, the areas x and y will
represent the total profit for A and B respectively.
From the producer's standpoint, price discrimination will be a success if total profits increase as
a result. In the diagram, it can be seen that Area x + Area y is greater than Area z, so the
producer has succeeded.
Advantages and disadvantages of price discrimination
Disadvantages
The main disadvantage will be experienced by consumers, particularly those having to pay
the higher prices who may object to the discrimination against them e.g. users of peak time
public transport. It could be argued that price discrimination represents a transfer of welfare
from consumers to producers and is a way in which producers gain at the expense of
consumers through the extraction of consumer surplus. In the extreme case of perfect or
first degree price discrimination, no consumer receives any consumer surplus at all.
In more general terms, the higher profits earned through price discrimination could be viewed
as an unjustifiable redistribution of income in favour of profit takers with higher prices reducing
consumers' real incomes.
Advantages
Producers of course benefit from the higher profits as previously shown. It could also be argued that
if such profits are re-invested, consumers might derive long run benefits in terms of increased
efficiency and lower costs and prices.
Those consumers paying the lower price may be able to obtain a good or service that they might not
otherwise have been able to afford e.g. half price tickets for children at football matches.
Consumer and producer alike may gain if a loss making firm is turned into a profitable one. This is
illustrated in figure 2 below.
Figure 2 Profits and losses (a) without and (b) with discrimination
In figure 2, the producer's best output, where MC = MR is at OQe, but the price of OPe does
not cover the average cost of OC, and a loss, equivalent to the rectangular area x, is made.
However, a loss can be transformed into a profit by charging those consumers who are
prepared to pay, a higher price of OPe1. The shaded area y shows the additional revenue that
accrues to the firm from charging a two-part tariff. As area y exceeds that of x, the loss
making firm is now able to make a profit at the current output level.
In the absence of price discrimination, this good would probably not be supplied in the long
run, which would particularly represent a loss to society if it were one which generated positive
externalities e.g. a doctor in a remote area charging wealthier patients more than the less
affluent ones.
Alternative aims of firms

Although the traditional theory of the firm assumes that all firms aim to maximise their
profits, in reality firms may have a range of objectives. These alternative aims particularly
arise in the case of public limited companies where there is a divorce (separation) between
ownership and control; i.e. one set of people own these companies (the shareholders) and
another set of people control them (the salaried managers and directors). Often there will be a
difference between what the owners want (usually the maximum profit which maximises
dividend payments) and what the controllers are trying to achieve (sometimes just a quiet
life!).
There are thus many different aims that firms could pursue, but we shall just concentrate on
the 3 specifically mentioned in the IB specification (sales revenue maximisation, sales volume
maximisation and environmental aims) plus the aim of satisficing.
Figure 1 below usefully enables a comparison between profit maximisation, sales revenue
maximisation and sales volume maximisation.
Figure 1
Profit maximisation.
Firms maximise their profits where MR = MC, indicated by the point Q in Figure 1. Firms will
also be maximising their profits where total revenue most exceeds total cost.
Sales revenue maximisation.
In Figure 1, sales revenue is maximised at Q 1 where MR = 0. This will correspond to the point
where the (total revenue) is at a maximum. This is shown in Figure 2 below.

Figure 2
So long as MR is positive, even if it is falling, TR must be rising, as more is being added to TR.
When MR becomes negative, TR must fall, as less is being added to TR. Thus when MR = 0, TR
must be at its highest point.
It should also be noted from Figure 1 that the sales revenue maximising output is greater than
the profit maximising level of output (i.e. OQ 1 rather than OQ).
Managers may wish to maximise sales revenue rather than profits because
their salaries might be tied to sales levels

financial institutions may be more willing to lend to institutions with high sales levels
rising sales may be deemed a more important indicator of success than rising profits.
Sales volume maximisation
In Figure 1, sales volume is maximised at OQ 2, subject to a profit constraint, where AR = AC.

The firm might be able to sell more than this, but the diagram shows that on all units of
output beyond OQ 2, AC is greater than AR and, therefore, a loss would be incurred. So, OQ 2
maximise sales volume without a loss being incurred.
Managers may wish to maximise sales volume rather than profit because
they may be seeking to maximise market share in the short run and to drive other firms out of the
industry
it may make the firm, being larger, less vulnerable to takeover
again, their salaries may be related to sales / size of the firm
Environmental aims
With increasing concern nationally and globally for the environment, firms may wish to be
regarded as responsible members of the community by adopting environmentally friendly
policies. Firms may enhance their 'green' image by sponsoring worthwhile events, donating
funds to environmentally based charities / organisations or adopting practices which show a
high level of concern for the environment. For example, supermarkets may sell fairtrade
products, usually at a higher price than normal products, to show support for producers in
developing countries.
Satisficing
In contrast to maximising behaviour,e.g. of profits or sales revenue. Satisficing theory suggests

that the people in charge of business may decide to achieve a satisfactory performance across
a range of indicators and not to maximise any one of them. This approach is more likely to
keep all the firms stakeholders happy and is what is known as 'satisficing'. For example a firm
hell - bent on making the maximum possible level of profit may have to reduce the quality of
its products, hold down the wages of its workers and pollute the environment, thus falling foul
of three of its important stakeholders, i.e. its customers, its employees and the local
community respectively.
Thus, if the managers can make a satisfactory profit, rather than a maximum profit, the
owners of the firm and the stakeholders will be happy and the managers will keep their jobs.
Market failure - introduction

Market failure is a situation in which the free
market leads to a misallocation of society's
scarce resources in the sense that either
overproduction or underproduction of a
particular good occurs, leading to a less than
optimal outcome.
Reasons for market failure
The reasons for market failure include:

Positive and negative externalities

Lack of public goods
Under-provision of merit goods
Over-provision of demerit goods
Abuse of monopoly power
Inequality

How do externalities affect allocative efficiency?
Possible government responses
Public goods
Merit goods
Demerit goods
Inequality
bottom of the page.

What are externalities?
Externalities are costs (negative externalities) or

benefits (positive externalities), which are not
reflected in free market prices. Externalities are
sometimes referred to as 'by-products', 'spillover
effects', 'neighbourhood effects' 'third-party effects'
or 'side-effects', as the generator of the
externality, either producers or consumers, or
both, impose costs or benefits on others who are
not responsible for initiating the effect. The key
feature of an externality is that it is initiated and
experienced, not through the operation of the price
system, but outside the market.
Proponents of laissez-faire would argue that externalities particularly arise because of the
absence of markets - as no markets exist for such things as clean air and seas, beautiful
views or tranquillity, economic agents are not obliged to take them into account when
formulating their production and consumption decisions, which are based on private costs and
benefits i.e. those which are internal to themselves. Another way of putting this is to say
individuals have no private property rights over such resources as the air sea and rivers,
and thus ignore them in making their production and consumption decisions.
Property rights refer to those laws and rules which establish rights relating to:
ownership of property;
access to property;
protection of property ownership;
the transfer of property.
Thus a firm may feel free to dump effluent into a river as the spoiling of the environment and
the killing of fish is not a cost which it would directly have to bear. Those on the political left
would be more likely to argue that such an externality would arise because of the market
system which is based upon the private ownership of resources, with individuals acting in
their own self interest and therefore not having to consider what is in the public interest i.e.
the problem is due to an absence of communal property rights and of a system of planned
production.
The above example of an externality is one which is commonly cited, but it is important to
establish at this stage that there are various types of externalities and that they can be
classified in different ways: they can arise from acts of consumption or production, and can
thus be production, consumption or mixed externalities, and, as previously mentioned
they can be experienced as external costs (negative externalities) or as external benefits
(positive externalities).

Figure 1 below summarises the different possibilities and provides some examples. It can be
seen from this table that there are in fact four different varieties of externality:
A) a production externality: initiated in production and received in production;

B) a mixed externality: initiated in production, but received in consumption;
C) a consumption externality: initiated in consumption and received in consumption;
D) a mixed externality: initiated in consumption, but received in production.
Each of these are sub-divided into two, according to whether they are experienced as an
external cost or as an external benefit, giving a total of eight varieties.
Figure 1 The various kinds of externality
In practice, the most important externalities are those which affect the environment, and it is
these which have received widespread adverse publicity in recent years, and which have
prompted the rise of 'green' pressure groups and political parties. Indeed, so great has been
the impact of environmental pollution, that in addition to the externalities identified in figure 1,
we can also, in a global context, identify externalities which are transmitted from one
country to another, and which may be mutually damaging; for example, the Chernobyl
nuclear disaster in 1986 in Russia, not only contaminated the local area, but also polluted
other parts of Europe; emissions of acid rain from West European nations not only harm the
environment in the initiating countries, but also wreak havoc on the forests, lakes and rivers of
the Scandinavian countries.
Task 1
Try adding a further example of your own to each of the eight types of externality given in
figure 1.
Task 2
Try matching the following examples of externalities to each type of externality in figure 1.
(Hint - there is one example of each). Once you have had a go, have a look at our answer
to see how you got on.
1. A person smoking a pipe at a football match causes the person sitting behind to passively smoke.
2. A large retail organisation attracts numerous extra customers to its store, some of whom spend
money in other shops in the vicinity.
3. Children are taken to school by car instead of walking or using public transport. This worsens
congestion and raises the production costs of firms.
4. Owner occupiers in a particular area take measures to increase the value of their properties.
Estate agents benefits from the extra commission earned when the houses are sold.
5. Juggernauts (large trucks) travel through inner city areas, causing traffic congestion for other

commercial road users which raises their production costs.

6. A power station belches black fumes into the air which discolours the paintwork of nearby houses.
7. Farmers provide pathways in the countryside which benefit walkers.
8. A private gardener plants an assortment of beautiful plants in her front garden and enhances the
environment for her neighbours and passers-by.
Task 2 - suggested answers
How do externalities affect allocative efficiency?

Given the existence of perfect competition, allocative
efficiency would automatically occur where price equals
marginal cost in all markets, assuming that neither
negative nor positive externalities are present.
So, how do externalities affect our condition for

efficiency? We will consider the oft quoted case of a firm
which discharges its waste products into a river. Such a
firm would be treating the environment as a free
resource, and would be imposing a cost on society as a
whole, rather than just on the consumers of the good. The price charged to consumers would
not therefore, in this instance, reflect the true cost of the product; if the firm were compelled
to install equipment which could treat its effluent and render it harmless to the environment,
its production costs and prices would rise and consumers would, as a consequence, reduce
their demand for the product in question. Resources would then be reallocated to other lines of
production.
In this case there is a divergence between private and social cost.
The private cost is the internal money cost of production incurred by the firm i.e. costs such as
wages, raw materials, heating and lighting which must be paid to carry out production, and which
would appear in the firm's accounts.
The social cost, on the other hand, is the real cost to society as a whole; it is the private, internal
costs plus the value of the negative externalities (external costs ).
Similarly, if the firm's production decisions were to generate positive externalities, such as the
beneficial effects arising from the provision of employment, then there would be a divergence
between private and social benefit.
The private benefit is the money value of the benefits accruing internally to the firm from production
activity e.g. in the form of sales revenues.
The social benefit, on the other hand, is the private benefit plus the value of positive externalities
(external benefits).
Social cost
Social cost is the private, internal cost plus the value of negative externalities.
Social benefit
Social benefit is the private, internal benefits plus the value of positive externalities.
Now, the significance of this analysis is that allocative inefficiency will occur if private cost
or benefit diverges from social cost or benefit. Where externalities exist the condition for
allocative efficiency is that price = social marginal cost = social marginal benefit i.e. the
price must equal the true marginal cost of production to society as a whole, rather than just
the private marginal cost.
We will now illustrate the above in relation to the firm discharging waste into the river. Have a
look at Figure 1 below.

Figure 1 Negative externalities causing market failure
The firm's demand curve indicates the value that consumers place on each additional unit of
the good and it is thus the private marginal benefit curve. If no positive externalities are
present, it would also be the same as the social marginal benefit curve.
The marginal private cost curve indicates the cost of producing an additional unit of output.
If no negative externalities were present, output would settle at OQ, and allocative efficiency
would be achieved. However, the dumping of waste into a river imposes an external cost on
society as a whole, for which the firm would not have to pay. Clearly, if the firm had to pay
the full social cost of its production activities, the additional cost would shift the supply curve,
or private marginal cost curve, to the left. Thus S1 represents the social marginal cost, the
vertical distance between the two supply curves indicating the value of the negative
externality, or the marginal external cost. The intersection of S1 and D would indicate a
reduced level of output at OQ1. However, if the firm did not pay for the external cost caused,
MSC would be greater than price, and over-production, over-consumption and a
misallocation of society's scarce resources would occur.
Conversely, if the production of a good conferred net positive externalities on society, then
there would be under-production and under-consumption at the free market price and
again a misallocation of resources. This is illustrated in Figure 2 below.
Figure 2 Positive externalities causing market failure
In Figure 2, S is the private marginal cost curve, and as it is assumed that there are no
negative externalities, it is also the social marginal cost curve. If positive production
externalities are generated, for which producers receive no payment e.g. the beneficial 'knock-
on' effects of higher employment, the social marginal benefit would exceed the private
marginal benefit. The curve D (private marginal benefit) would shift to D1 (social marginal
benefit), the vertical distance between the two curves representing the value of the positive
externality, or marginal external benefit at each level of output. The socially optimum level of
production would be at OQ2 where MSB=MSC. However, if the firm were to ignore the external
benefit, which it is likely to do on account of receiving no payment for it, an output of OQ1 is
likely to arise which is less than socially desirable.
Hence externalities cause market failure:
when a negative production externality is initiated, the firm will not be made to pay for the cost
imposed on others, and will therefore have no market incentive to produce less; from society's
standpoint it will therefore overproduce;
when a positive externality arises, the firm will lack any incentive to increase its output to the socially
desirable level, as it does not receive any payment for the generation of the external benefit;

underproduction therefore occurs.
Externalities - self-test questions
Externalities
1
What type of externality is evident from the picture below?
a) Negative consumption externality

b) Positive consumption externality
c) Negative production externality
d) Positive production externality
Externalities
2

Externalities

Externalities
3

Externalities
4

Externalities
5


Externalities
6
The image below shows syringes used for vaccination. What type of externality is evident from this?

AnimateIT - Externalities
In this section we look at animated versions of the externalities diagrams. It is worth going
through these to see how the different externalities affect the market.
Negative consumption externalities

Positive consumption externalities
Negative production externalities
Positive production externalities
The economic theory of traffic congestion

Figure 1 below shows how the analysis of externalities that we looked at in the previous
section can be applied to the problems of traffic congestion.

Figure 1 Road transport, congestion and economic theory
Economic theory can be used to analyse the issues involved in traffic congestion as shown
here. Figure 1 indicates the relationship between the cost of travel and the flow of traffic along
a particular route. The essence of this theory is based on the fact that, when making a journey
by car, a motorist only considers the marginal private cost (MPC). This is the cost directly
attributable to him/herself, such as time, fuel and the maintenance of the vehicle, rather than
the full cost of the journey, which may include costs imposed on society such as pollution,
noise and time lost due to congestion. When added to the private costs, these are termed the
marginal social costs (MSC), the difference between the two representing the externality
imposed by the motorist.
In outlining the theory, it is assumed that,

when making a journey, congestion is the
only externality. The graph represents the
demand for travel along a particular stretch
of road over a period of time. Up to a flow of
traffic F0, there is no congestion, thus there
is no divergence between MPC and MSC,
although in reality, such a situation only
applies to extremely low volumes of traffic.
As the flow of traffic increases above F0,

congestion is apparent and there is a
divergence between MSC and MPC. Note that
the MSC is equal to the MPC, plus the social cost of congestion.
If the demand for travel on this particular route is of the normal shape (represented by D on
the graph) and is a measure of the marginal benefit, then the flow of traffic will be determined
by the intersection of the demand curve and the MPC curve at F1 and the private cost to the
motorist will be b. At a flow of F1, the external cost, not taken into account by the motorist, is
ab (the difference between the MPC and MSC). This means that resources are not being
allocated efficiently and that individuals are making more journeys than they would if they
were aware of the full social costs.
To get some up to date examples on traffic congestion, try searching the Biz/ed
In the News archive. You can do this in the window below.
Congestion
Traffic
Externalities

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Possible government responses to externalities

The outstanding characteristic of a
market economy is that production does
not occur as a result of some grand,
master plan; rather, it is the result of
the pulls and pushes of supply and
demand, of the numerous uncoordinated
decisions of individuals and firms. As
individuals are assumed to seek to
maximise their own satisfaction, and
firms their own profits, decisions made
are likely to be strictly on the basis of
private costs and benefits, and, as
previously explained, herein lies the
problem: unless the full social costs and
benefits of production and consumption
decisions are taken into account, so that MSC is equated to MSB, social inefficiency and a
misallocation of society's scarce resources will result.
So, what measures can a government take to rectify such inefficiency, and how successful is it
likely to be? As is the case with most important questions in economics, a range of answers
are possible, depending largely on the political perspective of the respondent. At one end of
the spectrum, governments could 'leave well alone', essentially not interfering with markets
but trying to gently persuade firms and individuals to modify their behaviour. At the other
extreme, the market could be completely replaced by direct government provision, and in
between various policy options are possible. We now turn to an examination of some of these
options.

In practice it is the problem of production externalities, particularly environmental ones, which

most occupy the attention of governments, and our discussion will mainly, but not exclusively,
focus on these.
The main measures that governments can take will be considered in the next few sections and
include:
Direct provision of goods and services - this means the government providing the good or service
themselves, perhaps through state-owned or nationalised industries.
The extension of property rights - this means giving people more right of ownership over their
immediate environment, so that they can enforce environmental and other standards.
Taxes and subsidies - where an activity causes negative externalities it could be taxed and where
there are positive externalities, it could be subsidised.
Tradeable pollution rights - this involves allowing companies to pollute a certain amount (a 'permit
to pollute') but then creating a market for the permits, so that if they pollute more than the allowance
they have to buy extra permits. However, if they pollute less, then they can sell their surplus permits.
Regulation, legislation and direct controls - this involves setting legal limits or regulations to
prevent negative externalities or perhaps to reduce their impact.
Click on the right arrow at the top or bottom of the page to start looking at each of these
approaches in more detail.
Direct government provision

Direct provision of goods and services by the government
The existence of externalities provides an important

argument for the common ownership, or nationalisation
of a number of key industries.
The argument is that privately owned firms, in order to

survive in a competitive world, necessarily have to put
their own interests before those of society at large, for to
do otherwise might be inconsistent with the goal of long
run profit maximisation, or even survival. This harsh
reality of the market is likely to manifest itself in the
generation of negative externalities such as pollution, as the control of these externalities
would involve higher costs and an adverse impact on profits; conversely, production activity
which conferred net positive externalities on society might not be undertaken in sufficient
quantities if the criterion of private profitability could not be met.
Nationalised industries, on the other hand, which, on account of being commonly owned, could
be operated according to broad social criteria, rather than the narrow commercial one of
private profitability, and this allows for the possibility of externalities to be fully incorporated
into production decisions. Thus, for example, questions of workers' safety standards and
atmospheric pollution could be accorded priority status, rather than being ignored on the
grounds that to do otherwise would adversely affect profits and competitiveness; and activities
such as the keeping open of 'uneconomic' pits and the provision of postal and transport
services to remote outlying areas, could all be maintained on the grounds that they provide
substantial positive externalities to society at large, although not necessarily being profitable in
the sense that the private revenues from such activities exceed the private costs.
Similarly, an important argument for merit goods such as education and health being directly
provided by the government rather than through the market, is that they not only confer
private benefits on individuals but also significant positive externalities on society as a whole
which individuals would tend to ignore when making their consumption decisions. As a result,
left to the market, under-provision is likely to occur; for example, individuals would be
prepared to buy education through the market if they had to, as substantial private benefits,
such as higher life-time earnings, are likely to result; however, a case for a higher level of
government provision can be made on the grounds that not all the benefits accrue solely to
the individual - society gains from a more efficient and adaptable labour force and perhaps a
more tolerant and more aware population. The issue of merit goods is considered in the rest of
this unit.
The above arguments for direct government provision would of course be strongly contested by
free market economists who would argue the case for privatisation, the desirability of using
markets to provide merit goods and the extremely poor record of pollution control of the

formerly centrally planned economies of Eastern Europe.
Extension of property rights

Property rights concern the legal entitlement to property
and the right to use or sell the property, as well as the
rights that other people have, or do not have, over the
property. It is argued that negative externalities in
particular arise because of the existence of incomplete
property rights over natural resources such as air, land,
rivers and seas i.e. as property rights are not fully
allocated to these areas as nobody really owns them,
individuals and firms are free to impose external costs
from their production and consumption activities without
having to pay any compensation. The dumping of toxic wastes into the sea and the riding of a
noisy motorbike provide two examples.
Thus by extending property rights individuals would be able to stop others imposing costs on
them or to claim compensation if they did so. A person purchasing a house, for example, could
also acquire a set of 'amenity' rights which would entitle the owner to peace and quiet in the
vicinity of the property as well as a supply of water and air of a reasonable quality. Any
infringement of such rights e.g. by neighbours playing heavy metal music unduly loudly, or
juggernauts emitting excessive exhaust fumes into the air, would give the owner of the
amenity rights entitlement to compensation. In this case the externality would be
internalised as the initiators of the external costs would be forced to pay for them, and
adjust their production/consumption decisions to more socially efficient levels.
However, there may be a number of problems with this solution in practice:
for compensation to be paid, it must be possible to establish the nature and extent of external
costs being imposed; in the case of most types of pollution, for example, this tends to be an
extremely difficult thing to do, and so appropriate compensation levels become almost impossible to
establish;
where there are many firms or individuals imposing negative externalities, it would be exceedingly
difficult to claim compensation from them all; for instance, if many juggernauts, low-flying
helicopters and joy-riding teenagers passed a property, making great noise in the process, it would be
somewhat impractical for the property owner to try to claim compensation from them all;
even if those generating the external costs are few in numbers, the time and cost involved of
pursuing the offenders through the courts may be prohibitive for all but the very rich; what chance
would an ordinary person have, for instance, in claiming compensation from a large, multinational
burger chain, which had permitted the neighbourhood to become unduly littered with burger
wrappings?
the extension of property rights has equity implications; extending private property rights is likely
to favour those who already possess property at the expense of those who do not: so, Gypsies and
travellers may be prevented from setting up camp, peace campaigners and other protestors could be
prevented from holding their demonstrations and ramblers' rights of way in the country-side might be
infringed; thus those on the political left tend to favour an extension of communal property rights and
a society based more on public ownership and a set of co-operative values which, they would argue,
are less likely to cause the problem of negative externalities in the first place.
Taxes and subsidies

The use of taxes and subsidies to tackle the problem of externalities is a market-based
method of control as it works through the price system, i.e. through the impact of changes in
prices.
If negative externalities exist, and there is allocative inefficiency at the free market price
because SMC is greater than price and overproduction is occurring, then the appropriate
solution would be to tax the good; if, on the other hand, the market is under-producing
because positive externalities are not being taken into account, it would be appropriate for the
government to grant a subsidy. We shall consider each in turn:
Taxes
There are two types of tax which may be

applied to address the problem of negative
externalities: a tax set equal to each

firm's marginal external costs and an

environmental or 'green' tax.
The policy of taxing firms according to the

marginal external costs that they impose on
society can be illustrated using figure 1
below. In this example we assumed that a
firm was dumping waste products into a
river. The government would have to assess
the cost to society of such an action, and
impose a tax on the offending firm equal to
the value of the marginal external cost (or negative externality); in this case the tax would
internalise the externality by making the polluter pay. The levying of such a tax would
shift the supply curve from S to S1,which would increase the market price to OP1, and cause
the level of output to fall to OQ1, where P = SMC and allocative efficiency is achieved.
Figure 1 Negative externalities - dumping of waste
An environmental tax could be imposed either on a product responsible for creating pollution,
or on the inputs to an industry which have caused environmental damage e.g. carbon
producing fuels, which are believed to play the major role in the process of global warming.
The aim of a carbon tax on each unit of carbon in fossil fuels would be to: raise the price of
those sources of power with high carbon contents, thus encouraging a switching to power
sources causing lower CO2 emissions; encourage greater conservation of energy in general;
and stimulate the search for more environmentally-friendly technologies.
Subsidies
Whilst a tax may be imposed on generators of negative externalities, a subsidy may be

granted to generators of positive externalities to ensure a higher level of consumption and
production than would arise through the completely free interaction of market forces. This is
illustrated in figure 2 below. In this case the government would have to assess the value of
the marginal external benefit (i.e. the positive externality) to society and give a subsidy
equivalent to this amount. If the good in question were loft insulation which confers benefits
on society in terms of energy conservation, households prepared to lag their lofts could be
given a grant, and this would shift the demand curve D=PMB to the right to D1=SMB.
Allocative efficiency is achieved as SMB = SMC at OQ1. A similar result could be achieved by
subsidising the output of loft insulation which would cause the supply curve to shift to the
right until the socially optimum level of production is reached.
Figure 2 Positive externalities - loft insulation

Issues arising from the tax/subsidy approach
Advocates of this approach would argue that it permits the forces of demand and supply to
operate. At the same time generators of negative externalities are induced to 'clean-up their
act' because the less pollution they create, the less their tax liability; and conversely, grants
and subsidies encourage greater output and consumption of those goods involving net social
benefits.
In practice various difficulties are likely to arise:
for the tax/subsidy solution to work in the way indicated in figures 1 and 2 above, the exact value of
the marginal external cost and the marginal external benefit must be established so that taxes
and subsidies, respectively, of exactly the right size can be applied; in reality it is not only extremely
difficult to identify external costs and benefits, but it also an extremely arbitrary matter trying to ascribe
a monetary value to them e.g. how should the emission of black fumes into the air from an industrial
chimney be assessed?
from an environmental point of view a tax on pollution does not solve the problem, as pollution is
still allowed to continue; the tax merely provides a market-led inducement to firms to find cleaner
ways of producing so as to reduce their costs; moreover, the unwilling third parties who receive
pollution as a negative externality are not in any way compensated;
taxation of pollution would require regular monitoring of pollution emissions and as offending firms
are likely to be generating different quantities and types of pollution, such monitoring is likely to be
administratively complex and very costly;
distortions and inefficiencies might arise in terms of the cost of collecting a pollution tax, the
inevitable temptation by the less scrupulous to evade paying it altogether and the possibility of an
inflationary impact on the price level.
Tradeable pollution rights

Like the use of taxes and subsidies, tradeable pollution rights (otherwise known as tradeable
emission allowances or permits), represent another market-based solution to the problem of
negative externalities, in particular pollution. They were first introduced in the USA in 1990
under the Clean Air Act in which the Environmental Protection Agency set a target rate of
reduction for power stations' emissions of sulphur dioxide. Initially, power stations were issued
with emission permits in proportion to their current pollution levels and were allowed to
discharge pollution into the air up to a specified limit. Thereafter, those power stations for
whom the cost of reducing pollution was low, could sell their spare pollution permits to
generators for whom the cost of pollution abatement, through the installation of appropriate
equipment, would be very high. Thus, a market in tradeable pollution rights is created,
stimulating pollution reduction through the possibility of making money out of selling surplus
permits.
Tradeable pollution rights
Tradeable pollution rights are emission allowances or permits which can be traded between
organisations whose operations generate pollution.
The main argument in favour of such a scheme is that it

operates through the market via the price system:
firms are given a profit incentive, i.e. through the right
to sell spare permits, to find cheap ways of reducing
their pollution levels; and such a system should be
administratively cheap and simple to implement , as
the regulatory agency need have no information
regarding firms' costs - it simply has to issue the permits
and arrange for their sale; in addition, consumers may
benefit if the extra profits made by low pollution power
stations, arising from the sale of their spare permits to other companies, are passed on in the
form of lower prices.
The main argument against the use of tradeable emission permits is that they do not actually
stop firms from polluting the environment; they only provide an incentive to so - where a
degree of monopoly power and relatively inelastic demand exist, the extra cost of purchasing
additional permits so as to further pollute the atmosphere, could easily be offset by the
possibility of charging consumers higher prices; moreover, the system of allocating permits
in accordance to existing emission levels could be seen as a reward for the greatest

polluters!
To get some up to date examples on tradeable permits, try searching the Biz/ed
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Regulation, legislation and direct controls

In practice the use of direct controls
represents the most common approach to
pollution abatement. Such controls can be
applied both to individuals and firms and can
take a number of forms; for example,
restrictions can be imposed on smoke
emissions from private homes and firms;
restrictions may be placed on all forms of
building in designated green-belt areas;
minimum environmental standards may be
stipulated for air and water quality; laws
may be passed to prevent drinking and
driving and the sale of alcohol and tobacco
to people under a certain age.
Apart from restriction, direct controls can

also be used more severely: activities
generating negative externalities could be banned completely; for instance, the dumping of
waste into rivers or the sea; or an activity which conferred net positive externalities on society
could be made compulsory; for example, all children under the age of 16 in the UK must by
law receive some form of education, whether it be in a state school, a private school or at
home and this is true in many other countries as well.

The main advantage of regulation is that it is the most direct way of tackling the problem
of externalities; for example, market-based solutions such as taxes and tradeable emission
permits provide incentives to firms to reduce their pollution levels but do not compel them to
do so; as such problems as global warming and the depletion of the ozone layer are thought
by many to threaten the very survival of our planet, it is argued that we cannot afford to trust
our futures with policies which allow for the possibility of non-compliance. Providing legal
restrictions are backed by inspections which are sufficiently regular and rigorous, they should
be effective.
Against this, it is argued that in reality the policing of regulations can present great
difficulties as the less environmentally conscious firms may attempt to circumvent the controls
e.g. through the generation of pollution during the night. Thus an extremely large number of
inspectors might have to be employed to ensure compliance.
It is also claimed that regulation can be a rather blunt, indiscriminate instrument of control;
for example the setting of maximum emission limits does not take into account the fact that
the cost of reducing pollution would vary considerably as between different firms, some facing
high costs with others facing low costs. Thus a uniform limit applied to all firms would be an
inefficient way of reducing pollution, implying as it would a high resource cost. Also it may be
the case that once emission targets have been achieved, there would be no further incentive
to continue to reduce pollution, as would be the case with a pollution tax.
Regulation may also give rise to the problem of regulatory capture - those being regulated
may be successful in manipulating the regulatory body to act in accordance with the private
interests of the firms concerned, rather than in the interests of society as a whole.
Public goods
What are public goods?
Pure public goods are ones that when consumed

by one person can be consumed in equal
amounts by the remainder of society, and where
the possibility of excluding others from
consumption is impossible.
Examples of public goods are:
national defence;
the police service;
street lighting;
lighthouses;
flood-control dams;
pavements;
public drainage.
It is likely that the market, left to itself, will

seriously under-produce such goods, or possibly
not produce them at all. This is because the
market will only provide goods for which a profit
can be made, and pure public goods possess
two important properties that together make
their production on the basis of private
profitability extremely difficult. These features are:
non-rivalry ( or non-diminishability);
non- excludabilty.
Firstly, consider the characteristic of non-rivalry: this means that one person's use of the
public good does not deprive any other person of such use or does not diminish the amount
available to others; for example, if one person enjoys the benefits of being protected by the
police-force, a flood control dam or the national defence system, it does not prevent everyone
else doing the same; similarly, if one person benefits from walking along a street at night-time
which is paved, free of pot-holes, and well-lit, the benefits and the availability to others would
not be diminished.
Secondly, consider the characteristic of non-excludability: this means that when the public
good is provided to one person, it is not possible to prevent others from enjoying its

consumption - sometimes summarised as: provision at all means provision for all; thus, if a
police force, a flood- control dam or a national defence system is successful in offering
protection to citizens of a country, once it has been provided it is impossible to exclude anyone
within the country from consuming and benefiting from such goods; similarly, for a paved and
well-lit public street - nobody can be prevented from enjoying its benefits.
The concept of a 'public good' can perhaps best be understood by comparing it with its
opposite, a private good.
A private good possesses two features, excludability and rivalry, and when consumed by
one person, it is not available to others; thus, a person buying a new washing machine can
exercise private property rights over it and exclude others from enjoying its cleaning
abilities, whilst, at the same time, diminishing the total stock of washing machines
available for sale to others.
Thus, in the case of public goods,the market fails because the private sector would be
unwilling to supply them - their non-excludabilty makes them non-marketable, because non-
payers cannot be prevented from enjoying the benefits of consumption, and therefore prices
cannot be attributed to particular consumers. This involves the free-rider problem, which
arises when it is impossible to provide a good or service to some without it automatically and
freely being available to others who do not contribute to its cost. For example, imagine a
situation in which you shared an island with five other inhabitants; if you paid privately for an
army to defend the island against violent invaders, your five co-inhabitants could 'free-ride' off
you by enjoying the benefits of the defence, without having to pay anything towards it; there
would probably come a point when you would withdraw your payments and, like the others,
leave it to someone else to foot the bill; eventually, the army would not be provided at all.
Free riders
Free riders are those who enjoy the benefits of a public good without having to pay,
because it is impossible to exclude them.
Hence, in a free market, a whole range of pure public goods may not be provided, and the
only answer is for the state to provide them, financed out of general taxation. Moreover, the
non-rivalry aspect of public goods means that the cost of supplying one more user i.e. the
marginal cost, is zero; for example, once paving stones have been laid, it makes no
difference how many people walk along them as there is no additional cost involved. As the
condition for the achievement of allocative efficiency is that price should be set equal to
marginal cost, it would therefore follow that to achieve an optimum level of output and
consumption of public goods the state should provide them at zero prices.
Non-pure public goods (quasi-public goods)
In practice, various ways may be devised for

excluding free riders from the consumption
of public goods, as the characteristics of
non-excludabilty and non-rivalry may not be
completely present. In such cases, the goods
would be referred to as non-pure or quasi-
public goods; for example, in the case of a
motorway, various methods could be used,
such as electronic tagging or toll-gates, to
make users pay ( an impossibility with a
pure public good), so excludabilty would be
possible; and, if the motorway were to
become sufficiently congested, non-rivalry
would not be present i.e. as the road
reaches its full vehicle capacity, as often happens in the rush-hour periods on urban
motorways, each extra road user does reduce the availability of the motorway to other
motorists and raises the marginal supply cost above zero. (The marginal cost would of course
be zero, or near to zero, on an entirely uncongested motorway.)
Thus a non-pure public good is an example of a mixed good, which is one which has both a
public and a private good content. A motorway provides an example of a public good with a

private good component, and conversely it is possible to identify private goods, with a public
good component e.g. driving a car is an act of private consumption, but when public transport
is not available, perhaps because transport workers are on strike, car owners may offer lifts to
stranded travellers creating some publicness. Hence, in practice, many public and private
goods contain some mix of both.
Merit goods
What are merit goods?
Merit goods are the opposite of demerit goods - they are
goods which are deemed to be socially desirable, and
which are likely to be under-produced and under-
consumed through the market mechanism. Examples of
merit goods include education, health care, welfare
services, housing, fire protection, refuse collection and
public parks.
In contrast to pure public goods, merit goods could be,

and indeed are, provided through the market, but not
necessarily in sufficient quantities to maximise social welfare. Thus goods such as
education and health care are provided by the state, but there is also a parallel, thriving
private sector provision. Indeed, there is considerable disagreement between economists on
the right and left of the political spectrum over the extent to which such goods should be
provided by the state or the private sector. We consider these arguments later in this section.
Before we proceed with our discussion of merit goods, and in particular the
question of why merit goods tend to be underprovided by the market, it
would be useful at this stage to summarise the main differences between public goods, private
goods and merit goods. Have a go at filling in the blank table below (we have put in a few
entries to help you along). Once you have had a go, follow the link under the table to compare
your answers with ours.
Main features Public goods Merit goods Private goods

Diminishability Non-diminishable (non-
(non-rivalry) rivalry)
Excludability Excludable
Benefits Individual and communal

(strong positive
externalities)
Provider Usually private
enterprise
Financed by Usually taxation
Examples
Main features of public, merit and private goods - full table
Why might merit goods be underprovided by the market?
Merit goods will tend to be underprovided by the market because:
they generate positive externalities;

there is an unequal distribution of income;
consumers may lack perfect information;
consumers may be uncertain as to their future needs;
and monopoly power may arise.
We shall examine each of these factors in more detail in turn below:
Merit goods generate substantial positive externalities

Merit goods confer benefits on society in excess of the benefits conferred on individual
consumers; in other words, there is a divergence between private and social costs and
benefits, as the social benefits accruing to society as a whole from the consumption of such
goods tend to be greater than the private benefits to the individual. This divergence means
that the private market cannot be relied upon to ensure an efficient allocation of
society's scarce resources. The problem is that individual consumers and producers make
their decisions on the basis of their own, internal costs and benefits, but, from the standpoint
of the welfare of society at large, externalities must be considered. This point can be illustrated
in relation to health care and education:
Health care generates a number of positive externalities; for example, if all people receive
adequate levels of healthcare, the nation's workforce is likely to be fitter and healthier, less
working days would be lost through sickness, and this would have beneficial effects on the
level of output and economic growth; vaccinations and preventative health care which prevent
the spread of contagious diseases such as small-pox and whooping cough, clearly not only
benefit the individuals receiving the treatment, but also the rest of society at large. Indeed, a
major reason for the relatively weak economic performance of many of the poorer countries of
the world is the widespread incidence of ill-health and disease amongst their populations.
Similarly, in the case of education, there are a number of positive externalities from which
society at large may benefit, which may not directly accrue to the individual pupil/student.
Individuals clearly derive private benefits from higher levels of education as, for example,
earning capacity is to a considerable extent a function of educational attainment. However,
society at large receives the benefits of a more highly skilled, adaptable and thus more
efficient workforce, which is one of the key ingredients of economic success - the West
German post-war 'economic miracle' has, in part, been attributed to its highly educated and
trained workforce. Society also benefits in less tangible ways as it could be argued that
educated people are less prone to crime and racial intolerance, although this argument is
obviously not foolproof!
The important point then is that if people had to pay privately through the market for such
merit goods as health and education they would consider only their private benefits and their
private costs and would thus consume too little from the point of view of the best interests
of society as a whole. This problem of under-consumption is illustrated in Figure 1 below.
Figure 1 Under-consumption of a merit good.
In the diagram, OQ is the free market level of consumption, as, at this point, individuals
equate their private marginal benefit with their private marginal cost. The existence of positive
externalities means that the social marginal benefit curve lies above the private marginal
benefit curve as the social benefits of consumption exceed the private benefits. Allocative
efficiency would require a level of consumption of OQ1 at which SMB = SMC.
There is an unequal distribution of income
Perhaps a more basic reason for the market tending to under-provide merit goods is that,
given the highly unequal distribution of income, and the widespread poverty such as exists in
most economies today, many people would be unable to afford adequate education, health
care and housing in the absence of state provision or subsidy. A market system only takes
effective demand into account; that is, demand backed by the ability to pay the asking price.
It does not respond to human demand as indicated by peoples' needs, so quite simply the
poor may have to go without. Thus, on the grounds of equity, it may be decided that such
merit goods as health and education should be provided free on the basis of need rather than
according to ability to pay. Underpinning this approach would be the view that all have a

fundamental human right to the various merit goods, which should not be determined by the
market criteria of prices and profits.
Consumers may lack perfect information
At one level, market provision of health care and education may not provide a socially
optimum outcome because consumers may not be aware of all the benefits of such goods, and
may behave in a foolish manner - they may choose to spend their money on demerit goods
such as cigarettes, alcohol and pornography, rather than making adequate provision for their
own and their children's medical and educational needs. In this case, government provision
may be justified on the paternalistic grounds of protecting us against our own folly.
At another level, consumers of such goods as health care and education may have every
intention of behaving wisely, but because of the particular characteristics of these goods, may
not be able to do so. A basic assumption of economic theory is that consumers are aware of
their own best interests better than anybody else, and providing they possess full information,
will act in such a way as to maximise their satisfaction. Thus, consumers of fresh fruit will not
usually experience too much difficulty in establishing the best prices available in the market,
and most would be able to make fairly accurate assessments of quality merely by sight and
feel; and, if an incorrect decision is made, for instance by purchasing sour satsumas which
were perceived to be sweet, the consequences of such a mistaken decision are unlikely to be
too catastrophic, as the amounts spent are likely to be relatively small, and the sour satsumas
could simply be thrown away.
However, health care and education are considered to be different from other goods, and the
sovereignty of the consumer is likely to be considerably less than in the case of fresh fruit, for
instance.
A major problem of providing health care through the market is that there is likely, in the
overwhelming majority of cases, to be an imbalance between the information possessed by the
suppliers i.e. the doctors, and the consumers i.e. the patients: medical treatment is usually
technically complex, and consumers will rarely possess sufficient information to make rational
choices between the alternatives available - most would have to rely on the suppliers of
medical care for their information; and it is somewhat doubtful as to whether a profit
maximising supplier could always be relied upon to provide completely impartial information.
Also, as many medical problems only occur once, any information acquired may be of no
future use; and finally, in contrast to buying a sour instead of a sweet satsuma, any mistaken
choices in the case of health care are likely to involve a far greater cost and to be considerably
more difficult to reverse; for example, the consumption of poor quality facial plastic surgery.
Similarly, in the case of education , consumers, usually parents, intending to act wisely, may
not be able to do so and the consequences of mistaken decisions may be extremely great;
education is a multi-faceted, complex process about which there is considerable disagreement,
even amongst the 'experts', and obtaining the necessary information on such variables as
teachers' qualifications, examination performance, intake according to social class, the
incidence of bullying and racial harassment, may be extremely time-consuming and difficult to
acquire ; moreover, in the case of higher education, it is usually far more difficult for those
who have not experienced it to appreciate its benefits and make wise decisions, as compared
with those who have. As it is generally accepted that education is a prime determinant of life
chances, future earning potential and quality of life, mistaken decisions because of imperfect
information can have particularly severe consequences.
Consumers may be uncertain as to their future needs
Not only is a lack of information likely to cause market failure, but so too can uncertainty of
information - particularly in the case of health care. A situation in which consumers are
uncertain about future market information can lead to allocative inefficiency, with too little
health care being consumed if state provision is not available. Few people are able to predict
with any degree of certainty the level and type of health treatment that they will require at
some point in the future, as the incidence of serious accidents or ill-health are essentially
unknown variables, even for the smartest of medical practitioners. As paying through the
market for an operation, hospitalisation or long-term disability would almost certainly involve
exceedingly large sums of money, it would be very difficult for individuals to plan their savings
and consumption so as to ensure that all future medical requirements could be met; the
market in this situation is unlikely to provide the optimal quantity of health care because at
the particular point in time when consumers actually need it, they may lack the wherewithal to

pay the market price. Direct government provision of health care, free at the point of contact,
overcomes this problem.
A possible market-based solution to this

problem would be that of private medical
insurance; in the same way that it is
obligatory for all motorists to take out some
form of car insurance, everybody could be
required to purchase a minimum level of
health insurance to guard against unforeseen
contingencies. However, such a scheme is
likely to present a number of problems:
As all motorists are aware, the quality of

insurance cover depends on the premiums
paid, and the type of policy purchased; a
driver who has the benefit of the more
expensive 'fully comprehensive' cover will be guarded against most eventualities; however, a person
with the cheaper 'third-party, fire and theft' type of policy will find that they are entitled to no
compensation whatsoever for a whole variety of occurrences, for example, damaging a car by driving
it into a lamp-post; similarly, and more seriously in the case of health care, those who have paid the
smallest premiums would be entitled to the least insurance cover, which may be insufficient to cover
serious ill-health, should it arise; and clearly those who are likely to have the lowest cover would be
the poorest, most vulnerable groups in society, who are probably the ones who need health care the
most, but who would be least able to afford it;
Not only are the most needy likely to have the least insurance cover, but, as is the case with motor
insurance, there are likely to be those who have no medical insurance at all;
Like other private sector business organisations insurance companies are motivated by the goal of
long term profit maximisation, and would thus be reluctant to insure such 'unprofitable' categories of
people as the long term sick, the permanently disabled and the very old; for all these people the
market solution is likely to be no solution;
In contrast to the problems of under-provision for the most needy, a system of health provision,
based solely on private medical insurance, is likely to lead to overprovision for those, almost certainly
the better off, with the most comprehensive and expensive cover: in such cases, neither doctors nor
patients may have any incentive to economise on treatment - fully covered patients may wish to visit
their doctor as often as possible to obtain value for money, and doctors may be induced to diagnose
the most expensive of treatments to maximise their earnings.
Monopoly power may arise
Previously we demonstrated how under monopoly, price will tend to be higher and output
lower compared to the case of perfect competition; and as price will be set at a level above
marginal cost, and the firm is unlikely to operate on the lowest point of its average cost curve,
neither allocative nor productive efficiency will occur. Thus, where monopoly occurs, the market
could not be relied upon to produce an efficient allocation of resources.
If education were provided solely through the market, it is likely that spatial monopolies
would arise, as various geographical areas would not be adequately populated to support more
than one school, college or university i.e. monopolistic educational providers would be
protected from competition by virtue of distance and such provision may lead to sub-optimality
in the market.
Spatial monopoly
Spatial monopoly is monopoly power obtained by a business organisation through locating

at a distance from its competitors.
Similarly, in the case of health care, market provision would be likely to generate substantial
monopoly power, and therefore market failure: as the consumers of medical services lack
perfect or even adequate information about the products they consume, scouring the market
place for the best deals is not possible, and in this situation the suppliers i.e. the doctors and
hospitals, would be able to act like monopolists and raise their prices with relative impunity;
and, not only might consumers face monopoly pricing, but may also, on account of their
relative ignorance, end up purchasing more health care than they might actually need: the
'sound of cash-tills' might induce the less scrupulous practitioners to be over-zealous as the

regards the amount and type of treatment they recommend; for example, in the USA where a
direct charge for childbirth delivery is usually made, many more caesarean deliveries on
average are carried out as compared to the UK, where most childbirth is provided free through
the NHS.
Types of goods - self-test questions
Types of goods
1
How would you classify the type of good shown in the image below?
a) Public good
b) Merit good
c) Demerit good
d) Free good
Types of goods
2
a) Public good
b) Merit good
c) Demerit good

d) Free good
Types of goods
3
a) Public good
b) Merit good
c) Demerit good
d) Free good
Types of goods
4
a) Public good
b) Merit good

c) Demerit good
d) Free good
Government responses - merit goods

Possible government responses to the under-provision of merit goods
One solution would be for the government to play no

role whatsoever and to allow the provision of merit
goods to be decided completely through the free
interaction of market forces. However, for all the reasons
previously mentioned, this would lead to extreme under-
provision of these goods and a misallocation of resources
from the standpoint of society as a whole. Thus, in
practice, governments play a substantial role in the
provision of merit goods such as health and education,
even where they are ideologically committed, as the
present Conservative government is, to the market system. However, the exact form that such
government involvement should take is a subject of much dispute, and we shall consider each
of the following in turn:
direct government provision

regulation
subsidies
a combination of government provision and market forces
Direct government provision
Traditionally in Western Europe the overwhelming majority of health care and education is still
paid for out of general taxation and provided free at the point of contact by the government -
for most people, when they visit their doctor, go to hospital, school or college, no direct
charge is levied upon them; the private sector still only accounts for a relatively small
proportion of all health and education provision. Apart from generating substantial positive
externalities and overcoming the problems arising from unequal income distribution, lack of
current and future information and potential private monopoly power, direct government
provision may also give rise to large economies of scale, and may thus be productively
efficient; for example, when a service such as health care is provided to the population as a
whole, greater scale economies are likely to arise in terms of capital and labour costs than
could be expected to accrue to the private health care sector, whose scale of operations is
necessarily much smaller than that of the NHS.
However, the idea of universal provision for all on the basis of need, with prices and profits
playing no role, is one which sits very uneasily with the philosophy of market economics, and
has thus in recent years come under fierce attack from right-wing, market-oriented
economists. They have argued that government provision of health and education has led to
an undesirable situation of state monopoly power in these areas and that to increase
consumer choice, lower costs and raise the level of efficiency, greater competition is
required.
Regulation
The government may also use a range of regulatory

devices both to increase the consumption of merit goods
and to ensure their quality. In the case of education, it
may be compulsory that all children between the ages of
5-16 receive some form of schooling, be it in the private
or public sector, and quality is controlled in such ways as
school teachers being required to have stipulated
qualifications before they are allowed to teach. In the
case of health care, vaccinations against various
contagious diseases could be made compulsory and
medical practitioners such as doctors, dentists, opticians and nurses could be required to

obtain certain qualifications before they can practice. The government could also use regulation
to enforce the consumption of a good provided by the private sector which is deemed to be a
merit good by virtue of the positive externalities that it generates: the compulsory
consumption of seat-belts by motorists provides one such example.
In the case of housing, the use of rent controls on private sector rented accommodation are
a means by which the market can be regulated so as to protect tenants from having to pay
high rents.
Rent controls represent a form of price fixing. More specifically, they represent an attempt to
fix a maximum price below the equilibrium i.e. a maximum rent that a private landlord
may charge for rented accommodation; and, to be effective, rent controls may also have to be
accompanied by further regulation preventing the landlord from ousting the tenant once the
rent has been fixed. Figure 1 below illustrates the fixing of such a maximum, and the possible
longer term problems
Figure 1 The use of rent controls
The diagram shows that, with a relatively inelastic supply of rented accommodation, the free
market rent would be established at a price of OP, with the quantity demanded and supplied
equal at OQ. However, if the government impose a ceiling of OP1 on the price that landlords
can charge, an initial shortage of Q1Q2 develops as the short term profitability of renting-out
accommodation declines. In the longer term , if landlords' rate of return falls below what they
could receive from alternative investments, such as government bonds, then existing landlords
could be expected to leave the housing market with little new rented accommodation coming
onto it. As a consequence, the supply of rented accommodation would shift from S to S1, and
the shortage would increase to Q3Q2. Thus, unless the government could shift the supply
curve to the right, for example by building more publicly owned council houses, the long term
shortage would worsen, with the existing rent-controlled stock descending into an ever greater
state of disrepair, as a result of landlords seeking to reduce their costs by postponing or
cancelling repair and maintenance work.
Subsidies
Subsidies may be used to increase the output of merit goods, provided both by the private and
public sectors, to the socially optimum level.
For example, the theatre is usually provided by the private sector , and is often regarded as a
merit good on account of the educative and civilising benefits that it confers on society. The
government might take the view that without state assistance to the arts, there would be an
unacceptably small number of theatres able to survive. Figure 2 illustrates how the subsidy
would operate.

Figure 2 The effect of subsidising a merit good
In the diagram, the free market price of theatre tickets is established by the intersection of
the curves D and S at OP, with the equilibrium quantity at OQ. A government subsidy,
equivalent to the vertical distance XY, would have the effect of shifting the supply curve to the
right, causing the market price to fall to OP1 and the quantity of theatre tickets demanded
and supplied to increase to OQ1. Consumers' expenditure on the theatre increases from OPZQ
to OP1YQ1 and the area P1RXY represents the total amount that the government spends on
the subsidy.
In the case of health care in several West European countries, the majority of it is provided
free to the user out of general taxation, although charges may be levied for prescriptions and
optical and dental treatment. In these cases the prices charged have been made cheaper than
they would otherwise be, with patients only paying part of the cost of treatment and the
government making up the difference through the payment of subsidies to suppliers. In the
case of housing, owner occupiers receive a subsidy through the receipt of tax relief on
mortgage interest repayments, which is not available to those people who rent their
accommodation. State education like health care, may be provided without direct charges being
made, although education vouchers represent an alternative form of market-based, subsidised
provision which has been proposed.
Demerit goods
What are demerit goods?
Demerit goods are goods which are deemed

to be socially undesirable, and which are
likely to be over-produced and over-
consumed through the market mechanism.
Examples of demerit goods are cigarettes,
alcohol and all other addictive drugs such as
heroine and cocaine.
The problem arises from the fact that so long

as an effective demand is present, such
goods are, in all probability, going to be
extremely profitable to produce, and this is
all that a price system takes into account -
the market neither possesses a 'heart' to
enable it to help those in need, nor is it inherently able to make value judgements about
which commodities are good or bad for society as a whole: it is prices and profits which act as
the 'guiding light' to resource allocation.
However, the consumption of demerit goods imposes considerable negative externalities

on society as a whole, such that the private costs incurred by the individual consumer are less
than the social costs experienced by society in general; for example, cigarette smokers not
only damage their own health, but also impose a cost on society in terms of those who
involuntarily passively smoke and the additional cost to the National Health Service in dealing
with smoking-related diseases. Thus, the price that consumers pay for a packet of cigarettes is
not related to the social costs to which they give rise i.e. the marginal social cost will exceed
the market price and overproduction and over-consumption will occur, causing a
misallocation of society's scarce resources. This is illustrated in figure 1 below.
Figure 1 Over-consumption of a demerit good

The diagram illustrates how the market fails in the case of demerit goods. At a market price of
OP, OQ quantity of the demerit good is consumed, where demand (private marginal benefit)
equals supply (private marginal cost). However, at OQ the social marginal cost exceeds the
price by the vertical distance XY, the value of the marginal external cost. Social optimality
would require a smaller level of consumption at OQ1, where price = social marginal cost =
social marginal benefit.
Government responses - demerit goods

Possible government responses to correct market failure arising from
demerit goods
The government may attempt to reduce the consumption of demerit goods such as cigarettes, alcohol
and addictive drugs through persuasion; this is most likely to be achieved through negative
advertising campaigns, which emphasise the dangers of drink-driving, drug abuse etc. The aim here
is the opposite of normal commercial advertising, namely to shift the demand curve for demerit
goods to the left.
A contraction of demand (movement along the demand curve for a demerit good) could be
achieved by the imposition of a tax on the demerit good. This would have the effect of shifting the
supply curve to the left, raising the price and reducing the amount consumed. If the government
could accurately assess the value of the marginal external cost caused by the consumption of the
demerit good e.g. in figure 1, it is the vertical distance XY, a tax equivalent to this could be imposed,
and a socially optimum outcome could be achieved. However, in practice, ascribing an accurate
monetary value to negative externalities is extremely difficult to do, and the demand for such goods
as cigarettes and alcohol is often highly inelastic, so that any increase in price resulting from
additional taxation causes a less than proportionate decrease in demand.
The government may use various forms of regulation. In its most extreme form, regulation could be
used to impose a complete ban on a demerit good, such that its consumption is made illegal; for
example, the Prohition Laws in the USA in the 1930s criminalised the sale and consumption of
alcohol, as does the law at the moment in Saudi Arabia; also in the UK and many other countries
today anyone found guilty of selling or consuming heroine can be imprisoned. However, the effect of
such regulation is rarely to completely eliminate the market for the demerit good; rather, it is usually
driven underground in the form of an unofficial or hidden market.
Less severe regulatory controls might take the form of spatial restrictions e.g. people may be
disbarred from smoking in their place of work, on public transport and in cinemas and
restaurants; there may be time restrictions in that it may be illegal to sell alcohol during
certain periods of the day, or there may be age restrictions in terms of a minimum age being
stipulated at which young people are permitted to buy cigarettes and alcohol.

A most important assumption of the ideal
free market economy is that markets within
it are competitive, so that a large number of
competing firms passively take the price
that is set in the market as a whole and
either increase or decrease their output in
response to shifts in consumer demand.
However, as we saw in the section on

monopoly, markets may be dominated by a
single producer of the good or service, in
which case a situation of monopoly exists,
or by a few producers, in which case an
oligopoly exists. In either situation,
producers may not be content to take a price set in the market. Having significant control over
supply, firms in pursuit of maximum profits may attempt to make the market price higher
than it would otherwise have been by restricting output. The outcome for consumers may
therefore be that they are paying a higher price for a smaller output. This would represent
market failure and a misallocation of society's scarce resources, as the economy would be
deprived of some of the output which would be valued more highly than that currently being
consumed.
Also, in a situation of monopoly or oligopoly, profits may not perform the function that they

are supposed to in the 'ideal' free market situation. Here, the making of profit is deemed to be
a sign of efficiency; that is, the goods that are being produced are precisely those that
consumers want and of a suitably high quality, and because firms cannot influence price, the
profit has been achieved by operating efficiently, with costs being kept below the ruling price.
However, given the power of firms in monopoly and oligopoly to restrict output to keep price
artificially high, the making of profits may reflect market power and dominance rather than
efficiency. Monopoly may involve both allocative and technical inefficiency. Refer back to
the section on monopoly and re-read the course notes if you are not sure about this.
Inequality
Advocates of a freely operating price system often liken it to a political democracy where all
voters can cast their votes for the candidates of their choice, with everyone who is eligible
having an equal say: the price system, according to this line of reasoning, is a consumers',
economic democracy; every time we go out and buy a particular good, we are affecting the
demand for that good, and hence also its profitability and supply. Hence, the simple act of
buying a good is akin to casting a 'vote' in favour of the production of that good, and is the
way in which consumers determine how scarce resources should be allocated.
Unlike the political democracy however, in which each person has equal voting rights, the
consumer democracy described above, given the unequal distribution of income that exists
in most capitalist economies, is unlikely to be one in which all have an equal say _ clearly
voting power is directly related to income so that the rich would have many more votes, and
thus a much greater pull on resources, than the poor. Consequently, the resulting pattern of
resource allocation may overlook the pressing, often life and death needs of the poor, and
reflect instead the more trivial wants of the rich. In the economics of the market place, human
wants are those that are supported by effective demand i.e. demand backed by the ability
and willingness to pay the market price. Human needs, however, if unaccompanied by the
wherewithal to pay, are simply ignored. This is the overriding reason for the existence of mal-
nutrition and starvation in the world today: it is not that there is an overall shortage of food -
there is more than enough in total terms to feed everyone; the problem, quite simply, is that
those who need the food lack the money to pay for it.
Hence the 'free' market, given the degree of inequality which typically exists, is likely to be
one in which many people are severely disadvantaged in terms of their market power.
'Electoral successes' will be the fast cars, exquisite jewellery and luxury hotels etc. for those
who can pay, with basic health care, education, safe drinking water and nutritious food for the
poor almost certainly 'losing their deposits'. Clearly, some consumers are a lot more
'sovereign' than others!
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Section 2 - Microeconomics - Table of Contents 7/5/10 10:17 AM

Two key terms have been mentioned, supply and

In this section we consider the following topics in detail:

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There are two main types of these:

1. Markets for consumer goods

2. Markets for consumer services

Capital goods markets

The world of competition is dynamic. Firms

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Market structures - monopoly to perfect competition

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Summary of market types

Market structures - self-test questions

a) An industry with significant barriers to entry and a single Choose...

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The importance of price as a signal

The process of resource allocation

As we have seen in Unit 1, the central problem of

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The process of resource allocation

Demand is defined as 'that quantity of a

The desire for a product

This definition is important. You have to pass

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all three tests for it to be demand.

Look at these questions:

Would you like to own a Ferrari? Probably, yes. Test 1 OK

The law of demand

Figure 1 Demand curve

Figure 2 Individual and market demand

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REAL DISPOSABLE INCOME

Movements along the demand curve

Figure 3 Expansion of demand

Figure 4 Contraction of demand

Shifts of the demand curve

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Figure 5 Increase in demand

A rise in the price of a competitor's products

Figure 6 Decrease in demand

Example - shifts and movements along a demand curve

Example 1 - Movements along and shifts of demand curve

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Figure 1 Demand curve

(a) The firm launches a new, effective advertising campaign.

Answer - change (a)

(b) The market price of the product rises to P2.

Answer - change (b)

(c) The price of a substitute good is reduced.

Answer - part (c)

Answer - part (d)

Answer - part (e)

Answer - part (f)

PlotIT - Build a demand curve

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Demand for tennis shoes

Demand - self-test questions

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a) An increase in advertising for the product

Shift in demand curve

a) An increase in the costs of producing the good

a) An increase in cocoa prices