Professional Documents
Culture Documents
Economics involves the choices people make when matching their limitless needs and wants
with a scarcity of resources. The word "economics" is derived from the Greek words "oikos",
which means house, and "nomos", which means manager. So the term originally referred to
management of the household. Today, the term has been broadened to refer to firms and all of
society.
Another way of looking at economics is to consider the field as a set of tools for analyzing
people and groups and the choices that they make. Accountants are trained to render an
account of financial activity for a company. Lawyers are trained into a certain mode of
thinking so as to resolve issues in a legal framework. Similarly, economists are trained to use
a set of tools and principles to analyze why individuals, firms, governments and other groups
behave as they do.
Models
Economists often use models, which are representations of what the economist wishes to
analyze. If, for example, an economist wishes to analyze the behavior of a labor union, the
economist will not try to include every possible aspect and piece of data about labor unions in
his or her model. Important factors will be focused on, such as wages, benefits, alternative
jobs, etc. Hopefully the economist's model will include all of the important variables and will
give little or no weight to less critical variables.
Most economic analyses include the phrase "everything else is remaining the same", so
attention can be focused on the variables specified by the model. Of course, this assumption
is rarely true in real life. If one were trying to analyze federal deficits and interest rates, for
example, there would be plenty of change during the time period analyzed.
The CFA Level I Exam
The economics portion of the CFA Level I exam touches on a wide range of economic theory.
The material covered would normally be taught in senior (or graduate level) microeconomic,
macroeconomic, money and banking, and international trade courses. You will need to
understand all of the material presented here in order to successfully answer all of the
questions given. There will be a few questions that require the solution of equations,
particularly with regards to foreign exchange.
This section focuses on preliminary economic concepts you should know for your upcoming
exam. Note that your upcoming CFA Level 1 exam will not test directly on these basic
concepts, but CFA Institute notes that you should have a basic understanding of these topics
to ensure success on the more challenging topics that lie ahead.
Look Out!
Note that supply and demand curves depict a
quantity supplied or a quantity demanded at a
particular price, all other things remaining equal.
Example:
Suppose, to continue the example given above, that the change in quantity demanded for the
good (10 to 14) was in response to a price decrease from $8 to $7. In that case, the elasticity
would be expressed as:
(10 - 14) / (10 + 14) = -4 / 24 = -1/6 = -15 = -2.5
(8 - 7) / (8 + 7) 1 / 15 1/15 6
Alternatively, the elasticity could have been calculated as: -4 divided by half of 24, which is
equal to -0.333, over 1 divided by half of 15, which equals 0.1333.
So the elasticity would be -0.333 over 0.133 = - 2.5, the same answer as above.
The following definitions apply to calculations of price elasticity:
1) If Ep > 1, Demand is elastic. The percentage change in price will produce a greater
percentage in quantity demanded. If the price goes up, then total revenues will go down. If
the price goes down, then total revenues willincrease.
2) If Ep < 1, Demand is inelastic. The percentage change in price will produce a lower
percentage in quantity demanded. If the price goes up, then total revenues will go up. If the
price goes down, then total revenues will decrease. Put simply, these changes will be less
drastic than if demand is elastic.
3) If Ep = 1, Demand has unitary elasticity. A percentage in price will produce the exact same
percentage change in quantity. Therefore, changes in price will no have effect on total
revenues.
If demand is elastic for a product, then a small change in price will cause a large change in
quantity demanded. If the demand for a product is inelastic, even a large change in price
might cause little change in quantity demanded.
Amount of time - consumers can make more adjustments to prices changes over time
and, therefore, demand tends to be more elastic as time passes.
Income Elasticity
Income Elasticity is defined as the percentage change in quantity demanded divided by the
percentage change in income. The calculations are similar to those for price elasticity, except
that the denominator would include a change in income instead of a change in price.
Usually the amount of goods purchased will be positively correlated with income; if
consumers' incomes go up (down), more (less) goods will be purchased. Any good with a
positive income of elasticity of demand is said to be a normal good. Luxury goods have high
income elasticity (greater than one). The proportionate amount of spending for those goods
will go up as incomes increase.
The amount spent on some goods decrease as incomes goes up. Such goods are referred to as
inferior goods. Examples of inferior goods include margarine (inferior to butter) and bus
travel (inferior to owning a vehicle).
Limited income enforces choice. Consumers have to make choices as to what goods
will be purchased or not purchased. Purchasing one item means that less funds are
available to purchase other items.
The Law of Diminishing Marginal Utility. This law refers to marginal utility, which
describes the increase in satisfaction from consuming one additional unit of the good.
The Law of Diminishing Marginal Utility states that as each additional unit of a good
is consumed, the amount of marginal (incremental) utility will decrease.
Economists believe that consumers make decisions at the margin; i.e. should one more unit of
the good be obtained or not? The consumer will compare the additional (marginal) utility to
be achieved by consuming one more unit of the good, to the additional (marginal) utility that
must be given up (buying power) in order to obtain the good. At any particular price, the
consumer will continue to buy units of the good as long as the marginal benefit, as expressed
by maximum willingness to pay, exceeds the price. The marginal benefit indicates, in dollar
terms, what the consumer is willing to pay to acquire one more unit of the good; it can also be
related to the height of an individual's demand curve. Another implication of the Law of
Diminishing Marginal Utility is that the height of the demand curve will fall as more units of
the good are consumed.
Another implication of marginal utility theory is that for consumers to maximize utility, the
following relationship holds:
MUa = MUb = MUc = and so on...
Pa Pb Pc
MU refers to marginal utility of the good, P represents the price of the good, and the
subscripts indicate a particular good. The last unit of each good purchased will provide the
same marginal utility per dollar spent on that good.
The term marginal cost refers to the opportunity cost associated with producing one more
additional unit of a good. Opportunity cost is a critical concept to economics - it refers to the
value of the highest value alternative opportunity. For example, in examining the marginal
cost of producing one more bushel of wheat, that number could be expressed as the dollar
value of corn or other goods that could be produced in lieu of more wheat.
Marginal benefit refers to what people are willing to give up in order to obtain one more unit
of a good, while marginal cost refers to the value of what is given up in order to produce that
additional unit. Additional units of a good should be produced as long as marginal benefit
exceeds marginal cost. It would be inefficient to produce goods when the marginal benefit is
less than the marginal cost. Therefore an efficient level of product is achieved when marginal
benefit is equal to marginal cost.
Consumer Surplus and Marginal Benefit
Consumer surplus represents the difference between what a consumer is willing to pay and
the actual price paid. If a consumer is willing to pay $5.00 for a gallon of gasoline, and the
actual price is $3.00, then there is a consumer surplus of $2.00 with the purchase of that
gallon of gasoline. The value to the consumer, or marginal benefit, is $5.00. Value is
calculated by getting the maximum price that consumers are willing to pay.
We expect consumers to continue purchasing units of a good as long as the marginal benefit
exceeds the price paid; i.e., as long as there is a consumer surplus to be achieved.
In the figure 3.5 below, the triangle defined by the points P2PmQm represents consumer
surplus, while the triangle defined by points P1PmQm represents producer surplus.
Figure 3.5: Consumer and Producer Surplus
Externalities reflect costs and benefits not borne by the person or firm making the
economic decision, which are imposed on or granted to others. Runoff from large cattle
feedlots can damage nearby farms, and this potential cost may not be considered by feedlots
when they look at their supply curve. A landowner who chooses not to develop her land may
benefit several other homes for purposes of flood control. The benefit to others may not be
taken into account when deciding to develop the land.
Taxes lead to lower quantities produced, higher prices for buyers and lower effective prices
for sellers.
Subsidies increase the quantity produced, lower prices for buyers and increase seller prices.
Quotas limit the quantity that can be produced.
High transaction costs reduce the price that customers are willing to pay and increase
supplier costs, leading to an equilibrium quantity that is lower than either party would desire
absent the higher costs.
Asynchronous information creates a perceived cost for buyers and sellers if they cannot
adequately evaluate a proposed transaction. Drug companies can charge premium prices for
pharmaceuticals due in part to the established evidence that the drug works. Auto makers
entering new markets often have to offer lower prices and/or better warranties because
customers do not have sufficient information about the new brands.
Discrimination deprives market participants of the ability to conduct business at prices that
otherwise be acceptable to them. Businesses that discriminate against certain types of jobseekers may have to pay more for labor, while customers that discriminate against a business
may have to pay more for goods.
A monopoly means that only one firm can provide a certain good or service. A monopolist
will charge a higher price and produce a lower quantity in comparison to a competitive
market.
With the exception of the above-mentioned obstacles, a competitive market will use resources
efficiently. Goods are produced up to the point where the marginal benefit is equal to the
marginal cost, and the sum of consumer and producer surplus is maximized.
Although price is the dominant means of allocating resources in a market economy, it is not
the only way for markets to allocate resources. A command economy relies upon a central
planning authority to allocate resources. Markets can also allocate resources by majority rule
(citizens vote on the desired allocation of resources), lottery, or force and theft.
The Fairness Principle, Utilitarianism, and the Symmetry Principle
Economists often like to examine the "fairness" of a situation or economic system. Ideas
about fairness can be lumped into one of two categories:
"Results" must be fair.
"Rules" must be fair.
Utilitarianism, which is a moral philosophy developed in 18th and 19th century Great Britain,
posits that an action is correct if it increases overall happiness for the performer of the act and
those affected by the act. Utilitarians argued that income should be transferred from the rich
to the poor until complete equality was achieved.
One problem with utilitarianism is the tradeoff between fairness and inefficiency. An effort to
transfer wealth by heavily taxing rich people will decrease incentives for people to save
money or work hard. This can lead to inefficient uses of capital and labor. Another source of
inefficiency is the administrative cost of transferring money from the rich to the poor.
The symmetry principle is based on the intuitive principle that people in similar situations
should be treated the same. From an economic perspective, we would like to achieve equality
of opportunity. The symmetry principle adheres to the viewpoint that "rules" must be fair.
Figure 3.6 illustrates the shortage that occurs when a price ceiling is imposed on suppliers.
Consumers demand QD while Suppliers are only willing to supply QS. If the price ceiling is set
above the equilibrium, consumers would demand a smaller quantity than suppliers are
producing.
Economic Efficiency: Black Vs. Legal Markets
Legal systems provide various benefits to economic systems.
Economic efficiency may be said to occur when an action creates more benefits than costs.
Legal systems help economic systems become more efficient by reducing risks to economics
participants. Risk represents a cost that must be compensated for by higher charges.
One risk reduced by government regulation is theft. Government protects the property rights
of owners so that they can benefit from the assets they own and use them in an efficient,
economic manner. Participants in a "black market system" face a high risk of theft in their
transactions as well as exposure to other forms of violence.
Governments often also provide a regulatory framework for the safety of products. In a
market operating within a legal system, purchasers of drugs have a reasonable expectation
about the quality of the drugs and the expected benefits of the drugs. Participants in a black
market for drugs will have incomplete information about the quality of drugs purchased and,
therefore, appropriate decisions are more difficult to make.
Price Floors
When a "price floor" is set, a certain minimum amount must be paid for a good or service. If
the price floor is below a market price, no direct effect occurs. If the market price is lower
than the price floor, then a surplus will be generated. Minimum wage laws are good examples
of price floors. In many states, the U.S. minimum wage law has no effect, as market wage
rates for low-skilled workers are above the U.S. minimum wage rate. In states where the
minimum wage is above the market wage rate, the law will increase unemployment for lowskilled workers. Although some low-skilled workers will get higher pay, others will lose their
jobs.
Figure 3.7 shows the original price for milk was $2 per gallon. After imposition of the tax, the
supply curves shift up and to the left. Consumers pay $2.60 per gallon. Sellers receive $1.60
per gallon after paying the tax. So sixty cents of the tax is actually paid by consumers, while
forty cents is paid by the milk producers.
The triangle ABC above represents the deadweight loss due to taxation, which occurs
because now there are fewer mutually beneficial exchanges between buyers and sellers.
Deadweight loss stems from foregone economic activity and is a loss that does not lead to an
offsetting gain for other market participants; it is a permanent decrease to consumer and/or
producer surplus.
Elasticity of Supply and Demand and the Incidence of Tax
If buyers have many alternatives to a good with a new tax, they will tend to respond to a rise
in price by buying other things and will, therefore, not accept a much higher price. If sellers
easily can switch to producing other goods, or if they will respond to even a small reduction
in payments by going out of business, then they will not accept a much lower price. The
incidence of the tax will tend to fall on the side of the market that has the least attractive
alternatives and, therefore, has a lower elasticity.
Cigarettes are one example where buyers have relatively few options; we would therefore
expect the primary burden of cigarette taxes to fall upon the buyers.
A subsidy shifts either the demand or supply curve to the right, depending upon whether the
buyer or seller receives the subsidy. If it is the buyer receiving the subsidy, the demand curve
shifts right, leading to an increase in the quantity demanded and the equilibrium price. If the
seller receives the subsidy, the supply curve shifts right and the quantity demanded will
increase, while the equilibrium price decreases.
A quota limits the amounts of a good that can be produced. If the quota is greater than what
would be produced under normal market conditions, then it will have no effect. If the amount
is less, than the market equilibrium that is achieved will be at a higher price than what would
occur without the quota, as consumers will be willing to pay more.
Making a good or service illegally impacts demand, supply and market equilibrium by
imposing a cost (prosecution and punishment) on the buyer or seller (or both) of the
good/service. Quantities of illegal goods will always be less than if they were legal, but the
impact on price is determined by whether the buyer or seller (or both) is punished. If the only
the buyer is penalized, the equilibrium price will be lower; the risk of punishment is regarded
by buyers as a cost, and reduces the price they will pay to the seller. If the seller is penalized,
the equilibrium price will be higher as the cost of punishment is factored into the seller's cost.
Prices will remain relatively unchanged if the risk and cost of punishment is shared equally.
Market - prices firms charge will be impacted by the offerings of other firms. Firms
are in competition with other firms for resources such as employees and raw
materials. Market constraints limit what firms can charge and enforce pricing on the
input side.
Technology - economists view technology as the methods and processes that firms
use to produce goods and/or services. There is a "technology" associated with any
business, and the set of available technologies will limit what a firm can do and
impact its profit.
Technological vs. Economic Efficiency
Technological efficiency relates quantities of inputs to the quantity of output, while economic
efficiency relates the dollar value of inputs to the dollar value of output. A firm would be
operating with technological efficiency when it produces a certain level of output with the
least amount of input. Economic efficiency would be achieved when a certain level of output
is produced with the lowest cost of inputs.
Suppose there are two available methods to produce widgets, one that is highly automated
with industrial robots, and a mostly manual one that requires significantly more workers. The
automated method costs $50,000 per month to produce 1,000 widgets over a monthly period,
using three robots and one worker. The manual method costs $40,000 per month to produce
1,000 widgets over the same time period, with 10 workers that have a minimal amount of
tools. We can't say that either method is technologically inefficient - the automated method
requires fewer workers, while the manual method requires less capital for the same quantity
of output. However, we can say that the manual method is economically efficient, since it
produces 1,000 widgets at the lower cost.
Ways to Organize Production
There are two broadly defined methods of organizing production. A command system utilizes
a hierarchical organization whereby commands flow down from the top of the organization.
Armies typically are organized by this method. An incentive system tries to provide marketlike incentives to each layer of the organization. Sales organizations predominantly use
incentive systems. Incentives also can be provided to personnel, such as assembly line
workers, by relating pay to certain production targets.
The Principal-Agent Problem
The principal-agent problem is an example of incomplete and asymmetric information.
Principal-agent problems occur when the principal (buyer) has less information than the agent
(supplier). For example, a patient at a hospital has much less information about the medical
treatments being conducted than the doctors. The patient would prefer to have the illness
resolved at the lowest possible cost to him. The doctors may be facing pressures or may be
influenced by incentives that are not in the best interests of the patient. It is difficult for the
patient to judge the quality of his or her own treatment.
Owners (shareholders) of firms face similar problems. The owner (principal) compensates an
agent (an employee) to perform acts that are useful to the principal, costly (or otherwise
undesirable) to the agent, and where performance is costly or difficult to observe. Because of
the difficulty/cost of observing the work, the principal finds it difficult to assess the agent's
competence and achievements and adjusting compensation accordingly. Likewise, there is an
inherent conflict of interest at work the principal seeks to gain maximum output for
minimum compensation, while the agent seeks to maximize compensation and minimize
output.
A firm can reduce principal-agent problems by giving the agent an ownership stake in the
enterprise, incentive compensation and/or a long-term employment contract. These serve to
give the agent a vested interest in the overall health of the enterprise and align the interests of
the principal and the agent.
Total Product: The total product is the total quantity of goods produced, in
association with specified levels of input.
Marginal Product: The marginal product is the change in output that occurs when
one more unit of input (such as a unit of labor) is added.
Average Product: The average product is the total product divided by the number of
input units, usually a variable input such as labor.
Example:
Suppose only one worker was present at an assembly plant and that worker had to do all
functions of the plant - order and stock supplies, assemble the good, provide maintenance for
the factory, prepare the good for shipping, etc. If a second worker is added, there may be a
larger increase in productivity, as the two workers can allocate the tasks according to their
abilities, and less time will be lost going to and from various locations in the plant.
A possible schedule of plant output could be as follows:
In this example, hiring the fourth worker increases output by 110 units, which is not as large
as the increase created by hiring the third worker.
The cost of all production factors is equal to the firm's total cost (TC). Total fixed costs (TFC)
include all fixed costs, while total variable costs (TVC) include the cost of all variable inputs
such as labor. Marginal cost is the increase in costs associated with producing additional
output. At some point in time, marginal costs will begin to increase because each additional
worker contributes less to total output. The average fixed cost (AFC) is the fixed cost per unit
of output, while the average variable cost (AVC) specifies the variable cost per unit of output.
AFC and AVC combined are equal to the average total cost (ATC). As production increases,
average fixed cost (total fixed cost divided by quantity) will decrease. When marginal cost
exceeds average total cost, average total costs will go up, at which point the firm must receive
higher prices if higher production is to occur.
The table below assumes that the firm has fixed costs of $1,000 per day, each worker is paid
$200 per day, and each unit produced has variable material costs of $1 per unit.
From the table above we can see that both average total cost and marginal cost initially
decrease as production increase, but both start going up at certain levels of production.
Low entry and exit barriers - there are no restraints on firms entering or exiting the
market
Homogeneity of products - buyers can purchase the good from any seller and receive
the same good
Sellers must take the existing market price; if they set a price above the market price, no one
will buy their product because potential buyers simply will go to other suppliers. Setting a
price below the market price does not make any sense because the firm can sell as much as it
wants to at the market price; selling below the market price will just reduce profits.
Because sellers must take the current market price a purely competitive market is also called
a "price takers" market.
The firm can sell as much as it can produce at the existing market price, so demand is not a
constraint for the firm. Revenue will be simply the market price multiplied by quantity
produced.
Maximizing Profit in Perfect Competition
A price taker can sell as much as it can produce at the existing market price.
So total revenue (TR) will be simply P Q, where P = price and Q = quantity sold.
Marginal revenue (MR), the increase in total revenue for production of one additional unit,
will always be equal to the market price for a price taker.
If the market price of a good is $15, and a firm produces 10 units of a good per day, then its
total revenue for the day will be $15 10 = $150. The marginal revenue associated with
producing an eleventh unit per day would be the market price, $15; total revenue per day
would increase from $150 to $165 (11 $15).
Marginal costs will vary, depending upon the quantity produced. We would expect the firm to
increase input up to the point where marginal cost is equal to the market price. In the short
run, a firm will produce as long as its average variable costs do not exceed the market price.
If the market price is less than the firm's total average cost, but greater than its average
variable cost, then the firm will still operate in the short run. Its losses will be lowered by
producing, since nothing can be done about fixed costs in the short run. Over the long run, the
firm will need to cover all of it costs if it is to keep on producing.
If the market price at least covers the firm's variable costs, it may make sense to keep on
operating. Any price in excess of the average variable cost will at least help to cover the fixed
cost. Unless the firm decides to completely leave the business, it will come out ahead by
continuing to operate.
If the market price is below the firm's average variable cost, it will not make sense for the
firm to operate as it will lose even more money. If the firm believes that business conditions
will improve, it will temporarily shut down. Seasonal businesses such as ski resorts or
restaurants located by vacation areas will shut down temporarily at certain times.
Manufacturers temporarily might shut down a factory and plan to reopen the factory when
business conditions improve.
When Does a Firm Maximize Profit in Perfect Competition?
Profit () is equal to total revenue minus total cost. We can express this mathematically by
stating:
= TR - TC
In terms of calculus, we can state that profit will be maximized when the first derivative of
the profit function is equal to zero:
d = dTR -dTC= 0
dQ dQ dQ
We also can rearrange the terms to state that profit maximization occurs when:
Formula 3.4
dTR = dTC
dQ
dQ
The term on the left represents the change in revenue from producing one more unit, which is
called marginal revenue. The term on the right represents the change in total costs resulting
from producing one more unit, which is marginal cost.
The firm's profit will be maximized at the level of output whereby the marginal (additional)
revenue received from the last unit produced is just equal to the marginal (additional) cost
incurred by producing that last unit. Maximum profit for the firm occurs at the output level
where MR = MC.
For a firm operating in a competitive environment, the marginal revenue received is always
equal to the market price. Therefore a firm operating under perfect competition will always
produce at the level of output where the marginal cost of the last unit produced is just equal to
the market price.
The following equation will hold:
Formula 3.5
MR = MC = P
experiencing economic profits (losses). Over time, markets with firms experiencing economic
profits (losses) will have additional firms enter (existing firms will exit) the market, and
prices will decrease (increase) towards previous levels. If cost conditions remain the same,
then prices will revert to what they were before the increase (decrease) in demand.
If the market price falls below a firm's average total cost, the firm will incur economic losses.
The firm may be able to lower its average total cost by changing to a different plant size.
Suppose a firm increases its plant size, and lowers its average total costs. If other firms
follow, then the industry supply curve will shift to the right. This will result in lower prices
and less economic profit.
If a firm does not expect market conditions to improve then it may decide to go out of
business. This would be the preferred option as, by selling out, neither fixed nor variable
costs would be incurred.
Impact From Changes in Technology
The impact of a permanent change of demand on price and output for a market will be
influenced by the cost structure of suppliers in the market. The long-run market supply curve
in a competitive industry will depend on the returns to scale.
For a constant-cost industry, if demand increases, then firms temporarily will make a profit as
price will go above the minimum needed for the firms to stay in business. This will cause
firms to expand output or new firms to enter the industry. Because costs are constant in the
long run, the long-run supply curve will be horizontal. In the graph below, as demand shifts
from D1 to D2, over the long run quantity will increase from Q1 to Q2. However, price will
remain the same.
Figure 3.12: Long Run Supply: Constant Cost Industry
For an increasing cost industry, if demand increases, firms will need higher prices over the
long run in order to justify higher levels of production. For example, prices for raw materials
used in the industry may go up with higher levels of production, which will force the longrun supply curve to slope upward.
Figure 3.10: Long Run Supply: Increasing Cost Industry
For a decreasing cost industry, if demand increases, in the long run firms can provide more
output at lower prices. The need to produce larger quantities of goods and services in
response to increased demand induces technological change, which lowers costs for the
producer and these savings are passed on to consumers in the long run.
Figure 3.11: Long Run Supply: Decreasing Cost Industry
To some degree, natural monopolies occur in the computer industry, where customers want to
adhere to a common standard. The common standard for personal computer operating
systems is provided by Microsoft. Alternative operating systems for personal computers (such
as LINUX) do not make sense for most consumers, so Microsoft has considerable monopoly
power.
The Monopolist and Profit Maximization
The monopolist has control both over the quantity produced and price charged; it also faces
the entire demand curve for the good produced. Therefore, it will face a downward-sloping
demand curve. It follows the general rule for profit maximization, MR = MC. As the
monopolist does not know exactly how much consumers are willing to buy at particular
prices, it must "search" for the optimum price.
Figure 3.12: Monopolist Profit Maximization
As shown in the graph above, a monopolist facing demand curve D0 will produce quantity Q0
and the price charged will be equal to P0.
What happens if the monopolist later faces a demand curve such as D1? In that case, the
monopolist cannot cover costs and will go out of business.
Weakened market forces - when consumers of a product have many alternatives, producers
must serve their customers efficiently in order to stay in business. If consumers can't purchase
competitive products easily, the monopolist doesn't need to worry a lot about losing
customers when poor service or a poor quality good is provided.
Rent or favor seeking - firms and/or individuals will put a great deal of effort into obtaining
or maintaining high entry barriers; by doing so, they hope to achieve monopoly-type profits.
Such efforts enrich some people, at the expense of many others.
Price Discrimination
Price searchers effectively price discriminate among their customers when they are able to:
a) identify sub-groups which have different elasticities of demand, and
b) ensure that the customers cannot resell the good.
A common example is airline travel. Travelers who plan in advance will have a higher
elasticity of demand than travelers who must travel within a short period of time.
With price discrimination, some consumers pay higher prices than they would if there was a
single price. However, many in the group paying lower prices will now be getting something
they otherwise would not have purchased. Universities are increasing their use of price
discrimination. Tuition rates for students without financial aid are increasing greatly while the
average price charged is not going up as much because more financial aid is being offered.
The colleges reap high revenues from wealthy families who can afford to pay high tuition
while more students from lower-income families can now attend college.
In general, higher output will occur with price discrimination. Furthermore, there may be
some businesses that could not exist without price discrimination. For example, a dentist in a
small town may not have a viable business without performing price discrimination.
As price discrimination increases output and gains from trade, it reduces allocative
inefficiency. Firms that successfully price discriminate will benefit by getting higher
revenues.
Why Do Monopolies Exist?
If a natural monopoly is to exist, the government can regulate the price and output. In the
graph below, the monopolist would prefer to charge price P1 and Q1 to maximize profits. A
regulatory agency will often set the price at P2. At this price, the monopolist receives enough
to cover costs and, in effect, it receives a competitive rate or return of its capital. The benefits
to society from the increased production outweigh the increased costs to the monopolist.
Figure 3.13: Results of Regulating Price and Output
The phrase "contestable markets" describes markets where there are few sellers, but they
behave in a competitive manner because of the threat of new entrants. For instance, an airline
may serve a particular route exclusively, but does not charge excessive prices because those
prices would entice additional airlines to offer that route.
Government regulation is often used to keep new firms out of markets. Economists generally
favor deregulation as this helps to keep prices low.
Prices over the long run in a competitive market will move to the lowest point of the firm's
average total cost curve. We then have allocative efficiency because desired goods are
produced at the lowest possible cost.
Because price searchers face downward-sloping demand curves, the price they charge will
exceed the firm's marginal cost. The price charged and the quantity produced will not be
where the firm minimizes average total costs. Figure 3.16 illustrates these points.
Figure 3.16: Monopolistic Competition: Low Barriers to Entry
Microeconomics - Oligopolies
What is an Oligopoly?
Oligopoly refers to a market with "few sellers". Oligopolies interact among themselves.
When an oligopolist changes a price, it must take into account how other firms in the industry
will respond. Within an oligopoly, the products can be similar or differentiated. Oligopoly
The optimum result for the two together is to stay silent, in which Dave and Henry will each
get only three months prison time. However, each prisoner does not have knowledge of what
the other prisoner will do. The most rational response from the individual is to confess. If the
other prisoner stays silent, then that person gets off free; if the other prisoner confesses, then
the prison term will be less (five years vs. 20 years).
The prisoners' dilemma illustrates a situation in which individuals arrive at a non-optimal
solution, due to a lack of cooperation and trust. A similar situation occurs with oligopolies. If
firms within an oligopolistic industry have cooperation and trust with each other, then they
can theoretically maximize industry profits by setting a monopolistic price. Firms would then
have to figure out how to fairly divide up the profits.
If oligopolies collude successfully, they will set price and output such that MR = MC for the
industry overall. In figure 3.17 on the following page, this is depicted as Pa and Qa. Without
collusion, firms will lower prices to attract more customers. Gradually, the price and output
will move to Pb and Qb, which is identical to what would be achieved with a competitive
market.
Figure 3.16: Oligopolist Profit Maximization
Oligopolies have strong incentives to collude because while acting together, they can restrict
output and set prices so that economic profits are earned. The individual oligopolist has an
incentive to cheat because the firm's demand curve is more elastic than the overall market
demand curve. By secretly lowering prices, the firm can sell to customers who would not buy
at the higher price, as well as to customers who normally buy from the other firms.
Oligopolistic agreements tend to be unstable due to these conflicting tendencies.
Obstacles to collusion within oligopolies include:
Low Entry Barriers - Particularly as time goes on, more firms will be attracted to the
potential economic profits, which will not be sustainable. For example, the OPEC's raising of
oil prices during the 1970s and early 1980s enticed more non-OPEC producers to produce
more. The market share of OPEC producers was drastically reduced and they had to reduce
prices in order to gain market share. In the long run, cartels are not usually successful at
raising prices.
Antitrust Laws - these laws prohibit collusion. Although firms may make secret agreements,
those agreements will not be enforceable in a court of law.
Unstable Demand Conditions - These conditions will make collusion more difficult, as
firms are more likely to have disagreements as to what is the best direction for the industry.
Some may expect large increases in demand, while others may disagree and prefer that
industry capacity remains the same.
Increasing Number of Firms - An increasing number of firms in an oligopolistic industry
will make agreements harder to discuss, negotiate and enforce. Differences of opinion are
more likely. As the number of firms in the industry increases, the industry will behave more
like a competitive market.
Difficulties with Detecting and Stopping Price Cuts - These difficulties will undermine
effective collusion. Sometimes oligopolistic firms will cheat by enacting quality
improvements, easier credit terms and free shipping. If quality changes can be used to
compete, collusive price agreements will not be effective.
Microeconomics - Conclusion
Within this Section we have focused on the basics of microeconomics, the properties of
demand and supply, price takers and searchers, and demand and supply for resources and
capital. For a quick review, we've summarized the characteristics of the various market types
below.