Micro Economics

Economics Notes
What is economics? Rationing systems Demand and Supply The Interaction of, and applications of, Demand and Supply Elasticities Indirect taxes, subsidies and elasticity Costs, revenues, and profits Perfect competition

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What is economics?
Adam Smith (1723-1790)
father of economics Wrote one of the first and most important books on economics An Inquiry into the nature and causes of the wealth of nations The book was written during the beginning of the industrial revolution. Smith believed in the free market

Economics before industrial revolution.

Economics after industrial revolution.

Simple Agricultural systems Most people involved in producing basic products Few people providing other necessities such as leather and farming equipment Coming of the steam engine Increased use of machinery able to produce more good with more efficiency Banks for investment Birth of stock exchange

Scarcity
All goods and services that have a price are relatively scarce. Scarce in relation to peoples demand for them. The earth is finite peoples wants/demands are infinite. Price is usually used to ration out goods; the more expensive something is the smaller the market for it.

Needs:
Things we must have to survive; food, shelter, clothing

Wants:
Things we want but are not necessary for our immediate survival

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Goods:
Physical objects that are capable of being touched/ they are tangible

Services:
Still give satisfaction but are intangible.

Opportunity Cost
The next best alternative given up from choosing between alternatives. If a good or service has opportunity cost it is therefore relatively scare and must be an economic good. Goods such as air, salt and water which are not in limited supply thus do not have an opportunity cost. They are known as free goods.

Basic Economic Problem

What should be produced and in what quantities?
Using scare resources how many bikes and computers should be produced? How much milk and wheat should be produced?

How should goods and services be produced?

Should sport shoes be produced in an automated production line, or by manual workers? Should crops be grown with high usage of fertilizer or grown organically?

Who should goods and services be produced for?

Should goods and services go to people who can afford them or shared out in a fair manner? How will the national income of the economy be distributed?

How should produced goods and services be distributed?

2 allocation systems FREE MARKET/ MARKET ECONOMY (greater depth later): . Economic decisions guided by the change in prices that occur as individual buyers and sellers interact with the market place. . Most of resources are owned by private citizens. . Economic decisions are based on free enterprise (competition between companies)

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. .

Important economic questions are answered by individuals not the government. NO government intervention.

PLANNED ECONOMY (greater depth later) . Government makes all economics decisions . Most resources and property is owned by the government. . No knowledge of supply and demand as government chooses everything.

Factors of Production:
Four resources that allow an economy to produce its output
LAND:
Everything that grows on the land or is found underneath it; this includes the sea and everything that is found in and under the sea. . Basic raw materials: gold, coal, oil and natural gas. . Cultivated products: wheat, rice, pineapples . Natural resources: renewable resources and all cultivated products . Non-renewable: including all fossil fuels LABOUR: Human factor; the physical and mental contribution of the existing work force to production CAPITAL: . Physical Capital: stock of manufactured resources . Human Capital: value of work force . Social Overhead Capital: large-scale public systems/services and facilities MANAGEMENT/ ENTREPRENEURSHIP: . Organising and risk taking factor of production . Entrepreneurs use their own money plus the money of investors to buy factors of production so they can produce goods and services . A profit is never guaranteed, investments can be lost

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Production Possibility Frontiers:

Used by economists to show concepts of scarcity, choice, and among other things, Opportunity Cost. PPF/PPC shows the maximum combinations of goods and services that can be produced by an economy in a given time. A PPF is a curve because not all the factors of production are equally usable/productive for both goods.

At point B, both product A and B are being produced at equal amounts and all factors of production are being used efficiently.

An outward shift in a PPF means there has been growth in the economy. The only way for this to occur is if there is an improvement in the quantity or quality of the factors of production.

Utility:
Measure of usefulness and pleasure The total satisfaction gained from consuming a certain quantity. Eg. If a person ate five ice creams the total pleasure gained from eating all five ice creams. The extra utility gained from consuming one more unit. In most cases marginal utility gained from extra units falls as consumption increases. Total Utility

Marginal Utility

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Rationing Systems
Micro Economics (continued later):
Deals with smaller economic agents and their reactions to changing events. . Individual consumers: how they make their decisions about demand and expenditure. . Individual firms: how they make their decisions, what to produce? How much to produce? . Individual industries: how are they affected by things such as government intervention?

Macro Economics (continued later):

Takes a wider view. Measuring all the economic activity Inflation Distribution of income within the whole community

Positive Economics:
Positive statement: can be proven right or wrong by looking at facts. Positive Economics deals with areas of the subject that are capable of being proven to be correct or not. "The unemployment rate for china for 2004 was 9.8%".

Normative Economics:

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Normative statement: matter of opinion, cannot be conclusively proven to be right or wrong; uses words like 'ought', 'should', 'too much' or 'too little'. Normative economics deals with areas of the subject that are open to personal opinion and belief. Unlikely to have a conclusive outcome in normative economics. For example theories as to why economies tend to move from periods of economic activity to periods of depressed activity.

Economists Model Building:

Economics = Social Science When building a theoretical model to test and illustrate theories the model is manipulated to see the outcome if one of the variables in changed. Holding all but one variable constant is known as Ceteris Paribus. This is done to test the effect of one variable on another.

Rationing Systems:

FREE MARKET/ MARKET ECONOMY

.

Economic decisions guided by the change in prices that occur as individual buyers and sellers interact with the market place. . Most of resources are owned by private citizens. . Economic decisions are based on free enterprise (competition between companies) . Important economic questions are answered by individuals not the government. . NO government intervention. THREE ECONOMIC QUESTIONS: Who decides what to Who decides how to Who are the goods and services produce? produce? produced for? Business base decisions on demand and supply and free enterprise (PRICE) Businesses decide how to produce goods and services. Consumers.

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PLANNED ECONOMY
. . .

Government makes all economics decisions Most resources and property is owned by the government. No knowledge of supply and demand as government chooses everything. . This system has not been very successful and more and more countries are abandoning it. THREE ECONOMIC QUESTIONS: Who decides what to Who decides how to Who are the goods and services produce? produce? produced for? Government makes all economic decisions. Government decides how to produce goods and services. Whoever the Government decides to give them to.

MIXED ECONOMY
There is no true market economy . Market + Demand = Mixed . There is no pure market or command economies. All modern economies, to some extent, exhibit characteristics of both systems; however closer to one system than the other. . Business owns most resources and determine what and how to produce however the government still regulates certain industries. . Most democratic countries fall under mixed economy.

THREE ECONOMIC QUESTIONS:

Who decides what to Produce? Business Who decides how to produce? Business, but government regulates certain industries Who are the goods and services produced for? Consumers.

DISADVANTAGES OF MARKET 1. Demerit goods (drugs/brothels etc) will be over provided, driven by high prices and thus high profit motive.

DISADVANTAGES OF COMMAND 1. Total production, investment, trade and consumption, even in a small economy, are too complicated to plan efficiently and thus there will be miscalculations of resources. Shortages and surpluses.

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2. Merit goods (medicine/health care) will be underprovided, since they will only be produced for those who can afford it.

2. Because there is no price system in operation, resources will not be used efficiently. Arbitrary decisions will not be able to make the best use of resources. 3. Resources may be used up too 3. Incentives tend to be distorted. quickly and the environment may Workers with guaranteed be damaged by pollution, as firms employment and managers who seek to make high profits and gain no share of profits are difficult minimize costs. to motivate. Output/quality will suffer. 4. Some members of society will not 4. The dominance of the be able to look after themselves government may lead to a loss of such as orphans, the sick and long personal liberty and freedom of term unemployed- will not survive. choice. 5. Large firms may grow and 5. Government may not share the dominate industries, leading to high same aims as the majority of the prices, a loss of efficiency and population and yet, by power, may excessive power. implement plans that are not popular, or corrupt.

Transition Economies:
. Countries such as Hungary, Poland and Russia, previously planned economies have been moving towards market-oriented balance in their systems. Them movement started mostly in the late 1980's.

Economic Growth:
. National income is the value of all the goods and services produced in an economy in a given time period, normally one year. National income can be measured by looking at the total value of the output of the good and services/ the expenditure on the good and services. Measure real national income per capita. This measure of the increase in economic activity is known as economic growth. Any increase caused by rising prices/inflation is ignored; once this has been done the national income is know as real national

.
.

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income. Real means having allowed for the effects of inflation. Economic growth is a money measurement and an average. Doesnt have anything to do with welfare of the people in a country.

Economic Development:
. Is a measure of welfare, a measure of well-being: using not only monetary terms but health, education and social indicators.

Demand and Supply

Demand:
Is the quantity of a good or service that consumers are willing and able to purchase at a given price at a given time. . Consumers must be able to actually purchase the good, not just be willing to buy it.

LAW OF DEMAND: As the price of a product falls, the quantity demanded of the product will using increase, 'ceteris paribus'. . It is important to remember that a shift along the curve will only happen if the determining factor is the price.

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A change in the price of the product itself will lead to a change in the quantity demanded and a movement along the curve.

The Determinants of Demand:

Income:
NORMAL GOODS: . Income rises, the demand for the product will also rise and the demand curve itself will shift to the right. The amount it shifts by is dependant on the good itself.

A shift of the demand curve to the right indicates an increase in demand for the good.

INFERIOR GOODS:

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. .

Income rises, the demand for the product will fall and the demand curve itself will shift to the left. For example cheap wine or "home brand" supermarket detergent. When income gets to a certain level demand for inferior goods will become zero.
If income falls the demand curve for inferior goods will shift to the right as the consumer no longer has the ability to purchase higher priced goods.

A shift in the demand curve to the left indicates that demand for the good has fallen and as income rises this is exactly what happens.

The Price of other Goods:

(There are 3 possible relationships between goods) SUBSTITUTES: . A change in the price of one will lead to a change in the demand of another. . These changes of demand would affect the curve directly.

COMPLEMENT

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. .

A change in the price of one will lead to a change in the demand for the other. For example if the price of DVD players when down not only would demand for that particular good go up the demand for DVDs would also increase.

UNRELATED . A change in the price of one will have no effect on the demand for another good.

Tastes:
.

. The size of the population

population grows = demand for most products increases.

A change in tastes in favour of a product will lead to more being demanded at every price. Marketing may/can alter tastes. Changes in income distribution
Relatively poor become better off and rich become slightly worse off there may be an increase in the demand for basic necessity goods.

Other factors
Changes in age structure
Age structure alters, the quantity of demand for certain products will be affected.

Gov. policy changes

Changes on direct taxes (taxes on income) increases peoples real income and people have more to spend.

Seasonal changes
Changes in the season can lead to changes in the pattern of demand.

Movement along the Demand Curve/ Shift of the Demand Curve:

A change in price of the good itself leads to a movement along the curve. . The price if the good is on one of the axes. A change in any other determinants will always lead to an actual shift of the curve.

Exceptions to the Law of Demand:

GIFFEN GOODS:

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. . .
.

Unique type of inferior good. Key aspect is POVERTY Price goes up , demand increases This is because as the price of the good goes up the poor can no longer afford higher priced/ quality products. If price goes down, real income increases and they can afford higher priced goods.

VEBLEN
. .
. .

Price Goes down, demand goes GOODS: down Seen as a luxury Failure to consume in due quantity and quality becomes a mark of inferiority and demerit. As price rises, demand increases. At low prices goods have normal demand curve, once the good reaches a certain price it achieves a snob value status.

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Role of Expectations:
(The bandwagon effect)
Quantity demanded rises as price rises . People expect prices to continue to rise in the future . More people jump on the bandwagon

Supply:
The willingness and ability of producers to produce a quantity of a good or service at a given price in a given time period. . MUST BE WILLING AND ABLE LAW OF SUPPLY: As the price of a product rises the quantity supplied of the product will usually increase, ceteris paribus.

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Determinants of Supply:
The cost of factors of Production:
.

The cost of a factor of production increases, this increases the firms cost, resulting in the firms ability to supply decrease (they supply less). [ Inverse relationship] This leads to a shift of the curve to the left.

Price of other products, which producer could produce instead of the existing product:
.

Producers have a choice of what they will produce; can they produce two different goods with a minimal change in production facilities? If the price of good A rises (more demand), more of A will be produced and there will be movement along the supply curve for A. The supply for B will decrease and there will be a shift of the curve its self.

State of Technology:
. . Improvements of technology lead to an increase of supply, thus the curve shifts to the right. Natural disasters can have a negative effect on the state of technology

Government intervention:
INDIRECT TAXES (EXPENDITURE TAXES): (Taxes that are added onto the cost of the product) . Because prices are forced up, this forces the supply curve upwards.

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SUBSIDIES: (Payments made to firms by the gov. to reduce firms costs) . Because costs are reduced more of the product will be supplied at every price. Forcing the demand curve downwards.

Movement along the Supply Curve/ Shift of the Supply Curve:

A change to the price of the good itself leads to a movement along the curve. . The price of the good is on one of the axes. A change in any other determinants of supply will always lead to a shift of the curve itself.

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The Interaction of, and Application of Demand and Supply

Equilibrium:
A state of rest, self-perpetuating in the absence of any outside disturbance. Equilibrium is simply when the quantity demanded equals the quantity supplied.

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Once this is achieved the market is in equilibrium as it will stay in this state until there is an outside disturbance to cause change. At Pe everything produced in the market will be sold. This is known as the Market Clearing Price.

If the market does not reach equilibrium there will either be excess demand or excess supply. To find out how much excess there is you subtract Q2 from Q1 ( Qs Qd )

The Effect of changes in Demand and Supply upon the Equilibrium:

Equilibrium can be moved by any outside disturbance, in terms of supply and demand a change in any of the determinates (except price of the product), which leads to a shift of either of the curves. For example: if income increases for consumers of foreign holidays. When income increases so will the demand for foreign holidays thus moving the demand curve to the right and shifting the demand curve to the right creating excess demand.

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Price Controls:
Governments usually intervene in the market to achieve a different outcome that a free market would achieve.

Maximum (low) Price Controls:

Government sets a maximum price, below the equilibrium. This is also known as a ceiling price as producers cannot produce above that price. Ceiling prices are set to protect consumers, placed in markets where the product is a necessity/ merit good. Even though this ensures people on low income can afford basic goods it creates problems as well, such as: . Excess demand which leads to shortages and the possibility of a black market and other unfair problems for consumers. Government deals with this in 3 ways: all shift the supply curve to the right. 1. Offer subsidies to firms 2. Start to produce themselves 3. Release buffer stocks

Minimum (high) Price Controls:

Government sets a minimum price, above equilibrium. Also known as the Floor price; producers cant go below it. Floor prices are set to: . Raise income for producers that gov. thinks is important . To protect workers: setting a minimum wage Problems created: . Producers will have a surplus and will try and sell excess supply for a lower price. . Firms may become less cost-conscious which will lead to inefficiency. Government deals with this in 3 ways: 1. Eliminate excess: buy and then . Store surplus ( this is expensive) . Destroy surplus ( this is seen as wasteful) . Sell surplus abroad ( foreign gov. get angry as it is seen as products are being dumped on their markets, harming domestic industries) 2. Limit producers with quotas, restricting supply to achieve the new equilibrium 3. Increase demand for the product through advertising or limiting supplies of the same product being imported from overseas.

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Price Support/ buffer stock schemes:

Government intervenes in a market to stabilise prices. Most often then happens for commodities (raw materials), whose prices are volatile. For example: wheat, coffee or cocoa are all at the mercy of the weather, insects and plant diseases. . If conditions are perfect a bumper crop is produced, driving the prices and thus income of the producers down. . If conditions are poor, supply for the crop will drop and prices will rise, only benefitting the farmers who have crops. Governments intervene to protect prices from extreme fluctuations by operating a buffer stick scheme. A buffer stock manager sets a price band with the highest and lowest possible price. If the market forces push the price above or below the band the government intervenes. . If it falls below the bottom price gov. buys up excess supply. . If it goes above the top price gov. sells stored stocks to satisfy excess demand.

Commodity Agreements:
Pioneered in the 1960s Commodiity Agreements are when different countries work together to operate a buffer stock system.

Elasticities
Elasticity is a measure of responsiveness; measuring how much something changes when there is a change in one of the factors that determine it. If something is elastic the percentage change in demand is greater than the percentage change in price. Usually wants/luxuries. If something is inelastic the percentage change in demand is less than the percentage change in price. Usually needs.

Micro Economics If something is unit elastic the percentage change in demand is equal to percentage change in price.

Price Elasticity of Demand (PED)

PED = % quantity demanded/ % in price NOTE: the negative value of
PED indicates the inverse If the answer is between 0 and 1 the good is inelastic relationship between price and quantity demanded. Economists usually ignore the negative value.

If the answer is 0 the good is unit elastastic

NOTE: the elasticity is NOT a measure of the slope of the demand curve, PED changes as you move along the curve. (PED decreases as you move down the slope)

If the answer greater than 1 the good is elastic

Determinants of PED:

The number and closeness of substitutes:

The more substitutes for a product the more elastic the product is (how close these substitutes are is also very important)

The necessity of the product and how widely it is defined:

If the good is a necessity is will be inelastic however depending of the definition of the good (e.g. Food can be defined as chicken or beef etc.) the elasticity will be affected.

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The time period considered:

It takes consumers time to change buying and consumption habits. In the short term PED tends to be inelastic and becomes more elastic as time goes by. NOTE: government will usually only tax inelastic goods.

Cross Elasticity of Demand:

XED = % quantity demanded of X/ % in price of Y
If XED is positive the two goods in question are substitutes. The higher the number the closer the products are related. For example different brands of margarine. If XED is zero the goods are unrelated If XED is negative the two goods in question are said to be complements. The lower the number the closer the complements are, for example Xbox and Xbox games.

XED Value
Negative Positive Close Close Complements Substitutes Zero Remote Complements Unrelated products Remote Substitutes

Relationship

Income elasticity of demand:

YED = % quantity demanded/ % income of consumer
(In the case of normal goods YED is always positive)

YED VALUE OF ZERO TO ONE MEANS THE GOOD IS INCOMEINELASTIC

Micro Economics or if the percentage increase of quantity demanded is less than the percentage rise in income.

YED VALUE OF MORE THAN ONE THE GOOD IS INCOME-ELASTIC

Or if the percentage increase of quantity demanded is greater than the percentage rise in income Necessity goods have low income-elasticity Superior goods have high income-elasticity Inferior goods have a negative YED (demand decreases as income increases), this is because as income increases consumers now can afford higher priced items.

Price elasticity of Supply:

The measure of how much the supply of a product changes when there is a change in the price of a product.

PES = % quantity supplied/ % in price of product

if the answer is greater than zero but less than one the product has inelastic supply. a change in price of the product leads to a less the proportionate change in the quantity supplied

if the answer is one then the product is unit elastic. A change in price leads to a proportionate change in supply. NOTE: if a supply curve starts in the origin it is unit elastic. If the answer is greater than one and less than infinity it has elastic supply. A change in price leads to a greater than proportionate change in quantity supplied.

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Determinants of PED:

How much costs rise as output is increased

If producer tries to increase output but costs rise significantly as a result it is implied supply would stop.

The time period considered

INELASTIC In the immediate time period firms are not able to increase their supply significantly In short run firms are able to increase quantity of raw materials or employees but cannot increase capital (machines) ELASTIC In long run firms are able to increase quantity of all factors of production.

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Indirect taxes, subsidies, and elasticity:

The effect of an indirect tax on the demand for, and supply of, a product:
There are two types of indirect taxes to consider: a) A specific tax: a specific or fixed amount of tax that is imposed upon a product.

b) A percentage tax (Valorem Tax): the tax is a percentage of the selling price.

When 1. 2. 3. 4.

imposing an indirect tax, four questions must be asked: What will happen to the price that consumers pay? What will happen to the amount received by the producer? How much tax will the government receive? What will happen to the size of the market, and so employment?

PED=PES
The burden of any tax imposed will be shared equally between producer and consumer.

PED > PES

The burden of any tax imposed will be greater on producers than on consumers.

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PED < PES

The burden of any tax imposed will be greater on consumers than producers.

The effect of a subsidy on the demand for, and supply of, a product:
A subsidy is an amount of money paid by the government to a firm, per unit of output.

Reasons for Government to give a subsidy:

1. To lower the price of essential goods, such as milk or bread, for consumers. This is done to try and increase consumption. 2. To guarantee the supply of products that government thinks is essential for the economy or the industry in question creates a lot of employment, such as basic food supply or power sources like coal. 3. To enable producers to compete with overseas trade: protecting home industry.

When granting a subsidy certain things must be considered: 1. The opportunity cost of government spending on the subsidy in terms of other alternative government spending projects. 2. Whether the subsidy will allow firms to be inefficient, if they do not have to compete with foreign producers, in a free market. 3. Tax payers are funding subsidies, who is paying taxes? 4. What damage will it do to the sales of foreign producers who are not receiving susidies from their governments? NOTE: although percentage subsidies are sometimes given, they are extremely PED = PES rare! The price of the product will fall by half of the subsidy. Specific subsidies are much more common.

PED > PES PED < PES

The price of the product will fall by less than half of the subsidy.

The price of the product will fall by more than half of the subsidy.

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Costs, Revenues, and Profit:

Cost Theory:
When a firm is producing some of its factors will be fixed SHORT RUN: period of time in in the which at least one factor of Short run (the firm will be unable to quickly increases the quantity production is fixed. All of the factors of production that it has). production takes place in the short run. Examples of fixed factors are: LONG RUN: period of time in . Capital/land which all factors of . Highly skilled labours production are variable, the state of technology is fixed. SHORT RUN: All planning takes place in The length of the short run is determined by the time it takes to increase the the long run. quantity of the fixed factor. LONG RUN: If a firm plans ahead to change fixed factors then all factors of production are variable, as soon as the fixed factors are changed the firm again is in the short run.

Total, Average and Marginal Product:

TP is the total output that a firm produces, using fixed and variable factors over a given time. Average Product is the output that is produced, on average, by each unit of the variable factor.

AP = TP/V
TP = total product V = number of units of the variable factor employed. Marginal Product is the extra output that is produced by using an extra unit of the variable factor.

MP = TP/V
TP = change in TP V = change in the number of units of the variable factor employed.

The Law of Diminishing Returns:

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The hypothesis of eventually diminishing marginal returns:

As extra units of a variable factor are added to a given quantity of a fixed factor, the output from each additional unit of the variable factor will eventually diminish.

The hypothesis of eventually diminishing average returns:

As extra units of a variable factor are added to a given quantity of a fixed factor, the output per unit of the variable factor will eventually diminish.

Short-run costs:
Firms have many different costs when producing whatever goods or services. In order to explain different ways of measuring costs we separate the subject of costs into three groups: 1. Total costs: the complete costs of producing output can be measured three ways: a) TOTAL FIXED COSTS (TFC): the total cost of the fixed assets that a firm uses in a given time period. It is a constant amount. b) TOTAL VARIABLE COSTS (TVC): the total cost of the variable assets that a firm uses in a given time period. c) TOTAL COST (TC): is the cost of all the fixed and variable factors used to produce a certain output. TC = TFC + TVC

2. Average costs: the costs per unit of output: a) AVERAGE FIXED COST (AFC): the fixed cost per unit of output.

AFC = TFC/q
Q is the level of output b) AVERAGE VARIABLE COST (AVC): the variable cost per unit of output. NOTE: as with AVC, ATC AVC = TVC/q tends to fall as output increases, and then starts to c) AVERAGE TOTAL COST (ATC): rise again is the output ATC = TC/q continues to increase.

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3. Marginal Costs: the increase in total cost of producing an extra unit of output.

MC = TC/q
The long run:
the long run is that period of time in which all factors of production are variable, but the state of technology is fixed. All planning takes place in the long run. When planning in the long run, an entrepreneur is free to adjust the quantity of all the factors of production that are used and is only restrained by the current level of technology.

We look at what happens to costs when all the factors of production are increased in order to increase output. However the theory of the long run is quite different to reality.

There are two reasons long-run costs may increase or decrease: 1. Economies of scale: any decreases I long-run average costs when a firm alters all of its factors of production in order to increase its scale of output. Economies of scale lead to increasing returns to scale. Specialisation, division of labour, bulk buying, financial economies, transport economies, large machines, and promotional economies are all economies of scale. 2. Diseconomies of scale: any increases in long-run average costs that come about when a firm alters all of its factors of production in order to

Micro Economics increase its scale of output. Diseconomies of scale lead to decreasing returns to scale. Control and communication problems, alienations and loss of identity are two internal diseconomies of scale.

Revenue Theory:
Revenue can be measured in three ways: . TOTAL REVENUE (TR): the total amount of money that a firm receives from selling a certain amount of a good or service, in a given time period.

TR = pxq
P = price a good or service sells for q = quantity of good/service sold . AVERAGE REVENUE (VR):revenue a firm receives from selling a certain amount of a good or service in a given time period.

AR =
.

TR/q = pxq/q =

MARGINAL REVENUE (MR): the extra revenue that a firm gains when it sells one or more unit of a product in a given time period. NOTE: MR is below AR as in order to sell more products the firm has to lower the price of all products sold; losing revenue on products the firm couldve sold at a higher price.

MR = TR/q

Revenue Curves and Output:

1. Revenue when price doesnt change with output ( PED is infinite) If a firm doesnt have to lower price as output increases and it wishes to sell more; it daces a perfectly elastic demand curve.

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2. Revenue when price falls as output increases ( PED falls as output increases) The firm wants to sell more of its output and it can control the price, at which it sells, and then it will have to lower the price if it wants to increase demand. Faces a normal demand curve.

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Perfect Competition
The assumptions of perfect competition:
. . . . . The industry is made up of a very large number of firms Each firm is so relatively small; it is not capable of altering its own output to have a noticeable effect upon the output of the industry as a whole. The firms all produce exactly identical products. Their goods are homogeneous. Firms are completely free to enter or leave the industry: no barriers to entry or barriers to exit. All producers and consumers have a perfect knowledge of the market.

The demand curves for the industry and the firm in perfect competition:

Profit maximisation for the firm in perfect competition:

Forms maximise profits when they produce at the level of output where MC =MR.

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The firm takes the price P from the industry, and because in perfect competition demand is perfectly elastic, P = D = AR = MR.

Possible short-run profit and loss situations in perfect competition:

In the short run in perfect competition, there are two possible profit/loss situations. 1. Short run abnormal profits: The firms in the industry are making abnormal profits in the short run. They are more than covering their total costs, including the opportunity costs. 2. Short run losses: The firms in the industry are making losses in the short run. They are not covering their total costs.

The movement from short run to long run in perfect competition:

If firms are making either short-run abnormal profits, or short-run losses, other firms will react and change until equilibrium is reached.

Short-run abnormal profits to long-run normal profits:

The firm is making abnormal profits, this means that other firms will start to enter the industry, attracted to the chance of making abnormal profits; as more firms enter the supply curve will start to shift to the right. Eventually D1=AR2=MR1. Producers are happy but there is no longer an incentive to enter the industry.

Short-run losses to long-run profits:

After time, some firms will start to leave the industry making the demand curve shift to the left, raising the price to P1

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Long-run equilibrium in perfect competition:

In the long-run firms will make normal profits. This is for a few reasons: . If going from short-term abnormal profits to long-term normal profits. There is now no incentive for outside firms to enter the market. . If going from short-term losses to long-term normal profits. There is not enough incentive for outside firms to join the industry.

Productive and allocative efficiency in perfect competition:

Productive efficiency:
A firm is productively efficient if it produces at the lowest possible unit cost (AC). MC cuts AC at its lowest point, if a firm is producing efficiently

MC=AC
Productive efficiency is important because if a firm is producing at this point they are combining their resources efficiently as possible, nothing is wasted.

Allocative efficiency:
Where suppliers are producing the optimal mix of goods and services required by consumers, also called socially optimum level of output. Price reflects the value consumers place on a good and is shown by AR. Marginal Costs reflect the cost to society of all the resources (including normal profit) required to produce an extra unit.

Micro Economics

If price is greater than MC the consumers value the good more than it costs to make it. allocative efficiency occurs when:

MC=AR

Monopoly
The Assumptions of a Monopolistic Model: . There is only one firm producing the product so the firm is the industry . Barriers to entry exist, which stop new firms from entering the industry and maintains the monopoly. . As a consequence of barriers to entry the monopolist may be able to make abnormal profits in the long run. Whether a firm is a monopoly depends on how narrowly we define the industry. So the important question is how much monopoly power the firm has. . To what extent is the firm able to set its own prices without worrying about other firms? . To what extent can it keep people out of the industry?

Sources of monopoly power/barriers to entry

1. Economies of scale:
Firms gain average cost advantages as their size increases (which is economies of scale) Monopolists have access to specialization, the division of labour, bulk-buying and financial economies which lead to cost savings and lower unit costs. If a monopoly is large they will experience economies of scale. Without economies of scale a would-be entrant has no chance of competing with the monopolist, who would simply lower the price to make normal profits and make the entrant run at a loss.

2. Natural Monopoly:
There is only enough economies of scale available in the market to support one firm. Example industries that supply utilities such as water, electricity or gas.

Micro Economics 3. Legal Barriers: The legal right to be the only producer in an industry, this is the case with patents, trade marks and copy right. These three are utilised to encourage invention and give profit incentive for firms to put resources into development. 4. Brand Loyalty: Such a brand loyalty is created that the consumers think of the product as the brand. 5. Anti-competitive Behavior: This will stop competition and can be legal or illegal. For example an established monopoly can start a price war. Lowering the price to be running at a loss but they can sustain the loss-running period longer than the new entrant. The mere knowledge of the capability of this is enough to dissuade new firms.

The demand curve and the profit maximising level of output in monopoly:
The monopolists demand curve is the industry demand curve. Monopolists can only control either level of output or price. Meaning because the demand curve is downwards sloping, monopolists cant charge whatever price they like and still sell products.

Possible profit situations in monopoly:

. Monopolist can make abnormal profits in short-run and has effective barriers to entry then the monopolist is able to make abnormal profits in the long run. Monopolist is making losses in the short-run; it would close down temporarily/ continues production. Whilst planning in the long run to see if at least normal profits could be made. If not the firm would shut down; firm is the industry, thus the industry would cease to exist.

Micro Economics

Efficiency in monopoly:
Monopolist produces at profit-maximising level of output. It restricts quantity of out put to force up the price and so is neither producing at allocative nor productive efficiency.

Oligopoly
The assumptions of oligopoly:
. A few firms dominate an industry expressed as a concentration ratio CRX, X being the number of the largest firms. Can be very different in nature with some producing identical products some producing highly differentiated products. There is interdependence; firms can influence the market. Price rigidity.

. . .

Collusive and non-collusive oligopolies:

Collusive oligopolies: . Firms in an oligopolistic market collude to charge same prices thus acting like an oligopoly. These are deemed against the publics best interest so is banned by government. . Explanation of price rigidity; making longterm abnormal profits want it to continue. . There are times when its ok.

Non-collusive oligopolies: . Very aware of the reactions of other firms when making decisions

Micro Economics . Price rigidity; if the firm raises their price, other firms wont and the firm will lose demand if the firm lowers price, other firms will undercut them, creating a price war.

Non-price competition:
Firms tend to not to compete in terms of price. Types of non-price competition include: . Use of brand names . Packaging . Special features . Advertising . Sales promotion . Personal selling . Publicity . Sponsorship deals . Special distribution features An oligopoly is characterised by behaviour to guard and extend market share; very large expenditure on advertising and marketing (firms try to make goods less elastic). This increases the barriers to entry. POSITIVES: Competition among larger companies results in greater choice for consumers. NEGATIVES: Represents a misuse of scares resources.

Micro Economics

Price discrimination and contestable market:

Consumer and Producer Surplus:
Consumer surplus is the extra utility gained from paying a price lower than which they are prepared to pay. Producer surplus is the excess of actual earnings that a producer makes from a given quantity of output, over and above the amount the producer would be to prepared to accept for that output.

Price discrimination:
In order for producers to be able to discriminate: The producer must have some price setting ability The consumers must have different price elasticities of demand The producer must be able to separate the consumers. Producers can spate markets in different ways: . Time: consumers are prepared to pay different amounts at different times . Age: firms charge different prices based on age, e.g. children are charged less than adults.

Micro Economics . . Gender Income: for example lawyers will often charge higher prices to wealthy clients and lower charges/ sometimes pro-bono to those who do not have high income. Geographical distance Types of consumer: industrial or domestic?

. .

First-degree price discrimination The consumer pays exactly the price they are prepared to pay; leeway for bargaining (e.g. Car sales) Second-degree price discrimination The firm charges different prices to consumers depending upon how much they purchase (e.g. Costco, electricity and gas) Third-degree price discrimination Consumers are identified in different market segments, a separate price is charged in each market, (e.g. train and movie tickets)

Advantages to Price Discrimination (firm): . Allows producer to gain higher level of revenue from given amount of sales, as consumer surplus is eroded. . Enables producer to produce more and thus gain from economies of scale. . Enables firm to drive competitors out of the more elastic market (as profits from inelastic market can be used to lower prices for the more elastic markets). Advantages to price discrimination (consumer): . Allows some consumers to purchase products they otherwise wouldve been unable to purchase. . Increases total output and so product is available to more consumers. . Leads to economies of scale and thus could lower the price for all market segments. Disadvantages to price discrimination (consumer): . Any consumer surplus before will be lost . Some consumers will pay more than the price that wouldve been charged in a non-discriminated market. Contestable markets: . Focuses on the probability of new firms entering the industry in the future. A market is contestable when barriers to entry are low.

Micro Economics . Likelihood of entry by other firms is determined by entry costs and exit costs.

Market Failure
Community surplus:
When a market is in equilibrium, with no external influences or effects it is in a state of Pareto optimality. If a market is Pareto optimal it is socially efficient. NOTE: Pareto optimality exists when it is impossible to make someone better off without making someone else worse off. Social efficiency exists when community surplus is maximised

Market Failure:
In the real world markets arent perfect thus allocating resources in an optimal manner is impossible and community surplus is not maximised, this is a market failure.

Imperfect Competition: Monopolists and other imperfect markets restrict output in order to push up prices. They are not producing at the socially efficient level of output. This will lead to a failure to equate MSC and MSB. Government try to reduce this by intervening: . Use legal measures to make markets more competitive

Micro Economics . Set up regulatory bodies to investigate markets where it is felt that a monopoly power is being used against public interest.

Lack of Public goods: Public goods are goods that would not be provided at all in a free market because they are non-excludable and non-rivalrous; for example national defence or flood barriers. Government try to reduce this by intervening: . Provide the public good themselves . Subsidise private firms, covering all costs, to provide the good. Under-supply of merit goods: Merit goods are goods that will be underprovided in the market and thus will be under-consumed, for example education, health, sports facilities and the opera. Government try to reduce this by intervening: . Increase the supply and thus the consumption, depending on how important the gov. thinks the good is they may provide the good themselves or subsidise them. Over Supply of Demerit goods: Demerit goods will be over provided in the market and thus over-consumed, for example cigarettes, alcohol and hard drugs. Government try to reduce this by intervening: . Reduce the supply and/or demand for the good, depending how harmful they feel the good is they may make it illegal (hard drugs) or tax it (alcohol/cigarettes). Existence of externalities: