Micro Notes

1
MICROECONOMICS1:
Microeconomics is concerned with the individual parts of the economy. It is con-

cerned with the demand and supply of particular goods and services and resources. It
focuses in other words on individual markets.
Scarcity: The excess of human wants over what can actually be produced to ful-
fill these wants (limited resources vs. unlimited human wants)
Human wants are unlimited. On the other hand the means of fulfilling these human
wants are limited, because the world only has a limited amount of resources (or, fac-
tors of production). As a result, choices have to be made. The opportunity cost of a
choice is the value of the next best alternative sacrificed
Resources (Factors of Production)
a. Land and raw materials (Natural Resources):
These are inputs into production that are provided by nature e.g.: unimproved land
and mineral deposits in the ground, forests, pastures etc. The worlds land area and
raw materials is limited. Some resources are non-renewable. If they are used now,
they will not be available in the future e.g. oil, coal deposits. Their rate of depletion is
very important. In general one can argue that their rate of depletion has to be such
that future generations are not disadvantaged. Other resources are renewable e.g. for-
ests (timber), fish; in general living things that will reproduce themselves naturally.
(related topic: sustainable development; see Smith and Rees, search the internet)
b. Labor (human resources):
All forms of human input, both physical and mental, into current production. The la-
bor force is, at any point in time, limited both in number and in skills. A basic deter-
minant of the amount of a nations labor is population. Birth rates, death rates and the
balance of migration movements into and out of a country determine the size of the
population. Note that the whole population is not available for use in production.
Only the people of working age are (16-65 years old), but many choose not to work
(school, early retirement, family). The total number of people available for work is
referred to collectively as the labor force or working population. The fraction of the
total population who are in the labor force defines activity rate or the participation rate
(Note: Human capital refers to the training, education and skills embodied in
the labor force; government investment in human capital is perhaps the most
significant type of policy especially for a developing nation.)
1
These notes have been prepared by C.H. Ziogas for use by the Higher Level Economics students of
the IB program at the Moraitis School. This is a 1st draft version.
c.h. ziogas (ziogas11@yahoo.com)

The IB @ The Moraitis School
(This is a DRAFT copy)
2
c. Capital:
Physical capital includes manufactured resources (produced means of production, or

man made aids to production, or, goods that are used to produce other goods). The
world has a limited stock of capital: limited supply of factories, machines, transporta-
tion and other equipment. The productivity of capital is limited by the state of tech-
nology.
Fixed Capital provides a stream of services during its lifetime and comprises mainly
plant and equipment. e.g.: machines, tools, equipment and buildings.
Working Capital (also, circulating capital) circulates through the production process.
E.g.: stock of raw materials (e.g. mozzarella for Pizza Hut) that a firm is waiting to
use, goods in the process of being produced and all stocks of finished goods waiting
to be sold. Note that the meaning of capital in economics is different than that used in
ordinary speech where people refer to money as capital (= financial capital)
d. Entrepreneurship
Close to, but different from, management. When a new venture is being contem-
plated, risks exist. They involve the unknown future. Someone must assess these
risks and make judgments about whether or not to undertake them. The people who
do so are called entrepreneurs. Today much effort goes into research and develop-
ment that lies behind new products (product innovation) and new processes (process
innovation). Entrepreneurship refers to the willingness and ability to take risks and
mobilize the remaining factors of production. Note that the minimum return (reward)
required securing and maintaining the factor entrepreneurship in a specific line of
business is known as normal profit.
Positive and Normative Economic Statements:
Normative Economic Statements: they are value judgments, opinions, statements

that can NOT be proven right or wrong, that can not be tested against fact (data), that
cannot be falsified. e.g.: inflation is rising too fast or the income distribution is not
fair. Key words in normative statements include: ought to be, should be, too much,
too little, fair, unfair etc.
Positive Economic Statements: statements that can be proven, at least in principle,

right or wrong. They can be tested against facts (data) and they can be falsified. e.g.:
a minimum wage policy will increase unemployment among unskilled workers.
Free Goods (in contrast to economic goods): goods that have a zero opportunity cost
of production (very few real world examples; perhaps sea water and air); Note that
free goods in the economists sense are NOT goods with a zero price.
Competitive Market:
A market is considered competitive if: there are very many (infinite many) small)
firms in it, if the good is homogeneous (i.e. it is considered identical across firms so
consumers are indifferent as to whether they buy the good from firm A or from firm

3
B) and if no entry or exit barriers exist (i.e. free entry and exit into and from the in-
dustry). Exit is free if there are no sunk costs involved. Sunk costs refer to costs
that cannot be recouped (recovered) upon exit. (Related concept: contestable markets
later in these notes)
Consumer Sovereignty
..the idea that in a free, competitive market economy it is consumers that dictate
to firms which goods and services and in what amounts will be produced. Paul
Samuelson (the first Nobel prize in Economics) characteristically wrote about the
dollar votes that consumers cast every time they buy a product. The idea is that if
demand for a good rises, more of it will be produced given that the price and firm
profits rise whereas if demand decreases then less will be produced since the price
will drop and firm profits will decrease and may even turn into losses. Complete con-
sumer sovereignty presupposes that consumer preferences are independent of firms.
In reality, firms, through advertising, are in a position to manipulate consumer prefer-
ences often creating demand for new products or increasing it. One may not claim
though that there is complete producer sovereignty. Even in the face of the huge in
size modern multinational corporations producer sovereignty is far from complete.
The bankruptcies of many giants testify to this. (see demand later)
Fundamental Questions of Economics (that all societies face, independently of their

level of development or the economic system adopted)
Scarcity necessitates choice and thus answers to the following questions:

a. What (i.e. which goods) will be produced and in what quantities?
b. How will each good be produced (using, say, a labor-intensive or capital-
intensive technology?)
c. For whom? (the distribution problem)
The Production Possibility Frontier (or, Curve or, Boundary)
A PPF refers to an economy (not a firm), which has (is endowed with) a fixed amount
of resources, is characterized by a given level of technology, produces only two goods
(or two classes of goods) and fully utilizes all available resources.
Because resources are not equally well suited for the production of all goods (in other
words, because resources tend to be specialized) the PPF is bowed towards the origin
(concave to the origin). If resources were perfectly substitutable (i.e. if they were
equally well suited for the production of both goods) then the PPF would be linear
(constant opportunity costs, constant marginal costs)
A PPF shows the maximum amount of good Y that an economy CAN produce for
each and every amount of good X it produces, if it fully utilizes all available resources
with its given level of technology. Alternatively, a PPF is the locus of points which
show the productive limits of an economy. A PPF is a technological relationship; it
provides us no information about choices. It shows what an economy CAN do, not
what it chooses to do.

4
Typically, a PPF is concave (bowed in) towards the origin; the slope becomes steeper
and steeper i.e. the opportunity cost of producing more and more of good x (the one
on the horizontal axis) is increasing: law of increasing (marginal) cost.
Points outside a PPF denote output combinations of the two goods that are unattain-
able given the resources available and the present level of technology.
Points inside PPF: denote attainable but inefficient output combinations in the sense
that resources are not fully utilized e.g. unemployment is present2.
Points on the PPF: denote attainable and efficient combinations (i.e. no waste of
scarce resources is present; also, it is not possible to achieve more of one good with-
out sacrificing some of the other).
Growth of an economy can be illustrated through an outward shift of the PPF. We

can distinguish between:
1) Actual growth: an increase in the amounts of goods and services actually produced
(a movement from a point inside the PPF to another one with more of at least one
good). Real GDP (related concept) has increased.
2) Potential growth: the rate at which a countrys economy could grow, if all its re-
sources were fully employed (an outward shift of the PPF) / (see Smith & Rees:
Economic Development)
(related concepts: trade cycle; potential output; trend output)
(Note: the idea of development is often illustrated within the IB with an outward
shift of a production possibilities curve where on the axes, merit3 goods and luxury
goods are denoted; development is said to have taken place if the outward shift is
greater for the so called merit goods. Strictly speaking, this is incorrect, since even
if the economy CAN produce more merit goods compared to luxury goods- it is
NOT a priori known whether it will indeed choose to produce more merit goods! It
could very well be the case that despite the potential for more merit goods, it is more
fur coats that are indeed produced! Remember, the PPF does not provide us informa-
tion about the choices a society makes; it provides us information only about the pro-
duction possibilities it possesses)
In general growth can occur either if the amount of available resources increases, or,
if technology improves.
More specifically, it occurs if there is an increase in:
Land: e.g. if new metal deposits/minerals are discovered.
2
So, if an economy suffers from unemployment, it is located somewhere inside its PPF (its production
possibilities); if unemployment decreases, it will move to a point further towards the PPF; the PPF will
not shift, since the amount of labor (resources more generally) available has not increased. It is only
that the existing resources are utilized more efficiently.
3
Later in this set of notes a precise definition of merit goods is provided. For the time being, typical
examples merit goods include basic education and basic health care.
5
Labor: if population increases (through a natural increase and /or if net in-
migration occurs), if there is an increase in the number of people in the work-
ing age, if there is an increase in the participation rate of some population sub-
set (e.g. more women decide to join labor force or, more teenagers), and if
skills / level of education embodied in the labor force improves (in other
words, if human capital increases).
Capital: if the stock4 of capital (i.e. of machines, tools, equipment, buildings
etc) increases. The stock of capital can increase by investment.
(Related concept: the HarrodDomar growth model; see later my development notes)
Investment
Definition: the change in the stock of capital (of a firm or of an economy) over the
change in time. When a firm spends to acquire more machines, more tools, more fac-
tories, we say that it is investing. (see my macro notes for the three types of invest-
ment spending)
Do not confuse with financial investment. Also note that it is only firms that invest.
Households (people) may undertake financial investments (but not economic in-
vestments since households do not produce goods / services)5
More formally: I = K/t
If a firm (or an economy) had at the beginning of a time period 22 machines and at the
end it had 28 machines then investment equal to 6 machines took place in that period
of time6.
The opportunity cost of increasing the stock of capital of an economy (in other words
the opportunity cost of investment) is sacrificing present consumption, presumably in
order to be able to enjoy increased consumption opportunities in the future (this can
be shown can be shown through a PPF with consumption goods in one axis and capi-
tal goods in the other axis)
Focusing now on a market economy:
A market economy is one where market forces alone, without Government or

God intervening, provide answers to the three fundamental questions, and in
which private property rights are well defined and enforced.
The participants in a market economy are consumers and producers. The interaction
of consumers and producers (firms) in markets determine the market price of each
4
note the distinction in Economics between so called stock variables which are defined at a point in
time and flow variables which require a time dimension.
5
Households may also undertake investment in human capital: by acquiring more education, more
skills, more training.
6
Check the idea of depreciation (capital consumption) in my macro notes.
6
product. Changes in market conditions thus result in market price changes which set
off a chain of events leading to more or less of the good being produced and thus to a
change in the allocation of scarce resources.
Definition of a market:
A market can be defined as a process (or, an institution) in which producers and
consumers interact in order to sell and buy a good or a service.
To analyze the functioning of markets we thus need to somehow analytically

summarize the behavior of consumers and the behavior of producers (firms).
Consumer Demand:
The concept is an analytical way of summarizing the behavior of buyers. Specifically,
we define demand as the relationship between various possible prices of a good and
the corresponding quantities that consumers are willing and able to purchase per time
period, ceteris paribus (i.e. all other factors affecting demand remaining constant)
Demand Curve:
A graph showing the relationship between the price of a good and the quantity of the
good demanded over a given time period. Price per unit is measured on the vertical
axis; quantity demanded per time period is measured on the horizontal axis. A de-
mand curve can be for an individual consumer or for the whole market. The market
demand curve is diagrammatically derived by the horizontal summation of the indi-
vidual demand curves.
Law of Demand:
The inverse relationship between price and quantity demanded; when the price of a
good rises, quantity demanded will fall, ceteris paribus7.
Exceptions to the law (demand being positively sloped) include Giffen goods and
Veblen (also known as status symbols or snob goods; ostentatious consumption).
All Giffen goods are inferior goods (but all inferior goods are not Giffen goods).
Veblen goods though are of course not inferior. The typical example in the litera-
ture of Giffen goods is the one provided by Sir R. Giffen himself: potato demand
by the poor Irish farmers during the Irish famine of the 19th century.
The Law of Demand holds because of:

the substitution effect: if the price of good X rises, all other goods automatically be-
come relatively cheaper; thus, people will tend to substitute other goods for X. The
size of the substitution effect depends primarily on the number and closeness of avail-
able substitute goods.
the income effect: if the price of X rises, consumers real income8 drops; thus, people
will tend to buy less. The size of the income effect depends primarily on the propor-
tion of income spent on the good.
7
A most common mistakes students make is to loosely employ the terms demand and quantity de-
manded: a change in the price of a product leads to a change of quantity demanded NOT demand!
More on this difference can be found later in these notes.
7
Note: Be careful about the meaning of the term quantity demanded. It refers to the
amount that consumers are willing and able to purchase at a given price over a given
time period. It does not refer to what people would simply want to consume. Note that
willingness reflects preferences whereas ability reflects the income constraint one
faces.9
Statement of the problem that the typical consumer faces:

He/she has a fixed amount of income (Y) and he/she faces a fixed set of prices.
We assume that consumers seek to allocate their expenditures among all the goods
and services that they might buy so as to gain the greatest possible utility (satisfac-
tion).
Definition of Utility:
Utility is the satisfaction one gains by consuming a good or a service.
Goal of (rational10) Consumer: To maximize his/her utility, subject to his/her budget

(i.e. income) constraint.
The logical rule for maximizing utility:
MU of the last euro spent on A should equal the MU of the last euro spent on B (1)
In general, the marginal utility derived from the last unit acquired of some commodity
divided by its price per unit should be the same across goods. So,
MU of A / price of A = MU of B / price of B (2)
Rearranging (2) produces the following result:
MU of A / MU of B = price of A / price of B
This means that in equilibrium the consumer will adjust purchases of any two goods
until their marginal utilities are proportional to their prices. For example if a unit of A
costs twice as a unit of B, the marginal utility from the last unit of A must provide
double that from the last unit of B.
We will now examine the relationship between utility and the quantity consumed for
an individual: as more of a good is consumed, the extra satisfaction decreases (and
after a point it might even become negative). This is the Law of Diminishing Marginal
Utility.
8
Income is not the same as money or wealth! Income is the sum of wages, interest, rents and prof-
its: the rewards to the factors of production one owns and offers to the production process. It is a
flow variable in the sense that it requires a time dimension to make sense: if I claim that my income is
500 euros you can not be sure I am making a lot of a little if I do not specify a time dimension: is it 500
an hour, or a week, or a month?
9
See later in these notes the discussion about the desirability of allocative efficiency that rests on this
point.
10
A consumer is rational if his preferences are consistent; for example if a consumer prefers some
basket (set) of goods A to some basket of goods B and prefers basket B to some other basket of goods
C, than the rational consumer must prefer basket A to basket C. For our purposes though, it suffices to
say that a rational consumer behaves in such a way to achieve his goal i.e. to maximize his utility.
8
A demand curve is negatively sloped due to the income effect and the substitution ef-
fect11 (and it follows from the Law of Diminishing Marginal Utility).
Other factors affecting Demand (so called shift factors):
1) Changes in consumers income (Y).

As income rises, demand for most goods will rise (demand will shift to the right).
Such goods are called normal goods. There are exceptions to this general rule, how-
ever. As people get richer, they spend less on inferior goods, such as low quality food
or lower quality clothing, and switch to better quality goods. The demand for inferior
goods decreases when incomes increase (demand for inferior goods will shift to the
left). They are characterized by a negative income elasticity of demand (more on this
later). Thus if incomes in an economy rise through time, the pattern of demand will
change. This has important implications on production, unemployment etc (related
concept in my macro notes: trade cycle)
2) Changes in preferences (tastes).

The more desirable people find a good, the more they will demand it. Tastes are af-
fected by advertising, by fashion, by observing other consumers, by considerations of
health etc. Note that the concept of consumer sovereignty rests on the idea that firms
in competitive markets are forced to respond to changes in consumer preferences in
order to survive. The consumer dictates (through his euro votes) which goods and in
what amounts will be produced. In the real world, consumer sovereignty is far from
complete as firms, through advertising, manipulate these preferences.
3) Changes in the price of other goods.

Two cases are distinguished:
Case of Complements:
Defined as goods that are consumed together (jointly consumed), such as peanut
butter and jelly, shoes and shoe polish etc. When the price of a complement of good X
rises, demand for X will drop (shift left).
Case of substitutes:
Defined as goods in competitive consumption, such as pizza and burgers: When the
price of a substitute of good X rises, demand for X will rise (will shift right; e.g. if
Pepsis price rises, demand from Coke will increase)
4) Size of the market i.e. number of consumers.

As the size of a market (the number of consumers) increases, demand for most prod-
ucts will tend to rise.
7) Age distribution of the population:

A change in the age distribution would affect the pattern of demand. Classic example
refers to an ageing population where demand for fake teeth will rise and for chewing
gum will drop.
7) Changes in the distribution of income

11
For most purposes it does not matter how you draw a demand curve: whether it is linear or not,
whether it intersects the axes or not, as long as it reflects the law of demand, i.e. as long as it is nega-
tively sloped!
9
If the income distribution becomes less skewed and more equal, demand for certain
luxuries may drop and for certain basic goods and services to rise.
6) Changes in the distribution of sex in the population

A change in the proportion of males to females may also affect the pattern of demand.
7) Expectations (of changes in market prices, in income etc.)

For example, if people think that the price of a good is going to rise in the future, they
are likely to buy more now before prices go up.
Shifts of Demand versus Movements Along a Demand (source of a typical student

mistake)
A shift in the demand curve occurs curve, there must have been a shift of
when a determinant other than the the supply curve. Given such an in-
price changes; we then say that a crease in price, the decrease in quantity
change in demand has occurred. A demanded is also known as a contrac-
movement along the demand curve oc- tion in demand whereas the rise in
curs when there is a change in price; quantity demanded that follows a price
we then say there is a change in quan- decrease is also known as an exten-
tity demanded. Note that for a change sion of demand.
in price to occur along a demand
Consumer surplus
Definition: The difference between area under the demand and above the
what a consumer is prepared to pay price line. This is a very significant
and what she actually pays for a given concept that will aid our analyses of
amount of a good. Represented by the welfare changes.
Supply:
The concept of supply is merely a way to analytically summarize the behavior and
goals of firms. It is defined as the relationship between various possible prices and
the corresponding quantities that firms are willing to offer per time period, ceteris
paribus.
Supply curve:
A graph showing the relationship be- to offer greater quantities per period
tween the price of a good and the only if market price is higher, given
quantity that a firm (or, firms) is (are) that (marginal) costs rise (as a result of
willing to offer over a given period of the law of diminishing marginal re-
time. It may be upwards sloping, verti- turns- later in notes) In the long run,
cal, horizontal or even negatively when producers have more time to ad-
sloped. In the short run it will be up- just fully to changes such as rising de-
ward sloping as firms will be prepared mand, costs need not rise. A supply

10
curve may therefore even be down- to scale later in these notes)

wards sloping. (see increasing returns

11
Note:
Three time periods are conventionally recognized for supply:
a. Momentary period (or, Market period): situations when there is insufficient time
to alter quantities offered for sale / all factors of production are considered fixed
b. Short-run: refers to a period over which production can be varied within the con-
fines of the producers existing productive facilities / some factor (the size of the
firm, its capacity) is considered fixed
c. Long-run: refers to a period long enough to alter everything that producers wish to
alter in response to a change in price. / all factors are considered variable
Supply and Price: The relationship (at least in the short run) between price and quan-
tity supplied is a direct (positive) relationship. Why?
A simplistic answer: at higher prices, a more and more costly (law of dimin-
firms profit margin is greater, thus it ishing marginal returns of increasing
will be willing to offer more of the marginal costs). If this holds, then a
good. More correctly: whereas the firm will be willing to offer more units
consumer is assumed to seek to maxi- of the good only if the market price is
mize utility, the producer is assumed to higher. Also, if the price remains high,
seek to maximize profits. Assuming new producers will be encouraged to
fixed productive capacity, producing set up in production. Total market sup-
ever increasing quantities of a good, ply thus rises. So, if price rises, quan-
becomes more and more difficult i.e. tity supplied is expected to increase.
Factors affecting supply (shift factors)
1) Costs of production.
The higher the costs of production, the ter the costs of production i.e. sup-
less profit will be made at any price. ply will increase (shift to the right).
As costs rise, firms will cut back on c. Change in productivity (output per
production, probably switching to al- unit of input).
ternative products whose costs have d. Changes in Government policy:
not risen so much. The main reasons costs will be lowered by govern-
for a change in costs are as follows: ment subsidies and raised by the
a. Changes in input prices: costs of imposition of indirect taxes (with
production will rise if wages, raw an indirect tax its as if production
material prices, rents, interest rates costs rise so, supply decreases, i.e.
or any other input prices change. shifts left: the vertical shift is equal
b. Change in technology: technologi- to the tax per unit; symmetrically,
cal advances can fundamentally al- in the case of a subsidy)
2) Size of the market i.e. number of firms in the market.
3) Expectations of future price changes.
4) Other factors, such as weather conditions as is the case for farm products

12
Producer Surplus:
defined as the difference between what a producer earns and the minimum required
to offer that amount. Diagrammatically, it is the area below the price and above the
supply curve.
Price And Output Determination in Competitive Markets
The interaction of market demand and tend to rise. It follows that there will
market supply determines the equilib- be no tendency for the price to change
rium price and output. If, at some (= equilibrium) if there is neither ex-
price, excess supply exists, then the cess supply nor excess demand in the
price will tend to drop. If excess de- market. In other words, if Qd = Qs.
mand is the case then the price will Diagrammatically:
At P = P1:
Qd=Q1 and Qs=Q0 : Qs>Qd i.e. there is excess supply (ES) in the market. If ES ex-
ists, then the price will tend to drop.
At P=P2:
Qd=Q3 and Qs=Q4: Qd>Qs i.e. there is excess demand (shortage). If ED exists then
the price will tend to rise.
Equilibrium condition: A price will be an equilibrium price, if neither ED nor ES

exists or equivalently, if ED=ES=0 or equivalently, if Qd = Qs.
In this case P is the market price (the equilibrium price) since at P, Qd = Qs = Q.
The Allocation Of Scarce Resources
Problem: Determine the optimal amount (from societys point of view) to be produced
of each good (and, as a result, the optimal resource allocation)
Assume two goods: apples and or- Should one more unit (a kilogram, a
anges, and one resource, land (e.g. the ton, whatever) of apples be produced?
island of Crete). Determine some allo- Consequently, should more land go to
cation of land, which, in turn, deter- the production of apples? The answer
mines some amount of apples and will be yes, if that one more unit of
some amount of oranges being pro- apples is valued more by society
duced. The question that arises is: (measured by how much society would

13
be willing to pay, the vertical distance a free competitive market (i.e. where
up from that Q towards the demand no monopoly power exists), where de-
curve) than what it costs society to cision making units (i.e. house-
produce it, i.e. more than the value of holds/consumers and firms/producers
sacrificed oranges (measured by the take into consideration the full true
vertical distance up from that Q to- benefits and costs of their actions (i.e.
wards the supply curve). where externalities are not present
see notes further down) and where
Thus, more should be produced as long consumers can not conceal their true
as the extra benefit to society from the preferences (i.e. where no free-riders
increased production exceeds the extra exist thus ruling out the case of public
cost it entails that reflects the value of goods see notes further down), then
the alternatives sacrificed. Output is the market forces themselves will lead
optimal from societys point of view to the optimal amount of each good
when for the last unit, Price (= MB) is being produced and consumed and thus
equal to Marginal Cost i.e. when all the to an optimal from societys point of
net benefits have been exhausted (al- view resource allocation. Social sur-
ternatively, when the marginal valua- plus (the sum of the consumer and
tion of the last unit equals its marginal producer surplus) is maximized. Allo-
cost i.e. the marginal valuation of cative efficiency has been achieved.
what has to be sacrificed). Note that in (more on this important concept later).
What if only OQ units are produced? (as is the case under monopoly)
Consumer surplus (C.S)= area (PHF)
Producer surplus (P.S)= area (AKHP)
Social surplus: AKHF
There is a welfare loss involved equal to the area (KLH) that reflects the alloca-
tive inefficiency resulting from the fact that less than the socially optimal amount
of the good is produced (under monopoly). The market forces (consumers &
producers) have failed to reach the socially efficient outcome (more on this issue
later).

14
ELASTICITY
Definition:
In general, elasticity is defined as the responsiveness of something (an economic vari-
able), when something else (another economic variable) changes.
We will examine:
Price elasticity of demand.
Income elasticity of demand.
Cross Price elasticity of demand.
Price elasticity of supply.
Price Elasticity Of Demand (PED)
definition: the responsiveness of quantity demanded to a change in price.

symbol: PED or, ep, or, Ep
measure: The percentage change in quantity demanded divided by the percent-
age change in price: Ep = %Qd /% P i.e. Ep = (Q/Q1) / (P/P1)
PED is thus the ratio of the changes of two variables (P & Qd) that change (move) in
opposite direction: if P rises, then Qd decreases and vice versa. As a result PED is
always a negative number. Often the minus sign is ignored. BUT, in PED computa-
tional questions, never forget to use the minus sign, even if it is not provided!
Ranges of Price Elasticity of Demand (ignoring the minus sign)

I. Demand is elastic (for small changes around the initial price): if Ep>1 i.e. the
percentage change in quantity demanded is larger than the percentage change
in price. Demand in this range is relatively responsive to price changes (de-
mand is elastic for small changes around the current price if a change in price
leads to a proportionately greater change in quantity demanded)
II. Demand is inelastic (for small changes around the initial price): if 0<Ep<1 i.e.
the percentage change in quantity demanded is smaller than the percentage
change in price (if the change in price leads to a proportionately smaller
change in quantity demanded). Demand in this range is relatively unrespon-
sive to price changes.
III. Demand is unit elastic: Ep=1 i.e. the percentage change in quantity demanded
is equal to the percentage change in price.
IV. Demand is perfectly elastic: Ep . Infinite elasticity arises when a small
decrease in price raises quantity demanded from zero to an infinitely large
amount. In other words, if price rises even slightly, nothing will be bought
from the consumers. A demand curve of infinite elasticity as a straight hori-
zontal line.
V. Demand is perfectly inelastic: Ep=0. A change in price has no effect on quan-
tity demanded. A demand curve of zero elasticity is a straight vertical line.
NOTE: Even along a linear (i.e. constant slope), demand curve, PED is NOT con-
stant, but continuously changes (from infinity to zero). There are however the follow-
ing exceptions, where PED is constant throughout the length of the curve:
1. The case of a perfectly inelastic demand curve.

15
2. The case of a perfectly elastic demand curve.
3. The case of a unitary elastic demand curve (rectangular hyperbola: Q = a/P).

Note: all areas below represent total revenues / total consumer expenditures and are
equal
Relationship between PED and Total firm Revenues (TR)

Total Revenue (TR) is the product of price times quantity bought. It is not the same
as profits12.
TR(Q) = P*Q
What will happen to firms revenues (and hence consumer expenditures) if there is a
change in price?
The answer depends on the price elasticity of demand:
If price changes and Ep>1

As price rises, quantity demanded falls, and vice versa. When demand is elastic, quan-
tity demanded changes proportionately more than price. Thus the change in quantity
has a bigger effect on total consumer expenditure than does the change in price. Since
demand is elastic, total expenditure changes in the same direction as quantity:
if P rises, Q falls proportionately more; thus TR / TE falls.
if P falls, Q rises proportionately more; thus TR / TE rises.
12
Profits are the difference between total revenues and total production costs.
16
When demand is elastic, then, a rise in price will cause a fall in total consumer expen-
diture and thus a fall in the total revenues. A reduction in price however, will result in
consumers spending more, and hence firms earning more.
If price changes and 0<Ep<1 (i.e. inelastic).

Price rises proportionately more than quantity. Thus, the change in price has a bigger
effect on total consumer expenditure than does the change in quantity. Total consumer
expenditure changes in the same direction as price:
if P rises, Q falls proportionately less, thus TE rises.
if P falls, Q rises proportionately less, thus TE falls.
If price changes and Ep=1:

In this case, price and quantity change in exactly the same proportion. Its demand
curve is a rectangular hyperbola. A change in price will have no effect on TE (hence
TR). If one graphs total revenues against P or Q, the function will be a straight line
parallel to the horizontal axis.
Knowing the PED for a product permits a firm to predict the effect that a price change
will have on its revenues.
Determinants of PED:
(Note: some students confuse these factors with factors affecting demand!)
1. The number and closeness of available substitutes:

The more substitutes there are for a defined Pepsi vs. soft drinks - : the
good, and the closer they are, the more broader the definition, the fewer the
easily will people switch to these alter- substitutes available to the consumer
natives when the price of the good and thus the more price inelastic de-
rises; the greater therefore will be the mand is expected to be for small price
price elasticity of demand. (related: changes around the current price)
how broadly or narrowly the good is
2. The proportion of income spent on the good:

The higher the proportion of our in- small proportion of our income on a
come that is spent on a good, the more good (if it is insignificant) then a
we will be forced to cut consumption change in price will not affect our
when its price rises: the bigger will be spending behavior, it will be price ine-
the income effect and the more elastic lastic.
will be the demand. If we spend a
3. The time period involved:

When price rises people may take a the time period after a price change,
time to adjust their consumption pat- then, the more elastic is the demand
terns and find alternatives. The longer likely to be.
4. The nature of the good, i.e. whether or not it is addictive: if addictive, then its
demand curve is relatively inelastic e.g. cigarettes, alcohol etc. This has pro-
found implications on the decision of governments to tax such products.

17
5. Whether it is jointly consumed. For example electricity is used for a number of

uses: oven, fridge, light etc. its demand is therefore more inelastic.
Uses of PED.
It allows comparison of quantity consumers in the form of a higher

changes with monetary changes. price.
It helps a firm predict the direction of Knowledge of PED is necessary in or-
change of total revenues given a price der for the government to calculate the
change. size of the necessary tax if it wishes to
It helps a price discriminating firm de- decrease the consumption of a (de-
termine its pricing policy. merit) good.
It helps determine the size of the It permits the government determine
mark-up in pricing decisions of oli- the incidence of an indirect tax.
gopolistic firms. (Mark-up pricing It helps predict the effect of currency
later) devaluation on the trade balance (see
It helps a firm determine what propor- the Marshall-Lerner condition in my
tion of an indirect tax it can pass on to trade notes).
Income Elasticity of Demand
Definition: the responsiveness of demand for a good when consumers income

changes
Symbol: y, Ey, ey, IED
Measure: y = %Qd / %
If y>0: normal good i.e. a good whose demand increases as consumer incomes
increase. They have a positive income elasticity of demand. .
If y<0: inferior good i.e. a good whose demand decreases as consumer incomes
increase. Such goods have a negative income elasticity of demand.
If y>1 i.e. %Qd>% then the good is income elastic i.e. a rise in income
leads to a faster rise (proportionately greater) in demand. Luxury goods (as well
as most services) usually are income elastic
If 0 <y<1 i.e. %Qd<% then the good is income inelastic (as income rises,
demand rises but at a slower rate). Basic (every day consumption, staple goods)
goods are usually income inelastic (food as a broad category)
If y=0 then the demand of the good is not affected by income changes.
Note: some industries are considered the construction (auto, furniture, etc)
cyclical and some acyclical as a re- industry also fluctuates in the sense
sult of their income elasticity of de- that demand for housing rises and falls
mand: as overall economic activity also, whereas the food industry does
fluctuates in the short run (the trade not (as much at least): it is acyclical.
or business cycle see macro notes),

18
Factors affecting Income Elasticity of demand:
1) Degree of necessity of the good.
In a developed country, the demand for luxury goods expands rapidly as peoples in-
comes rise, whereas the demand for basic goods, such as bread, rises slowly. Engels
Law states that as incomes increase, a declining proportion of income is spent on
food. This, it is often said, is because of the fixed capacity of the human stomach.
Food is therefore income inelastic. Furthermore, certain basic foodstuffs may behave
as inferior goods meaning that their income elasticities are negative. Thus, as incomes
increase people to some extent switch away from such basic items as rice, bread and
potatoes and substitutes them with higher protein foodstuffs; and as their incomes rise
still further total expenditure on food increases, but food takes a declining proportion
of household income (see Smith & Rees, p.96).
2) The living standards of the economy (Fisher-Clark theory, Smith & Rees, p.95)
3) The rate at which the desire for a good is satisfied as consumption increases.
Question:Why is the concept of IED useful to economists studying the economic de-
velopment of countries?
Cross Price Elasticity Of Demand.
Definition: The responsiveness of demand for one good (x) to a change in the price
of another good (y)
Symbol: Exy, CPE, XPE
Measure: Exy= %Qx / %Py = (Qx/Py) * (Py1/Qx1)
Here, the sign matters as to how we interpret CPE:

If Exy>0, then x and y substitutes (competitive demand)
If Exy<0, then x and y are complements (jointly demanded).
If Exy=0, then x and y unrelated.
The further away from zero, the stronger the relationship between the goods; the
closer to zero, the weaker the relationship.
Usefulness of CPE
Useful to delineate markets. Whether Kelloggs) can be determined by ex-

muffins and eggs are in the same mar- amining the size of their CPE of de-
ket or not as Kelloggs cereal (the mand.
breakfast market / re: The US. vs.

19
Price Elasticity Of Supply
Definition: the responsiveness of supply when the price of the good changes
Symbol: PES
Measure: PES = %QS / %QP
Sign of PES is positive since supply curves typically have a positive slope
If PES > 1 : supply is elastic, for small changes around the initial price: a change
in price leads to a proportionately greater change in quantity supplied)
If PES < 1 : supply is inelastic for small changes around the initial price: a change
in price leads to a proportionately smaller change in quantity supplied
If PES = 1 : supply is unitary elastic for small changes around the initial price.
If PES = 0 : supply is perfectly inelastic for small changes around the initial price.
If PES : supply is perfectly elastic for small changes around the initial price.
Note (useful for multiple choice ques- linear and goes through the origin then
tions): all linear supply functions that it has unitary (and constant) elasticity
cut the P - axis are price elastic, and all of supply throughout its length. In all
linear supply functions that cut the Q - other cases, PES varies along the
axis are price inelastic. If supply is length of the curve.
1. Perfectly price inelastic supply (PES = 0)
2. Perfectly price elastic supply (PES
3. Unitary elastic throughout length (PES = 1)

20
4. Price elastic but not constant (PES > 1)
5. Price inelastic but not constant (0< PES < 1)

21
Factors affecting PES
I. The time period: As mentioned the quantity offered remains the

in the section of PED, time is same while prices rise. In the
distinguished into the immedi- short run, some inputs can be
ate (market period), the short increased while other remain
run and the long run. In the fixed. Supply can increase
immediate time period, NO ad- somewhat, within the con-
justments are possible i.e. for straints that the firms existing
the firm, all factors of produc- capacity impose. In the long
tion are considered fixed. In run all adjustments are possible
this case, demand shifts but i.e. all factors of production are
supply is not responsive; thus, considered variable.
II. The extent to which excess capacity exists. If it does, supply is expected to be
more elastic.
III. Whether skilled or unskilled labor predominantly employed/used.
IV. Whether long or short time lags ply to adjust to new demand
characterize the production conditions. (Agricultural prod-
process. The longer the time ucts are characterized by long
lags, the longer it takes for sup- time lags.)
V. The speed by which costs rise the more firms will be encour-
as output rises: The less the ad- aged to produce for a given
ditional (= marginal) costs of price rise: the more elastic sup-
producing additional output, ply will be.
Importance of PES
It determines the extent to which an increase in demand will affect the price, and/or
quantity of the good in a market. The more inelastic supply is, the greater the increase
in price given an increase in demand; the more elastic supply is, the greater the impact
of an increase in demand on quantity.

22
Price Controls
Often, governments consider the mar- tervenes and sets the price of a god,
ket determined price of a product un- either below the market price or above
satisfactory i.e. either too high or too the market price.
low. In such cases, the government in-
I. Setting a Maximum price (or, price ceilings):
This is done to prevent prices from ris- tecting consumers. This policy may
ing above a certain level often for rea- also be seen in the housing market
sons of fairness. In wartime, or times (rent controls).
of famine, the government may set For a maximum price to be effective it
maximum prices for basic goods so must lie below the free market equilib-
that the poor can afford them. Thus the rium price.
government in this case aims at pro-
Effects:
A shortage is created. This means that good, even though they are both will-
the price mechanism, fails to perform ing and able to pay the price. There-
its rationing function, i.e. to allocate fore, an alternative rationing device is
the good: since a shortage exists, some required:
consumers will end up not enjoying the
a) Allocation on a first come, first served basis. This is likely to lead to queues de-
veloping, or firms adopting waiting lists.
b) Sellers preferences i.e. firms deciding which consumers should be allowed to
buy: for example, giving preference to regular customers.
c) Randomly e.g. by ballot.
d) Rationing using coupons. This alternative has been used in times of war, e.g. in
the UK during the Second World War.
A major problem with maximum tomers, unable to buy enough in legal

prices is likely to be the emergence of markets, may well be prepared to pay
black (parallel) markets, where cus- much higher prices.
In the long run additional costs may emerge::

e) Quality may worsen.
f) If other non-controlled goods may be produced with the same inputs, then supply
may further shrink making shortages more severe.
To minimize these types of problem granting subsidies or tax relief to firms.

the government may attempt to reduce Alternatively, it may attempt to reduce
the shortage by encouraging supply demand: by the production of more
(i.e. attempting to shift supply to the substitute goods, or by controlling
right), for example: drawing on stocks, peoples incomes.
by direct government production or by

23
Minimum price (or, price floor):

The government sets minimum prices wage legislation can be used to prevent
to prevent them from falling below a workers incomes from falling below a
certain level. This may be done to pro- certain level. For a minimum price to
tect producers incomes, usually be effective it must lie above the equi-
farmers. Another example may be librium price level.
found in the labor market: minimum
Effects:
A surplus is created. The government tained at the promised level, the gov-
might even aim at creating a surplus ernment must buy the surplus at the
(e.g. of grains) which can be stored in promised price. It must thus spend the
preparation for possible future short- product of the promised minimum
ages. In order for the price to be main- price times the amount of the surplus.
Overall:
Farmers are better off since their in- This means that society is worse off
come rises. Part of their earned income since there is misallocation of scarce
is by consumers and another by the resources. Also, government expendi-
government. Consumers are worse off tures rise, or alternatively, spending in
since they enjoy less of the good at a other areas has to decrease.
higher price. Overproduction occurs.
Indirect Taxation
Indirect taxes are taxes on goods / expenditures. They can be either per unit taxes (e.g.
2.00 drs. per pack of cigarettes), or sales taxes (e.g. a percentage of the price: Value
Added Tax, e.g. 18% of price).
Effects of a per unit indirect tax.

Analytically, its as if production costs rose by the amount of the tax: supply (which is
marginal cost), as a result, will shift leftwards (vertically upwards) by the amount of
the tax.
Market price is expected to rise.

Equilibrium quantity is expected to decrease.
Producers net of tax price is expected to decrease.
Producers net of tax revenues decrease.
Tax revenues collected by government = (tax per unit)*(number of units sold).
Question: Do consumers spend now more? Not necessarily, since it depends on the
PED.
The incidence of indirect taxes depends on the elasticity of demand and supply of the
commodity in question. The size of the increase in price and decrease in quantity dif-
fers in each case, depending on the price elasticity of demand and supply. The total
tax revenue is given by the amount of tax per unit, multiplied by the new amount sold
and is shared between the consumer and the producer.

24
The following formula holds (very useful for related MCh questions):
(% incidence on consumers) / (%incidence on producers) = (PES) / (PED)
Quantity will fall less, and hence tax revenue for the government will be greater,
the less elastic are demand and supply.
Price will rise more, and hence the consumers share of the tax will be larger, the
less elastic is demand and the more elastic is supply.
Price will rise less, and hence the producers share will be larger, the more elastic
is demand and the less elastic is supply.
Note: A sales tax is analyzed in the same way as a per unit tax except for that the shift
of supply is not parallel but the wedge (= vertical distance) widens at higher prices.
Subsidies
Definition:
A payment (usually per unit of output produced) made by the government to produc-
ers in order to lower the market price, increase output and consumption of the product
and raise producers income / revenues.
Analysis of subsidies is symmetric to that of indirect taxation. The effect of the sub-
sidy is to shift the effective supply curve vertically downward13 (to the right) by the
amount of the subsidy.
Effects:
Market price drops.(i.e. consumers are better off)
Equilibrium quantity rises (quantity produced and consumed of the good in-
creases)
Producers price (inclusive of the subsidy) rises.
Government expenditures (= subsidy per unit times the # of units produced) rise
Producers income increases
The following also holds:

% of benefit from subsidy for consumers / % of benefit for producers = PES / PED
Agriculture and Agricultural Policy

(Excellent analysis found in Sloman, paragraph 3.3, a must)
Governments often intervene in agricultural markets. This is because:

I. There has been a long-run downward trend of relative prices and of farmers
share of (national) income.
II. There are short run fluctuations of prices and incomes (prices and incomes ex-
hibit short-run volatility).
13
It will later become clear that supply is nothing else but the marginal cost curve: MC shows the
extra cost incurred of producing an extra unit of output. Consequently, a subsidy will shift the MC
curve down by the amount of the subsidy since it will lower production costs.
25
Why?
the long-run downward trend is explained as follows:
Supply has increased dramatically due However, demand has not kept pace
to the mechanization of production, the because of low income elasticity of
use of fertilizers, the advances in bio- demand: per capita incomes rose but
technology, disease control etc. which demand for food and farm products
have raised productivity of the sector. rose by proportionately much less
the short-run downward trend is explained as follows:
Short run supply is perfectly inelastic - since spending on such products is a

(due to the long production lags asso- small proportion of consumer spending
ciated with agricultural products), and and on the whole these goods have few
subject to random shocks (weather). substitutes - leading to sharp price
On the other hand, demand for agricul- fluctuations.
tural goods is relatively price inelastic
Note: Farm income varies inversely with supply conditions i.e. poor crop, higher in-
come!
Export revenues of developing countries:

These characteristics affect also the export revenues of developing countries that ex-
port predominantly primary commodities (farm and non-farm products; not oil): their
export revenues fluctuate in the short run and in the long run their terms of trade
worsen. See my trade and development notes on these issues.
Policies:
There are various forms of government intervention; one of them is granting a subsidy
which we have already examined. The government may also use buffer stocks, defi-
ciency payments, set aside policies etc
Buffer stocks (and Commodity Agreements)

If the government (or an agency) (or, the manager) buys up the surplus
merely wants to stabilize prices, it can and puts it into store. If there is a bad
simply fix a price which balances de- harvest it releases appropriate quanti-
mand and supply over the long term. If ties stored onto the market.
there is a good harvest the government

26
Problems / Effects
Price may stabilize but farmers incomes do not: they vary directly with output
There is an incentive to overproduce since government in essence guarantees that
whatever is produced and not bought by consumers is bought by the government.
It is costly since storage costs and financing costs exist which though may be re-
couped if good and bad harvests alternate.
Note: Buffer stocks can only be used with food that can be stored: i.e. non-perishable
foods like grain, wine or milk powder etc Commodity agreements are used, usually
unsuccessfully, by groups of developing countries for commodities (primary products
traded in world markets) such as coffee and cocoa (many data response questions on
these issues).
Deficiency payments.
Definition: are variable subsidies, where the amount paid per unit is that which is
necessary to make up the deficiency between the market price and the previously
agreed guaranteed price. An advantage of the system is that the deficiency payment
was based on the average market price. There was therefore an incentive for farmers
to improve quality and get a better than average price without thereby sacrificing any
subsidy.
Note:
So its the same thing as the government granting a subsidy, but we dont know the
subsidy from the beginning!
(Check out set aside policy, in Sloman, section 3.3)

27
The Theory Of Production And Costs
Production
Definition: the transformation of inputs into output.
A production function relates inputs and output. It assigns the maximum output (Q)
obtainable from each combination of inputs, given the level of technology (note: the
latter relates to the idea of X-inefficiency later)
Q = f(x1, x2, x3,xn)

or, simplifying:
Q = f(K, L) where K = capital, L = labor
Note that technology is reflected in the functional form f
Short run analysis:

Q= f(K, L): Output can change by varying the level of labor, given the level of capital
(K is constant) (i.e. given the scale, capacity, size of the firm)
Marginal product (of labor):
Definition: the extra (or additional or increment in) output obtained because extra la-
bor is employed; thus, the change in output because of a change in labor.
Measure: MPL = Q/L
This is the slope of the total product (TP) curve, i.e. MP is nothing but the rate of
change of TP (the 1st derivative of Q with respect to L)
In order to observe the behavior of MPL as L rises, all we have to do is to observe the
behavior of the slope of TP.
v From 0 to L2 we climb a mountain: slope is positive, so is MP.

v Beyond L2 we go down a mountain : slope is negative, so is MP.
v At L2, neither going up nor going down the mountain, slope is ZERO, so is MP.
v Between 0 and L1, slope is positive AND INCREASING!
v Between L1 and L2, slope is positive BUT DECREASING!
Average Product (of labor).
Definition: output per worker
Measure: total product over units of labor: APL = Q/L ,or, TP/L

28
APL is a measure of labor productivity.
Diagrammatically, the slope of the ray from the origin to the point of interest on
the TP curve is the AP of L at that level of L. To determine thus the behavior of APL
as L increases (moving to the right on the horizontal axis) one needs to observe the
behavior of the slope (NOT the length) of this ray.
Short run analysis

How does APL behave as L rises?
AP(L)= OQ/OL= AL/OL

APL is the slope of the ray from the origin. To determine the behavior of APL, you
just need (as mentioned previously) to observe the behavior of the slope of the ray
from the origin to various successive points on TPL .
The Law of Diminishing Marginal Returns:
v It is a short run law: it assumes the existence of at least one fixed factor (usually K
i.e. the size/ scale of the firm)
v The variable factor, usually labor, is assumed homogeneous.
v Thus, any difference in returns is solely due to the capital/labor ratio employed.
v Thats why its also known as the Law of Variable Proportions.
v Technology is assumed constant/given.
v If K and L were perfect substitutes, then the law would not hold.
v It can be shown that as MPL decreases, MC rises (useful for MCH questions)
Statement of the Law:

As more and more units of a variable factor (labor) are used with a fixed factor (capi-
tal), there is a point beyond which total product will continue to rise, but at a decreas-
ing rate, or equivalently, that marginal product, will start to decline.
v Note that past L2 units of labor we encounter NEGATIVE returns.

v The L of DMRs is a purely technological law
v The firm will not hire more than L2 workers since MPL <0 (too many workers for
available capital), nor less than L1 since MPK<0 (too much capital for the avail-
able labor)

29
v The economic region of production is thus between L1 and L2.
Short run costs of production
The short run is a period of time over which at least one factor of production is fixed,
the calendar time will vary from firm to firm. All firms are subject to costs which can
be split up into fixed and variable costs as follows:
1. Fixed Costs are costs that do not vary when the level of production varies and
exist even if output is zero e.g. rent, interest on loans, insurance costs, fixed
contract costs etc.
2. Variable costs vary with the level of output e.g. raw materials, components,
labour.
Definitions
Total cost (TC) = Total fixed cost (TFC) + Total variable cost(TVC)
Average total cost (ATC) total cost TC TFC + TVC
= =
= output Q Q
Average fixed cost (AFC) total fixed cost TFC
=
= output Q
Average variable cost (AVC) total variable cost TVC
=
= output Q
Marginal cost is the extra (additional, increment in) cost resulting from an increase in
output; it is thus the change in costs because of a change in output or the slope of the
total cost curve (and of the total variable cost curve, since the two vary by fixed costs
which do not affect marginal cost):
change in TC (or VC) (VC)
Marginal cost (MC) =
change in output Q
Due to diminishing returns, these short run cost curves will be U - shaped. The cost
may fall initially as there are increasing marginal returns, but eventually when dimin-
ishing returns set in the costs will start to rise.
More formally, since MC = VC/Q = (wL)/Q = wL/Q = w/MP, so if MP rises

then MC drops and if MP decreases (L of DMRs) then MC rises.
Equivalently, AVC = VC/Q = wL/Q = w/AP
The only curve this is not true for is the average fixed cost curve. This will decline
continually as the same level of cost is spread over more and more output. These
changes can be seen on the cost curves below.

30
Note that MC cuts through the minima of ATC and AVC; this is the result of the laws
governing the behavior of marginal and average magnitudes: if marginal less than
average then average will decrease and if marginal greater than average then average
will rise. (think of the example with your grades to remember the logic behind the
above)
Production in the long run
In the long run there are three possible effects on output from an increase in the scale
of operation, in the level of use of all factors. These are:
Constant returns to scale - the % increase in output is equal to the % increase

in all inputs. For example, doubling all factors (size), doubles output Q. As a
result, average (unit) costs of production remain constant.
Increasing returns to scale - the % increase in output is greater the % increase
in inputs. For example, doubling all factors (size), more than doubles output
Q. As a result, average (unit) costs of production decrease. The firm enjoys
economies of scale.
Decreasing returns to scale - the % increase in output is less than the % in-
crease in inputs. For example, doubling all factors (size), less than doubles
output Q. As a result, average (unit) costs of production rise. The firm suffers
from diseconomies of scale.
These possibilities are shown on the diagram below where the long run average cost
curve initially slopes down with the increasing returns to scale, then is flat with con-
stant returns and then slopes up with decreasing returns.

31
The long run average variable cost curve (LRAC) describes the average cost of pro-
ducing each output level when the firm is able to adjust all inputs optimally, when the
firm is able to optimally adjust its size, its scale of operation.
Economies of Scale (EOS):
A firm enjoys economies of scale if EOS are cost savings for a firm that
unit (average) costs decrease as firm originate from developments outside
size increases. EOS are cost savings the firm, for example from the indus-
due to increased scale of production. try in which it operates. This implies
They can be distinguished into inter- that a firm can create conditions that
nal EOS and external EOS. Internal lead to internal EOS but can only
EOS cost savings that are a result of hope for external EOS.
actions of the firm itself. External
Internal EOS can result from technical, marketing, management, financial or risk-
related reasons. More specifically:
Technical EOS (or, Plant Economies of Scale:
1. a larger in size firm bay be able to adopt technologies of production not avail-
able for smaller sized firms: capital equipment (which embodies technology)
is often indivisible (indivisibilities of K)
2. Larger firms offer more room for specialization of workers and managers
3. Law of dimensions (also known as the container principle): these cost sav-
ings arise because of the fact that volumes rise faster than surfaces (a, a) e.g.
a tanker of double length can carry more than double the amount of oil etc. or
a storage tank that can store double the volume of anything, costs less than
double to manufacture (also blast furnaces, pipes, vats, lorries).
4. The law of multiples
[A] [B] [C]

40units/ 30units/ 20 units/
hour hour hour
3A 4B 6C

32
Many production processes require sequential use of a number of machines.

A larger size firm can buy such a combination of machines that idling time is
minimized.
Marketing nature (Marketing economies of scale)
1. On the input side, a larger firm buys inputs in bulk and thus secures better
prices from its suppliers.
2. On the output side, distribution costs are usually lower for larger firms (eg it
may own its own truck fleet).
3. Advertisement on TV requires a certain minimum threshold level of messages
to be effective. A large firm can divide this cost over a large volume of output.
4. Research and development - as firms grow they may be able to put in place
R&D that benefits them across a number of areas of their activity
Financial nature (financial EOS)
a large firm is able to borrow from banks at lower interest rates (i.e. faces
smaller borrowing costs) compared to a small firm (both because of size of
loans and because of reputation/credit risk). Also, as firms grow they may get
access to more efficient and cheaper methods for raising finance (e.g. equity
markets)
Management EOS
Large firms can employ specialists in each department (eg a large supermarket
hires financial experts to manage its cash on a daily bases, a large department
store hires specialist buyers for each type of product it sells.
Risk-related EOS
a large firm can diversify by selling not one but many products in not one but
many markets (or, even countries) thus spreading and minimizing risks
External economies of scale

There has been a revival of interest in idea of Marshallian industrial districts. It is ar-
gued by some economists and economic geographers that there are substantial bene-
fits to be gained from firms in the same area of production clustering together. Areas
frequently quoted as examples are the Emilia Romagna area of Italy, Baaden Wurtem-
burg in Germany (engineering), Prato for textiles and clothing and Silicon Valley in
California (more recently, Slovakia is heralded as the new Detroit for the car indus-
try).

33
External Economies of Scale originate outside the firm; as the industry grows, firms
unit costs decrease; as a result of similar firms locating together in one area econo-
mies of agglomeration.
Why? They may benefit from the presence of suppliers, distributors, a skilled labor
market, and specialist research and development institutions.
More specifically:
1) A specialized labor force may develop (e.g. technical schools catering to their
needs may also be established.
2) Complementary firms may also be established
3) Better transportation and telecommunications, networks may develop
4) Marketing of by-products may become an option.
Diseconomies of scale
Internal
When firms get beyond a certain size, costs per unit of output may start to increase.
There are several possible reasons for these diseconomies of scale.

Management problems of coordination.
Workers' motivation may decrease and industrial relations may deteriorate.
Complex interdependencies of mass production may lead to disruption if there

are any hold ups in any particular part of the firm.
Put succinctly, after a point, size may become a problem since, problems of con-
trol, communication, co-operation may emerge & workers incentives may deterio-
rate; diseconomies of scale are a major reason for firms to divest.
External
After a point, congestion costs may develop. Also, as an industry grows, after a point,
input prices (raw materials, specialized labor etc) may start to rise.
(Question: Can a firm be characterized by Diminishing Marginal returns and increas-

ing returns to scale at the same time?
Answer: Yes, if, given its scale, it produces with increasing MC (i.e. decreasing MP,
Dim. Marginal Returns) but, if it increases its scale of operations, unit (average) costs
drop (= Economies of Scale, thus IRS))

34
Goals of firms
profit maximization (Q) = TR(Q) TC(Q)

sales / revenue maximization sales = TR(Q)
satisficing theories: the firm tries to achieve at least a certain level profit /
sales.
long-run profit maximization (which may entail suffering short run losses)
(Read on the principal-agent problem, Sloman p.217)
Role of economic profits in a market economy
Profits are the reward of entrepreneurship. They differ from the other factor incomes
in that profits are not contracted (as wages are) but are a residual and may thus even
be negative (losses).
Supernormal profits attract resources into an industry whereas losses free up

resources permitting their use in other industries
Striving to achieve profits results in greater efficiency
Supernormal profits provide the incentive and funding for firms to finance ex-
pansion (i.e. investment)
Supernormal profits can be used to finance R&D programs and may thus lead
to product and process innovations
Economic Profits
Economic profits are found if from total revenues we subtract economic costs of pro-
duction. The key to understanding the term economic profits is to realize that from
an economists point of view the term economic costs refers to the value of ALL re-
sources that are sacrificed during the production process! (Remember that the funda-
mental economic problem is that of scarcity). This means that economic costs in-
clude not only the so-called explicit costs of a firm (also known as out-of-pocket
costs), i.e. the explicit payments it makes for the use of factors) but also implicit costs
which include the value of firmowned resources (for which it is not forced to make
any payment but, for the economist, are still sacrificed resources) AND the minimal
reward that the factor entrepreneurship requires to remain in that line of business.
This last item is known as normal profit and is formally defined as the minimum the
firm requires to remain in business. Normal profits are thus included in economic
costs! The idea is that to secure the scarce factor entrepreneurship in a business some
minimum reward is necessary for the risk that the person(s) is undertaking. If this re-
weard does not materialize, then the firm will close down. Remember, for a firm to
secure labor, wages have to be paid which, of course, is an element of cost. To secure
entrepreneurship a minimum would also be required which, symmetrically, should
also be included in costs (remember, entrepreneurship is a very- scarce resource!)
Consequently, if total revenues are equal to economic costs thus defined, then
economic profits are zero this means that the firm is just making normal prof-
its! Zero economic profits thus imply normal profits: there is no reason

35
MARKET STRUCTURES
We distinguish four (4) market structures:

* Perfect Competition
* Monopoly
* Monopolistic Competition
* Oligopoly
Perfect Competition
Assumptions - Characteristics
Very many (theoretically, infinite many ) small firms
Homogeneous product (i.e. identical across sellers; examples of such products
are few, mostly in primary sector: farm products, metals, etc. Note that the
foreign exchange market is also a good example of such a market)
Free entry and exit (i.e. No barriers to entry / or to exit)
Perfect information
Perfect mobility of factors e.g. no geographical or, occupational immobility of
labor
These assumptions are not realistic nevertheless the model is useful:

Economies of scale (IRS in production) exist and firms exploit them in most produc-
tion processes. In the production of most goods larger in size firms can produce at a
lower unit cost than smaller firms can. Firms thus have an incentive to grow either
internally (through investment in physical capital) or through mergers and acquisi-
tions. Thus large firms are very common in most industries. The number of firms in
a market can be explained by the relationship between the minimum efficient scale
(MES) (or minimum optimal scale MOS) and the size of the market. The MES is
defined as the smallest scale with which a firm can attain the lowest long run average
costs. It should be understood that, given market size, the larger the MES the smaller
the number of firms that can profitably coexist in a market.
Firms also have the incentive to differentiate their product either in real ways (by im-
proving quality, changing characteristics etc) or in imaginary ways so that they ac-
quire some degree of monopoly power. Monopoly power is defined as the ability to
raise price above marginal production costs. The Lerner Index of monopoly power is
defined as the difference between price and marginal cost as a proportion of price (a
perfectly competitive firm thus has zero monopoly power since as it will become
clear, price is equal to MC). A firm selling a even a slightly differentiated product
faces a negatively sloped demand curve for its product and thus has the ability to in-
crease price without losing all of its customers.
Firms also have the incentive to create entry barriers so that they can maintain super-
normal profits in the long run. Exit barriers in the form of sunk costs also are com-
mon. Sunk costs are costs that a firm can not recoup (recover) upon exit. Sunk costs
are low if a firm can sell or in other ways dispose of its capital equipment without a
loss.
Information is in the real world costly. Uncertainty and risks surround all business
and consumption decisions. Search costs also exist and may be significant. Lastly,
both capital and labor may suffer from immobility. Labor, for example, suffers both
36
from occupational and from geographical immobility (which lead to structural unem-
ployment)
Short Run Equilibrium in Perfect Competition
Typical firm Market
A perfectly competitive (pc) firm considers the market determined price as a

parameter. It is thus known as a price taker. It can not increase the market
determined price (no one would buy from it and it has no incentive to lower it
since being by definition so small compared to the market it can sell all it
wants at the current market price: it thus faces a perfectly elastic demand curve
for its product; consumers face infinite perfect substitutes to choose from)
The demand curve a firm (any firm) faces always shows the Average Revenue
TR pxq
(AR) it collects at each level of output: AR (q) = = =p
q q
Thus, the AR for each q is the market price (P).
AR = P, in ALL market structures
Since only in PC is a firm able to sell any quantity it wants at the same (cur-
rent) market price, it is only in PC that MR = P for all qs
To maximize profits it chooses q* for which MR=MC (and MC is rising)
Visual / Geometric determination of the level of profits at q*
>0: positive economic profits i.e. firm is making more than normal profits: it is mak-
ing supernormal profits! (it is making more than the minimum profit it requires to re-
main in this line of business)
i.e. resources in this market are being rewarded more than what they would
have earned in their next best alternative! This by itself is an incentive for other
entrepreneurs to organize the necessary factors and enter this industry.
{note the role of profits and losses in allocating and re-allocating scarce resources in a
market economy: profits attract more resources assuming no barriers -- while losses
free-up and channel resources into more productive uses; note that whether freed up
resources may or may not be channeled into more productive uses depending upon
their mobility}

37
As a result resources will be attracted from other less remunerative activities into this
market.
entry will take place
>0 (= supernormal economic profits)

Entry
Market supply
Market price
AR (=P) will drop until economic profits become zero i.e. until typical firm earns only
normal profits (=0).
(Note that a firm earning normal profits is making money just enough money to
induce it to remain in the market)
Shut down rule Short run and long run
if price is at P1 or P2 firm is profitable and will thus offer q1 and q2 respec-

tively
if P=P3, then firm is making losses!
(Since ATC (q3) = q3C > AR = q3B)
Should it perhaps shut down?
if it produces, its losses = area (P3BCF)

if it shuts down, it will be losing the fixed costs = area (HACF)
but area(HACF) > area(P3BCF)
Thus it will not shut down; it pays to operate until fixed costs do not exist, until all
contracted obligations expire.
if P=P4 firm is once again making losses
if it continues to operate producing q4 its losses = area (P4BCF)

if it instead shuts down it will face its FC = area (H ACF)
Area (P4BCF) > area (HACF) thus, in this case it will shut down!
38
A loss making firm, in the short-run, will shut down only if P < AVC or, equivalently,
if TR < VC
Example: Assume a pizza parlor can sell a pizza at $10.00 each14. Assume that it
costs him $9.00 to make each pizza in terms of the cheese, ham, sauce, labor and elec-
tricity required (his variable cots). He is making $1.00 on each and say, he sells 1000
pizzas a month. If his rent (fixed cost) is $2,500.00/month, he is making losses
$1,500.00 per month. If he shuts down though he would have to pay his rent until his
contract expires losing $2,500.00 a month. Clearly, it pays NOT to shut down until
contracts expire (or, loans repaid). If though it cost him $10.50 to make each pizza in
terms of ham and cheese then he would be losing the rent and $0.50 on each pizza!
Clearly, it would pay to shut down immediately.
Long Run Shut Down Rule

. while In the long run (i.e. when all adjustments have been made) it will shut
down if P < AC i.e. if < 0
Thus the short run supply curve of a PC firm is that portion of MC above
(min)average variable costs. (note that only perfectly competitive firms have
supply curves; for reasons explained in class, firms facing negatively sloped
demand curves for their product do NOT have supply curves; there is no one-to-
one correspondence between Q chosen and market price)
Long-Run Equilibrium Condition
In the long run, the price and thus the market demand curve each perfectly competi-
tive firm faces will be forced to touch (to be tangent to) its average cost curve at its
lowest point. Zero economic profits (AR = AC) and with profit maximization (MR =
MC) together with the fact that in perfect competition P=AR=MR combine to give the
following long run equilibrium condition:
q* : P (=AR) = MR = MC = min AC .
Efficiency in Perfect Competition
Allocative efficiency is achieved if markets are perfectly competitive since, for the
last unit produced, P =MC (1)
Technical (or, Productive) efficiency is also achieved if markets are perfectly com-
petitive, since firms are forced to produce with minimum Average Costs (2)
Interpretation:
(1) Just the right amount from societys point of view is produced, not more, not
less scarce resources are allocated in an optimal way the impersonal, decentral-
ized market (price) mechanism (i.e. the invisible hand) leads to the best (from so-
14
I am assuming the pizza is a price taker.
39
cietys point of view) allocation of scarce resources; it solves the fundamental ques-
tion that all societies face (which goods to produce and in what amounts) in the best
possible way, a way that maximizes social welfare.
(2) This socially optimal amount is also produced with minimum Average Costs i.e.
with minimal waste of scarce resources
If one realizes that the fundamental problem of economics, namely scarcity, forces all
societies to answer the 3 fundamental questions (what, how and for whom) it is real-
ized that achieving allocative efficiency is most desirable. Perfect competition an-
swers the what question in the best possible way and thus it leads to a socially opti-
mal allocation of resources (allocative efficiency). In addition, given the scarcity of
resources, the how question is answered in the best possible way since perfect compe-
tition guarantees that there is least waste in the use of resources (productive effi-
ciency)
But:
There is no guarantee that the goods produced will be distributed to the mem-
bers of society in the fairest proportions.
There may be considerable inequality of income.
Thus, there is no guarantee that PC will lead to the optimum combination of
goods being produced. Dont forget that allocative efficiency is achieved in
perfect competition given market demand; but market demand is defined as the
willingness and ability to buy a good at each price, and ability reflects the in-
come constraint that each one of us faces. A very poor person may thus not be
counted in the market demand for a basic product!
Even though firms under PC may seem to have an incentive to develop new
technology, they may not be able to afford the funds necessary to invest in re-
search & development. (note the Schumpeterian argument concerning the de-
sirability of temporary monopoly power see these notes further down) Also
they may be afraid that if they did develop new more efficient methods of pro-
duction, their rivals would merely copy them investment would be a waste
of money.
Perfectly competitive industries produce undifferentiated products. This lack

of variety might be seen as a disadvantage to the consumer
Price in competitive markets change given any change in demand or cost

(supply) conditions. These fluctuations may deter long term investment. In
contrast, the price stability often found in oligopolistic markets may seem de-
sirable for planning considerations.
Monopoly
Industry coincides with the firm i.e. one firm producing a good without close
substitutes
40
Unique product
High barriers to entry
The concept of monopoly is relative since it depends crucially on how narrowly /

broadly the product / market is defined.
Note also the importance of the geographical factor i.e. location in relation to trans-
portation costs.
Some interesting points:

1) A monopolist can choose either the level of output or the price but not both, since
the monopoly firm is still constrained (still faces) by a negatively sloped demand
curve.
2) A monopoly firm does not necessarily make huge profits. It may even make losses
[function of relative position of demand (AR curve) and average costs].
It can be shown that if demand (AR) is linear, MR is also linear, has the same vertical
intercept and double the slope
(1) Linear demand can be written as P = a bQ

(2) Total revenues equal by definition P x Q
Combining (1) and (2) TR = (a bQ)*Q TR = aQ bQ
Marginal Revenue =
TR dTR
MR = = a 2bQ MR = a-2bQ
Q dQ
{Same vertical intercept but slope is double (2b)}
A monopolist can set the price (not a price taker); the degree of monopoly
power is given by the difference between the price charged and marginal cost
expressed as a proportion of price (Lerner Index of monopoly power)
A profit maximizing monopoly will never choose a rate of output that corre-
sponds to the inelastic section of the demand it faces it will always choose
elastic section (since for profit maximization MR = MC and since MC is nec-
essarily non-negative, it follows that MR must be at the profit maximizing Q
non-negative. MR is non-negative only for the set of Qs corresponding to the
elastic region of the demand curve)
Assuming that MC > 0 the profit maximizing output level is necessarily less
than the revenue maximizing level of output (where MR = 0) and thus the cor-
responding price charged is higher. In other words, revenue maximization
leads to more being produced at a lower price.
Natural monopoly: A situation where long-run average costs would be lower if an

industry were under monopoly than if it were shared between two or more competi-
tors. The MES is so large compared to the market size that only one firm can profita-

41
bly exist in the market. Obviously, a natural monopoly is a result of massive scale
economies. Natural monopoly examples are sometimes found in utility companies.
Pricing policies in public regulated utilities include average cost pricing and marginal
cost pricing (the latter being unacceptable by the private natural monopolist since it
would imply a loss making situation; if adopted it necessitates subsidization by the
government)
(Study Sloman and Mankiw on Regulation of monopolies)
Barriers to Entry / Exit
definition: Anything that deters entry into an industry or, that prevents exit from an
industry (exit barriers; examples of exit barriers: contracts that necessitate compensa-
tion of factors, single use machinery that can not easily be sold etc.. See the sunk cost
discussion later in these notes)
Alternatively, a barrier is anything that raises the unit cost of a potential entrant above
the level enjoyed by the incumbent firm.
Types of Entry Barriers:
I. Natural Barriers
(a) Natural Monopoly

Often, production technology is such that massive economies of scale are present. As
a result, the minimum efficient scale (MES) is such that, given market size, only a
few, (or, sometimes only one) firms can profitably (co)-exist: when only one firm can
profitably exist in a market it is the case of natural monopoly described above.
A diagram can illustrate why only one firm can profitably exist (if 2 firms coexisted,
each facing half the market demand, both would have been loss making firms)
Examples utilities distribution of electricity, water company, post office

These firms are either nationalized, or, if privatized, then regulated.
If regulated, then efficient pricing would require setting P=MC (Marginal Cost Pric-
ing)
BUT, no private firm would accept this regulation since it would have been making
losses (since AC are decreasing for the relevant output range, MC will lie below it)
The maximum output that a private monopoly would accept to produce is Q (i.e. gov-
ernment may demand average cost pricing, i.e. setting P=AC). This is the next best
solution (2nt best solution).

42
b. Exclusive ownership of some vital input

For example, ALCOA (Aluminum Company of America) owned or controlled virtu-
ally all known bauxite reserves of the US thus, no other firm could produce alumi-
num.
II. State Created

a) patents exclusive right to produce granted by the state to protect innovations
(question on optimal patent time)
b) licenses
for example, for cell phone services, taxis, doctors, lawyers, etc.
c) tariffs, etc. (tariff: a tax on imports trade protectionism)
State created barriers are the only type of barriers that may create entrenched mo-
nopoly positions see later the section on the Schumpeterian critique.
III. Firm Created

Firms have every incentive to try to erect barriers in order to enjoy monopoly power
and long run supernormal profits.
a) heavy advertising and brand name image creation (but firms in other industries
may have an equally significant brand name permitting them to enter a different
market (case of Bransons Virgin brand name and others)
b) excessive product differentiation / proliferation
c) maintaining excess productive capacity because potential entrant know that in-
cumbent (existing) firm can easily increase output thus depressing price to unprof-
itable levels (e.g. cement firms do this).
d) limit pricing setting price NOT at the profit maximizing level but only slightly
above unit costs: the extra output from entrant will depress price to unprofitable
levels.
Comparison of PERFECT COMPETITION & MONOPOLY

(insert diagram; make the competitive market supply (which is also the MC curve)
linear and close to the vertical axis so that you can easily illustrate the case where the
monopoly firm being larger enjoys EOS by drawing a 2nd MC curve to the right and
below- of the initial one that will lead to lower price than PC and a higher output
level)
Assume a competitive industry and note the long run market determined equilibrium
price and output. Assume now that this perfectly competitive industry is now mo-
nopolized. Further assume that cost conditions remain the same (i.e. that production
technology is the same)

43
Monopoly restricts output and charges a higher price: Qm < Qc and Pm > Pc
For the last unit produced by the monopoly firm, P>MC

i.e. fewer units than socially optimal are produced
allocative inefficiency results (misallocation of scarce resources).
In addition the monopoly firm is not forced (in the sense that perfectly competitive
firms are) to produce at minimum AC. Thus, typically the monopoly suffers also from
technical / productive inefficiency.
Lastly, monopoly situations are characterized by a 3rd type of inefficiency known as

X-inefficiency, a term coined by H. Leibenstein that refers to the internal slack-
ness, typical of monopoly practices. It is the result of the protected position! (i.e. of
barriers). i.e. that a monopoly may NOT be operating at the lowest set of cost curves
possible (since, in production, for each combination of inputs, it is not forced to pro-
duce the highest output present technology permits)
but,
Monopoly firms may lead to Dynamic Efficiency
If the monopoly firm enjoys Economies of Scale then it may be the case that output is
even greater than that under PC and the price charged even lower.
In addition, the monopoly firm, because of the fact that it may maintain supernormal
profits in the long-run, may end up financing R&D (=research and development) pro-
grams and thus it may be characterized by a faster rate of innovation (= new methods
of production (= process innovation) and new products (= product innovation)). The
Schumpeterian argument presented below argues that temporary (non-entrenched)
monopoly positions are the necessary result of successful innovations. And temporar-
ily advantaged entrepreneurs would be constantly challenged and eventually displaced
by other innovations (the perennial gale of creative destruction).
Note the importance of potential competition and of the threat of (hit and run) entry
(see Baumols theory of Contestable Markets presented below where even a monop-
oly structure may be forced because of the threat of competition to produce with a so-
cially efficient cost structure)
(Remember that a monopolist or any firm facing a negatively sloped demand for its
product - does not have a supply curve as explained earlier)
Price Discrimination (PD)
A pricing policy that certain firms adopt to further increase their profits.
definition: Price discrimination exists when a firm sells the same product at two or
more different prices in two or more markets (provided that the price differences do
NOT reflect production or provision cost differences; (if they do reflect cost differ-
ences certain examiners within the IB call it price differentiation; in my opinion an
error; google search the term restricting results to university sites i.e. .edu sites or
.ac.uk or consult major textbooks)

44
Examples:
Airline tickets / train and bus fares / clubs / theatres, cinemas / phone services / law-
yers - doctors consultants / dumping when a firm sells abroad at a lower price
than in its protected domestic market (a form of international pd).
Question: Can all firms practice price discrimination?

Answer: No, certain conditions have to be met for price discrimination to be
feasible:
1. The firm must enjoy some degree of monopoly power i.e. it must face a
negatively sloped demand curve (a perfectly competitive firm cannot thus
practice price discrimination).
2. No resale of the good (seepage) should be possible; the two markets must be
separable (otherwise, arbitrage buying low and selling high will guaran-
tee that one price will eventually dominate)
3. The price elasticities of demand between markets must differ some con-
sumers must be willing to pay more (usually because less substitutes are avail-
able to them).
Types of price discrimination

1) 1st degree price discrimination (or, perfect price discrimination; a highly theo-
retical case)
Here, it is assumed that the seller is fully aware of the consumers willingness to pay
and charges her the maximum price she is willing to pay for each unit consumed.
Note:
In perfect PD,
all of the consumer surplus is appropriated (taken) by the producer
Allocative efficiency is achieved! (since all units for which P > MC are pro-
duced and sold up until that unit for which P=MC)
The closest real world approximation of this highly theoretical construct may be open
air markets where haggling is common, typically found in the Middle East.
2) 2nd degree price discrimination (or, block price discrimination)
Here blocks of units of output are sold at different prices to the same consumer
e.g. if you buy the first 10 units you pay 100.00 but for the next 10 you pay 90.00
3) 3rd degree price discrimination (the commonest type)
Here markets are segmented to the extent that conditions 2 and 3 are met.
e.g. hotels in high is low season and most other cases
Price is higher in the market characterized by the more inelastic demand curve.
Equilibrium Condition (useful for multiple choice questions)

since MR1 = MC in market 1 and MR2 = MC in market 2
45
it follows that MR1 = MR2 = MC
Do consumers ever benefit in the presence of price discrimination?
Yes, there are situations where certain groups do benefit:
1. The group that pays the lower price if it is lower than that in the single price
case
2. If it permits the firm to sell more output and as a result it enjoys economies of
scale (that are at least to an extent passed along to the consumers in the form
of overall lower prices)
3. If a good was unprofitable to offer without pd (in other words if pd makes the
provision of a good profitable to a group that otherwise would have to do
without it)
Monopolistic Competition
Two economists who worked separately developed the theory of monopolistic compe-
tition: Edward Chamberlin (The Theory of Monopolistic Competition) in Cambridge,
Massachusetts and Joan Robinson (Imperfect Competition) in Cambridge, UK.
The assumptions on which the theory of monopolistic competition is based are three.
The assumptions are:
A very large number of firms just like in perfect competition. This implies
that each firm has a very small share of the market. Each monopolistic com-
petitor is not aware about what the other firms are doing.
Freedom of entry and exit. There should not be excessively specialized assets
(sunk costs) to make exit from the market difficult when a normal profit is no
longer made.
The product is differentiated: Each firm sells a product, which is somewhat

different to that sold by its competitors. This assumption is the one that makes
the model monopolistic. If each firm sells a good or service that no other
firm sells then it enjoys some (a very small) degree of monopoly power.
It is the second assumption that distinguishes monopolistic from perfect competition.
Examples: retail businesses such as hair salons, gas stations, restaurants, textbook
markets, VHS and DVD rentals etc.
Predictions of the monopolistically competitive model:

Allocative and technical inefficiency result
The monopolistically competitive model predicts that there will be excess ca-
pacity. This means that the firm will produce less output than the one corre-
sponding to minimum average costs. Too many firms enter so that each indi-
vidual firm is unable to use all the capacity at its disposal. The many empty
46
tables often found in restaurants and the fact that seldom does one has to
queue for the pumps in a gas station illustrate this point.
Firms offer a wider variety of products than under perfect competition. This is
usually considered welfare improving. Firms are thus forced to advertise. The
higher than minimum unit costs of monopolistic competition are often seen as
the cost of variety.
The model also predicts that firms will adopt non-price competition. The vari-
ety of services that monopolistically competitive firms often provide is testi-
mony to the non-price competition methods adopted.
Short Run Equilibrium

Analysis is identical to that of a monopoly firm.
Long Run Equilibrium

If > 0 (positive economic profit i.e. supernormal profits) entry is induced up until
= 0 AR = AC)
As a result, demand that each monopolistically competitive firm faces shrinks and
tilts. The demand that each firm faces shifts left, since as a result of entry, each firm
enjoys a smaller market share; it also becomes more elastic (flatter) since consumers
now have a larger set of closer substitutes to choose from.
Note that the long run equilibrium diagram is difficult to draw: first draw a shallow U
shaped average cost curve; then a demand tangent to it; then its MR curve; and,
last, the MC curve.

47
Oligopoly
Characteristics:
Few firms: as a result, firms are interdependent; a market is oligopolistic as
long as interdependence in decision making exists; (definition of oligopolistic
interdependence: the outcome of an action of one firm depends on the reac-
tion of rival firms
The good can be either homogeneous (e.g. as in the oil or in the cement or in
the steel industries, etc.) or differentiated (almost any industrial market e.g.
cars, detergents, appliances, air craft, banking, insurance, etc.)
Significant barriers to entry (which may be natural; relationship between MES
and market size; see above)
Simple Illustration of Interdependence
Assume a duopoly (a market with only two firms). We realize that the demand that
firm A faces depends on the reaction of (the rival) firm B to any price change initi-
ated by A demand is thus indeterminate unless we assume a certain type of be-
havior (reaction) by rival firm B15.
Oligopolistic markets are characterized by the tension between competition and collu-
sion: Firms on the hand desire to collude (cooperate) and thus maximize joint profits
but on the other hand they desire to compete thus increasing their own market share
and profits at the expense of rivals.
Collusive Oligopoly: the case where oligopolists agree (formally or informally) to

avoid competition with one another.
If the agreement is formal we have the case of a cartel. (Definition of a Cartel:

a formal collusive agreement)
If the agreement is informal then we have the case of tacit collusion. (Tacit
collusion: where oligopolists take care not to engage in price cutting, exces-
sive advertising or other forms of competition. There may be unwritten
rules of collusive behavior such as price leadership etc.
15
As a result there are very many models of oligopoly!
48
NonCollusive oligopoly: where oligopolists have no agreement between themselves.
A few notes on Cartels
A formal agreement between members of an oligopolistic industry to behave as if

they were a monopoly: they agree to restrict output in order to raise price and joint
profits. Cartels were common in the late 19th century but are now illegal in the EU,
the US and other countries.
Cartels are inherently unstable because of the incentive to cheat. Each member would
prefer the others to stick to the output restricting agreement while it exceeds it.
Cartels are more stable i.e. they have more of chance to last (not to collapse), if:
1) it consists of only a few members who control most of the market (in other words
no major producers are out of the cartel)
2) the good is homogeneous (standardized)
3) production costs are the same and are stable
4) the market demand is stable at high levels
If cost conditions are not similar or if they change, if market demand starts to shrink,
if somehow major non-members emerge, then it is very likely that the cartel will col-
lapse.
A most famous cartel is OPEC: it is perhaps interesting to know that OPEC members
control only 39% of total oil production!
Kinked demand curve model (Paul Sweezey)

P. Sweezey had observed that in certain oligopolistic markets, prices were sticky
despite changing cost conditions. To explain this he developed the kinked demand
curve model:
He assumed that a firm believes that if it cuts its price all other firms in the industry
will match this price cut but if it increases its price then this will induce no price re-
sponse from competitors.
More formally, assume a duopoly in which a price cut by firm A is followed, but a
price increase is not followed by the rival firm. This implies that firm A faces a
relatively inelastic demand curve for prices below the current price and a relatively
elastic demand for prices above the current price.
The kink in the demand curve creates a discontinuity in the MR curve above the cur-
rent profit maximizing output choice.
Price remains at Po ( i.e. it is sticky) even though costs may change: marginal cost
may shift between a range defined by the discontinuity in MR
But this model does NOT explain why and how the kink is formed at the current
price / output combination.

49
Note that the IB accepts (and perhaps expects) this model as an illustration of interde-
pendence in oligopoly.
Mark-up (or cost-plus) Pricing Model
Here, prices are rigid despite changes in demand conditions.
Firms adjust only output (not price) when demand changes.
Assume:
Firms face saucer shaped unit cost curves i.e. That unit costs are constant
for normal capacity utilization levels.
Prices are set as a fixed percentage on unit costs (depending on the extent of
competition; thus, price elasticity of demand as well as cross price elasticity
of demand are useful to the firm in estimating the size of the mark-up).
The size of the mark-up is bigger the greater the extent of monopoly power that the
firm has (i.e. the lower the cross-elasticity of demand for its product)
Note:
Oligopoly firms avoid price competition because of the risk of a price war. Their in-
terdependence usually deters them from using a price cut as a means to control a lar-
ger share of the market16. Instead, they resort to non-price competition.
Typical forms and examples of non-price competition include:
advertising and brand-name creation (Pepsi and Coca Cola)

coupons and gifts (newspapers and magazines etc.)
product differentiation (cars, DVD players and TV sets, TV stations, etc)
product proliferation to cover all imaginable market niches (Delta yogurt, ice
cream, breakfast cereal)
extended guarantees (electric appliances, computer hardware devices)
after sale service (BMW and Toyotas customer plans )
volume discounts (shampoo / conditioners)
Definition: Non price Competition is competition in terms of product promotion or

product development.
Lerner Index of Monopoly Power
P MC
L=
P
This measures the degree of monopoly power that a firm possesses.
16
To illustrate for IB exam purposes that price competition is not a desirable option you may employ
the kinked demand curve where for a price cut, because of the expectation that others will follow, de-
mand is price inelastic.
50
If the firm is perfectly competitive, then L=0 (since perfectly competitive firms have,
of course, no monopoly power and P = MC). The greater the degree of monopoly
power the firm possesses the easier it will be to raise price above marginal cost.
n-firm Concentration Ratios (4 or, 8 or 12 or 20 firm)
The ratio of the sales of the n (4 or 8 or 12 or 20) largest firms as a proportion of total
industry sales (or, instead of sales one can use levels of employment or the value of
fixed assets)
The greater the extent of concentration in an industry, the closer to 1 (or, 100) the ra-
tio will be.
Hirschman Herfindahl Index

n
HHI =
L=L
Si the sum of the squared market shares of the firms in the industry.
Si = is the market share of the ith firm.
In case of pure monopoly upper limit of HHI is 10,000 (100)
In case of perfect competition the lower limit tends to zero since each firm has an in-
finitely small share of the market
Note:
On any discussion concerning comparison of competition with monopoly or with effi-
ciencies you should choose to include some of the following:

51
Schumpeters Vision (or, a defense of large monopoly power firms)17

(Joseph Alois Schumpeter and the Austrian School)
Schumpeter challenged the traditional wisdom respecting the competitive ideal and
developed a startling defense of monopolistic practices. While competitive market
structures would ensure allocative efficiency, Schumpeter maintained that imperfectly
competitive market structures were essential for dynamic efficiency. Schumpeter
stated the proposition as follows:
A system any system, economic or other that at every point in time fully
utilizes its possibilities to the best advantage, may yet in the long-run be infe-
rior to a system that does so at NO given point in time.
Schumpeter reasoned that firms would never invest in research and development un-
less they could control the market long enough to ensure a profitable return. Thus
firms in competitive industries simply would not have the motivation to innovate be-
cause rapid imitation and uncertain prices would virtually eliminate the possibility of
a profitable return. Schumpeter also discounted the significance of static, allocative
efficiency and argued that the importance of perfect competition was drastically over-
stated:
But in capitalist reality, as distinguished from its textbook picture, it is not

that kind of competition which counts but the competition from new sources of
supply. The new type of organization competition which commands a deci-
sive cost or quality advantage and which strikes not at the margins of the prof-
its and the outputs of existing firms but at their foundations and their very
lives.
Schumpeter saw the economic system as fundamentally dynamic in nature and com-
petition as entrepreneurial challenge.
Temporary monopoly positions were the inevitable result of successful competitive

innovations.
Moreover, monopoly profits provide the baits that lure capital on to untried trails.
Schumpeter reasoned that temporary monopoly (and associated allocative ineffi-

ciency) was the necessary tradeoff for a more rapid rate of technological change (ad-
vance).
Entrenched monopoly positions would never develop in the absence of government

intervention because of the perennial gale of creative destruction. Temporarily
advantaged entrepreneurs would be constantly challenged and ultimately displaced by
new technologies, new products and new organizational methods or by some other
entrepreneurial innovation.
17
This section is based on the analysis found in Industrial Organization and Antitrust: A Survey of
Alternative Perspectives, by Ross C. Singleton, Publishing Horizons, 1986
52
For Schumpeter the welfare effects of perfect competition were immaterial because
the powerful lever that in the long-run expands output and brings down prices is in
any case made of other stuff.
Schumpeter believed that even in the short-run monopolistic excess would be moder-
ated by the threat of potential competition. The behavior of oligopolistic firms or even
of a monopolist would reflect the sure knowledge that high profits inspire more rapid
entrepreneurial challenge.
Yet, Schumpeter did expect that advantaged firms would attempt to limit price com-
petition among themselves and take every measure to dissuade new entry into the
market.
Viewed in a static context, this behavior would be considered by most observers the
epitome of anti-competitive behavior, resulting in allocative inefficiency. Schumpeter
however, defended this restrictive behavior as an attempt by those firms to keep on
their feet, on ground that is slipping away from under them. Firms must be able to
maintain and take advantage of their dominant position long enough to recoup the in-
vestment associated with their original innovation.
Certainly, the question of optimal market structure is far from settled. Schumpeters
critics argue that protected market positions can lead to technological lethargy. Most
research seems to suggest that markets with moderate levels of concentration and
moderate barriers are most often found to be optimal. Firms in such markets have
some opportunity to earn economic profit through innovation (the carrot) but their
profits and market shares are vulnerable to erosion by technologically audacious new-
comers (the stick).
Compare the above analysis with Baumols Contestable Markets Theory below. In
questions about efficiency, about benefits of more competition, about costs and bene-
fits of monopoly etc., make sure you make a special reference on the theory of Con-
testable Markets!

53
William Baumols Theory of Contestable Markets
Related key terms / concepts you should feel comfortable with:

Structure conduct performance model (Joe Bain)
Entry and exit barriers
Sunk costs
Hit and run entry
Average cost pricing
Marginal cost pricing
Normal profits
Potential competition
Threat of competition
Austrian school
Efficient / competitive outcome
Airline industry / capital on wings
Degree of contestability
CONTESTABLE MARKET THEORY18
William Baumol, (together with Panzar and Willig in Contestable Market and the
Theory of Industry Structure, 1982) have developed the theory of contestable mar-
kets. This theory can be viewed as a generalization of the theory of competitive mar-
kets.
Contestable markets like competitive markets exist when there are no barriers to entry
or exit. However, contestable markets unlike competitive markets may be character-
ized by significant economies of scale and / or scope19 and may, therefore, be highly
concentrated with few or even one firm in the market.
Baumol et al. claim that contestable market performance will be competitive in the
sense that a cost-efficient industry structure will evolve and firms will earn zero eco-
nomic profits in long run equilibrium. Or, in other words, equilibrium in a perfectly
contestable market must result in a socially efficient outcome. Since a contestable
market is subject to hitandrun entry, incumbent (=existing, entered) firms will be
forced to charge prices which reflect their costs of production. Without barriers to en-
try, potential competition will insure competitive performance even in highly con-
centrated industries.
A market cannot be contestable if entry entails substantial sunk costs. Sunk costs are
investment costs or other entry costs which cannot be recovered upon exit from an
industry. Sunk costs deter entry in two respects. First, sunk costs are borne by entrant
firms but not by incumbents in that, from the perspective of the entrants, incremental
18
This section is heavily based (at points, verbatim) on Industrial Organization and Antitrust: A
Survey of Alternative Perspectives, by Ross C. Singleton, Publishing Horizons, 1986; as well as on
a variety of other sources
19
Economies of scope arise when there exist complementarities in production between or among
products, such that the products can be produced most efficiently simultaneously by a single firm
rather than separately by specialized firms.

54
(extra) costs include the full amount of sunk costs while sunk costs are bygone (past)
costs to incumbents. Second, sunk costs permit incumbent firms to engage in or
threaten retaliatory strategic responses that increase the risk that new entrants
perceive. In particular, incumbent firms may depress prices to a level that covers their
variable costs but does not allow new entrants to cover their sunk costs (a pricing
strategy known as limit pricing). Examples of sunk costs include: development costs,
such as new models and products ( especially high in the car industry and pharmaceu-
ticals industries); non-transferable capital, such as specialised machinery; contracts to
provide a service for a specific period of time; advertising and marketing costs.
More specifically, three conditions must be met for a market to be considered per-
fectly contestable:
a. Potential entrants must face no disadvantage compared to incum-

bent firms meaning that production technology, input prices and in-
formation about demand conditions are available freely to all.
b. All entry related costs must be fully recoverable: no sunk costs
must exist.
c. The entry lag should be less than the price adjustment lag20 for
incumbent firms.
In practice, what matters is the degree of contestability since perfect contestability

does not exist in the real world (as perfect competition does not exist eitherThe degree
of contestability increases the higher the size of supernormal profits, the lower the en-
try barriers and the lower the extent of sunk costs.
POLICY IMPLICATIONS OF CONTESTABLE MARKET THEORY
The principal policy implication of contestable market theory is quite obvious and
quite profound. High industrial concentration (i.e. the existence of only few firms)
does not necessarily indicate poor market performance. Rather, high concentration
may well be defensible by economies of scale or scope. Government intervention in
such industries must keep an eye on the efficiency consequences of any structural
remedies. Contestability theory has succeeded in forcing antitrust and competition
analysis to reduce emphasis on market concentration and focus more on potential
competition.
Moreover, according to the theory, it is possible that some highly concentrated mar-
kets may be more or less contestable. The link between barriers to entry and market
concentration assumed by neoclassical theory is broken. Concentrated markets will
not require government intervention to insure efficient performance. In the absence of
actual competition, the desirable properties of perfectly competitive markets may be
attained if there are no entry or exit barriers. The standard criticism that under mo-
nopoly consumers are worse-off by restricting output, raising prices and earning su-
pernormal profits is no longer relevant if neither entry barriers nor sunk costs exist.
20
Entry lag: the period between the time entry becomes known to incumbents and the time the new
firm is able to supply the market. Price adjustment lag for incumbent firms: the time lag between de-
ciding to change prices and actually being able to do so.
55
The Civil Aeronautics Board (CAB; responsible for the US airline industry) in the US
did not use traditional concentration ratios to judge the competitive impact of mergers
in the airline industry. The CAB reasoned that the airline market, while certainly not
perfectly competitive, was contestable and that potential competition would restrain
the excesses than merger might otherwise permit.
The importance of sunk costs in determining contestability suggests two things. First,
competition policy efforts should be focused on those industries in which sunk costs
are likely to be significant due to rapid technological change or any other unavoidable
circumstance. Second, efforts should be made when and where possible to stimulate
contestability not only by eliminating artificial barriers to entry and exit but also by
limiting the entry deterring impact of sunk costs.
In conclusion, it should be noted that Baumol et al. believe that contestability analysis
reinforces the position of those who favor laissezfaire, pro-market and anti-
intervention policy attitudes.
Their analysis demonstrates that a variety of market structures that depart substan-
tially from perfect competition can yield excellent performance without governmental
intervention.
Examples (besides the airline industry) of markets that have become more contestable
may include:
Online services such as publishing, home shopping, databases, travel services

etc
Retail banking and financial services (in the UK with Egg, the online retail
bank owned and run by Prudential, a world leader in the insurance business;
with Tesco and Sainsbury supermarkets providing banking services; also in
the US)
Electricity and gas supply (not, production)
Parcel delivery

56
Market Success & Market Failures
You should explain what the fundamental economic problem that all societies face is:
scarcity of resources vs. unlimited wants this necessitates choices to be made, i.e.
decisions about which goods will be produced and in what quantities in other
words, how will scarce resources be allocated.
In a market economy, the answer is given by the market (the price) mechanism: the
invisible hand of the market, the interaction of demand and supply (consumers trying
to maximize utility (i.e. their satisfaction) / firms trying to maximize profits) deter-
mines the way both blades of a pair of scissors do, how much of each good will be
produced.
If markets are competitive, if externalities do not exist, if preferences are fully re-
vealed and if resources are mobile, then the resulting allocation of scarce resources is
optimal from societys point of view: neither too many units of any good nor too few
are produced!
Explain why:
society would want to produce all units of a good that are worth more to consumers
than their cost of production (i.e. than the value of whatever goods had to be sacri-
ficed), up until that unit for which the Marginal Benefit (given by the willingness to
pay, by the price consumers would be willing at the most to pay) is equal to the Mar-
ginal Cost of producing it (= the value of whatever had to be sacrificed, i.e. the O.C.).
Social surplus or welfare (the sum of Consumer and Producer Surplus) is at a maxi-
mum; if either more or less is produced then social welfare would be less (this implies
that allocative efficiency has been achieved market success)
Note though that allocative efficiency is achieved given some any- distribution of
income, even if it is very unfair; in that sense, a specific efficient allocation may not
be desirable. (remember that demand is defined as the relationship between various
possible prices and the corresponding quantities that individuals are willing and able
to purchase per time period, ceteris paribus: those with severe income constraints,
those below the absolute poverty line, will thus not exist in the formulation (expres-
sion) of demand of even perhaps the most basic products such as foodstuff! As a re-
sult, even if allocative efficiency is the case, the underlying income distribution may
be socially unacceptable diminishing thus the desirability of allocative efficiency!
BUT:
Market Failure 1
If monopoly power exists then less than the socially optimal amount of the
good is produced (since monopolist restricts output!)

57
Possible Solutions: The Government should ensure that competitive conditions pre-
vail in markets. It should ensure that no mergers or acquisitions materialize that ex-
cessively increase the monopoly power of any firm (by examining perhaps the post-
merger increase of the Hirchman Herfindahl Index); it should monitor firm practices
that seem anti-competitive; it could tax or fine firms found guilty of such practices; it
should even breakup such firms into smaller independent pieces. But, as the Schum-
peterian critique presented earlier in this set of notes suggests, there may be very sig-
nificant dynamic social benefits arising from the existence of such large monopoly
firms in the form of economies of scale and faster rates of innovation and technologi-
cal change. In addition, contestability theory strongly suggests that even highly con-
centrated industries may be capable to approximate competitive outcomes if sunk
costs are low and the threat of hit and run entry exists. The regulator should thus
make sure that such EOS are not sacrificed and that the rate of innovation is not jeop-
ardized, a task not at all easy. An entrenched monopoly firm (operating behind state
created barriers) is the worse type and should be avoided at all costs. Deregulation
that aims to increase competition should be also very carefully designed since there is
a good chance of regulatory capture when price caps or quantity goals are set. The
poorly designed deregulation of the California energy sector where the few electricity
generating firms colluded, did not invest and even closed down plants in order to arti-
ficially raise prices is a good example of how a theoretically sound idea (deregulation)
may lead to the opposite results (see the unofficial Paul Krugman site for plenty on
this issue; also, Sloman on the issue of monopoly regulation)
Also, remember that a very effective way to reduce domestic monopoly power is
through liberalizing international trade: free trade automatically increases competi-
tion, increasing efficiency, lowering prices etc etc.
Market Failure 2
Externalities (as well as merit demerit goods)
An externality arises if a transaction between two parties creates benefits or imposes

costs on a 3rd party for which the latter does not pay for or does not get compensated
respectively. Or, equivalently, an externality exists whenever there is a divergence
between private and social costs or between private and social benefits.
If an externality exists . then either more or less than the socially optimal amount
is produced / consumed; market forces fail to lead to an efficient resource allocation.
Externalities may arise in the production process (production externalities) or in the

consumption process (consumption externalities). They may impose costs on 3rd par-
ties (negative externalities) or create benefits (positive externalities).
Some definitions:
Marginal private costs: refer to the costs of production that the firm takes into consid-
eration in its decision making process. They include wages, costs of raw materials
etc. As a result the MPC curve is the supply curve of a (competitive) firm.
Marginal social costs: refer to the costs of production borne by society. They reflect
the value of all resources that are used up (i.e. sacrificed) in the specific production
process: the labor, raw materials etc that are used up there (and not in their next best
alternative) and which comprise the MPC taken into consideration by the firm owner

58
but also any external costs (if they exist), say, in the form of pollution (wate dumped
in a nearby river). As a result, in this case, MSC exceed MPC and should be drawn
above the MPC (supply) curve. This would be the case of a negative production ex-
ternality.
If though a production process creates benefits for a 3rd party (say, another firm) then
the MSC curve lies below the MPC (supply) curve as there is an external production
benefit involved in the process.
As a result: MSC = MPC + external costs (or, minus external production benefits)
If MSC > MPC then the market fails since the market forces lead to overproduction
If MSC < MPC then the market fails since the market forces lead to underproduction
(make sure you are able to recognize the social welfare loss area in the diagram you
draw)
Also:
Marginal Private Benefits: refer to the benefits that the individual consuming the
product enjoys and which he/she takes into consideration in his/her decision making
process; Thus, the MPB curve is the demand curve of the individual / market.
Marginal Social Benefit: refers to the benefits from the consumption of the product
that accrue to society: they thus include the benefits to the consuming individual plus
any external benefits (if they exist) that the individual does not take into consideration
in his/her decision making process. In this case, the MSB curve lies above the MPD
(demand) curve. This would also be the case for merit goods such as vaccinations
with underconsumption resulting and reflecting the extent of market failure.
If though the consumption process creates costs on 3rd parties then the MSB curve lies
below the MPB (demand) curve. This would be the case of demerit goods (Vodka)
with overconsumption reflecting the resulting market failure.
The Tragedy of the Commons

(see Mankiw, chapter 11)
Assume a commonly owned pasture and n ranchers (herdsmen in the 1968 original
article by Gareth Hardin). Each rancher has the incentive to have his cattle feed in the
commons as well as to increase the size of his herd: he will enjoy all the benefits
while the costs will be shared by all. Since each rancher has the same incentive after
a while the commons will be destroyed.
Thus:
If a resource is commonly owned (be it a pasture, or the atmosphere, or the seas, or a
forest, or the downtown of a city) it will tend to be overused since the user enjoys
all benefits but the costs of using the resource are borne by all. As a result, society
suffers from overgrazing, air and water pollution, overfishing, soil erosion, deforesta-
tion, congestion, global warming etc.

59
It follows that, whenever feasible, property rights should assigned (defined) and en-
forced.
Note that this analysis suggests that pollution is the result of not enough markets ex-
isting: case of missing markets. If, say, there was a market for the right to pollute and
one had to pay to exercise this right then some of these problems would not exist.
Market Based Approaches to Externalities
The Coase theorem
Ronald Coase, a Univ. of Chicago Nobel prize economist in the tradition of the Chi-
cago School, showed that externalities need not be a market failure requiring gov-
ernment intervention and regulation. Markets forces alone will reach a socially effi-
cient outcome.
More specifically:
If property rights are well defined and enforced, and independently of their allocation,
then private parties will have the incentive to negotiate and through a set of bribes and
compensations reach the socially efficient outcome, assuming that transaction costs
are zero.
To illustrate the validity of the Coase theorem consider the case of a negative produc-
tion externality with a steel mill located upstream polluting by dumping waste in the
adjacent river and thus negatively affecting the production process of a paper mill lo-
cated downstream.
The marginal social costs of steel production are greater than the marginal private
costs that the steel mill owner takes into consideration thus leading to more steel pro-
duced than the socially optimal amount.
Now consider diagrammatically the costs borne by the steel mill if it produces the so-
cially optimal amount of steel. Next consider diagrammatically the benefits of the
paper mill if the steel mill decided to produce less steel (at the socially optimal
amount). Since the benefits to the paper mill of steel production being reduced to the
socially optimal level exceed the costs of the steel mill itself of such a decision, the
paper mill has the incentive to offer the steel mill a bribe that exceeds the costs to the
steel mill but is less than its own benefits. Both parties will be better off and will ac-
cept the solution (a Pareto improvement and a Pareto efficient solution since no other
reallocation exists that may improve the position of one party without compromising
the position of the other).
Criticism of the Coase Theorem:
While the Coase theorem is illuminating as to the powers of the free market forces
(and several research papers have confirmed such forces indeed operating see the
research of S. Cheung on bee keepers and apple orchard owners in the state of Wash-
ington) it suffers from several drawbacks:

60
Transaction costs are seldom zero (Mankiws example is that the parties involved may
have to hire interpreters if they do not speak the same language) and most often are
very significant or even prohibitive: negotiations require lawyers; litigation may drag
on for long etc. In addition, if the parties involved are large in number there is always
the incentive to behave as a free rider avoiding the costs of the process while hoping
to benefit from the outcome.
A market based solution to the problem of pollution:

Tradeable (or, Marketable) Pollution Permits (or, Licenses)
Assume in an area a number of firms of different age, some older and some newer.
The government may require that all firms cut down their operating hours by 50%, or
that they each decreases output by 50% Government regulates output; direct regu-
lation (a command and control type solution)
Instead it may do the following:
It may determine the maximum acceptable level of pollution X* and then issue n
permits, each worth X*/n units of pollution and hand them over to the polluting firms.
Newer firms which may decrease pollution easier (at a low cost) will be willing to sell
off permits to older who can not decrease their pollution level at low cost and who
will thus be willing to buy permits so that they do not have to decrease their output as
much.
When all trading is over, a new allocation of permits will result with the optimal level
of pollution achieved but with total industry output suffering the lowest decrease.
The Government sells a limited stock of exchangeable permissions to pollute. Com-

panies finding it expensive to cut down on emissions would be able to buy permits
from others who found the costs less prohibitive.
But, this is a costly solution as the need to monitor firms arises: The government has
to make sure that each firm does not exceed the pollution level constraint that the
number / value of its licenses dictate.
Other market-based solutions:

Imposing an indirect tax equal to the external cost (environmental / green taxes) or
granting a subsidy equal to the external benefit
Effectively these solutions force the MPC or the MPB curves to their socially optimal
level thus ensuring that the socially optimal amount is produced / consumed.
The problem is that it is exceedingly difficult in practice to estimate correctly the true
level of external costs or benefits generated. Many of these costs (or, benefits) extend
well into the future making it even more difficult to estimate their present value (diffi-
culty of choosing appropriate rate of discount)

61
Also:
Command and Control Solutions:
Government can regulate directly output, prices, location, operating hours etc. Usu-
ally, bureaucrats are not very good in designing and enforcing such solutions. But,
especially in LDCs direct regulation may be the only realistic solution. Bans on the
use of certain pesticides in, for example, Thailand and parts of South America have
had considerable success. Water use quotas have been implemented successfully in
Israel in a region where water use has been growing into becoming a serious problem.
Logging bans in Costa Rica and quotas in Malaysia have had success, albeit limited in
protecting the rainforest. However, the activities of poachers and the difficulty of en-
forcement have complicated the success of national parks in preserving biodiversity in
countries such as Brazil and India21.
Lastly:
Advertising (or, its ban), moral suasion, education etc
Bear in mind:
The problem of pollution (of, say, global warming, the ozone problem etc) exceeds
national borders. Pollution is considered a public bad: if it exists for one, it exists
for all. It is an international problem requiring international cooperation. Unfortu-
nately, no supra-national body exists that can impose solutions on sovereign nations.
Treaties are a movement in that direction (Kyoto treaty, the Rio Summit etc) but even
if a nation signs, it may still choose not to abide by it; even worse so, it may choose
not to sign, as the US has done. Russia is only now considering ratifying the Kyoto
protocol in exchange for the prospect of becoming a WTO member.
Perhaps the most effective way for developing countries to lower their level of pollu-
tion emissions is by helping them grow faster. Grossman and other have shown that
pollution follows an inverted U- path when traced along per capita income with the
8000 10000 USD level being the critical level of per capita income (in 1985 con-
stant dollars) beyond which further increases in per capita income lead to less emis-
sions22: clean environment one may thus argue is an income elastic good! As a re-
sult, free trade may be the optimal policy choice for global environmental problems to
decrease. The US and the EU and Japan should open their markets to developing
country farm and light industry products as soon as possible.
Market Failure 3
Case of public goods: because of non-excludability consumers have the incentive to
conceal (to hide) their true preferences hoping to benefit as free riders. As a result,
private profit oriented firms will not have (normally23) the incentive to produce and
offer such goods and services through the market.
21
See the article How do environmental problems differ between developed and developing countries
by R. Pratt in Economics Today, volume 7, number 2, November 1999.
22
The generalized inverted U relationship between the level of development and the level of envi-
ronmental degradation is known as the Kuznets curve.
23
Think of off-the-air TV and radio broadcasting
62
Definition:
A good is considered a public good if
it is non-excludable i.e. if, once available to even one consumer, it automatically
becomes available to all, in other words, no one can be excluded from consuming
the good once even one individual consumes it. Consequently, individuals have
the incentive to conceal their true preferences because they know that they can be-
have as free-riders.
its consumption is non-rival, i.e. if consumption of the good by one does NOT
decrease the amount available for all others (non-diminishable); this implies that
the marginal cost of an extra user is nil.
Examples:
traffic lights, sidewalks, lighthouse, national defense, law and order, price stability,
off-the-air TV & radio broadcasting (Fame Story)
Merit goods:
Definition: goods that are excludable (thus private firms would have the incentive to
produce them and indeed do so) but non-rival, at least up to a certain point (beyond
which congestion costs begin to arise) and which when consumed generate very sig-
nificant positive externalities.
Note that other definitions of merit goods stress:

The fact that individuals are often NOT fully aware of the true / full benefits de-
rived from the consumption of the good so the government has to step in and en-
sure that people DO consume these goods in adequate amounts e.g. basic educa-
tion (for example the state has made education compulsory until 3rd Gymnasium
in Greece), childrens vaccinations (a child can not be enrolled in a school if there
is no proof that all necessary vaccinations have been made), etc.
The fact that low income individuals often can not afford to consume these goods
so the government has to ensure that all, rich and poor alike, consume sufficient
amounts of these goods (note the paternalistic role of the government in these
definitions)
On a diagram, the marginal social benefits curve lies above the demand curve,
which depicts the marginal private benefits involved.
Demerit Goods
Their consumption generates negative externalities (or, individuals are not fully
aware of the costs they face when consuming these goods): thus, the government
has to step in to reduce consumption of these goods e.g.: tobacco, alcohol, drugs
etc
Diagrammatically, the market failure resulting in the case of demerit goods can be
illustrated with the marginal social benefits curve drawn below the marginal pri-
vate benefits curve (the demand curve). Alternatively, illustrating the case of a
consumer, we could draw a demand for the good along with a marginal private
and marginal social cost of using (not of producing) the good.
Note that free markets also fail when resources are not mobile, when information is
not perfect (asymmetric information, moral hazard) and in the case of non-renewable
resources since preferences of future generations are not reflected in current demand
(say, for oil)

Micro Notes

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Micro Notes

Uploaded by

Copyright:

Available Formats

1

Microeconomics is concerned with the individual parts of the economy. It is con-

Resources (Factors of Production)

a. Land and raw materials (Natural Resources):

b. Labor (human resources):

c.h. ziogas (ziogas11@yahoo.com)

Physical capital includes manufactured resources (produced means of production, or

Positive and Normative Economic Statements:

Normative Economic Statements: they are value judgments, opinions, statements

Positive Economic Statements: statements that can be proven, at least in principle,

c.h. ziogas (ziogas11@yahoo.com)

Fundamental Questions of Economics (that all societies face, independently of their

Scarcity necessitates choice and thus answers to the following questions:

The Production Possibility Frontier (or, Curve or, Boundary)

c.h. ziogas (ziogas11@yahoo.com)

Growth of an economy can be illustrated through an outward shift of the PPF. We

(related concepts: trade cycle; potential output; trend output)

More specifically, it occurs if there is an increase in:

Land: e.g. if new metal deposits/minerals are discovered.

More formally: I = K/t

Focusing now on a market economy:

A market economy is one where market forces alone, without Government or

To analyze the functioning of markets we thus need to somehow analytically

The Law of Demand holds because of:

Statement of the problem that the typical consumer faces:

Goal of (rational10) Consumer: To maximize his/her utility, subject to his/her budget

The logical rule for maximizing utility:

MU of A / price of A = MU of B / price of B (2)

Rearranging (2) produces the following result:

Other factors affecting Demand (so called shift factors):

1) Changes in consumers income (Y).

2) Changes in preferences (tastes).

3) Changes in the price of other goods.

4) Size of the market i.e. number of consumers.

7) Age distribution of the population:

7) Changes in the distribution of income

6) Changes in the distribution of sex in the population

7) Expectations (of changes in market prices, in income etc.)

Shifts of Demand versus Movements Along a Demand (source of a typical student

c.h. ziogas (ziogas11@yahoo.com)

curve may therefore even be down- to scale later in these notes)

c.h. ziogas (ziogas11@yahoo.com)

Factors affecting supply (shift factors)

2) Size of the market i.e. number of firms in the market.

3) Expectations of future price changes.

c.h. ziogas (ziogas11@yahoo.com)

Price And Output Determination in Competitive Markets

Equilibrium condition: A price will be an equilibrium price, if neither ED nor ES

The Allocation Of Scarce Resources

c.h. ziogas (ziogas11@yahoo.com)

c.h. ziogas (ziogas11@yahoo.com)

Price Elasticity Of Demand (PED)

definition: the responsiveness of quantity demanded to a change in price.

Ranges of Price Elasticity of Demand (ignoring the minus sign)

1. The case of a perfectly inelastic demand curve.

c.h. ziogas (ziogas11@yahoo.com)

2. The case of a perfectly elastic demand curve.

3. The case of a unitary elastic demand curve (rectangular hyperbola: Q = a/P).

Relationship between PED and Total firm Revenues (TR)

The answer depends on the price elasticity of demand:

If price changes and Ep>1

If price changes and 0<Ep<1 (i.e. inelastic).

If price changes and Ep=1:

1. The number and closeness of available substitutes: