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Microeconomics

M croeconom.s s concerned with the indiv dlal pads ofth economy. lt s concerned with goods, the demand andsupply of parilculaf services andresourcs. lt{ocuses in otherwods on ndviduamarkets.

. A nrarket canbe defnedasa process or an instiiution n whichprodlcers andconsumers nteract in order to sell andbuya goodor a sevice. A mafkteconomys one where marketforces d oneprovid answers to thethree flrndamentalquestions andin whichprvaieproperty rights arewe I defined andenforced. ln a puremarket conomy theres no qovernment interventon beyond selting andenforc nq propertyrights.

. Thepartcipanh in a market economyare produers. Theinteracton of consumers and


/ ir^1s'rr -d lF- detFrnine rl.p n dr' oTpri' p o :{rr ah" 1qp.i ndrL" t.ordi tors l ^ r< r-, J: r ' orodu... marketprce changes wh ch set off a ch;ln of a,sE aadno l o n oreor Fr. of -h" good bp 1q proiL@ thusto a changein the a locationof scarce resc---a

An. y5sof how marketsfunction requresexan the behavour of consumers andproducrs.

Thebehaviour of consumers

Ih conceptofdemand is a wayof summarizing the beha our o'b ryA\ Spp itnally. e dpr 1p d"n ano d. r'r" possble prices rlatonship betwenvarious of a good and

Figure (and<onsumer 2.i Thedemand curue suel6)

quanttes the corresponding thatconsumers arewilljng (i.e. andabeto purchase pri meperod,cter s padbus aliother factors affcting demand remaining constant). (negative), Ths reationship is nverse mean ng tharif the prceperunt ofthe product decreases consumers wil be w ingandable padbus). to buymorepefpe od (ceteris Tl'ei_/rs" p-i,"drd qu"1i' e dlorship bFrw"er d,"manded is referred to asihe law of demand. Thlaw of demand assears thai if the prce perunitof a good quantry rses perperod then demanded of timewillfal, A dernand p c!fr'enowshows th s inveEe relalionsh perunltof a qoodandthe quantity bet\rveen the price ofthe gooddemanded pert meperiodPrice perunit ls rneasured quantity per on theverticalaxls; demanded t meperiod i5measured on the horizontal axis. For exampe in Fg 2.l,iftheprceperuntisPthen consumers wj bewilling dndab to buyQ unts per period, whercas if prcedecreased to P'perunitlhen consumeBwi bew ingandabeto buyQ'units per

oe od. .prp.i<par bLs A der drd d bF -:? "L-ve an ndividuacongurner orforthe whole marke: -rE

market dernand c!tueisdiagrammatcaly den'e: horzontalsummat on of theindivdualdemand

. The incomefiect:if the prcprunt ol goo. r Thesubstitution efiect:if the prceof qoodX rss, al othergoods (thepurchas auromdilcalt become relattyely cheaper; consumers'rea/ ncome ng power c=; people thLrs, w ltend to substtute othergoodsforX. The drops;thus, peopewil tendto buy ss. Thtize size ofthe substitution pr marilyon efiectdepends the ncome p mary on the proporc.r effect depends d numbef andcloseness goods. of available substtute rncome spenl on the good

Goalof
tr es to maxmlze thatthe typicalconslimer t i5assumed htJorher utility, defindas the s.tisfacton dedved from consumng a qood or a bunde of goods Shew I

her of goods whichmaxlmizes thatbundle thuschoose given herincom.nd s.tisfacton andwhichshecanafford, the prices shefacesn lhe market. payrng w llend Lrp to payto njoy unts Q/andwhatsh astheonsumer and s known for themin the market surplus.

y' read'vertca canaso b-a curve Note thata demand Pastheywould 2.1isworthto consumeu Unt Q in Fig. bewl ingto payaithemostPto lrlryt, not a cenrmor-": the at the levelof s/rghtth qher(say if the prcewaseven will ng to have been wou d not reddotted ne)thenthey P as to consumers is worth /asf urla Un it buyrfiar 0. Q' theywoird bewii nq to paytoacquref thatisihe mosa perperod, greater amounts andqrcater Toconslrme o price a5consumption rnundecrease the nrarket perperod swoalhessandessto andmoreunits rnore marginal the lawof d m nishinq This refects consumrs. f ._ r,pd c..r" or de .L tla.l 1"-F . t dt .l'F ut:lily. per perod typ calv qreater amounls of theconsumption
h paLh u 16 . r l- a ' . r e v r L j o \ or . e . llF r \ h o w - (0Q'HF) extfa un t ls worth to consLrme6 then the area

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a//unitsQ areworthto howmuch in Fig 2.1 measures .e.howmuchshewouldbew lingai theconsumer, unlts.I th marKet a//thes rhernost to payto enloy ng and able to consume prlces P'thenshe will bewi (P') theywou d spend al unts up until!nit Q'forwhich r1e Q'-dea'0O Pr Are. PrE 5f.o"'e'lce wouldat the mostbew ling betlveen whattheconsumer

theymayor canbe linar or curvedr Demand curves thatthey make sure the axes;just theymaynottouch youwantto illustrate some soped(uness arenegativey olthe the notion fyou wishto illustrat-" spcalcase) curve to have the dernand it s easer consumer surplus to rele6 the abov d scLrsson axes. Not thal touchthe for a factorol the demand for a producl: the demand ('derved sewices for labour production dmand';say, be careful Also, i5sirn larbut not dentical. byfrrms) demand-"d' mean ngof the1rm'quantty aboutthe arewil ng and thatcons!mbrs It refe6to theamount time at a I venprceovera glvn able to purchase peop wou d srnrply period. to whdi ll does not refer refects wantto consume. Notethat'willngness' 'ability' preferences refects the ncorn whereas nt people lace constr.

incom in consumers' changes goods w llr seand for most rses, demand As ncome goods qht. Such to the curve w shift the demand thls There arexceptlonsto areca ed norrnalgoods. theyspend genera As peop e qt richel, rue, however ty foodor as ow_qua ess on inferiorgoods,such goods clothing, andswtchto betteFqualty ow-qualty incomes when decreases for inferorgoods Thedemand for nleior goods curue increas andthusthe demand l"el ot _co-eir ar w ll 1if .o I e le . 't'le pe caoil" w I h iime,thepatern ot deman.l economy r ses throug for production, mpications This hasimportant change. o{ incom in the distribution Changes andmore ess skewed bcor.es distr bution lf the income maydrop.ndfor for certain Luxuries equal, demand a pollcv goods andserv cesmayrse.Thus ce ainbasic may transTe6 taxes and nq ncome throlrgh of redistrlbut patterns of demand. altr the changes in preJerences {tastes) thevwill e people f nd a good,the more Themore deslrab q b ldsFo. r'p d{ecteo o.n d-d Tasle\ "dvprtsrro. ol byconsiderations consumers, byobserv ng other

changes in the priceof other goods aredistinqulshedl Twocases thal are del nedasgoods a Case o{ complments: ('lontiyconsur.ed'), such as iogeihr consumed pollsh,.offee peanut shoes andshoe buiterandielly, of the prceof a complement etc.When andsLrgar, goodX riss, for Xwil drop(shifileft,e g demand for sugarwll isesthendmand of coffee fthe price defined asqoodsn compentrve o{ subrtitutes: b Case ori.e .or'ullptor. a.. offp""10 "". WnpllrrF -Lcf for X wll rse demand of qoodX rises, of a subsitule A' 1lr e e oo'ri.p oe.on 'w | 1iFri91.e o it offee for te. wi incrase). thendemand Sizeofthe market,i.e.numbroJ consumers (thenumber oi consume6) Asthe slze of a market williendto rse increases, demand for mostproducts ofthe population Agedistribution thepaltefi on wouldaffect A change n theaged stribut refers to dn ageng example of demand Theclassc where popu theaverag ageis rsing) aton (where gumw L for chewing and demand for fd seleethwill rise

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. Expectations (of changes in ma*et prices or in income) For exampe, f people th nkthaith price o{ a good s going lo rse nthefuture, theyare likelyto buymore prices of it now bfore go up,shlring is demand curue to tlrerght. _ shifts ofdmand versus movements along r denand curve Ths s the source of a typca m stake. A shft in th. demand c!rveoccurs whena dtemnantotherthanthe prcchanqes:we then say thaia change ndemandhas occurred A movement along the demand c!rveoccLrrs when

there s a changn pdce:w ethen5aythere s a changen

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N e.e s" v rhaL de-" ' l d 5h ., Jp or do,M a_ r-credses the chance of getting confused and makinga m stake. Aways usethe expression drnand sh fts right (when it increases)and shiftsleft (when t dcreases) Also nore thatthe new dernand cufr'edoesnot haveto be paralle

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prceto eadtoanincreas higher n quantity demanded prperiod. c ffenqoods goods andVeblen aretwo exceptons where a rse in the prc eads to more of the goodbeing perperiod. consumed Figurc2.2 Positively sloped demand curves:Giffen and

Bengvery qoods, strongly nferior the ncorne effect runs ln the oppost direction of the substitution effecl and dornnalest, ading to the perveGe result desc. bd. AI G ffengoods goods areinfrior bLrl not a infero.goods areGiffen goods. qoods Giffen wrefirslmentiond in 1895byAlfred Ma6ha/ln hisPrnc4ries. Thoriqna exarnple was brcad, wh ch n SirRobert ciffenstime(191h century) wasconsumed bytheverypoor n Londof. Thetypca txtbook example has potatoes, since been consumed by very poor dshfarmers durinq the 1845 famlneBoth
F , o " r p e . h a \ a b o a . r 6 Jr r o d b i . r a , . , , o I h . 5 . o . . d"..

Recent panedatahasshown resarch usnq dtailed that n Chna,whre 30%of the popu ationnil survives on ess thana dolara dayperperson, noodles in the nofth
ar dILe -lL ".o I F i bI sL.h crffenbehd. oL

goods Vebln . Veblen goods arethe otherexcepton to the aw of demand These aregoods viewed asstatus symbos. They arevalued becalse ther h 9h prce s beyond the reach ol other ndvidua s . BeugaGviarandFranck MLr lerwatches se ng for may $750,000 begood exampes. ncreasngtheprce ior these goods maynot decrease quantity demanded. Vebn goods eho!d obvousy notbeconfused wth

q/ priod Giffengoods Giffengoodshavethe fo ow ng lhreechdrdcterstcs: . they areverystronglyinferof goods; . they are conslmed by the verypoori . expenditlrre on theseqoodsmun represent a very signficanl proportionof tota consumer expend tures

j re-.ruer r" i e orsood.L l- -aldrFdl.o


i G ffn goods)havetyp ca , negatvelysloped,demand

i
i

Throlof expedations when isthe case to the lawof demand Afuftherexceptlon prce product rlses as the quantty of a the demanded l'alr'r"orcewil'i,ee.r o- expectations '|.es. o"LdL5e

in thefut!re.Ths is known asthe 'bandwagon' more Nota wth buye6l!mp ng on the bandwagon'. effect, prcferabe perhaps to treat econornists agree aboutth s lt is prce a shiftfactor oi a ncrease as expectations of a future page10) demand c!rve(see iypcaldownwdrd sopeing

of producers Theb_ehaviour
supply':',:.,i.:,3,
. supply the behaviour slmmarze isa wayto anay4cally goa of firms. andth s poss p bt\,veen ble varous asihe relationsh t is defined quantits thaifirmsare prcesandlhe corresponding parbus. pertimeperod, ceters w lling to offer p the reatonsh ftrrve isa qraph showing Thesupply between the prceperunt of a goodandthe quantty ol t me to ofirperpedod willing thata fnm (offlrms)ls that Llthe sop ng, meaning suppys upward lypically, price perunitof a prodlctlncreases thena f m w ll b quantiyperperiod of time, willinq lo offera grcater producers w lbe willlng n Fq.2.3,lf theprice isPthn whereas if the prce ncreased to offefQ unts perperiod, r . bp ,^/ lli g ro o"F' O' Llits per ro p,r-ar p,oouLers . Thequestons why?A s mp sticanswr s thatat hrgher ihusit w ll b pfices, a f rrn! profilmatgn is greatef, Also. gooo "ir.e oe'pet:od. ,^ nq roofle'no'e of rl'F dlffcl]tfor a firmto produce it becomes more andmore it will be wl ing exlstmg capacl4/, moreper periodus,ing pef unitrises. to do soonly f price
(andproducersurplut 2.3 Thesupply curve Fisure

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. \ote t-rat -h"'Lpp) rrve ir l ra.).3 ca^dto be ead a firmwouldbewil ng to offerunitQ on y if 'vertically':
.fe p1 .e ir '1- r "lle. s dr laa ! b. D$t n4m innum P t l .

the firn wauldbe wiling ta accept. . Even if the prcewassrghtt ower(atthe rcddottedllne leve )the f rm woud not bwillng to offerunitQ. Why? the extra con of producing Becaus twou d not covef howmuch thusrefects that!nit. Thvertca distance unitcosts thefirmto produce. each extra

. Thus (oQ'TJ) how mLrch a//unl15 area measures Q'cost it the minm!m amount the f rm to produce. t reprcsents lf th market a lthse lnils requ rcs n order to offef Q' prlces P'pruntthen thefirmwill bewi ingto offera I (P') times would earn they units up untl!nit Q'forwhich (Q')= area (OQ'TP'). between whalthe the difference Area(lTP') rpresents andthe andse ng Q' units f rm earns whenprodLrcing resto bewill nq to it reqLr minimurn anoirntof mony surpLul. offerthese units. Thiss the'producer

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Changesin inpul prices ' . I or F . a. ] p e .w .o e s o | d w ma te fl . p ,p \o F..ease then a fim at eachprcewill be w linq to ofier morepe, prlodas producton is now lessconly.The suppty curve wlls hif t t o t h e ri g h t Changesin technology mprcvements in technologyower the costsof producton sincethey permir essto be spenton inputs.

Theexpectaton thata prlc wil be higher in thefuture rnay cEuse suppyof the prodlctto decrease now Other{actors Weather conditons forobvious reasons affect thesuppy ol iaffnproducts; a trrodsr actor a war mayaffecr th

Supply wii thus ncrease andshifr to the rghr. Change in productivity Productivlty of a factorisdefined asoutputperunitof nput.lf, ior example, labour becomes rnore experenced, bettr trained or health er then abour productivty w increase, mean ng thatoutputpefworker wit be greater It lolowsthatsupply w increase andshiftro rherighr. Changes in government policy Covernmenl (perunt of outputpayments subsdies ro 1rm, will owerproduction costs, whileirnposing indirect taxes wllifcrease produclion costs. Thesupply decison s thus n bothcases affected. . Sizofthe market Themarket supply wil beaffecled fthe fumberoffirms in the market changes. As,for exampe, more firmsare lurcd intoa m.rketth markt yw tttend supp to rjse

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Suppy curves maybe nfaightlines of curvesj theymay or maynot startlrorn thevertical(of horzonta )axs lun make sure theyare(inthe qeneratcase) upward slop ng.Toil ustrate the prcducer surpus t iseasir ro have yoursupply crrvestairfronr theverricataxis. The , .opy o'. d(.o. ot oroou(-io,] rry o ,dooJr se^ .e. by 'workers') issimilar but not deitical io thesuppry ol a good. Alsoan increas of a decrease n suppty shoutcl always be referrcd to asa shiftto the righror to tlre err, respecrively. Using'!p'or'down' may eadto confusion as,tor examp e, a shft downon rhediagram rcftects an incrcase in suppy. t isa shftto therght.

Equilibrium

Theprceatwhich a good w lbesotdn a compettive rnarket wii bedetermined bythe inreracUon beiween consumers andproducers, in oiherwords bythe nteraction of demand andsupply. orcee,( e . . iupo, e. r. it qLdrry.Lpp eo 'ar .o."r" perperod exceeds quantity demanded)then the price wi

lf at some price excess demand exsts{if quantity demanded perperodexceeds quantity supptied)then th price willtendto rise. It fo owsthatthere will be no tendency for the price to change fthere s neither xcss suppynorexcess demand in the mafket. This rquires thatquanttty demanded perperodat thatprice isequaltoquantity supplied Ths prices theequilibriumprice(ormarkt claring price)and the corresponding quantry isthe equilibrium quantiry.

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Figlre 2.4, cou d Pl bethe'quilbriunr'prce? Referr nqto Fig. per prod buy units are w lling to At Pl consLrmers Qdl prperoo. unjts while fums arwil ngtoofferQsl greater quantity perpe'od than s supp ed Quantity eqlalto There s excess supply demandd {asurplus) pressure perperiod wh ch wil create Qs1 Qd1= HFLrnits a supply creates the excess for the prceto fal. Since thatP1 js for the marktpric to fall t fo low5 tendency price librium' notan'eqlr 'qu P2 be the libriumprce?At P2consLrmers Coud drew llinqto buyQd2unitsperperodwh e f rmsare perperod.Quantity demanded units willnq to offerQsZ 2.4 The determination of equilibrium price ln a

i p o l i F dl l er. i pqpe! odsq e d .a .h " n q L " n t, xcss demand(a shoirdqe)quato Qd2 Qs2 - lv Lrnits forthe priceto per peiod wh ch wi createpressure fol the a indency the xress demdndcreates rise.Since fo o \. .n .- " / i . .ro a n ar . 6r pr i o ro .-,o ,t-.ro p ' equillbr i L rm ' p rc . d e rp ro d i s e q u a l toq uanti l y Q uanlt yde m a n d e p demand supp ed on y at prire P At Pthre i5 no excess suppy so th market'c ears'.PriceP is thusthe or excss

Qd1 Os2 a

Qd2 Qs1

Q/ pedod

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:;J:rlliiiliiii,iii..-1.1,

j e strortaqe but the a surp ut s not an area 1or i quantity demanded and i hofizontal d betvveen the stance i i i rheoranrt. --oo ecr dt o.ne orc..

allocation Thequestion of resource


The allocatioh:
of<arce resour<es rigure2.5 Theallocation G) is howmuchlo prodlce A problem dnysocielyfaces resources should qood, thLrs how many of each and n-1oproo,r, io o "r.1. oil . ldre 06dlro!.reo wth 1wo th nk of a society endowd the problem, two abour andland, wsh ng to produc resources, rs Theproblem t iaces goods, apples andoranges say oranqes apples to produce andhow many how many how muchandandhow muchabour and,consequently, andhownruch in the prodrctonof apps to allocate producing more scar.e, Since resources are to oranqes. canb prcduced imp sthatfewer oranges appies iniormalon 2.5;n.orporates a lthe necssary Fglrre drawn curve nethe answer Thedmand to determ unt of dppess valued howmucheach extra reflects y by soc Thesupply genera ety. andmore byconslrmers extra unitot appescosts reflects how much each cLrrve (ast shows prcerequired for the minimum to produc t shou d be In s s mpe stup the unitto beofiercd) th requresmore produc unt ot apples clarthat nq an extra production, sothe.on ol resources d ocated in apple thai arethe oranges each extra unitof appesproduced need to besacriliced.

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rh;;i;;;;;;;;;;
. Should po nt ol view? asit consto produce be unitQ unt Q] be produced frcmsociety's it. In Fig 2.5thiswoLrld Stopping nq a t ny bit essthan Theanswerwill beyes, if t s valued more thanwhat t shoftofthat unt (produc lniorrils !nit Q)would whynotproduce. llny consto prodlceit. Thedemand curve lor apples begthequeston (or yuan), usthatunt Q] svalud bysoc etyat P1do lars . Thestdri nSrsult isthrt ever asthatis how much cofsumels wou d arthe mosfbe of compei/flv rnarkets js lookjnq producer thoLrqh after wr rngrc pay. each consumer andach (consurnG hisown self nterest Ihe suppycurv for appsnforms usthatit costs aiming at maxmizng (oryuan)to produce ut ty andprodLrce6 m zingprofit)th C1dollars unt Q1asthati5the a mingdt max poss rnarket be from ninimum supplieswouldbe willing to acceptta offer outcome s precisely the best pont of vew;this socetyS wasfrst expressed bythe fhaft]rli. SnceunitQi s valued mor thanwhal ft cons, dea famolseconomist m.*et, the answer s ihal it should be prodlced. AdamSmithln a compettve (n general, prcewi indeed gravtate unt Thus, moreunis of appes more ot anyqood to Pdo aG(oryuan)per 'x )should producd of the and output be as ongasthevaluaton w I be exacty Q lnits perperod,5oal unts worthmore are nde-ad extra unit(whatpeop e woud be atth monw llnq 10 thanwhatthey cost to prodlce pay) it. exceeds ihe xtra costof producinq ll fo owsthatthvery astunitof appes socetywolrd wantto be prodrced isthatunitwh ch i5vauedasmlch

The power ofl


(b) Assume nowthatpreferences in th s society chang and Figure 2.6 TheaLlocation ofscarce resources rhat,for ex.mpl, morcappes arc n dmand Whyand howwi more apps beproduced andihus additona scarce regources.ttracted andempoyedln appe prodLrction? Whatmechanisms w lcomeintopldyto glarantee preferences thatthese changd ot soc etywi bsatisf ed7 Focusing on Fg.2 6,letthprice of app es nitallybePl pruni andthe outputof the applndlstryQ1 !nits prperod.A grearer demand for apples canbeshown asa shft ofth demand for apples to the rlghtto D2 Of n the market see5 theshft but nowthere per wil bexcess demand for apples equaltoHFunits
p e o d. a. d F L D . no lo1gFr

There is pressure forthe price to rse. Therise ln the price of apples isvisib e and t lnitlates chanqes n thebehavour of both frmsandconsumeE. prices Changing reative thushave'siqna ingpowel. orw Some consumers wil drcpout of the market higher cut downon the r purchases. Ontheotherside, prces profts ngfrmsandan mean incrdsed for exst and oppoftuniiy for otherfirms to nter the rnarket partake proflts, quantity suppd n these Asa resull perprodrises but t shou d be reazedthatfor th s w have to shft nto appe to happen more resolrces

"' r

FqL ib L1 p . i . "

Q/ pe r iod The prce r.echansril thus eadsto a chang n resourc prices alocaiionas rsing rlative and prof ts provde the slqnalandthe inceniive forfirms to producemore. y, the extension Eventua of supply(from H to J)and the contracionof demand(from (Fto J)wi stop when th-b new equilibfiumpriceP2pr un i is rached and ndustry output s h gherat Q2 un ts pr perod.

Elasticity
varab, when In qeneral, elasticity i5def ned asth responeierisol someeconomic anothereconomc vari.blechangs.

to a Definit'on: TheresDonsiveness of ouantitv dernanded :ymbol: PED percenlaqe n quantiy dmanded Measure:The change n price: divdedbyth percentage change .= PtD-ooAOd/ooAD -usP D- Ao/OIrAP,D (AQ/P).(P1lQ1) -heratioo{ ihe charges P D s rl^Jq o h^o.d dbes (price qu.ntty demandd)that moven opposte and p i e ot l.pqood gop.Jp. ler Lhe d.F.ror": if rhF quantity goes demanded downandvice versa, mpying h.sa plus sgn(thprice that fthe denominator jncreased)then thenumeratorw lhave a negatve siqn demanded will have dcreased). Chequantty Asa rsult PED isalways a ,egaalve number. Noteth.t often theminus sign isignored.But in anycaLculaton questonsneverforget to usethe m,inus s/qnevenif t is Rangs of price elasticity of demand

(urve Priceelasti(ityof demand varies alonga typicaldemand

Notethateven a onga inearnegatively sloped, demand curve PED contin uously varies, taking on a lvalues trorn . Referrins to FiS.2 7, at themidpolnt M ofthdemand curve ABthai corresponds to pric Pm(located attlre = 1. midpo nt of segment 0A), PED . Wthn neseS higlrer mentAlvlcorrspon din 9 to prices thdnPm within thesegmnt APm, demand s price eastc (PED >1). . Withn nesegment owr MBcorrespond ng 10prices Dr v\ h.r le .egm" pTB.defrrd s ori.p .l-"n (0<PED Lne astic <1) . Lastly, to at pointA prceelastic ty of demand tends inf n tywh dt pointB prlce iszero. easticlyof der.and rigure 2.7 PED along a negatively doped linear demand curue

. Denrand (forsma changes s elastic around the init al prce)ifthe percntage change in quanttydemanded (PED >1). is arger thanthe percentage change n pric leads to Atern.tiveywe cansaythatf a change n price a prapaftianately change n quanttydernandd Eearet fortheprodlctspr.eelanc then dem.nd . Dernand (forsma changes is inelastic around th nital price)if percentage s ch.ngein quantiiy demanded the (0<PED <1) sma lerthanlhe percentage chanqe in pric to Altematlvly we cansay ihai if a change in prce eads a propaftianately smar chang ln quantity dem.nded ihendemand forthe product is pric inelastc. . D-1d d . unit elasti( f .l_"p"rce ..9echa1o" i_ quanttydemanded in isquato the percentage change = r). prce(PED . DFr pefectly if d,ad Lctra-qe rr o ' F elasti( "ro , leads to an nfnitelyargechange in quanltydemanded : (PED the prceof means that f, for example, -+ -) This i by a product flss even srqhrt, nothnq wi be bought i sa consumrs. A demand curye of nfinte plce elasticty i Ine paralle io thquantity axs. i . Dmdrd ( i, perfectly inelasti( '.3-a lchalqen or i eads to no change nthequanttydemanded(PED=0) purchased i Pric changes have no effect on theamoLrnt i prcelasticty perperod. sa A demand curve of 2ro i ineparalelto theprice axis. i Notethatthe minus s gn s gnord. i i I

l ;'o;
A or11o-

'. ii',,
aa,6 q ro.ors oF" r-e prrce o easr cr w

r linear dmand for' a demand cuwethatisat a 45 degree i5not dnq to bothaxes asconstant andquato 1.This th;case.Price eancityfor such a clemand curve a/so is 1 vareslrcm inl n iy to zerc. Theslope of such a cufr'-" bui slope ierorlasticry. Stdcty speakinq tis nconect to characierze anylinear demand aspric eastcfit s fat, andasprice inelastic f it issteepB!1,5ncefor two lntersecting I near dernand curves, thef alterone s pri.echanges indeed fot moreprceelastic then, snatl , pr,ae, t is accepted arcundthe inErsectian to clam that prceelastic wher.s a a fatterdemand curvs reatively reatively y price inelastic. neponeis rlative

15

Dema
. The case o{ a perfectly inelastic demandurve: PED=0 (Fiq2.8)isthusvertical Thedemand curve at some quartityAnychange n price w ll lead to no change n quantity demanded. Figure 2.a Prfectly price-inelastic dema ndcurv
equa tototare&endirures

Figure 2,10 Unitary etastic demand.utue

a/Period

A lareas beowthecurve reprcsent fnm revenues andare equaIn size n otherwords in a untarylasUc demancl clrrve a change in prcedoes notchange tota firmrevenues. Relationship betwen PED andtotalrevenues . Whatwill happen (andhence io flrmy revenues !u Oltenused to describe the case of hlghyaddtctive goods consLrmr expenditurs) if there isa change in price? The such asdrugs orto descr betheindivdualdemano ror answer depends on rheprceelasticiy of demand Tota pharrnaceLrtcal producisforwhich nosubstitutes exist. (TR)wh revnLrs ch a firmcollects arerheproduct oT the . The(aseof a perfectly elastic demandcurvei prceperunt andthe qLrantiq? = PQ).t is nor sod (TR PED 'J thesame asprofts wh ch arethe d tferefce between the (Fg.29)ishorizontalar The demand curve some totalrevnues co lected andthetota costs incurred. prce.ft s used to describ the demand ihara perfectly Three cases canbe distnqrishd: competitve f rrnfdces. Such a f rrnisso'tiny'lnsze . Case li Price changes whenPED >l (demand rs compared to thema*etthattcanse anyamount at the price elasti<) gorng market prce.lt s asif t isfacing a perfcrly elastic A change in prceleads to a change n the opposife demand at the market price dre, io'r. o ,"--rr\ oF^"noao. W.er oe-onoi p.i.e qlanlitydemanded Figure y price elanic, 2.9 Perfect propottionatety elastic .hanges demand curue morc than prce. Thus thechange n quantity has a bqgef effect on revenus thandoes th chanqe in prc.th!s, tf derandiset..i . rorale'pprdir .ro--a-ge\i lF .j-p dlrecton asquantry demanded. t.fp rsesthene falk proportionately morefhusTRw ll fal/ Burif Pfa s, then more Q rres propoftionatly andthusTRwill,se. Case 2: Price changes when 0< pED<1 (demand is prjceinelastic) h lh s case, price ses pfoportlonaret morethan qlantrty. Thus, the chanqe in prcehas a bigger fiecr on totalrevenue thandoes the change in quantity. Tota rcvenues change in thesame d rect on asprice.f Pr/Jes thenQ fa s propononatey less, rhus TRr6es. But J p lal/s, propononatey less, Q rises thusTRfal/s. (hanges Case 3: Pri(e = I (demand whenPED it unitaryelasti() Inth s cdse, prceandquantity change n exactty the proportof.Thedemand same curv isa'rcctangutar hyprbola' Thecareof a unitaryelastic A change in price will have no effect demandcurve:pED= 1 on (Fg.2.10) lotalrevenues. lhe dmand qraph curve On a of bra/ reyerueJ n this case isasymptolic aqainn to e, the function bothaxes,.e t nevertouches wil bea nra ght linpara eitherThedemand le to the curue s a rectangu ar hyperbola.
Q / period

. (Hl ont) Defnemarg na revenue asthe extra revenue lrom se ling one more unit of output. I\rtR is thus the t lo owsiromtheabove thatthere isa close reationship change in TR because of a change nQsoit sthesope price between elastjciq/ of demand andthe shape ofth oltheTRcurveAt Qmwhre TRis max mum tfo ows totalevenues curve a firmfaces. that MRiszero lfdemafd s a negatvelystoped nethen Focusing on Fig.2.l la whichillustratesthe typ;cat, NIR has dolble thesope.ln Fq 2.11a tiw thuj 90 linear,negatively sloped demand<urve: through outputQm. quantty(attheorgin)roral At zero rcvenues arezercand Fo(using on Fig.2.11bwhich illustrates a un;taryelastic (point at zeroprice H)totalTevenues arca sozero. 4sp':ce decre"se,4h nl of wdllr'gdo*n .l.ep:ce . Thepercentage increase n qu.ntty demandd sequal axis) ftompointFto Pm,quanUty dmanded increases to th percent.ge decreas in price. Asa resu ttota lrom0 to Qrn.Sncedenrand for that price range is prce revenues (constant). remain unchanged In the bottom elastic the result ng ncrease in quanrry demanded is draqram TRisthusdrawn as a paratte straight tine to the proportonatey greater sotota revenus rise. quanityaxis illustraUng thai rotalrevenues do not chanqe Now skipto the rndpointprcePrn. tf prlce continus pastPmallthewaydownro zero, to decrease qudntiy Focusing on Fig. 2.11c whichillustrates the case of a demanded increases frcmQrnto H. Slnce demand s perfectly elastic demand curve: now price rnelastic, th resulting incrcase n quantity . Here thefim issotinythat demanded t can s proportionalely sellall twanh.t the smallef, sototalrevefues prceP',say, for example, f3.00 pefunii.ttfottows that thetotalrevenue Since we established curve isa rlsing stEight neslanng that revenues rse attrhe way fromthe orign asthe revenues r o t e Tidoo-.Or drdrher. fromoneunt sotd wi be right df,arOr.-l^ej f3.00,the revenues decrease, fromtwo unirs it necessan yfollows sold wi be f6.00, thatai Qmtheyareat a the venues ra\ TL1. ThLs.gl . belowtLe lrornthree units sod will be f9.00 erc. Tidpo 1t o+rhe inedr dema nd curvewhere PED isequal to 1, tota revenles ar
Figurc2.tl Price elasticity of demandandthe shape ofthe total
l4 (b)

PED andthshape of theTRcurve

=1 PED equa to tota expenditures

17

;;i;;;;;'
Thenumbe'dnd(loseness ot available subnitutes ' Th time period involved Themore subnitutes there arefor a qood,andthecloser Wlren prceof a prodlctrsesit takes som t mefof these are, peopeto findalternatves the more easiypeopewillswtchto these andadjustthn consumprion {he'l r' e or' e o--_. oood 'se<. patterns. or..l L_e lt lolowsthatthe longerth t meperiod after " .e'ni-i\Fs (Aso threfor,. wr bethe price lasticty of demand. a pflce chang, price the more eastcdemand is likely th nk of how brcadly qoodis defined or narrowythe e.g Pepsivs softdr nks ihe broader the definitlon, The natureof the good,:.e.whetheror not it is the fewerthe subnituts available to theconsLrmer andthLrs the moreprcejnelastlc demand isexpected to befor Demand for addct v prcducls i5relatvey price inetanrc prcechanges (cqarettes, small alcohoetc).Ths hasprofound ) mpicarions The propo(;on of income spenton the good on the decsion of governments to impose a taxon such Theh ghertheproporton of ncome spent on a 9ooo, the more consumrs w lbe fofced io lower cons!mption (theb qgerwillbethe income when B price riss effect) andthe more elanic w bethe demandf we spend (f it s a smalproporton of ourincome on a good thefactors affecting the demandi ; Studentoftenconfuse 'nsgnfcant)thena change n price willnotaffect our p p odLL\^il -_. raclols lor g r' i a' e, i ori i " sodi,o bll d!ror'. dep..e n"d." ".rd \i op i p" | , ,
"r, ^ ""--^^ '^ , ^,^^

Usesof pficd el
t permits a f rnrto predict the d rect on of chanqe of its given totalrevenues a price chang. Forexanrple a f rm wishing lo increase 1srevenues w lowerthe pricef dernand isthouqht to b price eastcanditwil ncrease the price lf itsdemand s price inelastic. . lt allows comparlsof of quantiry change\ withnanetary (le.price)changes . (Ht ort) lt permits a firmto,"mpoyprlc d scrm nalion. prce Thh ghr willbecharged n themarketwth the reldtively neastcdemand. . (Hront) lt hepsa firmdterm newhatpropod on of an nd recttaxcanbe passd on to the consumer t permits a govrnment to estmate thesize ol th necessary taxrequired to decrease consumption ol a 'demerit'good, such ascgarettes or alcoholtc beverages ontl t peffnits the government fHL to determ nethe ncdeiceof an nd recitax. t hepsd governmenl predici rheeflect of currency deva udtion on thetrade balance ofth country

Income etastici!,i,j
Definition Theresponsiveness of demand whenconsumer canthusdistnguish between normaland inferorgoods based on whther YED is positv or negative . f YED >0:thegood isa normal goodsince demand (dcreases) ncreases asconsumr ncome increases

Symbol:YED percentag Measure:The change in qlrantiydemanded d vided bythe percentage change n ncome: . lt YED <0 thegoodisan inferiorgood s ncedemand vtD = o;AOo oo^\.tLus vtD = Ao/O,/A"n j.(rncrease, decreases a! consurner ncome incrcass (AQ/ YFry,/Q,) (dcreaset. . Since ncorne eastcity of demand stheratoofthe Focusing nowon normal goods: percniag changes in demand andincome eves t . YED >1:thisirnples ihat %AQd > o/oAY therefore we say folowsthat f bothchargs (plus arpostive sign) or fa. F den drd r),r, o ne d.acarseInrnrome oos (m f botharenegatve nussiqn) thenYED isa posltve to a taster rse (aproporrlbratet greater ncr-6ase)in (plus number t onechange ispositiv sgn)and theother demand. (as Luxury goods we as rnost services) usuatty (minls s negative sgn)then YED isa ngaiive number arconsidercd ncome eastc,lor exarirple demand for For exdmpf an incrase n ifcome ads to a decrease planic surg-ary or for spa iherapy for or haute couiure !n quantity demanded thenYEDs a negatve numbr We

lxome e
o/o^Qd . -< YED we <1:this mpiesthat < %AYtherefore :.y rhatdernand is ncomeneastic asa rise in ncome (apropo,'tlonaiely :dd5to a slower rise smaer ncrease) (everyday qoods) goods goodsi Baslc 'stapie' - demand. (e.9. y .r. usua ncome inelastic dmand forfood asa
1. . : d . , 1 r . ^ n , k n . ^m o i.!l:< ii.l

'

: YFD= 0 then demandfof the good ls not affectedby a c.d ngeI n nc om e i YED= 1 then ihe perceniage change n ncomeis equal percenlage quantity the n demanded. change -o

income eve Y] low evels of lncome andup to some the Engel curve isABil ustrating thatthe qoodis norma i. " dsde-li'rds r yrg w, I .EDpos. /e ._d rhe'p " greaterthan fse more verticalintercepi one) 16 nconres fromleveY1allthewayto some ieveY2the quantity prperodstays demafded cofstant soYED iszero'and, past f lncomes ris further Y2 perperiod thendemand for th s goodstarts to shrink signlfying thatthe good product behavs asan nfedor andthatYEDs ngative

nps
Remembr thatelast cityandsopearenotthesam th ng soven{ threeEngel cutues areparalle their citles d fferas n Fig. ned elast 2.1 2a.A so,Engecurves pont notblnear n this caseludging whether at some theyare ncorne eastcor inlastic becoms a bit more indunresare Some considercd'cyclical' andsome 'acyclical'as a result ofthelrincome elasticrly of dmand asov,arall economic actvityfluctuates n theshortrun(ths f uctuaton of economjc activ ty s known asthe 'trade' or 'busness'cyc), sales in th constructon, the carandthefurntureindusiries are y.ffectdwhereas s gnficani sales in thefoodindustry arcnot affected asmuch. TheJormer industries are 'cyc ica'whereds the latter is'acyclical'.

hgel curves :.aphsthatshowhowquantity vares wlh lhe demanded ve of consumr Lncom ncome areknown asEngel curves. 5.rsually onthevert calax s. . ln Fig.2.12athree A three Engelcurver aredepicted. represent normagoods asa three arpostivey s oped ustraUng thatasincome vesrse,quanttydemanded perperod also riss. But, ncome elasuciues d ffe( Engecurve 1 wh ch hasa vertica inircept at po nt F (without s incorne eanicthroughout itslength YED being connanD; Englcurve 2 whichgoes through the orign0hasan ncome lasticry of dmand equalto onethroughout itslengthiastly, Engecurve 3 wh ch has a horizontal ntercept at pointH s ncome inelanic lhrolghoutits ength(without YED binq constdnt). . 'lo ) )h.heprobdbee"el.o ri,ngtr.one/eh on the demand for a product fror. s shown:starting
Fl9ure2,'12 In.ora eldrLkiLyof deTd-d: t-gel (utue( (b)

. Thedegreeof 'necssity' of the good lr a dveloped counlry the drnand for llxurygoods and services expands rapdlyaspeople3 incomes rseturther, whereas the dernand for bascgoods, such asbread and most{ood products in genral, rsesdow y. Engel's law states thatasincomes increas, a declining propo,'tlbt s spent on foodbecause of ihe'fixedcapacty'oithe hLrrnan stomach. Demand forfood s therefore 'icorre nel.stic. Furthrmore, certain bas c foodstLrffs may beh.ve goods, as nferior meaning thattheir ncome eancitesarcfeqative. Thus, asincomes peop increase, e

maysubntute basmdtirce andmLrltgra n brad for ow'qualty rce or wh te sliced brcadAsthe r in(omes

'. e J u - . l e . o t i l e , o e n o u . F o - l o o o n d y e v e i r L r e a A

but t takes a decin ngproporrlolr oftheirincome. . The livingstandafds ofthe economy Wheiher market demand for a good is ncomeeasicor incomneastc is notwith n ts 'naiure, but isa function of the livnq standards pa(cipanh. of the market The goodmaybehave same goodw rh negative asan nfedor YED in a hiqhly developed counrry andasa highly ncome-eastc one n a least devloped country

. Frmswo! d keto knowwhether . A government dmand for rher mayalso be interened in knowng income product s hghy ncome lastrc or rather income neastc elasticty of dernand n v.rious sectoK in ordertopan to hep thembetter plantheirinvestments. tf an economy ahead tra ningfor displaced workers: theconorn c rsgrowing and ncomes are noeasing fastthenf rms sgnficance andviabilty of income inelastic sectors w produc ghrinkn th ongrunsosome ng h qh y income-elastic products mdyhave ro workers in these sec@rs nvest nowrnexpand ng theircapacityto be able io meet may osetheirjobs andw need rtrain ng.Inth s sense, 'he rrLea.ao derc o..o,lvFrcp!, .d). . -e " 9ro\^'r9. a growing economy (structura maysufJer ffomincreasd ) potatoes may th nk of swtching ro kiwifrut lthisexpains unmployrnent andmov awayfrom ful mptoymft. whyin Ethiopia grow6 coffe areswtchng to chat,a Aho,assecroE producing h gh y income-etastic products rorroaqo oJr .- \^f ch h. e d l. qf'a . ,o.re ^arcoLi (e.9. serv cet willgrowf.st,enrployment needs w ta so e astcityof demand. growTast sogovernmnrs shou d pldnahead changes n schoolcurri.! a andvocat onalschook. Empoyment botiefecks willthusbe avoidd.

prir Cross
De{inition: Theresponsveness of demand fof onegood(x) to a chanqe in the price of another good(y). Symbol XPE or CPE Measure: Thepercentage change n thequanttydemand-ad ot qood. d vided bv ,h- o".ilr-aoe c d 96 In ha pr, F oi goo0y: = %AQ"/%APY XPE lje'" .l e sor de-"rTtr e- \o!1 wa i--o.oret cro$ p i,e e ancityof demand for a product: . if XPE >0,thenthetwo goods x andy aresubstitutes meaning thattheyarein comperitve demand: Tone becomes more expensve thenconsumer w llswitch to . lf XPE <0,thenthetwo goods x andy arecomp ernnts mean ng thattheyarejointly demanded f onebecomes more expensv andthuspeople buy i less, theyw lt a so buyless ofth othefone = 0, thenthe two goods l XPE x andy areunrelated. It io owsthatthefurthr away fromzero XpEs, the lLo redlor"'r.o srronoe/ oe.we6r I p oood<. Co-\e -e,/. the coser(absolutey)to zero XPE is,rheweaker the relationship between thetwo goods. Figure 2.13allustrates the case of substirutes in which pnce cross elastciiy of demand s postive. tf the prce of coffeencreases fromP] to P2thenwe expect rh.t the qlantty demanded perperodof teaw increase ircm Q] to Q2assome w I switch away fromthe now To'e e o- li\e .os-F to -eao n\ rg. \o-o rl-a-r'ris is not a demand curve ason theonaxiswe have lne prce perunitof onegoodandon the othertheqLrantty perperiod denranded of another

Cross
. Figure price through cross eastcity.anbe ustrated in which Alternatvely 2.13billustrates the case of compemenls _eoat of d lle the set agraras below: 'osc pri.p /e. L_ or:c. Liry o der cnd s "d, of cotree incrcass fromP1to P2thenwe expectthat . In Fi9.2.14 isshown on the eil to r se the prlce of cofiee perperlod wil decrease thequanttyof sugar demanded to ng consumeB to switch fromP] to P2perun1,lead coffee fromQ1to Q2assome w ll quitor decrcas for teaisshown to shft to th tea,a substtute. Demand perperiod cofsumplon leading to ess sugar demanded r ght fromD to D'.
A gair. iL c \ ro .

have the prceperunt of onegoodandon th otherthe quantity perperiod demanded of another. . ll instead vey soped newe had of a posiuvely or negat of tlvo totally a verticalne it wou d lustrate the cas products of unreated where XPE iszero.fthe price for iPhones lo cheesecake rises we expect thedemand remain unaffecred
(cPE (cPE <0) Figlre2.13 S!bstitutes >0)and complements

"

d Fr dnd . L v e as or I l p o e d\ is t p

Figure 2.14Case ofsubstitutes

! g

Q2

Q1

Q2

! I

Q2

Q2

o1

Cross
Figure 2,15 Case of complement!

I
E I

a2

Q1 per period ofCoflee Quantity

perp od ol Sugar Qu6ntity Uses of closspriceelasticity ofdemand . priceeastcity o{ demandis usedby poticymakers Cross to dlrneate ma*e1s t helpsto know the s ze of cross pfice ro decde whethermuf{ ns and egqs -aastcites ' ho- o oe Lo i oorpooeo' gi .g t-e.an" ma." ra s K el l oggS cerea. Firms can usecrcssprce elastictyto guidethe r p, qrg

n Fg.2 15theprlce of coffee isshown onth efrro rse tromPl to P2peruf t, eading consunreB to cui down on sugar, a complement. Demand for sugars shown ro shit io rhe eft fromD] to D2

Price
Definition:The responsveness of quaniiB, suppted when Figure2.l6 Pri.e-elasticsupplycurue the prceof the goodchanges. PES Measure:The percent.ge change in qlantitysuppd d vided bythe percntage change in prce: = %AQ5/%AP, PES = (Aas/a1y(Ap/p1) thLrs PES = (^Qs/ P)*(P,/Qr) Thesignof PES s postives ncesuppycurves typicdry nave a postive (firms slope ofiermore perpe od.r a higherprice). Ranges of price elasticity ofsupply . Suppy (fofsm.lchanges ispfice elastic aroufd rhe nital pric) fthe percentage change n quanritysupplied s larqerthan thepercentag chanqe in prce(pES >1) (Fig. 2 16). Alternrtively w cansaythatf a change n prceleads to a propo,.T/onatet qreatr change in qlantty supped thensupply for the prodlct s price eastc
(b!i not.onttano PEs > 1 ar all poinrs Linear throushthe vertkal(prjce) aris

Priceela
Infi ni tel y(perfedl y)el atti csuppl v.urue thatcutthe Paxsareprceelastrc: Fi gure2.19 supplyfunctons Al inear the (forsmaLl around . Supply changes s priceinelastic suppLied ln quantity change prlc) ifthe percentage iniiial nprice(0<PES<l) chang ihan thpercentage issmaler 'I g /l,.Alterdrvey^"'dn-dv-l'd rra'no,lgFi' ln quantity change smaller pdceleads to a proportonatet prce ineastic product is the thensupply{or supplled curve lnelasti.suPply Figure 2.17 Price

(Perfectly) Elattic SuppLy Inllnitely

(quantity) axs horizonial


Q/Pe r iod

. Supply in prce inelastic if a smallchange is perfectly = 0) ied(PES supp in the quantity to no change leads (Fig. no effect on the amount have 2.20). ftce changes elasticty of zeropric-" perperiodAsuppycufr'e offered isa verrical ineparalto the pice axrs prke-inelasti(5upplycurve Fi9ure2.20 Pedectly

thatcutthe Q axsarepnce All linear slrpplyfunctons inelanic: ln quantity . Supply change is unit elasticf the percentage pn'e n percentage cnang the s equalto slrpplled (PEs = 1)(F g 2.18). curve elatticsupply Figure 2,18Unitary

Llrearthrolghthe or glr

Q/Pe i od

go .l' ouon theorgir are rsl'ror A li-"". -.pp ,1 .n(.ro !nitarylastic: in prce . Supply elasti(if a smallchange is perfectly quantty suppled in argchange leads to an nfinitely rm iswl Ling (Fiq. the f (PES means that 2.19). Thrs -) -) the current at market demands much as the lo offeras
p,-.Asuo olv L1eot nf i, lilep. elos i' I \ \ oli _ D

: ::. (of supply)and are (price) slope elasticiq? Rememberthat ihe slrpply iswhethet ]rorthsame thing.Whatmatterc the odglnorthe horlzontal cuts theverticalaxis, curve curue 1or supply lf asked to drawthe(short-run) axis. (e.g i as e coffee), draw prodrct wheat or larm a = 0)asproduction of suchptoducts vertcal ne(PES to descr be s charactefized by org umelags.f asked coud,draw a tennis or say, mafket conditions for a hotel f any, ability ls limited, curue vertic.asthere the supply per etc.) rooms, to change'quantity'offred 6eats, tions cond period ln demand fo lowing a chang

Tips

.=

axs. para le to the quantiq/

Thetime period Inconom cs,t meisdistinguished intothe momentary (ormarket period), the shonrLrn andthe longrun.The distnction i5based on the extentto whichadjustments (ormarker) canbe made. Inthe mornentary perodno adjustments areposs b e n the short runsom, bui notall, adlLrstments arepossibe nthe ongruna adjustments areposs ble. Concerning more thetheory of producUon theabove (or dei n_tt ofs be.ome more specific. Themomentary markei)period iswhena factoEof producton ar cons dered fxed,thefirmlsoperating in the short runwhen some, butnoia, factors of producton are consdered fxed whilein the longrunai factors of production (nofixedfactors areconsdered variable exist). tfollowsthatin the momntary run,supply s perfciy (vertcal). ineiasUc lf demand for the product increases quantity supped rcrnains unchanged. The ncreased der.and w be expressed onlyasa h gherprice. Supply is notat allresponsve In theshortrun,rhe ncreasecr demand wl be partia ly expressed asan ncrease in quanttysupplied andpartiay asan ncrease in prrce wh e n the ongr!n, whenallfactors arevarabe (and thusthet rm caneven (15 increase itsscale of operations sze),outputcoud expand even moreThrsinthe onq run,slrppyistypca y expected prceelastic 10be more thanin theshortruf.

. Extento{ xcss capa(ity. Thefurrher belowfurl capacitya frm isopratinq plce eastcity the greatefthe ofsuppy isexpecred to be. . Whether thef rm mploys mostly skilledor unskilled labour.Expanding process output n a production that predominanty re eson highly sk ledlabolrmaybe more difficutthan f monly!nskilled workr wererequ red. . Whether long or sho( time lagscharacterze the producton process. The onger thetime aqsinvoved, thelonger t iakes forsuppy to adjustto newdemand cond tions Aqrcuturalprodlrcls arecharacterzed by ong timelags sosupply isoftenconsidered perfcrly neastc . Thespeedby which costs rke asoutputexpande. Firms w ll b. e.r'oLraoeo .o e.o"10 or-o-. bvrore p-. pe.iod thelowerth add tional(marg na)cost of doing so lmportan( of pric elasticity of sopply . Piceeastcity of suppydetermtnes theextenr to which anincrease n dmand wllaffect qlanrty theprceand/of oftheqood in a market. prce-ineanic Themore suppty
r , . l l _ o 9 p d t p . l r r e 'l . p d s F i r p r c e g v e , l d , l , pd,e n

demand; the more lastic suppyis,the qreater ihe mpact ol an ncrease in demdnd on quanrty.

Price controls
Prcecontros refr to cases where for some reason the government consders th (eqLrilibrium) market-determined priceunsatisJacrory andasa resultntervenes andsets the price erther beow or above it.

Maximum
. An authorty, usuay thegovernmenr, sets a maxrnum Figure 2.21 Maxlmum pdce(p ceceiling) price to asa prcece ng)if it conscters la so referrcd themarkeldetermined prceas toohlgh ltthusams to protectthe buyers of the product. As such it s seton 'sens tive'prodLrcts that mony ower nconre houshotds buy A maximlm prce s a prlc serbeowthe markt prceas t makes no sense to setit above. n Fg.2.21 atthprice Pmaxfirmsw I bewilllng to offer ts prperodurhereds consumers w llbe wii ng Q1 Lrn andabe io purchase pefperiod. A shortage thus Q2irnits resLilts geometrically equal to Q1Q2 unts perperocl (orHF). 5 ncea shortage exstssome consumeBwillend up not
6 .ovi-o lr p good ov6r ho-91- hF/ drp bo-h *illirq a-d abe io pdythe pfice.lhis medns that the priceme.hansm ; - o pedo _i r ' o ro n r_ g L -c i o 1 , ;.F . d i . -o o o..l e the good to whoveriswillingand abe to payfor lt. Therelore an a ternative ratoning mechanisrn is requrcd.

Allocaton on a'{ rstcome, fi6t served'basis. This s lkely Policiesto reduce thersulting shortages -o oueJei o lo ledd 'ire. of oaop e)de.e oprg d. ppop . Tominm zethese probems goverriments mayattempt wll rush to buybeforc supp iesareexhausted)orf ms io reduc the (.e. shortages byencouraging suppy adopting waitng ists. attempring to shift supply to the riqht), for example by se'"'s p e e e,r(e, 1a! oecroe goo.. v\ho 9e.,.,re dfawing on govemment nocks, by direct producton or product The maythus beallocated on the basis of who by granting iubs/dies ortax re ief 10 f rrns Alternarlveiy, the cLrstomer is.k hea regu ar?ls heattract ve?k she thymayattempt to rduce demand byencourag ng the ':r oo-d_rI -ferrdrLer \rotonqer-lp',or dl'd mdjo production of more and cheapersLrbsttutes. advantage)but becomes'persona', sod sclmlnaton may Theproduct could be a ocated on a random bass(for example, by ballot). Coupons could b used to faton the qood. This a ternative hasbeen usedn t rne!of wa. probem A major pdces with maximum isthe likely ernrgence of b ack(para lle) markts where custorler5, unable io bry enouqh in egal markets, may wellbe prepared to paya muchhigher prce.In Fiq. 2.21ther areconsumers w lingto payPbto acquire unt Qb The willngness to p.y,measured bytheverticaldistance from the horzontaaxsto the demand curve, ls greaterthan ihe maxmumprice, for allavaableunts up to lnit Ql. Inthe longrunadditonalcosts mayemerge TheqLralty or certarn products mayworsn asproducers maybe -.moredo .4(t^Faper rp_._. aso. .o.hFrror_prrp_ controld products canbeproduced using thesame nputs thensupply m.y shrink furthr, makng shortages

nps
Rernembef, thatevn though seemingly countenruitve, a maximum price mustbedrawnbeowthequlibrum leve.Toavoid confusion asio whther a max mumprc shoLl d be dfawnabove or below the market-dterm ned prc-A think of thealternaUve term'price ceiling':the qova'lrre - b nld-d'ce'lir .hep ce 'on s o otove'rr risng towards the equ ibrium level. Also, theshortage crated rsnotan area butthedistance between the ouo'rlrLy -y rrpphed dendrdeoard rreqLdnr d. .re ,e price. L near demand andsupply curves arepreferable to use Lasi y, lent controls'are analysd n thesame waywtrr rentprunt on thvrtcal, apartment units perperiod on the horizontal, the shoar,run supply of apartment units dmwnperfect y nelastic ard the ong runsupply of apartments price more lastlc.

Minimumpi

.riiiit Fiqure 2.22 Minimumprke (prke floor)

An authority, Lrsually the qovernment, sets a minirnum (referred price to also asa pdce floo, (rg.2.22) fii consideB the market-determ nedpdceas'too ow'.A minmumprices setabove prce the market-determrned (most and t arms at protecting producerc oftenf.rnrers). In order for a pdce floorto beeffective it mlst beset price. above the equlibrium price Setting a m nimLim isako known aspricesupport. h Fig. 2.22at the prcePmn flms arew lingto offer whereas buyers arew lingandabe Q2uniisperperiod to buyonlyQ1 unts perperod.Assum ng competitve markets, a su|pusrcsLrlts eqlal to Q1Q2 unis prperod (orHF). Thegovernment s forced to buythis surplus. il it doesn t Lhe Ie'ndr."rorcew d b"owr'"pqLlib.iLTpce assellers willwantto r d themseves ofthe extra unhs not bought at Pminl This surplus mustbe bought at tlre

'::-.;

Minimum
(Q1Q2HF) whichsthe qovernment spends area The thus t musl buy, prcet pays thequantty Pm n trr.es QlQ2 oT the (blyert areworse off astheynloyess Consumers
p o o-cl a r " I q her oer J r " p '. D odl q\ d e b p - o

Tips

(a ne but a d stance is nol an area Thercsulting surplLrs rather price. supply cutue Drawthe segrnent)at the set xpendrturs areh gherGovernment off dsthelrrcvenus us s not 'unreastjcally tingsurp steep sothatthe resLr (orqovernment has to ng n otherarcas spend rise curves andsupply near demand large Preferaby Lrse beaf eventually thentaxpayers lf spend nq r6s decrease). 1ive, counterlntu even though 5eemingly Remember, thrt asthypayforit in thefom ot of thispo icy, the blrrden _11'1pri.o !o rilbiLa a^1ooo'e LLre Trr 111 . oe o a p . l pnt ro ,-. . ' o d t F d . o o, e. p- ooLr e s 1 C.6a ,od ^n qovernment a 'f oor' sothatthe prce levl:the builds for ToomuchIand, misallocaton. res!ting n resource level. Thesame not dropbeowthe desired does of th s f:rm in the producton w lbe a located example, y,tical to dessbe can be employd .na framework thevertica wagelegisationr theeffects of mlnimum rate(W)per measLre in thiscase isthe nroneywage (t) of workers worker; the horizontal depctsthe number _r .\ -ne_oor-F'rl .1d -l'p 'p . rpo.ed ep'esp

andsubsidies lndirect taxation


Actions
by mponng resource allocaton a soaffect Governments andby granlng subsldies nd recttaxes . Indire.t(orexcise)taxes on a per be imposed caneither (known 0 80 per for exdmple, as'speclflc' taxes; unt basis oT theprce(known pack or asa percentaqe of c garettes) tax). added for example a 19%value as'advaorem'lax; oi conslrmptron to discoumge ndircttaxes areimposed yon ooodsildL{redle goods de"n"ri a^dro - oelera to rase arealsomposed negative extrna tes.They
.c\e ,lro, o 'le gov . r - Fr \ oLe r d d' r t J . olo e, "andservices goods to discourdge mposd on imported y,s ncean ndirecttax caL Diagramrnat thel consumption. shftingthe supply, prodlrcton costs tdecreass increases betlveen the dstance Thevertica supply c!rvetothe Left. Fg 2 23,beow) t tax(see istheperLrn i\rvo supply clrrves

to nrms, bythegovernment Subridies arepayments whichainrat typica ly on a prunI of outputbasis, prce, producton costs andthusthemarket lowering aswelasfirm andconsumpton wh rais n9outpLl n groupt esaregranted to s!pportcerta revenues. subsid producton (farmeB)or the to enco!rage of producers pos tL\ n goods thdtcreate of cefta andtheconsLrmption (malaria a form oi They are a so vacc net. externalites of a protecUon to domncprcducers sma5theycon{r to lewerLmports product edg thatleads a competilve s ncea sLrbsidy or even to expoG D agrammatically, shiftng producton suppy, cons t increass decreases Thvertca distance to the rlght. thesupply curue isih,"perunitsubsidy between curves thetwo supply (se q.2.2s, page F 28).

i Indirecttaxation
indiredtax Figure 2.23 Effects of specific c!rve wth a demand is llunrarcd In Fig. 2.23a market ons condlt 5.Demand andsupply D anda suppy cutue bfiLrm at polntEw th ma*et an in tia equil detemine quantlty of prceeqlaltoPoperunt andaneq! librium perperiod QoLrnits of asanadditonalcosr Theunttax may beconsidered amount rcse by the producton. costs lt'sa5lfproducton Lrpward bv verucaly curv shifts of thetaxsothe sLrppy Thevertca distanceAB the amount of thetaxABto stax. thatin the perunt tdx (Note in Fig 2.23isthls equalto bth marginalcosl the supply curue cornpetitive markets the marginaL vey in.reases curue. 50an nd recttaxeffect up at each unit,shftifg the MCcurue costof prodLrcing each Levl of output.)

r&ft

indirecttax =. : :l :he market pfice r ss lromPoto Pmprunt - r -liE.:i quantity .'i!m decreases fromQoto Qmper thus shrink. of thegood Frc :-ip!t andconsumpion (= +:,:rr-:arn per they have to only Pp HQm) unt as -ir Ther newaverag than revenue isthlrsless 3ai prceandaverage revenue Po :rE -: -al, pre-tax -:

d.

Thegovrnmnt taxrevenues equaltotheshaded collects (PpHFPm). thetax area isfoundby mutiplyinq This area (PpH) (which perunt (FH) is of unts sold bythe nunrbel equa!to Qrn) (unlessthe good s a demert Resources arernsa ocated qoodor a goodwh ch creates negativ externalltet as t".- 1r... ,o-d /opinatarour.o tpgoodi(now prodlced andconsumed. Wlfare losss eqlalto arcaFHE.

. -ar n.dencerefe6to who pays will have sothe denomlnalor mun tend of a tax. to tendto nfinity whatproportion . producGw be price to zero. ncden.eon g.2.23 d d not tfollowsthatthe F reva s that the rnarket --..inq 0% andsoit w lbe 100% for cofsumers Note that f ofthe nd rcttar imposed. -c--:e bythfullamount -_--tze of thetaxi5FH(thevedcaldistance = PED ly PES shar equa ihe thenconsumeE andproduce|s between (s0% prce each) a tax. :---.x.nd the post-tax supplycurve, wh e market 1-.ied onlyby Fl . : 3wsthatthe incidnc ofthistaxison bolh . Equlbr umqlantitywi de.rease are ess, th ess eiastic producet9. :..i!mers and consurners andprodLrcers lor the demand andsupply. lt fo owsthattaxrcvenLr (= PoPrn) is FJ i:? ihe tax.Tax incidence on consumers government w! be greater .1-ieas tax lncidnce on produceBslH (=PoPp). prcwi rise N/larket more andhence the consumerc' . ;, :rcidence demand depends of the priceelasticiq/of s demand share ofthetaxw belarger, the esseastc :.1l.e prce elastictyof supply. The fo owng holds: andthemorc easicissuppy. q of t ax in( ; d e n c e o n (o n s u me rs ^ --,^ -.. pic wil rise the producers' share N/larket less andhence \ ot ta'( Incrdenceon ploou(ers will b arger, isdemand andthe less th morc elastlc e anc s suppy. F5_9 n mindthat the two percentages on the eft
:. jd up o 0 0 o o .l -" - e ' o red l o r o ' .h ea b o vp i

. c thenthe moreprc-elast :1en prcee astic ty of supply, on producrs. tax ncdence ::Tdnd is,the qreaterthe -"is s sens the wi be morepice-easlic bleasdemand j.e.tr the number subntuies andclosenss of available alternativs to resod consur.erswill have ic consumers. good. :o folow nq a taxon some rp' n fie e"rrcme Ldre \ here .l'ere.'4 o,Jb5.il . prce neanLc(PED=0) .vaiable afd dmand isperfectly mustbe 0% andvetica thentaxincidence on prcducers (thedenominator side of the equatlon) on the eft-hand consurners areburdened soit is 100%on consumers. s holds if supply bythefull amount of thetax.fhe same on the eft perfect y eastc(PES tends to aslhe fraction -)

ll isafgued thata taxistypically fuly paidbythe consumels. Howcanthatbethe casefthe aw of lity? Theanswer demand has almost universa applcab oftenbelng s lhatsuch cases arca result of f ffis very qudntties perpfiod atthe same able lo supply ncreased prlce thelraverage returnsto scaler becaus o{ constant outpLrt. andmarq na costs do not change astheyexpand fo owing Doconsumer tures increase or decrease expend on tlre prrce an indrecttax? Theanswer s that t depends 2.23t should lre elastic Focus ng on Fiq. ty of demand. , er. .fa. ,-re o. gl a,"ld .l.et'ralpo lib'L-ooi ( whethef ara curue. Thus, EandFaron the demand area OQoEPo depends OQmFPm or smallerthan isbrqger
O NP E D .

E tr
D
D

. What fthe tax s a percentage 1ax? Sucha tax s anaysed n the sameway as a per un t tax exceptthat the sh ft of suppy is not pafa l but the 'wedge' {= vefiica d stance) wdens at h gherpdces. TheefJects are identca tothose

p
Figufe 2.24 Effectsof a percentage i.directtai {VAT)

E i.

n Fg.2.24d percentag tax s i unmted. n l al y ma r kei demandand marketsupplyarc at D and 5 rsp-activey with Poth nit al marktpr ce and Qo the nit al quantir bought and sold per pe od. Let a percentaqe t.x (e.q.a 19% VAT)be mposed. The do ar (or yuan)amountof the tax at eachpossib e pricis no longerconnant Thisis why the vertca distance UR s greaterthatthe vertcaldistance AB. The new suppycurve S taxs no ongerparal el to the ori gna supplycLrveS.The 'wedge at eachoutput level, wh ch ,! i p dn oLl o h- o. bF o^ ol b qqer..l d b qqo.

Tips
Todrawa specifc lndrecttaxdiagram a ways usea r!ler andstafioff by drawnq two parael supply urves. Labelihem properly andthendrawthedemand curve From the intKcton of the 'rew' supp y (Stax)and the (point demand curve F n Fgs2 23 and2 24)dropd Ine (Qm)Reazingthat to findthe neweq! librium qLrantity the newprcePmisqlalto ne FQm yo! nust subtracl th tax(thevearical disrance) to f nd the newnetof tax prce(average perunitof rvenue) the producer earns = oPp). output(HQm

subsidie5
A subsidy isdefned.s a pefunt payment to f rmsby Figure2.25Effects of a per unit subsidy the governmenr a m nq at owerng ther costs andthls production, thema*etpdce and ncreasng consumpton andfirm revenues ts anayssissymraetcato thatof (and an nd rccltaxasnowthe qovernment s paying not gettlng paid) a pefLrnit ar.ountof money to l rrns Product on costs are owrbytheamount of thesubsidy (the sosupply shfts vertically downward bythatamount marglnal costof producing each unt of outputs now ower). n Fg. 2.25 the nlia demand ands!ppyconditlons represented bycurves D andS ledto anequi brunrprce qu.ntly Qo perperiod oi Poperunt andan quilibdLrm Thenewsupply fo owingthe gfaftingofth subsidy is -i e /ed di. dr, AB \ ,hFpF' I dI ssLbs dy. " " subsidy andrepresnte thedecrease ln costs ach frm nowenjoys. Thenewequillbrium s at pointFwherc oaoa. market prce s owerat PmandqLri br umqLranlty Q / period biqger at Qm. Nowyouneed to b extra carcfuin the nextstep.lhe . Boththe prodrcerand the consumer of a productbene'. newmarkt prics Pmwhlchis equato lineFQm. The lrom a subsdy.Howthe subsdy 5 split betweenthe t\r': producer though earns fromeach Lrnit norjust whatthe
' o r\L_ 1e o cv.bL Ld, or hJ b. idl9dr pdby hFtd F .

Theproducer thusearns FHs the subsidy QmFlwherc (FHPpPm)which Theqovernment spends in totalarea is the product of the perunt subsdy FHtimee theqlantty produced andconsumed oQm(= FPm).

part es aga n depnds on the pr ce elastictyof demanc andthe prce el asti cty p of suppl y. Thesam reatonsh holdsas in the caseof an nd recttax (seepage27), on'l r ov t F r:..o or hp t-r i I p "d-ioof -ho pol e -dgF benefitfrom th subsidy consumers enjoyoverthe p" ' e be r f 01 .re,Lo.a/ p oo ,- p1j o, " a"

_h's.

given PES, benfit more, '?r example, the producers : -:.e price-eastc forthe good s demand a]lsa : dreoftengranted thir to far.ergto ncrcase (mporied lrcr a5wellasto protect themfrom mports y become automatca relatively more -?*:roducts :rce-:]e). The owerprice prodlrcts of dornestcfarm rre, -:i onlyblockmports but nray lead to the creation f:- .riif cia conrparative advantage andthlrsp-"nelrate r"-<::3s maya so begranted production to encourage tt-- :-.iJr prio,l poetveco,,.'"rp-io'r orqoods\^itrr o' 3:'r-.ion extern.tiesandof co!rsein the case of mert servces such ashea th andeducairon. ;ro-nd

Tip
Todlawa subs dy diagram always usea ruer andstart off bydr.wingtwo paralsupply curves. Labethm propery andthendrawthedemand curve. From the inte6ecton of the'new'suppy andihedemand curve (poinlFabove) go veirically up io ihe in tia suppy curve (i.e.dfawllneHF) to fnd the newaverage revenue fof (oPp = HQm). the producers Fai ureto do soleads to mostrrorsn thisdiagram.

lgriculture policy andagricultural


Ihy do g
ErFirnents often ntervenen aqrcu turalmarkets. . l'rthe long run therearefactorsthai leadro ihe r.ic ne n the reatv pficeofsuch products and thus of ihare of natonalincome enjoyed by the farmer. -=e . r ie short run (fromyarto yeaf)pficesof suchproducts =-ciuate a ot and thus {armers face high lncefta nty over :-. ve of the r expectedncome(prices and ncomes b i rs ho r . . r ot d. iti ,y . L i g J re )..1 6i r J ,r,d re .rh e )e -.' . a per od of n yearspr cesfrom prlodto perod -1,er = jduate but overthe long run the trend is typca y ::,lnward asthe trend line FHshows. prices Fisure 2.26 Relative of farm prodlctsthroughtime

.:E

lbE is a long'run pri(es downward trendin relative . Srpply of agrculuralproducts hasdEmatcay jncreased :!e to the mechanizaton producton, of of the use ihe advafces in biotechnology, control, ',iilize|s, dise.se wh prcductivity. ch have raised and However, -.:c iemand products for such hasnot keptpace because Ji ts low ncome elast city. A3percapita incom eves products demand for foodandagricult!ra may 'ncrease n.'Fase bLrby p opo'rio1"-ely n .chlp.s ( ofee pri(e, :rc an example. yea|s y Overaperiod of many wondsupp Jf coffee has ncreased fromsays to sn but demand -houqh haslncreased onlyfromD to Dnleadlng to a iower word price for cofiee, Pn, as lunrated in Fig.2.27. But . Lalely, therehasbeen a sgnficantupward trend n world foodpdcesOnthesuppysde,g oba warming is b aried lorshrnk nq cropyeldsdndrecoddroughts, adversey affectifg manyfood producers such asAustralia. On the otherhand, worlddemand for grains hasbeen ri, 19'd,- becd,se n of .heq o$ 19 -urber o peoole

Figure 2.27 The ong run downwardtrend of relativefarm

Why do
emerglng countrs, such asChna,who have reached leves of income thdtprrn tthem to consume mor-" rneat. Toproduce mormeat, moregrains arenedd to
fFe d cd le.Ar l p. p r l6onFl/ o\ ^ F. p. o i, o - 1 a .

demand forfood products maybe rather lncome eastc tor sorn t rneto come. Demand isalso rs ng because (mosty grain rnore corn)s beng d vertd away from hunran consumption intothe production of bofues. Whetherth s trendcanbeconsiderd shortrunor long rLrn iemains to beseen. Ther is a sholt-run downward trend because: produc1s Shofirunsupply for agdcu tLrral s q?picaly (vertcal)due perfect y inelasric to the associated long producUon y is also i melaqs. Supp sublect to shocks (shifts leftor r ght to S1or s2)typically asa resu t oi the effect of weather andotherrandom factols Ontheother hand, demand for agr.uturalgoods s relatively prce neastcs ncespending products on such s (at east proporton a small of consu merspnding in h ghircoa e e.o .ro-r , p. dnd o . o' r A. 04 ho wL olF, t h p F

. Notethatthese two characterist csalso atfect expoar revenues of deveop ng countries since many pre'iominantly pr mary export commod iies(farm and prodLrcts) nonJarm ihe r expoft revenues fluctuate trom year to yar and nlh ongrunther terms of trade tigure2,28Thesho.t{un prices fluctuations of fam product

goods have few substitutes. Theshifts prce of suppythuslead to thesharp fllctlatons shown nFg 2.28

. Governments often ntervene in agrc! turalmarkets producers aiming at protecting aganstthese characteristcs. There arevarious forms of govrnment inirventon. Oneof themis gEntingsLrbsdies or settng ^ rin J n p'. F\ 'e a-1r-.d e. e l Buller sto(k5 dre mployed ln an anmpt to stabilze the price. . BliJrnocks areako a subset of so-ca led.ommodity producing pr nrary prod!ctr agreements that.ounlries have employd in ordefto stabizetheirexport earn nqs (aqricultura prodLrcts Commodities areprimary or nonaqricu tura)usedas nputsn manufacturing andtraded n worldmarkets coffe,coco.,.otton,lute, r n and copper areexamples of prmaryproducts. commodity
o ri rL d d . e o p F rr-o . o , " ,p o - q j o-d. -,v h .h p ro d J 1 9 ,o rr' i p rry o ^' . c ' dedgeene enforce to limit the amountof, say,cofieeor copprthat reaches world rnarkts. Theoperation of a bufferstork . T heoper at on of a b L rffe ro c k s l u n ra te d n F i q 229 n t s assumed that the goalis to stab ze, say,coifee prces . t output s at Q* ihere is no needfor anyactionas mdrketdemandand supplyconditonsare suchthat th-o t ar getpr c ewil b e a c h i e v e d .l ofu tp !t i s a t Q 1 th enthe bulfr nock authortiesnedto take acton as otherwEe the prce w dropto P] as a rcsLrt of the excess sLrppy FHat P*. Authoriteswi havto buy and nock th

Lrn t5of coffee at P* (bufier stocks canthls Q*Ql (= FH) be used onlywth foodproducts thatcanbestorcd). Revnues (0Q1HP-) of producrs arcgiven byarea . t neil perodoutputs dt Q2Lnits prc then wouldrise above Pi, asxcess dernand equato lF unts resu h at pace P* Authorites wilise fromstocks un Q2Q* ts (= lFr of coffee at P*, mantaningthe prceat P* Revnusof producers ararea {0Q2lP*)

Figure2.29 Theoperation of a bufferrtock 52 Sr 51

. Theprcemaynab lizebut lncomes do not:theyvary direcdy wth the evelofoutput. . Af incentve government in to overproduce resu ts asth,e guarantees essence i5 that twill buywhatever amount produced andnot bought by consurneB. . lt s cost y s ncestorage costs andfinanc ng costs exst which couldbe recouped if goodandbadharvests dlirnate andthe price hasbeen setat a truelonq-run avrage. . Commodity (historica y they agreements usually collapse a have co apsed) because of financ ng problems that result.

| | r 's l o r a w l u i r a o e n d r o . I n , ea 0 1 1 0 ( ] \ F ' e r d i 9 e

! : | : : I

prce.Nexldrawthesuppyclrveforwhlchno byth buffer intetuertion stock managef is needed (drawth supply curves vertcal, a sens blechoice y fyourexample especia s an aqrlcultura commodity ascofie). Lasty such drawtwomore suppycurves, one
to i-a q o _ i l ^ e - ' d l , J D o l vL r r , e ",lo o e to I e p1

l _9: L'.__- ___- __ _____ _

Theory of production

Theshort run s defined asthatpe od durng which at least onefadror of production s consdered Jxed. lf we assune two factors of production, capita(K) (L), (K)thai and abour it s typically capital isassumed constant rnthe short run. (output) Totaproduct canchange byvarying the evel ol giverthe levelof labour capltal. ln the short runthe behavour of outputls determlned by thelaw of diminishing marginal rturns. Thebehavour andshape of shortruncostss d direct consquence of the behaviour of outputandof the law of d m nishing rnargina returns.

to remember A fewpoints . t is a short-run aw lt assumes the existence oJat least (Lrsually onefixedfactor of production capita ) . Technology s assumed constant . Thevariable factorusually labour, s assumed (ouipui)as Thus, anyd ffrences in returns moreabour s employed arenot because of difiernces in workerc' db irp,burd'psr,r.of l-etonrruou,y,h"9 9,ap " to labour ratio. That's whythe aw isalsoknown asthe proportions. lawof variable lfcapia andlabour wereperfecrly sLbsitutabe factorsn process the prcducton thenthe lawwor d fot hod. (of labour) product Thmarginal s defined asihe change ir o.1o. be""r(eo i' tbo. ,oil 5lh-.lope ",hdnge of thetota product curve

(abour) As more then2i units andmore unitsof a varabie fadror are worker will be produced. Butsince thercis added to a f xedfdctor(capta somuchcaptalcornpared to abourtherc sa ot of room ), thres a pointbeyond which total productw contnueto rise, for specializa but at a on to takepace.Theiwo workers may d minshnq rate, thatonew I be in charge or equvalenty, thatmarginalproduct agree of the wholekitchen, the w I start to decline. othefof a the serv ng.Output wi asa resuit mor than Vsuaizea pizzera equipped with ovns, tabes,etc. . OLroLiD rFd,,ng Withzero ./ | rrru,be rr .t y , r"d.i I workers, outputperperiod wll bezerc.lt one " "'r worker isempoyed rrte up untilsome then some levlof output w lbe unt of labour, sayL] in Fig. 2.30a. producd perpeiod,say have to \o i .ro .ld ror ce .l-". t.re dr9,"r poir b 5 ,.eppe x unitsThis workerwill " p eoa ng fe prl/as, do - erfh .q: -at'roo ders. lhanat pointa. Since se'.iro marg nalproduct istheslope of pad froma tables. thfoodandgetting totalproduct andth s sope s increasing, t fo owsthat It nowtwoworkers areemployed iheMPcurve in Fiq2.30bs is ng up until then t shoLr d be 11. reaLized thatif thesecond fist worker sirnply'coples'the

The
i n th e 5 h o rtru n(a r )T P a n d P r od u c ti o f igur e2, 3o

nps

:' ll

in tia lywith a risng Drawthe TPcurve in three'steps': g l'rw-nddecreaci posi/e sope.t'orretoIo I I'. (frcm wth a neqative positive L2)and then Ll to sope 'switch', (past dropa rnetowards L2). At each slope Youwi thushave the quant!yaxes of bothdiagrams. diagram. points deterrnined L1andL2in the bottorn lhat making suf Finilh it off by drawngthe MPcurv, Ll andthat at L2 t is it slarts rightabove lo decrease zero horzonia axis andcrossesth . AveraSe asthetotal productof labour s defined (i.e output)over product the n!mberolworkers (AP = Q/L). employed refered to as also empoyed, It isthusoutputperworker productivity labour. the o{
E o ,J ', l q o r F i g l . l . a D . L d _ v p o i r r 0 1 t 1 " l P ( Jr vp i ,

fromthe oagin of a nra ght linedrawn equato the slope APat L' i5 For exarnple, to that polnton theTPcurve. of workers dedbythenumbef equaltooutput(L'H)div rato isthe sopeof the siralght rnployed {0t') This line 0H. . lt folowsthatto determine ot average the behaviour of theslope the bhaviour product examine oneneedsto ve po ntson inefrcmthe orign to success of thestraight curue thetota prcdlrct at L'soAPhasa ineisthe neepest The slope of this workers w lstj//help adding At thlspo nt though, wofke|s. that levelof maxmurn at (theTPcurue 2 30a s sti// in Fig. totalproduct ;ncreare up product of laboutncreases ln Fig. 2.:1b the average gairy W) but naw it will tiseat a s/owelrate (it lrecomes decteases to L' and then the worker contributesto Each extra fatter andflatter). produciion butnot asmuchastheprevtaus o{ pzzas Figurc2.3l Produdionin the shortrun:(a)TPand are specalizaton of more andmor one.Thebenefts but at Thetotal ptodu.t cutuestill rises sowly exhauned. positive but product is thus rate Marginal a de$easing decreasing fron L1 ta 12. at pointc is f atterthan Youshould notethaitheslope of TPi5zero at pointb andthatatworkerL2the slope (point product iszeroin Fig 2 30b. d) somarginal ol for the amount istoo much Afterworker 12,labour (ihe ofthepizzia) size andequipment capitalavalabe Workers are50many will startdeclning. sotota product of way. Thecontribution other's ihattheygei in ach (her prod altef uct) is ,egative marginal worker each xtra L2worke6areemployed. . Thelawholds andL2units L] units of labour bet\rveen to rise continues worker L] tota product of labour:After proo ucl margrnal words rate,n other but at a decreasing more thanl2 employ Nofirmw ll ever is decreasing to captal worke6asthereistoo muchabollfcornpared Ll worke6asih-"re fewerthan employ norwillii ever Distance to laboLrf capta compared woud betoo much producton. ol reqion asthe economic LiL2is known

. i:- :re MPandtheAPcurves areshapedkean Inverse . Reiurning to ourAPandMPcurves, ir mustberh.r mustbetaken whenthe average whenonedraws bothcurves product s rsingthenMPmustexceed - :-i car | :ie d agram p betlveen asihe relatonsh APwhilewhenthe avrage marginaldnd product isfa ng thenMP :F,zge product s very specific. 1ngenera thefo lowing mLrst b ess thanAPAt the maxmumof theAPcurue marg naland avrage must beequal.
= \!r > AP then AP wil rise = r . l?< A Pt henAP w i l d ro p . = uP = AP then APwill be at a r.ax mLrm. -_ brsic ded behindtheserulesthat governth :.raviour of marginaland avefageproductis simpleafd : . olds f or anym a rgn a l a n da v e ra q rn e a q n i t!d e. -- nk of a studenttakinga seresof tests n her :(onomicscourse. lf in her sixthtest (her marginaltest) ;.e earnsa h gher qradethan her average gradeto that 30 nt (in otherwords,if her M > A)thn her average wil gradeto -:te. lf sheearnsa ower gradethan her average :rat po nt (n otherwords,lf hef M < A)ihen her average jfade w ll iall And lf she earns n her sixthtest exactiy the rameqradea5 her avrage to rhat point,then her avrage .villnot chanqe. Figute 2.32 Marginaland productcurues average in on

Cost theory
Short-runco5t5
rnentoned ear er,the shoftrun s a period of timdurng -5 ,rhich at least onefactor of production isfixed. Asa resu t ':rns n ihe shortrunfacebothfixed andvariablecosts . Fixed costs arecosts thatdo notvary whenthe level of production v.ries. They exst(and theyhave to b paid) evenI outputiszero Exampestypca y include rent, intersi on loans, insurance costs, fixedcontract cons, . Fiqur 2 33a ustrats fixedcosts asa ineparael to the . Fiqur 2.33b ustfats averaqe flxedcostsSnceaverage firedcosts aredefnedasJxedcosts d vided by outputt folowsthatihe averag fxed costs contnuousy decrease asoutputrises, but never become zero. Notethatthe arers beneath theAFC curv areallequalto th fxed con the { rm faces. . Variable rostr ncudecosts thatvary wth the leveloi output, e.g.rawmateria s, components, abourAverage variable consareihusdefnedasaverage costs over the evelofoutput. Theaverage totalcost of produc ng somevel of outputs thenthesumof average variable andaveraqe fixedcosts of prodLcing that evel of output: ATC= AFC+ AVC . . llarginal costisdel nedasth addtiona costof producing .n extra unitof output. lt s thusthe change (totalor in costs varabe)result ngfroma change nthe leveof oLrlput: lvlc = AC/ Q. lt s the sopeofthe tota (orof thevariable cost con)curve ai eachvel of output
Figure 2.33 Fixed and averagefixed costs

. Theshape run s a reflectlon in the short of con curves (TP) Output returns shnq m.rginal ofthe aw of dimin rate!p Llnt n theshortrunin tialy rsesat an ncreasng r.afg na retufns shng at whichdimin that unlto{ labolrr . Th!s, rsbut nilaly varabe costs asmore s produced, rnore andmore rate.Producrng theyrseat a decreasing the !nits of labolrf, wth double outputs'easy'slnce theoutplt I it lhandouble more the f rm canproduce th outputitwouldneed wished to produc lustdoLrbie do not butthey costs rise labour:varabe less thandoube
vd rdDp .o.t5 In ig. 2. 34. a

2.34 Variable and marginalcosts Figure

up uniilthat unt of output Q] atwhchdimn shlng of that level prodlction. Beyond set n marg nd rtunrs
o.p JrOIv/db e(o -t s ^. lled

^ll'

"dt ado

ed. r o' d l F

ng n Fiq2 34bun1 wllbe decreas Marginalcons output leveQ1. rateand r seat a de.reaslrg blecosts Since in tia y vada ratpir at an increasng alieroutputQ] theyincrease wl decrease follows that Mc (thsopeof VC)lnitally leadlng to a 'NLke to ncrease andthnat Q1wl start rises l\,4P rsesandN,4C whenin plodlrction IVCfalls (i.e whend m nishrng MPdecteases when n producuon nart in Producton) marg na returns

"n

1 Fd. - ' o' r lF

costs in onediaglam andlixed Toral,variable . \o{ rl_dr'ne bee_ of .l'e\a abe,o,. c-1e l'ds snape ramthe tota to ncudein ondiag it is posslble expaind andthefixedcons costs curve curve, thevariable costs justlikethe . In Flg 2.35thetot. cost isshaped curve shfted up by it has ben except that varabe cost cutue fixed cons. amount of the the cLrrve . Thus, thetotalcost disiance bet\,veen thevertlcal .b, fh, isthesameD stances con curve andthevariable 0c fxed cost disiance the and uv are allequallo lk

variable andfixedcosts figure2.35 Total,

4r.n_:e tota cost s the sum oJ average varabe cost arc :,:rage fixdcost.Ihrs the avefage tota costcurv |e 33ve1h averag variable cost curve The fvrtca riE_{e is equalto avfage fixedcosts. ; . ! - r v " r " g"f p d -o 1 . 0 1 ( -r,o u s yd .. o a c e a . o.-p-rc=res (seeFg. 2.33b) tfollows that this vertical rs-"ce (ab in FiS.2.36)becomes sma r and sma er but f:r.o U shapd curves nevertouclr n.::he averdg tota and the avefage varab e cost : r ' - dF U ho p -db F o .eo f -l ' p l a ^ o ' d r ,l i .hi rS na returnsand the behaviouf and shapeof the -al :'e=le produ.t curve(seeFg 2.31b). - ' E . v er agev a ra b ec o n c L rrvie s th e m rro r ma geofthe r'* age prodlct curve. fi+E 2,36 Theaveragetotaand the averagevariable cost

. Figve2 37a llustrats po nt n a simp the general e setlip wiih MCandanAC curye whercas Fig. 2.37bI ustrates thesame po nt usng ATC andAVC clrves.n bothcass, notethatthe Mc curve cuts the average costcurves at ther respective minma. Figure2.37 Marginaland average cost in thesame diagram
E

(b)

0a
Q/p e od

How to drawmarginaland avrag cost curv5 in the . Theruesthathave y the same to befol owed areexact as ihose expained n Fig. 2.32.
. Average (ATCand AVc)are U-shaped costscurues and MC is ke the 'N ke-swoosh'. li tolows that f average costsarefa ling then margna r.ust be lss than avefag wh f average costsarc fsing then margna must exceed averaqe. Lastly, marginalcost on ts way up mun

cutan averag cost curve at ts minmumpo nt. f MC< ACthn ACw lldrop. f MC> ACthn ACwll rse. = f MC ACthnAPw I be at a m nimurn.

i i i i i i

lf youwanttodrawanATc andanAVccurveon thes.med agram, filst drawthe ATC curve. Notethe m nimum of yourATC curve. Thn drawtheAVc be/ow (, making surc thatitsm nimum 6 to the/eftof theATC m nirnum andalso thatiheyget daser andclaset lb'-)t -o -.re o rr do no. tou,rr a. -ove 'or-

Production and'
costcurve:economies and Remember, the longrunisdeflned asthatt meperiod durinq Figurc2.3aThe long{un average diseconomies of sale whicha adlustments arepossible. lt folowsthat n the ong run. firmcons allfactors of production variable. lt can ders thuschanqe itsscale of producton. lt cangrowor t can shrink in size I po$tble In the lonqrunthere arthree ffects on oltput froman ncrease in the leveof use of a//facto6. Increasing relufnsto scale: the percentag ncrease in outputs greatefthan the percentage ncrease in a lnpurs. For xample, doub ng al factors of producton more thandolbles the eve ol outputQ. Stated ditrerenty, an ncrease in all nputsbyl%will adtoa grcater than1% ncrease in outpLrt Asa result, average rJr - . on. o' p'oriL,-ion oe 'Fd,F. The r n eljo\s
OQ

constanrrerurns to scale: .hppe Le .ca -r. ea("ir ouipuiisqual to ihe percentage Increase n all nputs. For xample, doubinga fadorsof producuon doubes in aLl the levl of outputQ. Stated d fferently, an increase Asa nputs by 1% will eadto a 1% incras n output. (unt)costs n constant rsult, average of production rema ncrease rn Deceasing return, to sal: the percentaqe in al inputs. oltput ls less thanth prcentage ncrease lessthan Forexamp e, doubling a lfactors of prodLrcton an doubs the levlof outputQ. Stated d fierently, increase na inputs by 1% adstoasmalerlhanl% (unit) costs ot increase n output. As a resu t, average producton of rse.Thef rm sufirs fromdiseconomies Fgure2 38 llustrates esof econom esandd seconom reiurns scaie correspondinq to ncreasing anddecrasing respectively. returns to sca (and thus to scale Constant to s mpit constant ong-run averaqe costt areiqnored nitaliy.lheong-run slopes average cost c!rve(LAc) downward. asthe szeof a firm Average costs decrease andoutputlncreases Thedownwadsecrlon of an LAC (EoS). curuellLrnrates econom esof scale (LAC) polnt,the long-run Aftersom avefage cosicurve slopes upwad Average costs dseasthe szeol a lirm and oLrtput increases. Theupward-sloping scton of an LAC clrrve illustrates d seconomles e (DOS) of sca Noteat each leveof output(Q)thecorresponding
r pa- r c r r " r i7 prd n dt J , d \p E ' l . .h o r ' u ' d verdge costcuwe,SAC)withwhich the J rm can achevethe
ln /a <i n ^ << h a :!p,;np.^< t<

Q/Pe od

Forexampe,cutueSAC2is the shoft-r!n average iota costcurvewhen a firrn er.ploys,say,K2 capta (imagne a lirm wiih a size'2' factory) The SAC: cutueis the average totalcost.utue when a firm empoys K3 capital wh ch s g reater than K2 (im agirc a f tn having gravn to a factory size '3' whi.h is larger than the factory size 2' ) l f i hi sfi rm n Fg 2 38 now w oul dl i keto produce'Q ' Lrn ts i t co!/d do so w th ei ther a' sze 2' faci oryor wt h a larger'sze3'factory But it paysto grow n sze as t co!ld produce thseQ un ts of output at an average cosi ot Qb ratherthan Qa. tfollows that the ong'run aveEgevafiable cost curve /LA (\dei r oe l ^an n nL1 ov. dqF o I o' prodr , ' 9 achoutput levl(Q)whenthe fnn is able to atljustall tnputs optimally, . when ihe firm is ableio adjust ts

Tip

-l

Draw the U shaped tACcurve raiher shallow making sLrrc thaton ts decras ng rgon the SAC cuvesare tangent po ntswh le to t or rhe/eftof ther lowest on itsis ng section theSAC curves aretangnt to t on the rght of theirminimaAlsonotethatthesize correspondlng to shoar-run avefag cost curve SAC*is (siz)lhat the opt ma scale as t iswth th s scale the f rm canachieve m nimum longrunaverage costs

r.n duto esof sca e (EOS)are dfind ascon savlngs rced scale into o{ production They canbedistnguished |Ie-;l Eosandexrernal arecostsavinqs EOS nternal EOS n- -r actions arccost savinqs ofthe i rm itself. Extrna EOS rg..i nqirom devlopments outsrde thefirm,for example qrows. re=-;e the indunryn wh ch t operates sorresof conomies of scale canresu tfrom techn ca, of sca -:-aleconornies reasons nranagement, f nanc alor rsk related -..<:tinq,

Financial Eosarisebecause: . A arS firmoftencanborrowfrom banks at ower Managemenl EOS arisebecause: . Larser f rmscanemploy specalists n each departnrent (alarqe ts superm.rket h rcsf nancalexpears to manage cash flow on a daiy basis; a argdepartment norehiles specid st buyrs, eic.) RiskrelatedEOS arisebecause: . A arger f rm isoflenmore d versifled, se ng not onebut

r d r r ' p o d L L . , . , r 1 o o e b J t a c 'r ) - . 1 dt p l o r F / " i _.(hnical EOS arisebecause: costs, arethus rnany countrier. Risks, andthe associated of f rm mayb abie to adopitechnologies ' : arger better sprad andm nirn zed Capiial :.oduction not avaabe for sma lerfirms. (eq. the assembyne). 3u pments ofrenindivsib External economies of scale ization ofiermoreposslb litesfor specia ' Largerflrms grows, Somet mes, asan ndustry unitcosts ofthefrms in it . ts a resLr t of ih 'conta nerpr ncple'{orthe ' aw of locat ng may decrease. Typicallyth s is a resu t of similarfirms vo umes oimensons'). cosrsav ngsmdydrise because (also together in one area rferred to as agglomeraton nse tankihat laster thansurfaces. Forexampe, a storage t. why?Because: ng costsss than econorn canstorcdoube thevo umeof someth (technlcalschoos, A specid zed abour force rnay develop furndces, double to manufacture. This app esto blast \po ng shedn th rd cater to their needs, may a so be estab o io ' oipe.. .rL, L drd o -oL seshrporq MarktingEOS arisebecause: Cornplementary f rmsmay also be established. . on the inputslde, f m bLrys nputsn bu k and a arqer Better transportation andtelecomrnun catorsnetlvorks prces fromsuppliers. thusmaysecure better . on th outputside, costs areusuay owerfor distribLrtion Marketing oJby-products maybe poss ble. l:rqer tirms.

-ihese duto ardefnedasincreases in averag costs increased wthln a sca e ol produ.ton. They canorqinate firm(/rternal DOS). DOS) or oLtsid thef nr (external
Intemaldiseconomies of scale Alter a po nt, sizemay becomed problem. When frms grow o e yo loa pr ldr r' i- p I p r J r o s l . c d y s .a _i . r." .i r g Poss ble reasons ifclude: . Management problems controland ol coordination, com m lr nic at on as s o c i a te w d th h u g es z e .

. Motvatonmaydcrease. . Interdependencies f rm may eadto wthin a hlrge probems if there or bottlenecks in any arehold-ups paricuar paftof thef rnr. External diseonomies of srale . Aiter a pont,congston costs nanareamaydeveop. . Asan ndustry grows, for factorpices(formaterak, ized asa speci. labour, etc.) maya sostartincreasing res!lt ofthehiqher factor demand.

Goals of firms
Maximizingprofits
isthatf ms a m at Theworkng assumpton in conomics profts.Ths s not though th only maximiz ng economic othergoals available behavioral assumption. Frrns mayhave . lt maybethattheya m at max or long m zingrevnues share r!n prcfirs or longrunrevenue andmarket . There Thetem was arealso 'saf6tcn9'theor,er. andsuffice'): lntroduced by Herbert Snron('satsfy imtatonsfirmscannot because of informationa profits maxml2e b!tthey on y nrivetc or revenues prcdefined acheveat /eastiome eve (of profits or ABa, nanagetial of theftrn (Baumol, W lliamson thearies andothe6)sLrqgest thatmanagers maysek to nraximize ther own 'Lrtility' wh ch mayinclude salary secur ty, power prestiqe. and/or

Econom c profitsare definedas ihe difiercnce between tolal revenues and totalecofomic costsof producton.

n(q)= rR(q) - rc(q)


pro{its Thekeyto !ndrstanding the termeconomic paintaf viewI|e isto real zethat fromar e.onamist's termeconomic costs reJ6 io ihe vaueof a//resources procss. thataresaclfced durng the producton Thiss because in econom csthe drivng forcs thfundamentai econorn c probmof scarcity t imp esthateconom c costs includ not on ythe so called explicitcosts of a firm(theexpl cit payments t ma ks for the useof tacto6 known also as'out of pocket' costs) but a so implicit costs. Thes refr to thevaueof f rm owned resources forwh ch thefrm ls notforced to rnake anypayment but,fromthe economists pointofvew represent saar f cedScarce resources lmp cit costs thatthe also include the rnnirnunreward factor'entrep.eneu6hip' in that ne rquires to remain of busne5s lhis s known asnormalprofit and s an
eement or economc co51s. . The idea s that, to securen a business activly the s.arce factor'entrepreneurship', sonrem n mLrm rewad !s necessary for the rsk rhai rJurdertakpr.lh s min mum s equa to what could be earnedby entrepreneurship in ihe next bstaiternatveavail.ble.lf th s m nimum reward doesnot m alera l i z e ,l h eth n e fl rm w l c o s e d o w nsothat the financial capita tjed up n i1w I be fredand moved prcjectthat commands nto the nxt bestaltemative the

Remembef, for a frrn to secure thescarce factor'labour', wages have to be pald which, of course, arean lement oi cost. Inthe sarne way, to seclrre the scarce fador 'entrpreneurship', a nrnimum reward woud. so be reqLrired which, n symmetrically, sho! d also be incllrded

tfollowsrhat ftota revenues areequaltoeconorn c consihuscreflred, theneconom c profits arezerobutthe film is makng money /t /snakingthemininun rcquned to renainin thisbusiness Wsay thatit s making normalprofits Zefoeconomic profitsthusimp, nomalprofils sothere is no reason for theentreprcneur to ext andmove on to the nextbestbusiness opportunity lf totalrevnues exceed tota econom c costs thusdefnec thnthefirm s makng more thanthe minmum t (.e. more requires to rema n ln th s busness thannormal profits). pro{its. t is making supernormal

Tips
Bedr 1 Trrd thdtd((ounting pro{its d " dr ow. proftsastheyrefer in scope thaneconomic to the d ffrence between totalrevenues collected and accounting costsThe atler ncudeonlyexplictcosts Aso,the leveof outputat which tota revenues equal tota production is known costs dsthe breakeven level ol output. Theterr. is lsed bothin the account nq sense and n the broader econom c sense.

profits Role ofeconomic in a market economy . Prof ts arethe reward for ntrepreneurship. They d I{er iromwaqesn that proftsarenol contracted, aswages are,blt arca residua andmaythus even be negatve

. Suprnormal profihcanbe used to finance research and devlopment programmes andmay thus eadto producl (to dynam andprocess lnnovatons c effciency).

Condition for profitmaximization . . Su t canbeshown pernormal profts attract that f a firmwishes to maxim ze protits rcsources ntoan indunry t munchoose anoutput leveqatwhich[,1R=lvlcand w\ - pd, o, . p. .p -J p ,e \o J r F \ p -.- i rg r e L)e the MCcurve is rising. in other ndustries. Relailveprice changescoupled wth . Many proftsare erroneousLy thinkthdith s meansthat supernarnai profits and lassesdrive resourceallocatian in zero, torgettng thatthetrmmarglnal refrs to onemde a narket economy. . SlrivnS to acheve profiisresults un(, theextra unt. in less wastand thus n . Torca zewhyprofits greater(technical) aremaxmumwhenMR= MCone efficiency. . S uper nor mpr rnust considr thea/iernatives. Tha ternatives aretwo. a o ftsp ro v i d e th n c e n tv a n d fundnqfor (investmnt) Ivlarg na revenues greater couldbeither or less than firmsto financeexpansion marg na cost.

r"sume na outputq, niarg levelof thatatthe chosen =--;nre ng cost(MR > MC) Read thanmarqlnal is qreater Tronr revenue collected thalthe exra :;; carefultmeans cost oi the extra ng ore moreunt of outputexceeds unLt. ..oduc ng thatextra leveof prcfts, then,whaleverth ::rt, l thatisthe case, produc ng these by ab e io ncrease f rm would be -ae pronts then f MR > lvlc lt fo owsthai extrd un t -'dl

2: lVlR < MC Case . lf theftrmhadchosen an outputrateq at whichMR< ng oneunit/e$ itwolld not co ect MC,then,by produc the greater but it wouldnot incur the assoclated revenues wdsthe eveot thatwhatever cost.tfollows, associated unt prcfilby produc ng one ess proft, it wou d hcrease (case MC l) lf MR > profits at a maximum cannot be Thus, 2). or f lvlc > MR(case . lf N,4R mizng f rm should > l,4C thenthe profitrnax .da, or oe dL a Ta/ - . r d9 hp/ "n be 1c ' "d\ ed f itsolrtpLrt rateto acheveitsgoalwhere.s lncreaJe fthefrmwas nclrlng ossesatthat \ote thatevn achreve output rate to d decrease l1s MC> lVlR lt shou losses bv these q, t wouldb able to decrease .nosen ts goa q couLd not have oroducing ihatexlraunt, sothe chosen itsoutplrt nordrease A f rm shouLd thlrsneitherncrease (1he optimum) cholce. best, the oeen the riqht ratelMR=Mc.
M R> M C

lty sho'rld Mc be rising? of outputq at evel Tounderstand whyat the chosen costt must s equaltornarginaL which margina revenue the is risng,considr cufr'e ,/sobethatthemargifalcon thalthe (rhatIVCwasdeclln ng)andassume altefnatve

onemorcunilof output Proiits firmdcdedto produce wouldexceed d further ncrcas as the eftrareven!e wou tfollowsthatat the chosn theextfacostincurred. MCbut a sothe NIC mustMRequal outplt q notonLy

alocation andefficncy li turns outthat resource structLr-" affected by market .onsidefatons aregreatly (whther fewor are many, there Thestructure of a market offinns th condlrct nes oneflrnr)ismportant asit determ

ther (whethr prcingpower)and consequntly theyhave evedn resource isaclr performance, i.e whether eff ciency laterwith the theory This modew llbe conlrasted a ocation. i5not reevant markets in wh ch structurc of contestable

f o.

nd rre. s.r-(IL 'F.dr e I . d r r o, ld i d t 10'

ed:

competit on Monopolistic Oligopoly

ol rhe on the basis Ma*et nructures arcdistnguishd (vry the few one), many, of firms n the mafket nLrmber (homogeneous and or differentiated) typeof th product or not. whether ntry barfers exEt

Perfect co
] ll;

characteristics . Very many sma firms. s . Homogeneous product, thatthe prcdLr.t meaning se erc'Exampe! /derrtalacross cons dered byconsumers products of such arelew andmonlyfoundin the pnmary (farmproducts, meta s). sector

. Noentry (i.e perfct mobiltyoffacto6of b.rriers exist pants paftic to all market Perfct informaton avarlable

ls the
veryfew markets in the rea worldw share these . Frmsa sotry to create entry barrers sothaltheycan profits mantan anysupernormal in the lonqrun.ln addtion,exit barriers are in theformof'sunkcosis'aso comrnon. sunkcosts recover arecosts thata firmcannot uponexitng an ndustry . nformaUon n the real and word s not iree.Uncetainry risks surro!nd a b!sines5 de.sions. andconsurnption Search cosB exist andmaybesignifcant . Lanly, prfect mobil 1yseldorn character zes factors of production. Labour, for exampe, oftensutrers trom occupatona andgeograph ca immobilty.

. F|5tof all,scd y in the economies, especia mairutacturing sector, arevery common. veryolten afger f rns cdnproduce at a owerunitconthansmallerfirrns can Fjrms thushave an incentive to groweitherntemally (throLrqh investment n physicalcapital) or throuqh mergers andacquistions. Ths expla nswhy afgefirms aretypcalyfoundin mostindustries. . Firms a so have the ncent veto different atetheirproduct (by mprov ng quality, chang ng characterstcs, etc.) power in order to acqu resome degree of monopoy thenis perfedcompetition Why stillusefulto study? Molopo/pov\e ,de' edds.hedb rry.o'ar_.p'i'F above marq na costTheLerner;ndex monopoly of . Despte these nrtatons,perfect competiUon retans ts power isgiven bythe rato (P- McyPA firmrhar y usfulness. tissimp andt iscapable of successfu manages to produce andse even differentated a 5lghtly predicting chanqe itsefficiency Nlost importantly, productwllface a negatvelysoped c!rve for demand propearles areconsdered desrabeanditthusserves asa p - i1d -hL.l-a.p -l^p irsp odL' ablirrro ir. rada pri' model aqanstwhichrea worldrnarkts canbe cornpared w thout osng allcunomers.

short-run equilib
Figurc2.39Pedect .ompetition: in (a)the short{un analysis Assume a perfeciy competitlv marktlllrstrated in -iq.2.Jqb. (b) typicalfirm the market N/drLFr for. e. dFre.-re -hordrlp piFa P td.\ fi r pere' o-rpprit ve1"'l p. isd'prne (.) U, " taker'meaning price thaithe market-detemined Ps a q venfor each frrm Since there areso many other fnmsofferng an denilcal prcduct to perfectly nforned cons!mers it cafnotincrease the prceabove the nrarketdelermined eve dsno onewoud purchase even a single

It also hasno incentive to lower the price belowthe market determ nedlevelas t is,byassumpton, sosmal compared to the marketthat it cansel a itwantsat Il_Fqorrgndr'e pri(eD lrr"5"ro) bed-\v\.1 dch qrain of sand beinq a firm.Even if t doubles itssize and becomes no asbigastwo gransof sand it wouldmake d fference. Ths mp esthata perfectly competitve f rm 'a.lrell10 F a hF .o-Fp 16 <oi rs dcrno ". if . oere-lyela,i( de 'ra.o o' . prodJct dt .heoo'r'o
(b)

5ince it cansela it wants at Pperunitit means thatthe exlrarevenLre {Tom se ng an extra unt is Pandthat,on averaqe, it arns P perunit Price isthusequaltomarginal revenu for a prfectly compet tivefirmandis,of co!rse, equai to average revenues: P = MR= AR,in perfectcompetition perfectly This f m (th nk of a farmer named competitiv Joey) has howmuchoutputto offerin the on y to decld perpeiod given prceP market the prvailing market Sinc we assume we know thatloeyisa prcfitmaximizer, ihe answer. Hewi choose that evel of outputfor which: MR= MCandtheMCcutue ir rising TheMCcurve lntersects at in Fig. 2.39a the MRcurve polniH whichis riqhtabove outputq*. lt fo owsthat Joeywlchoose at P perunt to sel q* ufits prperiod

in short-run equilibrium
Figure 2,40 Perfect case of competition: rhort run analysis: e.chof theq* units Theaveraqe cost of producing losses in (a)the typica firm (b)the markei Gong up fromq* s q venbytheaveraqe cost curve. we f nd po nt Fandfromthre toward theAC curve to we turn leftandf nd that t costs loeyC on average produc each of the q unts. o{ units Total revenues collected areequato the number peruntor q* times P Ths sthearea sodt mes theprice (0q*HP). of reclangle prcduced Totacosts areeqLral io the numbef t mes how muchit costs on avefag to produce each or (0q*)t mes (q*F). (0q"FC) Thiss ihe ara of rcclangle profits Economic bet\,veen tota arethedifference revenLies andtotalcosts of production, so collected geometically on Fig. 2.39a theyareequato the p nk (cFHP). ara proftsfor Joy, Economic thetypicalJ rm,areposit ve Ths means thatfirms n thisma*et aremakng morc thanlhe m nimum theyrcqurc to compensat tor the (defined fsources employed andthe rsk taken asnorma profits) profis. loeyis m.kingsupemorma
(b)

Tips
A typ ca m stakenudents mak s when they'shade' the profit area.Makesureyou coffctlydentifyon your d aqrarnthe avrage cost associated wth the chosen l ev elofout pui.A s o , l i n eF Co n F g .2 .3 9 a cannot be tangentto your U shapedaverage curvein the shortrun as MC s shaped ke the 'Nikeswoosh'.

Short-run equilibrium in perfedcompetition: case o{ conomic losses . lt s not necessary perfecty forthe typical f rm cornpetitive to be making supernorma or normalprofits in the short run. t couldbe makinqosses. FigLrre 2 40 i ustrates . n Fq.2.40b market demand issuch thatthe equlibr um price s determined at P The fifm n Fg.240aseects ts opt mallevel of outpuiat the intersction of MRand MCat q*. Average consarcequ. to q*Fwh e averaqe (price) revenue ison y qt H.Ths f rrnis makingosses (HFCP). eqLralto.rea

Long-run equilibrium in perfct competition . Rsources areattrdcted ntoan nduslryn whichf ms earnsupernorma proftsasihisimplies thatthese firms earnmore thanin th nextbest alternatve use. on th otherhand, econornic osss wil nduce ext off rms fromthe industry asthe resources iheyemploy coud earnmoren thelrnextbest a trnative. it fo or,E that if econom c profits in an indunry arezeronetherentry nor extwill beobserved asf rmsin such an industry make justasmuchmoney astheywou d ir theirnextbest a lernatve. Whyenter or exitsuch an ndustry?

Assunre, as ustrated in Fg. 2.41, y compet a pefict tive ndustry n which thetyprcalfirm is makng supernorma protls.As mentioned on paqe 38,thiswillinduce ntry oi fewl rms ntothe industry As newfirms enter, rnarket supply increases, shifting the rnarket suppyc!rveto the rght andpushing priceowerThis the market process (theenlryof f rmt w nop whenthere is no lncentvefor more i rmsto enier, profits i.e.wheneconomic aredriven to zero. Fiqure 2.41I ustrates y thissituation. exact The prcein Fig.241bhasbeen market driven to P Thtypica f rrn n Fig.2.41a produces q* unts At th s lveof output (0q*FP). totdlrevenues andtotalcosts areequalto area

Short-run equilibrium
ll

E
o o
qJ

Figure2.4l Periectcompetition: ong{!n equilibri!m in (a) the typkalfirm (b) the market

. Note hre theroe of profits andosses na ocatng andrealocat nq scarce resources in a market economy Prof ts attracl scarce rsources dsnewf rmsentr the (a5surning ndunry no entry barrlers)wh le osses force t rmsto exit, freeing up scarce resources. Bankruptcy tfi perlorms a most mporrdnt role n a rnarkt economy as t makes scarce resources available again for us n othr, moreproductve dreas. Of course, whether lreedup resources rnay or maynot be channe ledinic more productve uses asodepends upon ther mob :. rr ddd (r1 he,ff-4pdpdr1".//orlF."rdo\r- .. capita) may faces gnficantadtunrnent cons. . In the.aseof shortruf osss, ilustrated in Fg 2 4C lirmsw ext, decrea5 nq andshiftnq to the leltthe nrarket push prceanc supply andthus nq up mdrket (theext off rms thLrs average revenue. Theprocess stops wirnaverage revenue becomes equato aver:;-E cost, n otherwords when thetypcaf rmismakin_c::1
economc profits, .e. as mlrchas t wou d earnin lf: bestat-"rnatve(nornra for r.o.: ) Thereis no reason i i rmsto xt. F g!re 2.41 l l | nrates exactythi s si t!.::-

nps
To llustrateofg-run equilibriumn perfectcompet::,_ start by dfawinga U-shaped avrage cost curvefor:_: l rm and then draw, lirng always a ruler, a honzan-:' tanqentat ls min m!m. Th s I n,cwi be the dema.: s flrm fa.es :nd thus land MR and AR curues)th determi ns the prce.Makesure the MC cl rrves dr... in suchd way ihat it cutsth AC curv t its m nimLa 1oi F," o. orl avR a-d.LoN / cJ..o a ne to determine th eqlr libr um output of the 1'" W hc- . e gl Idnoradp-oaga' rr,.l -e" 0" .. makesure the markel demand and rLppy cutues
Q / pei o d
i r Ff.1d. ,6p..6)o oFr6.^.Foo l ato.

OQ

d agramYoucould of course starttheotherway.'---r


aqL o|r b r i '- d e . F r p 'd 1 q 1-^olextendinq lt a the way to the eJt-hand d agram

Longrunequilbrium thusrequresthatat the chosen q thtypca frmismaximiznqproJrsard output rate (norma thdtthese econom c proflts arezero ) so no entry MR= MC(andMCis risinS)

IJr||4 -r.:

2.42 Shutdown tirm: Figure rulefora perfe.uycompetitive

ng ir_r- l be clear thatin the longruna oss-nrak - _rr,' shutdownandxt the markei. In the lonqrun il :i::ible adtustments h.vebeen made andtheiirm (and ra -,: ;ixed thus thus faces no fxed factoEand ra,c dable) costs . rE short are runthough som factors of production fixed =.;.ered flxed. Thismplies thatthefnmfaces to be =s=, costs thatareunavoidab in thattheyhave :ac Ft.n rrof.n p'odLLe.1 o 'r' .sot oLroL :!-'e 2 42 il[]strates f rm a perfeciy competitve d agram :crralinq n theshortrun.This shutdown are =.Ji.esthatboththeATC andthe AVc cLrrves prce s dterm nedat Pwh ch :r:sent Themarkei r.; flrmmusttakeanddeterm nethe opt ma, prolrt . So,anyloss-making revenue and level of output. Marginal {irmin ihe short runshould shui -3ximizing lev|q1. (theprc)does areequalexacty above output -narginalcosts downonly f average revenue not cover (price) s equal This f rm is making losses. Average rvenLre the mLnlmum avefage variable cost. At anyprcebelow (total)cons io qll whileavefage arequaltoql Fso per AVC thefirmshould shutdown thisby Pl unr losEes areequato distance lF.Muhiplying < minimum Shutdownin the shortrun if P (=AR) (equalto (IFCP), thered output 0q1)givesth loss area AVCi.e. if TR< VC rectangle. . Should firmshutdown? lf lt shuts thisloss-making (for downltwillstillface andhave to payltsflxed costs examp\e, rronth\ palments{or an ouisiandinq bank I , In' s,(ot..,r/ddql drn o ct' ar1/ loan). lf these unavoidable fixedcosts arebiggerthan i ard reeds-one ,Te1,L,hor,d,endn 1 the lo e. faced b/ p oduc;ng, Staft oftbydrawing theU-shaped i praciice ATC and i business asitwill be losing ess I AVC c-ftA pr J. n9 n" r1":. vF i. d, o.s,dn,p ...re i r,,Fd , Note thatthevenical disrance at each outputevel i ovo-agF o s , i o e . o T e , \ n d l 'e . o , l d " l r a l t p , i oetween the average tota andth averag variable cost as output increass. Make sure (th th MC curve ' i .i\ad crftp s equo io ' e cos ,. Fo. o.dn p.F or i N.e-\,oo.a,Jr.o,(ur\r.roLglhp-1o,r .^ai "ve.agp i outputvelq2 the corrcsponding avrage fixedcosls are i ,p.Loo\oap ele,eloeh^een.1"-rndo-AIC i d stance db,the difference between average totalcosi! j andAVCanddenore rhelineMRandAR.Fnd the i q2aandaverag varabecosts q2b. ofth Mc andMRcurues i nteEection andbrinsa ne i Geomtrca comparson berwen fixedcosts andthe i downto the Q axis ro f nd the profifmaximiz n; ourpur i losses incurred at outputq] s fac tdtd f we caculate rate. Make sure po nt Fis not arrhesame thdt tevet as i ' thetxed cost ara usng the dverage fixedcosts atrne ThevericaL d st:nceFHisrheAFC I minmumATC. so i chosen outputlevel q1. MLrltiplying outputC'H(= 0q1)by i multplied by cF (= oql) w I g veyouarea (HFCC,), rhe i FH(theAFC (HFCC,), at ql) is area i fxed costs theirm's fixed(os's, and osss ncurred if rheffm decdes to shut i the rhlckblack outlnerctangl. down. To find theATC whenq1 units areproducd you i i t fo lowsthdtin the short runthisfrm shou d remarn n i oo up roT o .nl por I roa.l ed.ro., p"r f L.if i , l g 'i . - 1 c o r . r . " , - o o r o o J F . . . I L busness t w ll oseless nroney by pfoduc i 'h " l o . - 1 1 d L ng than f it i shuts down Byproduclnq t not onlycovers i itsvaaabte - - - - - - - - -- - - - - - - -- - - - - ____ costs bLrt a so pafiofthe unavoidabe fxed costs.

Thesupply
ln theshortrunthe supply curue ol a perfectly competitve frm isthatportonof ts marglnaicost curve thatles above the m nimum oJitsaveraqe varabecost. n Fig. 2 43,thesuppycurve isthusihe redsegment ol the lVlC cu&e Why? Rememberthat a supply curve shows how many unts a f mr w bew llingto ofierperperiod prce, ai each LFrarrr oi'|b-. Perer 19 o-ig./.4J.if 1--dlF prlc wasat Pl thenthe proft maxm zinqperfect y competitve f rm w llofferql unts perperiod asitsMR curventersects the lvlc curve at pointf. Simlarly, if price the market wasat P2thenthe profitmaxlmiz ng pefctly competitive i rm w ofierq2 unts perperod as ts newMRcurve interscls the MCcurve at po nt y, if the market price h Last wasat P3thnthe protit maxim zifg perfecty compettive firmwi offerq3unts perperiod asitsnewMRcurventersects the MCcurve at
Figurc2.43Short{unsuppiyofa pedectly competitivefirm

q/

peiiod

However, n theshortrunit wil beon y thatsegment above the mrnmumAVCasat any owerprice it wasesrab ishd Pojnts f, h andj thusshowhow many unts thisfirmwrl thatthefrm willnot offer anyunts butwil shutdown.In prces. offerat differcnt !t folowsthatthe IVCcurve lsthe the ongrun, t w lbe thats ection ofthe MCclrrue that s above thATC curve as t w ll notofieranyunits andshlt downil prics less thanATC

probm Given rharthefundamental Allocative of anyeconomy s elficiency in prfect competition scarcty, it s lmpefatve to consider efficency ssues. Severa . ln Fiq. 2.44ba unilsthatarewo(h morcto consumers types of eficiencyare distinguished in econor. cs. ihanwhatli costs to produce thmareproduced. . Allocative efiiciency exists if 'junthe r qht amoLrnt'oi a lhsisaful versionofFg 2.5wltha thnecessary good is producd point af view A oca\1re tom sociely's backqround preseni. knowedqe Unt Q1 sworthQla ettcency isachievd if all!nitsof a goodthatarevau-cd andthemarginalcost of produc ng it s Q1b. lt should by consumer morcthanthe cost to produce each are be produced andin a perfecty compelitive markttwill i-deed Fd rpJr- | rraLrr . for ch pnce prodJ s b p o 'o d i . F o A L - 1 ( 9 w o 1 l o r o d u L , r g r o . r l , o p . ) 1 '^h equaltomarg produced, na cost. lf, for the lan Lrnit po nt ol vew areindeed produced For the lastunitQ* P= N,4C thena locat v eff c ncy isachievd. produced n a perfectly compettve market, P= MC. . Te(hnical efficien.yexsts f prcducton . Focus {or productive) ng on Fig.2.zl4b it canbe seen thatsocalwlfar, pace takes wth minimalresource waste,ewit deJ nedasthe sumof consLrmer andproducer surp us, minmumaverage costs. (FP*E) s maxmized. Consurner surplus iseqLralto area lf markets (HEP*). (HEF) ar perfectly competitive then both andproducer surplus isarea Therr sunr, area allocative and productive efficiency are achieved. s maxmumsince allocatve efficency is achieved. lf any otherquanttywas produced, socialwelfare woud b

Efficien(y
Figure2.44Efficiency (a)theJirm(b)the market in perfect competRion raj (b)

(orproductive) Technical efiiciency in pe ectcompetition consq*2.l\,4in ma resource waneisthusacheved. Af rrn ncun ng higherthan qiz unft cons wou d be forced to . Inthe iongrun,f ms if perfectly competit ve ma*ets ext the industry as itwo!ld be making losses dretechnica y efficentastheyareforced to produce . t follows thatperfect y compet tivemarkets noronly ead wth mlnimum average coslsnFg.2.44a ong-run to the product opt mal mix bLtt a so scarc resour.es are equilbrjunr q* isachieved output wth minmum averag

Evaluation of perfectlycom
Thre s no guarantee produced thatthegoods w be d strbuted to the membeB of society in thefairen proportions. There maybeconsiderab e inequa ty of Remember thatmarket demand isdefnedasthe wil ngness brt a/so fheabllity to buya goodat each priceAb ty reflects the levl of ncome each rnemDer or socety faces. Poofhouseholds maynot be'counted' n the market dem.nd for a 'basic' product if theydo not 'uros' have enough to cast their'vot1. Ther-6 isthusno guarantee thai pedect compelition eads to a ||utsocally optimum combination produced of goods Perlectly competit vefirmsdo not have an ncent ve to nnovate. Notonlyr.aytheynot be able to afford spend ng on rcsearch anddevelopmnr bLrtthey (a newproduct also knowthattheI nnovaton or a procss)wllb better copedbythe other firms. 5lch nvestment spnding wo!ld be a wasie of money. Perfect y competit veindustr esproduce undlfferentiaid ptodLrcts. This lackofvariety mightbe seen asa drsadvantage to the consumer. Price in competitve g venanychange markeii changes in demdnd or costGupply).ond tionsThese f uctuations increase unce(ainty andmaydeter long-term nvesrmnt In an Industry Incontrast, the prcestabilty oftenfound in ollgopolistic markets maysem desrable for investment piann nq conslderations. Theperfectly compet tivemodelis norcompat blewiih 1- ed\-I ptL .l ro scale. r e. r\ tr Frorlo.]eso ), dle. Tecofom esof sca e werepresentthen th s woud mean lhatther wouldbea cost advanrag in bggersize sothe ndustry woud endup wth few large frms.Theabsence oTscale econom es n perfect competiton mayimpythat p iLe dfier dll .l-gr.rr'la-ir$orloha/Fo""i .her werelew large firms nvolved

45

Mon

;;il:j:lii

Charactefttics

Theconcept of monopoly s reatves ncelt cruc.llydepnds on how naffowly or broadly the prodlct.nd the market . One firmpfoduc nqa qood wthoulcose substtutes;the aredelined. Notealso the mpo(ance of th geogrdph ca ndustry coincides withthefirm. lador, i.e. ocaion n reaton to trdnsportation cons. . LJn (aslhereis byde{n tiononlyonefirm n queproduct

(oncerning some intersting points themonopolyfirm

(short-run Equilibfium andlonq-run) of a monopolyfim . A monopolist canchoose ither the leveof outputor A monopoy, beng the onlyfirm n the market, facs ihe prcbut not both,s nc-" the ngatively the rnonopoly f rm isst sloped rnarket demand cuw.f t s a protitmaximiz connrained by a negativey sopeddemand cuwe. nq frrmit w choose thatrateof output A rnonopoly f ffn doe5 not necessarily make hugeprolts. at whLch MR= VIC andMCisrisnq.In Fiq. 2.35 th s is t mayeven make losses; remembr thatprofits area the cas-a at olrtputQ*. Havinq determlned the profit (the iunction ofthereatve postion max ofthedmand AR) miz ngoutputtw ldtermnetheprceatwhch curve anorneaverage th s quantltywill coslcurve. beabsorbd byconsumers. Ths qenerally, A monopoly f rm (more ifformaton isgiven anyfirmfacing a bythe demdnd curve. lt wl thusst ngatlvely sloped denrand the price cutue)doe5 norhave a supply al P*.lt cannot set t anyh qhrbecaus at any y cLrrve price curve:ihe mafgna costcurve isnofa supp lor above P* fewerthan the proft maxirniz ng eve ol such firms; each outp!t f.te corresponds 10mor-" than outputQ* w be bought. price oneposslble asan infn te number may . Focus of MRcurves ng on Fg.2 45, at Q* unts of outputperperiod, go through protits (cFP*C). anypoift on the MCcufr'e arequato area Thdifferenc betwen t canb shown thatlf the demand the average c!fr'e{theARcurve) revenLre and the averag cost Q*F Q*G s the profitperunitwh ch,if mutip ed bythe number s linar, the rnafg na revenue isahoI near, has the cutue of unts sarn vertcalntercept anddouble theslop. cG (equal to Q*),g vesusthe profitare, (GFP*C) A monopoly f rm canstthe prce(it s a prc'setter and . This f rrnis making proftsblt s nce, supernorma by l: lh" deg'F" -otd p ip ^1o1opo y po,^pr q /" of assumpton, " baneu xst, no newf rms w llenterthe "le bythedifierence between the pric charged andmafgina industry f demand cond tions, con cond tionsandthe (P*,Q*)will not cost xpressd asa prcporton of prce. persist bdrriers then this equilibrium -"ntry A profitmaximizlng monopoy firmwi nevr choose. change so t isa so. long-rLin equilbiunr cond ton. rateof outputQ thatcorresponds to the price-inl.stjc . Notethat f the monopolist a msat maxirnizinq ,eyerues segment ofthe demand curve it facs.lt wi always instead of proflts thenit w choos th.t leveof output = 0 (rfer ocate belowthe elastic segment. Ths is becalrse lor profr al whrch N/lR to Fg. 2.11a). In Fiq. 2.45 th s i5 max.n zatonMRmunequaMCbutsince marginal th case at Qr costis necessariy a posiUve number it fo owsthat IVR Figure 2,45Monopoly: short-run and ongiunequilibrium musta so bea postive number at ihe proft maxim zing (i.e.lles output. lvlarg na revnue s poslive above the Q axis)only for thatsetof outputratesthat correspond io theelastic regon of the demand curve. Theproft-max m zingoutputevel is necessa r ly /ess than = 0) the revenLre-max miznq levl of output{where [?]R andthusthecorresponding price chargd is higher. n otherwords, revenue rnaximization eads to moreunts binqproduced at a lowerprce.

46

A ocative efficiency is not achieved Lrnder monopoly Why? . At the leveof outputQ* chosn bythe monopoyfrms/ prceexceeds rnarginalcost. Society wouldvaue more unts to beproduced. Soctywou d ketoenjoyalllnits up unt| lnit Qsocn Fig2.45, wh ch s vallred asmuch as (dstance twoLrdcost society io produce lQsoc)Unlts arenot produced andthussoc etydoes not enloy Q*Qsoc (HlF). wefareeqLralto area Area(HJF)is the result ng wefare ossrefeffed to asd-"adweght loss asll is net value that is ost.
This s a casewhere mdrketforcs ead to inefficient a locaton of scarce resourcs. lt s a marketfailLrre

FiguE 2,46 Monopoly and perfed competition

Produclv neffciency a soresults under monopoly Why? Themonopoyfirm s not forced to produce wth m n mumaveraqe costs. At Q* average costs areQ*G which archgherthan rnnimum !d1Fvrp be-lrtern L.s1.. Lord he rFrr X-inefticiency for a differcnt typeof netficiency thatsom vry protctd y post onsmayl-aad monopo to 'X-neffcienry' rlers to ihe /rterrals/ackestthai .haracter zessome monopo es.Ths s the case whn,on a diagram, th ACcurve isnot as ow asit coud be,given theavailable lechnoogy. ls there a case genelally, in favour o{monopoly and, more in favour of largefimswithmonopoly power? . Theanswer s yes. Issurne a prfectly compelitive indlstry wth a market supply at S(also th Mc curve)and market demand at D.s in F9 2 46.Equibrumprice w lbe at Pcandequ ibrum quaitityat Qc.We have shown tlrat th s outcome isfficient. lssumenowthatsomhowth s perlectly competitve ndustry s monopo izedbutthat the production technoogy rema nsunchanged. Thus, the mdrg na con curve forthe monopolyfirm remains at MC. Themonopo istw I choose P*. Q* unts andseI at a price We have also estabshed thatth s outcome s inf{icient. Thernonopo st rcstdcts prce.Wefare oltput andrases . Howevr, th s resull renson the rather un ikey
oc(.-o.io .r tL dr d dr oar 10- opoly r . 1e- pt o/ 5 t\e

fthat s ihe case thenthe monopoywill hav a new marginal cost curve thatcoud be aslow asMC,.MC, refc1s the deaofscale econom es f this s the case thenthe monopoly mayendup produc ng even more (Q*")thanthe perfectly competit ve ndustry at an evf Perhaps, ven more importantly, a drqe fm with monopoy powermaylead to a faster rateof techno ogicaadvancenrent. Innovations, defined asnw products or newprocsss, nray resu t ai a laster ratein such markets. Why? Because, assuming the monopoy Jrm is nol enfrerche4 meaning that t is not protected by nate-created barr rssLrch a5 cenes, ihenin oroer to mainta n iis poston it maybeforced to innovate. In addiion,the suprnormal profits it enjoys actasbaitihat lures othrfrms io nnovate in an attmpt to displac the monopolst. Perfecty cornpetiUve flrmswoud not have the incentive to innovate becalse freeentry woutd e n nate the possib ty of a prcfitab e return. These ideas areoftenreferrd to asdynamic efficiency and aredssocated withtheAustdan econonr st loseph A. Schumpeter

sanre technoogythat thesmall perfectly competitve ('loey') f rnrs probab employ. t isvery e thatthe monopoly t rm w llenloyeconomies of scale.

47

Batriers to
Barrets aredefnedasantthing thatdeteuentry nto an I dL r) o h" p'F/"1rs ro"1 an 10 i r./. A oo_re ",( rases th unitcon ol a potniia entrant above ihe levl enjoyd bythe incumbent firm Barrets canbe classfed irto natLrr., state created andfirm
Figure 2.47 Naturalmonopoly

Naturalbarders . Naturalmonopoly pfoducton Often, thatvrysgn fcant technology s such economies of scale market arepresent. Asa resu t, given sze,of ly fewor even ony onef rm canprofilaby coexst. When onyonef rrncanprofitaby t s eristnamarkt the case of natural monopoly. Fg!re2.47illustrates th point n thisdiagram s gf fcant econom esof sca arc present at lhe LAC curve slopes downward throughout the engthof the demand curve thatdefines the reevant a at2 a Q / Priod market. Assume that nitl. ly there ison y onefirm n thLs mdrket andthatthe profit-m.xirn zingoutputisat Q wh ethep ceatwhichtheseQunitswl beabsotued th price w I rema n at P Eah firmnow is making a Loss Ar_oy p'o . pqJoro s P - - rn i\ prcrr"ole anaiT equdto hf perunit.ft s much too expensve to produc-o ab prunt. f nowth s ma*et s equa ly shared bytwo asFg.2.47Iunrates Q/2units, . Exclusive producing { nns,each andsel ng Q/2units, thenthe ownership vtal nputcoudasolead ofsor.e tota amount enter ngthema*twilsti beQuntsand rc a monopory positon. State created . Patent!.e 9 dr .edbygove r ne " drd d e r9ht5 Lo produce exclusively ior a fixedperiod ofUme.Patents airnat protect ng the incentive to spend on research and Frrilshave veryncentve n order 10try to erect barriers to enjoy rnonopoly power profts. andlong-rLrn supernorma . Advertising and brandname mag cr.tion:The strongr the brand name in a market the more difficu t it . Licences areexcusve permits thatoneor few f rmshave. rsroT a newcomerto enter ry andradio broadcasting firmsrequire a licnce. . Product differentialion Firms tryto d fferent atetheI . Tarifft ". LLoapt. o- ro-1fore9r rn .'ed.e prodLrct or produce rnanyvadet esof tto rnake entry -.'ld more diffcut . lnc!mbent firmsmaydelibratey rnainta n excess producfive capacityPotent al entrants knowthat the ncumbentf rm canthuseasily ncrease output, deprcss ng prceto unprofitabe levels.

charactedstic . verymany smallfrms(each firm hasa very snal share of . D fferentiated (differentaton product canbe a ong qualty, lity, dLrrab desgnor product serr'ice andcanbe rea or imagnary). . lt s thesecond characteristc thatconfers such f nnswth power product a very sma degree ofmonopoy Snceth ls not hornoqeneols a negatively theneach f rm faces

sloped prce dem.ndfor the prodr.rct t sels.lf t increases twillnot ose a lof itsclstomers. Typ ca xamples industries of monopo istcaly compettive ncudehairdressers, restaLrrants rentastores. andDVD Note y in rnanlfactur thatoftn,especia ng,the exnence of many brands for consur.ers does not necessar y jmpy monopolinica ly competitjve markes. Forexample, in the detergent ndusrrythre maybvery many brands to choos frombut behind these bfands there areonlytwo orthrcef rms.

48

Short.run andlong+un equilibrium in monopolistic (ompetition Theillunration of short-r!n equ ibrium in monopolrstc (Fq. compettion isidentca to themonopoy d agram 2.45). A monopo stcalycompettive firm mayenjoy profitsn the shodrun.Supernorr.al profrts supernormal rnthlscase wil induce entry asno bafiiers areassurned n thlsrnode.f haI salons n . market arcenjoying supernormalprofih, othersuch firrns w lbe attracted. Sooner or latr othrhaI saonsw ll open!p andlure place, Asntry takes thedemand thatthetyplcal ncumbent f rm facs wi 'shrink andtilt'. Demand will '9r'ir L bedJ,F rorpIrr,-npydsnale -r'ate. share pr cethe qLrantity for each. At each demanded perperiod w ll decrease Dmand will 'tilt' andbeconre fatter because the res!klng b ggerchoice avail.ble to
' o_sL1p - l ea'L h" dFr ",ld w bp.o1p ror" pice

. Entryw lcontnueuntthercsnolongeran ncentive for it to takep ace. This wi bethe case whensuprnormal proiits arecompeted away andihetypcaharsalonis m.kingnormal profts, .e.zeroeconomic profts LofgrLrn equilibri!m wi beachievd whenthetypicalfrm n such a market is maxim profits zingprofits andihese arczero,.e.normalFgur2.48illustrates long-run equ ibrum asat Q* thefifi equates MRandMCand (Q* s the opt ma outputrate) thusnraximizes prcfits but ARandAC arequato Q*Fsoeconom c profiharezerc Evaluation of monopolisric competition A locative inefficiency resu ts. Prceexceeds margina cost at the equlbr um levl of outputfor each f m. Technica inefficiency andexcess capacity ahoresult. Each rnn mum.veraqe costs. Restaurants typca y have rnany emptytables andonedoes not have to wat in lineto r-cnt a DVD Theqreater varetyof producis avaableisconsidered an advantage ior consumers. Frmsthough areforced to advrlse andto resort to othermethods of non-prce competiton. Thehiqher thdnminmumunt costs in such mafkets canbe interpreted asth 'con' of vadety.
li - orodJ.e. e- oL.pL. . dr .l.p o-F , orp\po1o 1q o

elastic. Remember thatprice el.sticq/ncreases when consumers tacernor andclosr substtutes


Fi gur e2. 48 M onop o i s ti c c o mp e ti ti o n :l o n ru g ne q u i i b ri um

Tips
Fiqure 2.48isvery tr ckyto draw FirndrawaU shaped ACcurveThen drawa linear demand curv at a tangent to the ACcurve. y,the profit'maxirniz Automatca ng outputfateisdetermined poift beowthetanqency dsat a otherlevls of ouiputAC > ARandthe f rrnLs mdkLng a oss. Nextdrawthe MRcutue as ts posiUon s nrictly determ nedat doubLe theslope of the demand curveDrawthe MC('Nike-swoosh')curve lan, mdkng sur thaion itswayup r cuts the MRriqhtabove the prolifmaximiz ng evel of outputQ* andthat t a socuts the minmunr of the U shaped AC curue.

Olig ;;;,,,i
Characteristi(s . Few nterdependnt fims. . Homoseneous (o , sleeor cement)or d fferentated produci (ahon dny ndunralproduct, e.g cars detergents, applancs, aircrafi, bank ng,insurance) . Sgnlicantentrybarrier.

continued Oligopoly
lllustrating interdependnc

'
Tocompt or to collud?

. The del n ng characterstic of oligopolyis

. Thed emma c nq ntedependent oliqopolist characteriz firmss whetherto or to.o ude. f conipete in1rdependent ntedepndence. Firms areconsidered . Through thirown market competiton theymayincrease on th theolrtcome of anyaction of onef rm depends profts of rvas ol share and iheir at the expense the success reaction ofthe rva firms. For example, . decreases uncerta nty Colusion, on the other hand, gn A depends on whether anadvertisng campa of frm jointprofits andfrms maymaximize asif theywerea iG priceat the same trmeor not iival {km B decreases in a diagfamln ifterdependence canbe illustrated (a Fg 2 49 a market wth two firms, A andB,isassumed collusion prce at Assume that{ m A iscurrcntly selinqQo Lrnits . Collusive oligopolyexistswhen two or moref rm io a Po. ncreas ng ihe prceto Pl maylead eiiher aqree io fx pdces orto engage in otherdntcompetiUv reat vey sharp decrease n lh sales or to a reat vey m ld behdvour. Agrcement canbeeithr formaor nlorrnal. lf f rm B one.it depends uponhowr valf m Bw react. . lf theagremenr of a cartel. isformaw have the case -l'e1| n A v .ee dp. oe lo fo,o\^lae plce I Crease Cartes aregnera ly egal.n mostcountriesfrrns quanttydemanded as decrease on yto Qlf (f:follow) cannot y enforceable Frmsthat have signl-pqa contracts. nthmarket.lfthouqh made both I tmswillbe more expensive r formal agreements tryto rnake sure thatth-a thenA3 fivalfm B does not folow the prce ncrease agreernents rma n secret. oPEcisa case of a formal many 01 ts saswi shrink to Qlnf (nf:notfollow)as aqreement in whLch betwen oil xporting countries customers wil swtchto trrmB. debed' on.drdoe' o d p p rb Lr. ed as - ooardle to P2sales rnay Symmetrica ly,by d(easing the price abovendtonal aws notfo ow expand siqniflcantly to Q2nf fthe rva does . Lfthe agreement is nforrnalthen we havethe caseof y I the rva wh theymay ncrease but not assubstantia 'tacit co uson. To illustrate the co llisve behaviourwhere decreass ts pric. f rm does folow andalso firms behave ds d monopoy firm, one can employthe . Not is m|ch broader thanthe case that interdependence n orooo) drdgr" .]l - 9. 2 r5\ r.pqL.b' J-no..p" s firmsmayextend in descr bedhere asrivaky between th loint profit maximzing output and th proflB mun to invenorto many otherdimensions, e q. the decsion somenowDesnar0. Figure 2.49Interdependence in a duopoly Howlikly is itfora collusive agfemntto collaps? Co usvestructLrrcs areunstabe because ofthe inherent ncentve to cheat. Each memberwou d prefer otheKto abde bythe outputrestrcting agreement wh le t doesn't andexceds it. Such agreements aremoreikeyto coll.pse, . the greaterthe number of member firms; . the smaer the propoirion of tota ndustryolrtput members of the agreement contro' . lf the goodisdifferntiated variets existl andnrany . f production costs d ffer; . f market demand s shrinking fonveBey, byveryfewarge whenthe rnarket s domnated produc prcduct firms, wth s rn ar ng a rather homogeneoLrs p-odLrio'rcosts d'rdderard s l's ng.rl^ardry "gree're '. w I b morelikely to ast.
a1f ao a2f Q2nf

---'.li

arnf

Non-collusive oligopoly Thetermrefe6to the case f ms have where oliqopolistic no agreement concern ng theirbehaviour andtactcs. sti , repeated interaction eads o igopostc firmsto avoid chang nq outputeven if costcond tionschange. The k nked model(Fig.2.s0)illustrates demand cutue th s point.lt waslntroduced in 1939 and by P sweezy p'i F ,r,I re"5 il din"dat e p" 1rno .l'" obcprvpd i' o gopostc markets whencost cond tionschanged. even It istypicaly cons dered a modelofnon-cousve

Thbehavora assumptior, n the k nkeddemand prc,f a firm curve modelis simpe:given thecurrent prcethenrva frmswil norfollowwh increases , f a price, firmdecrcases thenrva fims wi fo ow andcut prices too.lhus a k nk w form n thedemand curve the prce. indvdlalfm faces atthecLrrrenl
Figue 2,50 The linled demand

Thernodelis usef! asit ustrates theobserved stcklness n prices n o iqopo iesin a 5mpe way qrounds t hasbeen critlcized tholgh on theoretica as ttaik to expaln howtheorginalprice P* isformed anda so because the range of possibe strateq esand rcsponss n such setups s rnuch more compcated.

Tip
Sta.rdrawingthis diagrambyf rst (hoos ng the k nk somewhere ln th !pper eft cornerof the graphspace; then drawth demandcurvemak ng surethat the sectionretctingth resut of a pdcedecrease s not too steep.Nextdraw f rst th MR secton coffesponding to the felatively elanicsegment of the demandcury, maintain nq the doube-the sloperule.The MR wh ch corrsponds to the lower right segment hg of the demandcurveshouldstari at sucha po nt b (seeFg. 2.s0)that db = bc and a so ma ntan the doube-th '

(ompetition Non-pric Oligopo istc f rmsavodcompet price ng through cLrts such a strategy coud adto a competitve downward spral n pices(aprice war)wh ch colld eav a lf ms worse off. point In Fig. 2.50, the k nk isat h corrcsponding io th-" Non-pr cecompetiton.an takesevera forms, such as: intia prceP*andthe nitialquantiiy Q* Segment . heavry advertsing andbrand name crat on (e.9. Pepsi fh o{ the demand curve is reatveymoreprlce elastic andCoca Coa); thansegment hg asa consequence of the behavioral (g. newspapers qiftsandcoupons andmagaz nes); assumption. Notethai demand blow the kinkdoes not (.ars, continuols product differentaton cl phones, DVD price have to be prce neastc but ony less e astc thant playels, TVsets, TVstations, tc.); isabove it, asthe exstence of a postive segmntfor MR exceEs ve product proiferat on to cover a I maginable (eg. icecfeam, ma*et n ches breakfast cereal); Thekinkleads to a d/sconrrurly n the marg nd revenue (typca y n eectrica xiended guarantees app ancer, curye whlchhasto bedouble the sopeof each sectonof computer hardware devces); (custornr alietsaes plans servic of carmakers)l 5 ncethe fmr isassumd to ba profitmaxim zer (oftenn products vo umed s.ounts such asshampoo and t fo lowsthatmarq na costmun have intrsected the marg na revenue curve rightabove the chosen ll a price warocc!rsn the real partic pants world, some outpLrt Q*. (typically those w pockets') th 'deep ook foM/ard to waker Ths couid bethe case either wth the MC,eFcurve or tirmsbeng forced qo oul of business to or b acqurred. withthe MCft,ercurve. Byinfrence, anychange in costs withinth s ranqe w ll alsoeadto Q* unts chosen and price thlrs to tlrsanre P*.ftce rssticky at P* in a non-collLrsive o gopoyevenf cost condtionschanqe.

tnce otscnmtnalton

.r.'.rtiti:
n p*eclPDth entlre consur.ef surp usisapproprated (bea). bythe producer who enjoys a sue usquato ara Aso,allocatve efficiency s acheved asa unitsforwhich prceexceeds marginalcost areproduced andsod up price unit(Qnin thed aqranr)forwhich isequa untilthat na cosi to marg
' hagql l ng' s common.

Price i

. Price dkcrimination n {PD)isa pricng polcythatceara ilrmsadopttof!rther ncrease theirprcfits. Forma ly,prce product trlscrirn nation exstswhena f rm selsthe same prices :i two or more n two or more markets d fferent .rovided thdtthe prcedifferences do nol refectcost

Third-d

This

. The closest rd world appfoxirnation of ihis highly incud. rlln t ckets, tra n andbusfars, ' L\anrples phone constr!.t may be open-ar markets whre aheatre andc nema serv ces,awyr/doctor/ thoretical tickets,

n inlernat onaltrade, dumping s a soconsidered a torm price of internalionai m natonas t lnvoves seling d scr .broadat a owerprcethanin the protected domenc

pdcedisrrimination (or blockprice Second-degree discrimination)

Eit h

conditions permitting a firmto pri(discriminate . Ihe firm mustenjoy powr. some degree of monopoy ji mlst fdcea negativey Thu5 sloped demand curve. practse prc . pe.fect y cornpeitive firmcannot No resale fromthe of the goodkferred to as'seepage') cheaper The to the prciermarket should be possible. rvo markets otherur'ise mun be somehow separable, 'arbitraqe (buying hiqh)w llguarantee ow andselling y oneprcewilldominate ihal eventua in bothmarkets. Price eastcites betwen rnarkets must of demand differSome to paymore, consumers mustbe prepared :iiher because areavailable to themor fwrsubstitutes 3ecause theyenjoy levelof ncome. a hiqher (orperfect rirn-degree price pri( discrimination diroimination) . A h qh y thoretical to case where these er s assLrmed beluly aware of theconsumer's wil nqness to payand .harqes prceshe iswii nqtopayfor herthe mdximum :acn!nrt consumed . r ihesimplf ed dlaqrdm, Fig. 2.s1,thef rstunt Ql s possib sod.tthe max unit, mumprice e,P] Thenext prce s also t can fetch, P2,dnd sold at the maximum Q2, (perfect Figue2.51Price PD) disdmination: firstdegree

n scond-degree PD'b ocks'of outp!tare50dat prices to the same Forexample, dfferent consumer parkng garages price in cty centres thf |st hour nrany the next2 hours at,say10.00, areat6.00perhoLrl LoL's a_d"nJdddirord. ac a-\'00 pFr'oL lr vdy greater portion extract a surplus they of the corsumer prceperhour to charging compared a single diagram, Fiq 2 52,the prcfil-maximiz ng n the s mplifld pr(e q sel ng f ffn in tia y s assumed to charge a single perperodandrnak proftsequa nq maximum Q Lrnits prce n t nowdecides to adoptsecond deqree to some discdmination andchafges a prceP'forthe f rstQ'units wh le r charges d prjce Pfof unitsQ'Q. Total costs have rema nedthe same asit s stillproduc ng (0Q' = un rs + 0Q) bLrt its revenles are higher by Q'Q Q (PhfP'). area lt fo owsthal it hasmanaged to incras profits above the even achievd w th a s nqe prce.
(blo<k Fi9ure 2.52 Pri(ed iscrimination: second degree PD)

ln th

The

hr gh

Consl

In gen in the e

ii
I Use th s claqram to showthatprice d scrmlnation f rm proftsabove the s nqe-price i can ncrease i Drofllmax..zinqleve. i i i

Third-dgre pri(ediscrimination

Figure 2,5! Price dlscrimination:third degree

. Ths isthe commonn markets aresegmnted rypewhere oi thattakes advdntage across some characterlstic permit price rcsa e. and that does not differing eastcites con a dayin advance Forexarnple, a rinetcketsbought a monthn advance more thanif theywerepurchasd lhe name ison thetickt thecompany of a f iqht Since to tl esto takeadva ntage of thefactthat f onedecides travea few days before a f ght ethershehasimportant busness to conduci or sheiswealthy andlhe tcket isa sm. l proport on of hr ncome expense pr ceiecharged Either way, the higher ln the market pic neastcdemand ch.racterzed bythemore are n thesimplfed d agram, Fq.2.53, thetwonrarkets sde,rcfects drawnsde bys de.Da,on the riqhthand rhedemand cond tionsprvailing n narkt'a' assumd (e.g busness Db, to be morcpric inelastic travellers). pfice-elastc on th eft-hand s de,refechthe more prevailng e,iourst cond tions n market'b'(for examp i When for simplcity,lo travellert. Margnalcosts ardssumed, drawinS rnake s!rc thelr i thetwo demand curr'es y sothatthe result dlffer ng prces subnantia i i slopes . Thefirmwill choose ng outputln eah i diaer on L"nt, th profit-maxlmiz i 'a' th s oclrs MR n market market by equat ng tvlcwitl-r --------i 'b' wlth the at outputQarsult nq n pice Pa. n rnarkt -ore p'i e e d.r, dendrdI'e p o'i-f a -lil'r9o-.p-. at Pb The isat Qbandthe price is ower, asexpected, characterized by the h qherprice ischarqed n the market rnoreneastcdrnand cond tions.

Consumers and orice discrimination


part(or In gefer., . pr ce-discriminating f rm appropriates in thexlreme case of filst-degree PD, all)of theconsumel to charge surplus. since the prcdiscriminating finn s able to pay, lt cosertowhatconsumers arat th mostwilling polcy gnera nnthe interesG foLlows thatthis n runs aga groups do benelt Ye1, theremaybe stuations where certain . Thegroup prce, pays if t is lower thanthe that the lower pric charged in the s nge-prce case. pricng policy This maypermit a I rm to se a gratr vollrme of of outputandasa result njoy economies sca e f these a ongin thelormol costsav ngsarepassed ovefallowerprces benef t. thenconsumers f otrrnq the qoodwaslnprofitab e at anys ng pr ce, thenpfice the prcvsion ot a d scrm naion maymake oror.cbleo d g ouoof ro-r(-1"' rho'orh-1\i.p oood woud have to do wthout t.

Theory of co
FiguE2,54 Contestable markets -rcorfdr..o .l'eo{'odo lof o ratel.rr.rrr.r. notfocLrs on ihe thetheory of contestable mdrkets does numbef lnstead dndsize of thefirmspresent in a markel. y,ext conditions. tfocuses on ntry and,especia Theided of market contestability renson the absence of sunkcosts defined asentry costs thatarenot recoverabe uponexit.Examples of sunk cons ncudeprodlct (which development costs areh gh n the pharmaceutcal or thecarinduniet, advedsing costs, specalzed

lf lhereareno sunkcostsnvovedthena contestab niarkets subject reap to 'hit andrun'.Firms canenter, the profits for aslongaspossibe dndthenexitwthout incurring anyexitcosts. possib This iryfor.es n.umbent firmsto seta pfice I' dr.e'1", r. rhe|osr\ o' p.odL(.io1. W rl-oL, b" riF. potential pet to entry afd sunk costs, it s com tionthat 'competit w ll ensur ve' pedorma nceevenn highly concentfated markels with few larqe firmspresnt Fms \ ll b"'orcpdro par,r Tpro ecolo-ni.pro'L drd p ; F will beclos to marginal cost, ensur ng in equilibrium a socially fficint outcom ln Fg 2.s4a proft-maxirn zing monopolist w lchoose prolrts to ofirQ units al a p ce Pmaking supernorma (P*hfP). perfectly equaltoarea lf nowthismarketwas conknabthnth s monopoly frm woud be torced io setihe pric at P* sellng un Q* ts,asatthai levlol profits outputthe result ng conomic arenormaland no'hi andrun'entry wi beinducd. Output s at the socally effcient evelas at Q* prces equalto marginal Perfect contestabilty does not exist in the realwordas perfect compettion does not exist eitherWhatmatte6is Allinone Figure2.55 y competitive lustrates a monopoly or mperfect firm,i.e.anyf rm facng a negatively sloped demand clrr'efor itsgoodor sevice n th s diagram d rnalor d agrarnmaticalpoints arI ustrated. of profits isachved, asMR= MC{poin1 Q1:maximizdtion a)andMCis risng asMC= AC ca (productive) efficlency G achieved, Q2:techn (point h)and thus Ac ismininrLrm efficienctj isacheved, MC(point f) asP(=AR)= Q3:alocative = of revefues isacheved, asMR 0 Q4:maximization (zero profits nomal conom c) are ach eved, asP(=AR)= asr perfecty AC;a firm n a concentrated conisiabe marketwould beforcd to price atthat vel

thusthedegre of contenab lity Contenab lityincrass, the lower the szeof sunkcosts, the lowerthe size of barriers to entry andthe hiqherth szeof supernorma Themainpolicy imp catonof contestable markel theory isthatif on yfew firmsexist in a market it should rot necessaily npy nefflciency. Thus markets with iew large government lirmsdo not necessarily need interventon andthescale mayeven bean economies oftenassocated addtonal reason to make themdesirabe. q/ theory policymakeE Contestab has forced ro foclrs more on potntia competiton theiremphass andreduce on t rrnsize andmarket concentraton.

Fi gurc2.55 A l l i n one

!h

54

Market failures

. The probem thatallsoctes face fundamentaleconomic versus un imtedwantsThis s scarcty: imted resolrces aboutwhichgoods necessitates choices, .e.decLslons Howwi scarce w lb produced and n whatquantites. resources beallocated? . In a market s g venbyth market economy, theanswer (the prce)mechan The interacton of demand and sm. a m ng to maxim ze ut ityand supply, with conslr.ers mlzeprcfits, detrm nes'lhewayth f rmstrying to rnax otde ol d pdi ol s sso s ac..1o\^nL' 1o ed- qood prcechanqes Relalve w be produced andconsumed. hand coord nateeconom c actvtyasif an invisible prcech.nges prcvdethesigna s andthe ex/sts Relatve Fr,ono. o1. r er..oLLraloe prooJ. rr! r r-ce_.he9lor

existence of externalities andth case of publicgoods A mdrket faiureexists f market{orces fa lto reach efficeft outcomes. In such too much or notenoughs a c.seeither produced or consLrmed soscarce resolrrces arenot a ocated n the socally optimaway. . OneshoLrd income notetholgh thattheundrlying And distributon of the popu ationmaybeveryLrnfair not since the market demand for anygoodrefects jlstwillngnss do so, to consume ii butalso abiltyto Liv nq,say, households w th severc ncome constraints, povrty the blowthe absolute lln, wil not'exist'in even markt exprcssion of rhedemand for perhaps the mostbascproducts such asfood Par.phrasng holsehods do not Samueson's famous expression, these have ng dnydo arsto votewith lt fo owsthatthe result oltput m x mayrefectalocative but maynil shown that efficiency lf ma*etsarefreeandcompttive thenwe hav y Lndeslrabe besocia fficientBut,in the rea word theoutcome s socally . markers arcoftennot compeitive dslirmsr.ay possess power Monopoly ar a source of market{ailure power; signif icantmonopoly . he e of e onom.rar'sa'to_. in the This marketfa lurehasbeen established arlier -o!Gdndbenelits " o " pad of enjoyed th market; byth rd parts outside prsentarion of rnonopoly ando gopolyFrmswith . tr! prcferences arenot revealed powefareabe to restct outputbeow the monopoly prce,eading to a competitv dealand charge a higher points impodant types ol Theabove three refer to three y power, the marketfailure:theexstence of monopo power Possible solutions to monopoly . Thegovernment thatcompettiv should ensure preva in markets.lt should nsure that no conditons materi. izethatexcessvey mer9e6 or acquistions y power increase the monopo of anyf rm. . lt should anl montor f rm pract ces thatseern of such compttive; it could taxor fne firmsfoundguilty praclces;t shou break up such f rmsintosrnaler d even pieces. independent . However, sgnficanldynamic beneits theremaybevery of such large monopoyirmsin aris ng fromthe existnce ca! of innovaton andtechnooq theformoffasterrates of scale. chanqe andeconomles In additon, theory strongly suggests that contesta bility evn hiqhly indlstresmaybe capable concentrated of approximate oltcomes. Theregulator compettve shou d th!s make sure thatsLrch s.ae economies are notsacrificed northepotentalrateof nnovation y A mostetfect vewayto rduce domestc monopo power nq nternatona trade. Fre isthrough llberaliz y incrases trade autornatca competiton, l,"ad ng to incrcased efficen.yandlowerpr(es.

Exter
produced Market forces alone lal to ad c activ ty or consumed An externallty ls present if an econom (production to anefficient or mposes resource allocaton. or consumption)crates benfts . Externa process ites mayarse n the producton in which costs on thirdpafties forwhichthe atterdo not payor production y. case externalities or In ve Equivalently, an theyareknown as do not getcompensdted respct process the consumption in which case they are known is a divergenc btlveen xtrna ty existswhenever there prvate asconsumption externalities. They mayinpose costs prvatdndsocalcosts or between of producton on thirdpaftes n whichcase theyarecons dered as andsoc albnefits of consumption. negative externalities, or crat benelits in whrch c.se lureasif t is An externality leads to marketfa (overprovision)or positive theyarecons errernalities. present less dered thene thermore (und opi malamount is erprovision) thanthe socially

Figure2.56Negative production externality

. Marginalprivatecosts 0vtPC) Thecosts of production thatthefirmrakes into ,lcroe .o']sderd io'r, it_decrsor l^ey -",irq prc(es<. wages, rawmalerals, etc.lt fo owsthatthe NIPC curves thesuppycurve of a (competit v)firm . Marginalsocial costs 0\45C) Thecosts of prcducton thatareborne bysoc ety These refectthevalue ofa//resourcs thataresacdflced in the prcduction specfic process Theythus includ notjustthe labour andothrrcsources thataresacfificed andwhich compnse th costs thataretaken nto cons deration by thef rm,but a soanyexternal cosrs ihararenottaken intoconsideraton in theformof, say, polltion. nlhis case the ma rginal soc al co5ls of producion exceed the marg nalprvate cosis andrhoud bedrawn above the (thesupply) MPC curueThis wouldbethe case of a producton negatve xternalty. lf though a productlo, process (say, creats benef ts for a thirdparty anoiher flrm)then (suppy) the IVSC curveiesbeowthe MPC curve astheres an externalproductionbenefit invoved in the process Marginalpr:vatebenefits(MPB) Thebenefits the individualenjoys fromthe consumpton ot an exifaunlt.Prvdte benefits determ nethew lingness to payand thusthe demand c!rveisalways based on and rellecrs the marg nd prvaiebenefits cufr'e. Marginalsocial benefits(MsB) Thebenefts lhatsociety enjoys frorneach extra unt consumed. They th!s include the prv.te benefit enjoyed bythe ndvid lal but in addition anybenef ts othe6may enjoy asa resu t. Thesociabenfirs ncudethe private benefts plusanyexternal enloyed benefits. ll fo lowsthat the MSB (anddemano/ (urve. curveiesabove the MPB li though the consurnpton actvityof individuals mposes a cost on othrs thenthe MB curve wil liebeowthe (anddemand) MPB c!rueasthercisan exrrna cost of consumpion generated bythe process. Analysis of a negative production externality

D, (MPB MSB) OQ'Q Q / Period

or owerthanthe private benefts sothe demand curve reflects bothprivate andsociabenefts. 5ocetywouldwantony Qi unts of steeproduced and consuned. At unitQ* theM5Cislust equalio theMSB Forall uniisbeyond unt Q* the ma rginal soc al con exceeds the marginalsocia benefit. TheldstuniiQ that is produced n a freemarkts worthto society on y Qf (= 0P), slnce th s is how much consumers arew lling at rhemostto payfor it, but socjeq/ sacr fices for rs production more, namey of unitQ Qh.Theproduction by market forces leads to a welfaross equal to fh Sinc Tor al unts Q*Qrhe MSC exceeds MsB, rhewetfare
oi i, poLdl o -hp or-t d ed ref )refa.-ng.ferndrrel

neffciency. Themarketfa ls because (Q*e) t leads ro overproduction oT th good gnoring po uton costseads the external to too much neelal too low a price for society.

Tof nd thewlfareoss triang takeanyunitof outpui . Fgure 2.56 illlrstrates a steemarket nwhichirmsare between the nrarg Q andQ* andcompare nd socia polluting the envronment. Ther.arketoutcome s found cost to themafg na socia beneft.TherdfferenceErne at the inteKcton of the ma*et demand curv D andihe wlfarcoss for that unit.Doing the sanre for all unjts market supply curue S.Themarkel w ll eadto Q unts of QQ*w g veyouthe result ng welfare loss steel at a prceof Pper!nit. Production externalities arise on ihe producton side Analysis of a positive consumption extrnatity sowe locus on the nrarket supply n thediagram. The supply curve reflects the privai cosis thatf rmstakeinto . Fgure 2.57 lustrates the marketfor hybrid cars. consideraiion so it s a sothe MPC curue. ThepollLrtion Owners of such cars crcate benefits to sociery asthey costs areth externalcosts which firr.sareassumed to hep dcrease pollution in a city. youcan Alternatively, rgnore (whatsoc Soc al costs of prodLrction etysacrif ces) th nkofthemarketfofflu vacc nations. f anindivdual arethusbigger thanthe prvatecosts of production and gets vac nated it s not hralone who benefits asrhe th N,4SC curve lies.bove th MPC curve for a lleves of prcbabirythatothers sufieffrom theflu somewhar stel = MPC output. lt fo owsthal MSC + extemal cos1s. decrea5es n bothcases the market outcome s rourro ar Thedemand curve refects the bnefits enjoyed by the ntersectlon of the market denrand curue D ario(ie consumers ar each level of outputso it s a sothe MPB market supply cuf/eS.Themarket will eddto Q unts of curve. Since in thisexanrple there areno consumpton hybrdcats or vaccins at a prceof Pperunit. externa tiesinvolvd, the social benefits afenot h gher

Exter
Figure 2.57 Marketfor hybid cau

= MsC) t (MPC

MSB= MSC

All units produc-"d betwen have been Q andQ" should fromsociety3 po nt of v w asfor each thesociabene{ t (NISC). enloyed is biggerthan the cost of producton Thus, the marketfa lsas t leads to underconsumptlon of vaccines andhybrid ca|s andthe result ng wefareLoss !s (efh). eqlaltothepink area Nolethatlor the lastunitsocierywou d keconsumed (Q*)themarqinal soc al benefits equathe marqinal socalcosts But since ndvidua s do notconsiderthe external beneflts ther consumptlon creates andbase
.hF dec5ro . on ,hdFr d1o . - v o . h p r d r l e r p ,i . e

mustsomhow y opt ma besetlower at P" for thesocia amount olvaccnesandhybrid cars to be consumed.Ih s couldbeachieved through a subsidy.

ini
Q / period

- *',"'

Consumpton externa tiesarseon the consur.ption sdesowe focus on market in the d agrarn. demand Thedemand curv refects the prvatebenefts that th ndvidual nloys andtakes intoconsideration n rnak ng buying decsions, so t isahoth MPB curue. The external benefits fromd v ng a hybfid caror fromgeftlng vacc nated are gnored bythe indiv dlal. Thus, thesocia benefits of.onsumption arebggerthanth pdvate bnefits of consumprion andthe MsBcury esabove the MPB curve for d levekofoutput. tfolowsihatMSB= MPB + external benefits Snceth producton of thecars of the vaccinations do-"s not crcat anyxterna ty t follows thatthesupply cuve refects bothprivate andsociacosts. Themarket fa lsasatthe astunt prodlced and (= Qh)exceedsthe consumed MSC of Q the IMSB (= Qfl.Thesocia producton prodLced ly opl malamount perperods more andconsumed at Q*. Analysis oI a ngative consumption externality Fqure2.58illustrates the market for cigarettes. Smokinq s presumdbly enjoyable to thesmoker bui it crates .osLs F. F p y to ro-ie "s " v ho Th- " e' e|r" os,ir theformofthe leffcts of pass vesmokinq aswe as the probabe hea th{elated care costs thatsmokers often mpose on society asther habitmayresu t in less heath relaled resources avaiab e to others since generated thisisan externdlty n theconsumption of thegoodwe focusn thediaqram on market demand. Thedernand curve reflects the prvatebenefits thatthe ndviduaenloys andtakes intoconsider.tion n maknq buyngdecisons so it s a sothe IVIPB curve . Theexterna costs of consuming thegood,i e. oT smok ng,are gforedbylhe iidiv dLral. Thus, thesocia benfts fronrsmok nq are ess thanthe prvatebenefils of conslrmpton andthe MSB curve les below the |\lPB = curve for all evels of output. lt fo owsthat MSB MPB .ostsol consumption - externa

fth external fromtheconsumption benefits ofthe goodof servce arevery signifcant in slz thenw have thecase of a merit good.Vacc natons andhealth caree1,.e.as d-ed-c..o .re ypc" e dn ples ^el oi mert goods. They area soa case of marketfailure. Analyss of rnertqoods i5identcato theonabov. Note thatothrdefn t onsof rnertgoods stress: . Thefactthatindiv duas aroftennot {uly aware ol ihe trlrebenefits derived fromthe consurnption ol a goodsothal thegovernmnt has to stepn andensure that people do indeed consume thes goodsn adeqlate arnolrnts Thusn manycountres chidren have to attend some schoo inq,theyhave to Devaccrnated, etc. . lhe lactthatlow-ncome indiv duas oftencannot afford goods to consurne such sothe governm-"nt has to nsure that.l, rchandpoor alke, consume sufflcient qoods. amounts of these

Figure 2,58 Marketfor.igarettes

57

EXte
5 ncethe prodLrclon of ciqdrettes does not creat any Figure 2.59 Thedeckron to drive externality it folowsthatthesupp y curve reflcts both private andsociacosts of produc ng cigartles. Themarkei fa s.s atthelan unt Q produced and (= Qh) s less consumed rheMSB iharthe Msc ol (= Qf)inFg 2 58 production yoptinralamount Thesocia produced of cqarclts and perperodis ess consumed at Q*. A uf ts betwen Q* produced andQ should have not been point frcmsociety's ol viewdsfor each thesocalbenefits enloyed are ess (MSC) thanthe socia costof producton Thus, the market lais as t leads lo overconsumpton of cgarettes andthe (efh) resu t ng wefare osssequato the pinkarea Notlhai for the lastuntsocietywouldkeconsumed (Q*) themarqinalsocal benefits equa themarginalsocral cons.Butsincendvidua s do not consider theexterna consthalther consumpton of ciqarettes creates and 0a'a base theirdecisons on theirdemand curve, the market KilometEs ddven per weel price mun somehow b sethiqher y at P* ior thesocia opt ma amount of cigarcttes to be consumed This could Altehative diagrammati( approaches: thedecision to ducat bacheved through a tax. a child

Tip
ll theextefna costs fromthe consumpton of some goodor s-arvice arevery sign ficant, asisthecas with smok ng ard drinking a cohollc beverages, thenwe have the case of a demeritgood. Dmrt goods area so
d, d.F ol r".le- iaJ - e And i. \ ide nt calto the one. bov e. o oF- Fit gooo i,

lnrag nea poorChinese farmer facng the decsion whethr or notto send hisdaughtr to the nearby pr mary school. Hew wigh the bnfits h expeds to enloy fromsend ng hisddughter off to schooagainstthe costs hewill ncurfrorndo ng so. i he is not capable of razingthetruefuturebenefts his ch d maynloy in ifefromschooling, he mayconsder the prvatebenefits derived vry low asMPB in Fig. 2.60 . Ontheothrhand, (private the costs he incurs cosrs) frcm each year extra of school nq ncudethe lost abour and (ash s child lncome couldhave hepedhimon hisfarrn) p usanytranspod andother costs. n F9.2.60 theMPC are tor s mpictyasslmed constant andequatoc. . Hewillthus decde rotsend heroff to school. burur soclabenefits fromeducat nq a child farexceed ihe privale benefih. There aresgn fcant external benfits arising fromprmary edlrcaton TheMSBcurvethus es above po nt ofvew the the MPB curve. From society3 child should altend There s thus Q* ye.|sof schooling. reason lortfr government to ntetuene.

Altetnative diagrammati( approachsr thedcision to drive

. Onecananayse the effects of d negdtve exlerna ry ol consumpion d fferently. Fqure 2.59illustrates th ndvidud 3 decsion to drive. Howmlch should onedrlve ther carlrornsocieiy's po nt ofvew? . Ihe indiv per dualwill drlvmore andmorekilonreres perodaslongasthe xtra benefits fromdrivng enjoyed exceed th extra costs he ncu6fromdrivnq. . These extra bnefits he enloys frommore andmore drivnq become smaller andsma lerandthis s shown ihrough the negatively sloped marg na benef ts of drivnq Figure 2,60Thede<ision to educate a child curve MBwh ch canbethought of asa demand tor drivnq schedule. As no onesebeneJts fromh s drivnq = [,4S8. i fo lowsthatIVPB . Theextfaprivate (MPC) costs frcmdrivlngncude gaso inecosts aswe las thevalue oft meandany d scomfo(the drvingperperodof timcalss. They are assumed for s mpicty constant.t c pounds for each extra . Driving onescar mposes costs on otheEln th formof po luton andconqestion increased Thes arexternal consandfor s mplicty areassumed constant andequa to cc' Thus the MSC curve whichlnclldes bothprvate andextefnalcosts of drivlng s constant at c'. It lolowsthatihe ndivldua w I choose ro drvioo much, perweek, spectca y Q k omtres whereas socjery would have wanted h m to d ve essatQ*kilometres perweek. Ther s thusrcason for the qovernment to ntervene.

MPC(=MSC)

58

y forth aflectd pddies to negotiate It s lsually too cost Asaresult benefcalsoluton andanveat a rnutlaly govrnmenl andtres to correct usuay intervenes or mechanism the extrna ityither usnq the market dndcontrolpo cres. clrcumventinq it throuqhcommand solutions Ma*et-based or where ethertoomuch Externallt esaremark-"lfa lures produced The good and consumed. not enolrgh of a is reason maynot exsior may rason isthatpr ces lor sonre fa lto rfectthetruebeneflts or thlrueconsol an actvrty. ng sure could try rnak li follows thatonetypeof solulion one thata prceexists andthat t i5thecorrci . Assisnins and enfor.ing propertyrightsovef thatotherws assets Assets mayinclldea panure thdt the fights to a ceanlake wou d be overqrazed, ones or the rightto drive otherwse wouldbe polllrtd w ll ned to vehcledowntownIn th s waylhe owner f propedy of hisactions. .onsldr the costs andbenefits .nd canbestandthe benefits rlghts exst thenpri.es ta canbeen matedForexampe, costs of an activty downtown qovernnent sets a prcefor the ight to driv to h s private to incudethisprlce thena drverw have be 2.59. A too oftenii s mposs consof drivng in Fig. prvatprcperty ot the rlghts, asin the case to assiqn or rnesea almospnerc ol prodrr.non lmposing taxesequato anyextern,costs on Green taxes cost of consumption. or anyexterna
po Jl 'rg 1 '1. d no "c , o_. oar p"" ; \ 4. 1' 1t Li.

n theopenmdrket to po ut ng f rmsthataretradable which rrns ascleanerf An incentive synems thuscreated to Lower their ve of pollulon w I have find t cheaper perrn ts to oldefanddirter dn incentive to sellunused po luton evek. Poluton that f to reduce { rnrs nd it costly torthe n9htto permlts arescarce ard a markets created a newa Locaton ot po ute Aftera ltrad ng ecompleted, pernr ts wi emerge withthfollownq properts: . the largteve of tota po uton isacheved; . the ossol oLrtput if the government s smalerlhan nraximum leveot for a firmsthe same hadassigned probemsof slch a markt-based sout on ncude: Potential . the nildlallocalon bedificu t fofthe of perm ts may governrnnr ro oererm ne; . monitor ng compianc s expensiv. Command-and-control solutions nq bleor not effect veto rey on chang Oftent is not poss sgnals. Governments thus reso todirectreguaton. market prices, y regulate ocation, cand rect outplrt, Governments hours of prcducton aswe aswhohdstherght operating cases d rctregLrlatron andwhre.n many to dr nk or smok vesolution but t maybethe onlyreast c and cost-effect outcoms. maya so ddto costly and neffcient (orbanning education Advertising of),moralsuasion, the government setof soluiions whereby Thiss a d fierent of to change the prcferences andpractces attempts ol the andof f rmsby ncreasinq theI awareness consumers theyundertake. costs or benflts of cert.Ln actvites xterna ol recycling awdre of the benefts Bymakng schoochldren governnrent makng a msat creat ng citzns todayth

cranting subsidies when the fu lbenefitsof an activty ar not captured bythe nd vidlalor ihe lrrm creatng them.Th s is the case n manyheath-calerclated products. lowercdso consumption The prce s effectively leve. increases to the socaly deslrable to are licences Tradeable pollution permits. These allocats polllte a specficarnountthatth government

'--------"-::,

Public
A good s considered rsnon a pub c qoodif consLrmption xcludab e andnon-rival. . consumpion if once isnon-excludable thegood s available to even oneconsumer it automatcaly from becomes avalabe to a , sono onecanbeexclLrded y, ndvid consum ng t. Consequent uas have the ifcentive to concealihe ftrue prefernces andbehave as'free rde ridets'(people whocling to thbus andgeta free wthout paying thefarc)becaus theyknowthatthey goodwithouthavlng canenjoythe to payfor it onceit becomes avaiable for others. . Consumpton s non-rivalf consumpton of thegoodby onedoes not decrease th amount availab e for a otheE; ths mp esthatthemarginalcost of an extrauseris . Examples . Few qoods exst.A ighthous, examps of purepublic dro1. dpe " "-^ple,. "e"nd ""r-'rqh6areLyp J a ghthouse in somesland no becomes avdilable Jsherrnan fiom ls benefits whileil t is canbe excluded 'used'by ab to the rest onethe amount of services.va (themarq arethesame na costof onemore fishlng boat usng theservices iszero). . 'Lawandordei and'pdce stab ty' aresomewhat d fferfl examples but theysatisfy bothcrtera andtheir implicatons ng.Lawandordr caneven be areinteresl extended institutiona framewofk, to imply a fLrnctiona y impodant which s especa for a deveop ng economy andon y a qovernmnt canprcvdet. . A ldst Bothcrtera exampe is lv andrado broadcaning aresatlsfed. f Fr'erdrs broadcan for oneholsehold, qood)can private no househod with a TVst(aseparate youLd e_.o. ra opp uooo ard it e Jolr'p .'ro\^ provrded rnuch. These servlces though areoftnprvately asthe broadcast ng firmdoes not sell theshows but andrva. advertsing t me, which isboth exc udable Pub ic goods fa lue becalrse area case of market have trLr consumers the ncentve to concealtheir preferences, As a result, hopnq to benfit asfreerldels. prvateprofitorented the frrms will (normally) not have goods ncentve to produce andoffersuch andserr' ces throuqh the market. Themarkt fa s. Cornpu sory (butnot necessarily produclion) andprovsion by taxation theqovrnmnt isrhetypicalsoluton.

tB

sL
'tb 2a 2b 3a

Tips
Whether a qood s cofsidered a pub c goodor not depends on whethef it satsfies thetwo crtera above. A commofm staks for studenh to believ thatany goodthata government orthe staieproduces isa pub c qood Furthr, the probm of po luton exceeds natonal globdrp'obl"T borde,s C ob" vdrnirgi ob,io-.1) " Polution s in th s sense a'publc bad': if t exsts for one,it exsts for alland,l onesuffers the rest wil probem requir ng sufferthe sarne. t isan internatonal onalcooperation. nternat Unfortunatey, no supra-n.tional body existslhat canimpose solutions gn nations. in that on sovere Treaties area movement d eclon/h/oo red).1 eBdl )Lnn.\brte/pn a'rato_ (on..rr_]oy" llLhoo"e 10.to abdebvr. sorne Worse, countres arnot wil nq to siqnsuch proposed Af interening by Nobe treates. soluton Josph aureate Stigtz sto consder thefirmsof such (as the US)as Not natons reclpients of natesubsdies paying thefull costs to of production s equvalent a state swithintheWTO receving subsidy. Since subsid system wouldhave the trade areillegd , othernations nations, forcng rightto mpose trade sdnctons on these themto cooperate dndreduce ernssions.

3b

4a
h

5a 5b
6a 5b

7b

HI

2l

3l

4l

Sections 1 and2 lB Questions:


5LLong Essays
1a Expla tLrnction oi pr.esif n thes qial nq and ncentive (10ma&s) d market economy thatgovernment nter/entonn 1b EvalLrate th proposiion sllstfd (l5mdrks) themarket fortobrcco in a market of mer;iqoods 2a Expain why !nderprovsion ta ur (10marks) s cons derd ro bea markt economy m tht 2b Eva b e rnearures thata government u.te the poss qlcha market u5e to coffect fd ure. of 3a Thebas c e,:onom c proberns oneof scar.:lly prodLrct!e ara ocat-"d resoLrrces. Expld n howresources
bo po .q i b o-ord 6 .o o r .

Expaln how prclt s determjned in prfctconrpetilon. (10mafkt 'Whaleverthetype of marketnr!d!re, proit


o^o\op po-t qodto r,|..

D sc!s5 (l 5 narkt oul i nethe w aysi n w h.h monopoypow erml qht shouldseek Evauatethe extntlo wh ch qovernnrent5 pow er(15 mar ks) to.ontro the qfow l hol monopol y p ay n the allocat on o1 rsoulces What fo e do prices l n d markel e.ofomy?(10 m.rks) 10 FvdLrate the oplons available to governments overcom the fa ure of markehin the producton and (15marks) consLmpl on of demerigood5. t

o -' o
l

E'

m ar k s ) 3b Di!.u5sth vw that therersstrcnqlustf catlonfor government intervention in the nrarketfor heakhcdre 115 ' nar k l ng sc.rce 4a Evallatethe impoft.nceof prce n a Locat (10 rnarks) resources. of mpLemeitinq 4b Evduateth possLb e consqlence5 (15 nafks) mdxmum dnd rn n mlrm pficecontrols.

( 10^ o 6 , . o .

considerd to bean 8a Whyarenvronmeftdprobems (10marks) exanple of market fd Lrre? nter,/enton rorrect 8b Towhaixlent cangovernrnent (15markt qovernment thrs fa ure? 9a c arelully expld n what t isthatpr.e, inromeandcross prlce ea5t aremant io rne.sure cite5 of demand {10m.rks) ol 9b D !c!ssthe pr.cti.alimportance of pr.e ldstrcty (15nrarks) dernand for ftrms andfor the government.

5a Expaln how a buffer slockmay be usedto stab ze (10 marks) aqr cLr iLrralprices. 5 b D s ( us s v ew th a t n i e ru e n to n n a g r.u tL rra l markeh t he in the 10a Whaldos n mean by ef{clency an e.onorn pr o b l e ms th a nl l s o v e s (1 . 5 ma fk s ) c dus es r nor e 6a What are posiive external es dnd how do lhey arrs? your answerwith examples(10 marks) Lislrat to 6b EvaLral the oplons dva .ble to governmnts overcome the Ia ure of markehto take acco!nt ol postv externallts. Refer to reirlworld exampes Ln your answer (l s marks) 7a What fa.tors dterrnne the pr ce;nd n.ome ldnicities (1 0 m rrk s ) of dem and lor a p ro d u c t? b rftelened to 7b Why m ght firms dnd qovernments e a s 1 .i e so t d e m.n dtof k nowt he pr lc e a n d rn .o m ? 5 n ' a rk s ) v ar ouspr oduc ts(1

(10marks) operation of a firm? 10b D 5cuqs whther the achievement of effcrenc\, ' (15rnarks) poss b e anddes rable.

HI Short Essays
. o o."b".\-pn i ol pod..n,d 6p.o\ j

of healthcare unrdtesthe problemof'oppodLrnlty cosi . Expl.n the ndtureof the problemlsifg a produdon posslb lii es cutue 2 'NofmallytwoLrtdbe expcled that morewouid be detemLfedat owr prices as oppos-"d to at h gher pr,:ei ,al otherth nqsbei ngequ., but thi smayfot a waysb the care' Expaln th s natement 3 ' A s pr cEfa s, ql antty suppl l ed {.l l s.A s suppy pr cefa s U sesl ppy.nddenrandanayss noease!, io exp.in why lhesetlvo statnnlsdo not contradict 4 U snq demand xpl a n how afd suppyanaysi s ocatedln a marketeconomy. of demdnd.fi ect th e 5 H ow m !hl the pr ceel astl .ty shapeof a frm's totil revenLre curvo? a nd 6 E xp ai nw hy the pi .e e ai l .l i e5 of bothdenrand supplyof pflmarycommoditles tend to be rclativey o!! prc eastci tyol demand and Lrsi n! 7 D efne cros5 d agramsoxplan what determne5whethercross eastrty Eposti ve or negatve. ha! r len nddily 8 li nany countries the pfl.e of houses overrecentyears wh e moreand morepeope lrave

Ht tong Essays
market ]a Exp a n how barriers lo entry mayaffect (10markt nructur. rabe 1b Evallate lhevlewthatrnonopoy s rn Lrndes (l5 markt markl nrLrctLre n.tion tionsfor prcedLscrim 2a Exp ainthe necessary cond mdrks) to t:kep !re.110
l a , d o .o ,,a o - o p 6 2 l) Di . . " o. " rl " J F dilcrimination for consume6and producers(l5 mdrks) mrt, dmil and pub c 3a Caref! ly drstnquishbet$reen qoods( 10 nr .rk 5 ) the vew lhat governments sho! d a way! 3b EvajLrnte and rn r.arketsfor s!.h goodt a5ciqarelts ntervene ( 15 nr a rk s ) . c oho
4d .1," .L.d oora b 4 .- lo poLi

ando gopoy(10rnarks) competiton 4b D sclrss thdifferencei bt\'veen co usveand (15marks) non'coluslv o sopoy.

IBQ

"s;9

'14 Explj

rurt.ri

62