Chapter 1: Scarcity, Choice and Opportunity Cost 1.

Introduction Study of the use of scarce resources to satisfy unlimited human wants Wants: things people would consume if they had unlimited income Resources: inputs to produce goods and services Scarcity exists due to unlimited wants + worn out goods + newer goals Positive (can be checked by facts) vs. normative (statement of value) 2. Factors of Production Land: productive resources supplied by nature Labour: human effort directed to the production of goods and services Supply: number of workers + average number of hours each worker is prepared to offer Specialisation Dexterity, greater use of machinery and more sophisticated production techniques Monotony, loss of craftsmanship, increased risk of structural unemployment Capital: man-made resource used in further production Involves postponing present consumption Entrepreneurship: takes risk of being in business Information: data for the basis of knowledge-based economy 3. Opportunity Cost Real cost in terms of the next best alternative foregone Calculating opportunity cost requires time and information Opportunity cost may vary with circumstance Economic rent: difference between what is earned and what could have been earned Used in specialization and trade 4. Production Possibility Curve Maximum attainable combination of two goods and services that can be produced in an economy, when all available resources are used fully and efficiently, at a given state of technology Assumptions: fixed amount of resources, factors fully and efficiently employed, technology fixed, time period give, 2-product model Fully: using all resources available Efficiently: do as many things you can with the resources used

Scarcity: unattainable combinations outside PPC + society has to choose among combinations of 2 goods Shift: quantity and quality of resources (think FOP) + technology skewed? Choice between instant gratification and improving economy in the future

Wheat *Draw dotted line to show comparison between 2 countries with a common yardstick

Cloth

5. The Marginalist Principle Consume till MPB = MPC: cost of producing an additional unit of good = benefit of consuming an additional unit of good For the price mechanism to work, information need not be known with perfect accuracy by every individual acting in the marketplace: dependent on marginal buyers who keep suppliers on their toes 6. Efficiency Static efficiency: how much output can be produced now from a given stock of resources at a given point in time Dynamic efficiency: changes in the amount of consumer choice available in markets together with the quality of goods and services available Productive efficiency: absence of waste in the production process = minimizing the opportunity costs for a given value of output Allocative efficiency: society produces and consumes a combination of goods and services that maximizes its welfare Distributive efficiency: goods and services produced to those who want or need them

Explain two ways in which an economy might move from a point within its PPC to a point on it. [10m] Introduction Define PPC Good X

A: resources not fully utilized underemployment and unemployment B A B: efficient use of resources full employment

Good Y

Body A. Increase employment of resources Lower wages to be more competitive may be enticed to produce more goods Fiscal policy: increase government spending eg. circle line multiplier effect Monetary policy: lower interest rate firms borrow more, increase investment B. Increase efficiency in use of resources Pay based on productivity: but only for jobs where output can be measured (factory workers) Reallocate resources to more efficient uses Retraining

Discuss the most effective economic policies to move the PPC outwards. [15m] Introduction Outward shift: increase in productive capacity sustain economic growth over long run Body A. Labour Increase birth rate but difficult to do so in developed countries female labour force participation + need lots of incentives Education and training but takes long time and does not necessarily yield results Foreign talent through tax incentives B. Capital MNCs investment (machines) + learn their technological knowledge Invest in r+d C. Entrepreneurship Incentives and subsidies to start businesses D. Land Reclamation Conclusion Depends on which country Eg. For USA: encourage capital goods, less consumption goods. For China: entrepreneurship

What is meant by the basic economic problem of scarcity? [12m] Introduction Scarcity scare resources, unlimited wants Body Scarcity choice opportunity cost 1) Individual: time; consumer; how to maximize use of limited resources more labour / more machines 2) Firm: least-cost combination of resources in order to maximize profits 3) Government: choice between competing projects; cost-benefit analysis 4) Economy: problem of how to allocated scare resources efficiently best illustrated by the PPC Good X E 6 4

Good O 5 6 (Brief) Implications: Y Trade as a solution to alleviate scarcity Trade-off between consumer goods and capital goods What (how scarcity affects decision-making of an economy), how much, for whom and what to produce (market system)

Discuss whether scarcity. [13m]

economic

growth solves

the problem of

Introduction Economic growth increase in national income generally get to consume more goods and services Body 1) Increase in quantity and quality of resources increase in productive capacity Labour: due to reduction in unemployment and underemployment Skills and educational level Land Capital stock: most effective way to alleviate problem of scarcity more capital economy produces in one period, more output capital can produce in the next to satisfy wants in society 2) Technological improvement increase in productive capacity: better and new methods of producing goods R + d technological breakthrough new products create more wants 3) Increase in income consumers able to satisfy wants But with greater affluence, people have more wants due to advertising and promotions luxury goods of the past may become necessities 4) Supply limited Demand accelerating China / India economic growth Crude oil important as it is a source of fuel Eg. land in Singapore But technological improvements allow society to make use of renewable resources as sources of energy But more wants created 5) Equity in distribution Economic growth does not guarantee a reduction in income gap Corruption, food shortages

Chapter 2: Resource Allocation in Competitive Markets I *Assumption: Many buyers and sellers such that no single buyer / seller can exert control over market price (price takers) 1. Demand Theory Demand: amount that consumers are willing and able to purchase at each given price over a given period of time Demand curve slopes downwards Income effect: effect of change in real income resulting from change in price of good Substitution effect: effect of change in price on quantity demanded arising from consumer switching to, or from, alternating products Determinants Price Taste: education, culture, age group, health scares Interrelated goods: substitute vs. complement Population: absolute change, change in composition Seasonal changes: climate, festival Expectations of the future: future changes in price / income Real disposable income: changes in taxes / money income Redistribution of income Consumer surplus: difference between maximum amount consumers willing to pay for a given quantity of good and what they actually pay 2. Supply Theory Supply: quantity of a good or service producers are willing and able to offer for sale at each given price over a given period of time Determinants Price COP: change in price of factor inputs Other prices: joint / competitive supply Innovation: lower production costs Natural factors: climate, unexpected events Government policies: indirect taxes, subsidies Number of sellers Producer surplus: difference between amount received by producers and minimum amount they are willing and able to accept for the supply of a commodity 3. Market Equilibrium Buyers and sellers satisfied with current combination of price and quantity bought or sold, and are under no incentive to change their present economic actions 8

Adjustment to equilibrium Below equilibrium Shortage consumers compete for goods, bidding up prices price increases, quantity supplied increases shortage eliminated market settles at equilibrium Above equilibrium Surplus - producers reduce prices to get rid of stocks increase sales and decrease production price falls, quantity demanded increases, surplus eliminated market settles at equilibrium Shifts in supply and demand: consider individual effects on price and quantity then sum up Interrelated demand and surplus Joint / competitive / derived demand Joint / competitive supply

4. Case Study When asked to explain how a group of people intend to affect a certain market, bring in limitations Elasticity of demand Responses of other firms / groups of people Analyse theoretically first, then see how and why the data fits / does not fit the theory Desirability: consider for whom: producer, consumer, society Effectiveness: limitations, long run vs. short run

A manufacturer wishes to sell more of his product. How may he try to achieve his aim? [12m] Introduction Sell more only considering equilibrium quantity increase demand / supply Effect: long run vs. short run Body 1) Increase demand: explain effect on quantity demanded Advertising and promotion: create product differentiation and brand loyalty Competitive market: other firms will do likewise as they fear losing market share Huge funds need to be devoted increase COP reduce profits If firm passes cost increase to consumers in terms of higher prices fall in quantity sold assuming demand elastic total revenue falls But unable to increase price in competitive market firms may engage in price wars But in long run if campaign successful in altering peoples taste and preference rise in quantity sold Expanding number of markets: go regional / global Easier to penetrate markets where demand for product more price elastic Increase supply fall in price more than proportionate rise in quantity demanded Improve quality of product / increase product differentiation through better sales service / improved packaging Effect of money spent for r+d on Costs then price of product Market share in long run (increase) Deliberate attempt to reduce price of good through discounts Price elasticity of demand How long discount can be sustained without eroding profits 2) Increase supply: explain effect on quantity demanded Investment in r+d Lower COP, more efficient production methods, better quality products Raising productivity through greater specialization and better labour-capital combination Sourcing cheaper sources of raw materials

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Evaluation Reduces price may conflict with profit maximization More effective strategy if selling product that is price demand elastic mass produce reap EOS lower prices increase sales volume more than proportionately

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Chapter 3: Resource Allocation in Competitive Markets II 1. Price Elasticity of Demand Measure of degree of responsiveness of quantity demanded of good to a change in its price, ceteris paribus Coefficient: sensitivity of consumers to price changes Negative: inverse relationship between price and quantity demanded Determinants Availability of substitutes Necessities vs. luxuries Proportion of income Time period: longer switch to substitutes more price elastic Usefulness Government taxation policies: raise revenue, discourage consumption Firms pricing policy Effectiveness of trade unions: can ask for higher wages if demand for product is price inelastic Price stability: prices more volatile if demand more price inelastic when supply shock 2. Income Elasticity of Demand Measure of degree of responsiveness of demand of good to change in consumers income, ceteris paribus Coefficient Negative: inferior good Positive: normal good Less than one: necessities More than one: luxuries Usefulness Production plans: boom vs. recession Targetting different income groups: segment market 3. Cross Elasticity of Demand Measure of degree of responsiveness of demand of good to change in price of another good, ceteris paribus Coefficient Negative: complement Positive: substitute Usefulness Effects on products demand when faced with change in price of rivals product Strong complements can sell jointly

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4. Price Elasticity of Supply Measure of degree of responsiveness of quantity supplied of good to a change in its price, ceteris paribus Positive: direct relationship between price and quantity supplied Determinants Time period: longer supply more price elastic because possible to change anything Factor mobility Number of firms: more supply more price elastic Stocks and spare capacity: more can produce more supply more price elastic Length of production period: shorter supply more price elastic Usefulness Taxation: incidence Price stability 5. Government Policies Taxation / subsidies Demand more price inelastic higher incidence Incidence: distribution of burden between consumers and sellers Minimum price Protect income of producers Creates surplus for future shortages Financing annual surpluses burden on taxpayers not good in long run Cushion inefficiency New producers attracted increase surpluses unless government has measures to increase demand Maximum price Lower-income consumers to afford necessities Protect consumers Allocation of goods may be biased Black market, especially during war time Government can encourage supply by drawing on past surpluses, giving subsidies and tax relief, reducing demand by controlling income 6. Case Study Note difference between elasticity of the product and the elasticity of the final product (which involves the use of the product) Note difference between less inelastic and more elastic

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When asked how a strategy might affect a company, consider effect on total revenue then profits

15

7. Essay Limitations to using elasticity concepts to explain price changes Elasticity concepts are static need to relax ceteris paribus assumption in reality simultaneous changes occur need to consider relative magnitudes of changes in demand and supply Coefficients of elasticity mere estimates Consumers not homogenous group Among high-income earners, there are the yuppies seeking the high life and are likely to be more price and income sensitive compared to foreign investors who would consider socio-political factors May not consider some goods as substitutes

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Explain price elasticity of demand and income elasticity of demand. [10m] Definition Formula Sign Coefficients: range of values for elastic / inelastic Examples with their estimated values

A government is proposing to increase the tax on petrol. Examine the relevance of price elasticity of demand and income elasticity of demand for this proposal. [15m] Introduction Assume specific tax for simplicity Uses of petrol: firms and commuters transportation Normal good: income increase demand for cars increase demand for petrol increase Body 1) Demand for petrol price inelastic: explain why Increase in indirect tax supply falls at given price supply curve shifts vertically upwards by amount of tax Demand for petrol inelastic fall in quantity demanded less than proportionate Relevance: need high tax if government wants to reduce consumption to desired level 2) Income elasticity of demand less relevant because it is due to changes in income tax on petrol affects price directly, not income Government likely to be less successful if they increase tax on petrol in period of economic boom Boom: incomes rise demand for cars (luxury good) increase by more than proportionately derived demand increase demand for petrol

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The terrorist attack on New York on 11 September 2001 caused a worldwide recession and an increased fear of flying, both of which severely affected the demand for travel by air. This led to the closure of some of the major airlines in the world. Assess the relevance of elasticity concepts in explaining the effects of these events on the airline industry. [15m] Body 1) Price elasticity of demand Definition When supply of airlines fell due to closure of major airlines price expected to increase quantity demanded fall by more than proportionate total revenue fall Relevance Airlines should expect that reducing supply causing a rise in price can lead to a fall in total revenue But the demand for travel for business is likely to be inelastic. So price increase less than proportionate fall in quantity demanded total revenue increase Effect on total revenue depends on size of business market vs. holiday makers Due to the ceteris paribus assumption, the above will only take place if other factors remain constant. In this context, incomes have changed causing demand curve to shift total revenue fall 2) Income elasticity of demand Definition Air travel luxury good for most, necessity for business travelers Relevance Recession fall in income fall in demand fall in total revenue Implication: individual airlines need to reduce price / engage in non-pricing strategies to increase market share 3) Cross elasticity of demand Definition Potential substitutes: train / coach / ship Degree of substitutability depends on the length of flight Long haul flights: weak substitutes especially business travelers Short distance: stronger substitutes

for

18

If another airline (eg. Qantas) reduces price to increase market share fall in demand for a particular airline (eg. SIA) SIA reduces price price war may not cover costs erode profits Budget airlines also pose as competition

19

Airlines close down routes / less schedules fall in supply increase price Demand inelastic: long haul flights no close substitutes total revenue increase Demand elastic: short distance flights switch to trains / coaches total revenue falls

4) Price elasticity of supply Definition Fall in price fall in quantity supplied But short run: supply price inelastic less than proportionate fall in quantity supplied Reasons Labour: need time to retrench / reallocate labour to other departments Flight schedule / routes: need time to deliberate which routes / schedules to close choose the unprofitable / lowest passenger volume Conclusion Cannot look at each value separately because in real world many variables change at the same time

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Chapter 6: Firms and How They Operate I 1. Production in the Short Run Short run: at least one fixed factor Long run: period of time long enough for all factors to vary, except level of technology, which varies in the very long run LDMR: as more units of a variable factor are applied to a given quantity of a fixed factor, there comes a point beyond which the extra output from additional units of the variable factor will eventually diminish Stage 1: TP increases at an increasing rate, MP rises due to specialization of labour Stage 2: TP increases at a decreasing rate, MP falls, LDMR sets in due inefficient use of fixed factor Stage 3: TP falls, MP falls MP = change in TP / change in L

2. Theory of Costs in the Short Run Factor Definiti on Total Fixed Cost Sum of all costs of production do not vary with the level of output aka overhead costs Must be paid even without production Total Variable Cost Costs incurred for use of variable factors like labour Varies directly with output level Marginal Cost Additional cost incurred in producing an extra unit of output in the short run while some inputs remain fixed MC = change in TC / change in Q

Exampl es

Rent of factory Raw materials, labour building, interest on capital invested in

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equipment Graph

Average curves ATC = AVC + AFC

AFC: amount of fixed costs per unit of output AFC = TFC / Q

AVC: total variable costs per unit of output AVC = TVC / Q

Stage 1: AVC falls, AFC falls. Since AFC and AVC fall, ATC also falls Stage 2: AVC rises, AFC falls. Since fall in AFC > rise in AVC, ATC still falls Stage 3: AVC rises, AFC falls: Since fall in AFC < rise in AVC, ATC rises

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3. Objectives of Firms Profit-maximisation: equilibrium level of output since there is no tendency to change Before equilibrium level, MR > MC so firms want to produce more After equilibrium level, MR < MC and rational firms will not produce at this output level Firm continues production as long as it can cover variable costs Motivation of owners vs. motivation of managers: separation of control and ownership principal-agent problem: managers tend to pursue their alternative goals while maintaining minimum level of profits to appease shareholders Revenue maximization: managers aim to maximize firms short run total revenue Long-run profit maximization: managers aim to shift cost and revenue curves so as to maximize profits over some longer time period Growth maximization: managers may aim for expansion to maximize growth in sales volume over time 4. Theory of Costs in the Long Run Returns to scale: measure of resulting change in output when all inputs are changed in the same proportion (can be increasing, decreasing or constant) LRAC: lowest average cost for given level of output when all inputs are variable Minimum efficient scale: smallest plant size beyond which no significant additional IEOS can be achieved IEOS: savings in costs that occur to a firm due to the firms expansion, and have been created by firms own policies and actions Technical: concerned with production process Factor indivisibility economies: larger plant size makes it possible to effectively use indivisible factors (combine harvesters, power transmission: large and costly) raises average output and reduces LRAC Specialisation of labour: simpler and repetitive jobs which require less training + more efficient eg. car manufacturing Managerial: functional specialization by employing experts to increase efficiency as a whole Greater use of existing staff Decentralisation of decision-making: increasing efficiency of management because of faster flow of information

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within firm distortions and delays of information avoided Commercial Bargaining advantage and accorded preferential treatment by suppliers because they buy raw materials in bulk Bulk sales from bulk advertising and large-scale promotion

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Financial Easier and cheaper to raise funds: given lower interest rate and larger loans because better credit ratings and more collateral Raise capital through issue of shares to public who has more confidence in reputed firms Risk-bearing Advantage in bearing non-insurable risks eg. conditions of demand for final products and supply of raw materials Diversification of products and markets Diversification in sources of supply R+d Better quality products increased market share and demand Better methods of production more productively efficient lower average cost Welfare: making workers feel they belong to the company more apt to increase efficiency and productivity of company IDOS Complexity of management Principal-agent problem Bureaucracy Strained relationships: impersonal no loyalty to firm apathy, strikes EEOS: savings in costs that occur to all firms in an industry due to the expansion of the industry Economies of concentration Availability of skilled labour: demand for labour large enough special educational institutions / firms can collaborate to develop training facilities No lack of labour to employ because experts want to migrate there eg. Silicon Valley Well-developed infrastructure to cater to that industry Reputation: builds up name which consumers associate with quality encourages brand loyalty and steady clientele Economies of disintegration Subsidiary industries developed to cater to needs of major industry Eg. car industry in Japan: range of firms specialize in production of different inputs for car manufacturing provide output at lower prices to main industry because specialization allows

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subsidiary firms to produce at large scale enjoy EOS Process waste products into useful products and sell them to cover COP Economies of information: publications help improve productivity of firms (research and expertise)

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EDOS Increased strain on infrastructure: taxed to limits eg. congestion loss of time and increased fuel consumption Rising costs of FOP: growing shortage of specific raw materials / skilled labour

5. Growth of Firms Methods of growth Internal expansion: make more of existing product or extending range of product when it builds a new bigger plant Merger Vertical integration: firms engaged in different stages of productive process Backward integration vs. forward integration Eg. Starbucks merge with firm producing coffee beans wants guaranteed access to raw materials Horizontal integration: firm takes over similar firm at same stage of production in the same industry Eg. Coffee Bean and Starbucks merge Eg. DBS and POSB Market domination Conglomeration Eg. bank taking over developing firm to build properties Diversify output 6. Survival of Small Firms Demand-side factors Nature of product Bulky and perishable goods: small, localized markets eg. fresh fish Variety preferred to standardization eg. fashion Specialised products: limited markets eg. highly specialized machines Prestige markets: limited by price eg. sports cars, luxury yachts Direct and personalized services eg. lawyers, doctors Geographical limitations: high transport costs for bulky products local market rather than national market Supply-side factors DEOS set in early: optimum size of firm small Vertical disintegration: entire production process broken into series of separate processes and different small firms perform each process Low BTE

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 Lack of capital

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 Unwillingness to take greater risks Larger firm higher expenditure greater risk of investment Fear of future fall in price of final product: expansion of output increase market supply excess supply lower prices and lower profits Banding: small firms may band to gain advantages of bulk buying while still retaining their independence Profit cycles: early stage of product cycle total demand for product low Non-profit maximization attitudes Owner values independence or wants to maintain control among family members Contented with reasonable income from domestic market Unwilling to take increased risks associated with expanding into foreign market 7. Case Study Factors: think long run vs. short run, demand-side vs. supply-side EOS lower LRAC able to reduce price Profits plough to r+d better quality products + further reduction in AC Block new entrants due to enormous FC less existing competitors increase market share Always end EOS with AC If a particular industry is stated in the extract, try to give egs of EOS specific to the industry 8. Essay Survival of small firms: for conclusion, use banding / small firms may want to merge in the face of globalisation

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Discuss whether rising costs limit the size of firms over time. [15m] Introduction Size: sales revenue / turnover, level of output, market share Over time long run firm no longer constrained by fixed factor Body 1) Can limit Short run cost Reason: over-use of fixed factor, inefficient labour-capital combination increase MC eventual increase in AC Increase costs fall in profits if total revenue is constant constrain firms ability to expand 2) Will not limit Long run All inputs can vary firm can expand enjoy fall in LRAC due to internal EOS (list 2 egs) Fall in LRAC fall in price to ward off competitors (erecting barriers to entry) increase profits plough into r+d better quality products + if yields results further fall in AC due to better production methods Size of firm determined by demand for firms product if firm making supernormal profits can still expand in size even if cost increases eg. monopoly selling unique products Conclusion: However, size of firm over time constrained by MES (list 1 eg of internal DOS). MES huge eg. electricity / water compared to MES limited eg. fashion. Banking Merger in Singapore Analysis Why merge? Face competition from foreign banks Singapore wants to expand beyond our shores: big enjoy EOS fall in AC can compete with foreign banks Core part of Singapore economy 1997 Asian financial crisis big stable Why should not merge? Possible monopoly power Increase price Quality of service 30

Reduction / removal of familiar products and services affects consumer satisfaction Neglect lower-income group Retrenchment

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Chapter 7: Firms and How They Operate II 1. Comparison of the 4 Markets Type Number of buyers / sellers Perfect Competition Large No one buyer / seller can influence price Firm price taker Monopoly Monopolistic Competition Only one firm Large Firm price setter FOP relatively mobile When firm makes decisions, does not have to worry how its rivals will react High No / Low Natural: huge sunk Firm lowers price costs (AFC falls over profits spread very large output thinly over many AC falls rivals rivals continuously suffer negligibly enjoys huge IEOS), Retaliation exclusive ownership unlikely of essential raw No collusion materials keen competition Artificial: non-price competition, contrived barriers (cartel), legal protection: exclusive rights Oligopoly Few large firms Interdependent

Barriers to entry

None FOP perfectly mobile No transaction / transportation costs Minimal sunk costs

Substantial Natural Artificial: legislation, collusion / mergers, nonprice competition, advertising

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Nature of products

Homogeneous Buyers no preference for any firm

(patents, tariffs to block foreign firms) No close substitutes CED and PED very low

Differentiated: quality, design, location, promotion Demand price elastic

Homogeneous / differentiated

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Knowledge

Perfect Seller knows rivals prices, market costs and available technology Buyers know all sellers prices, quality and availability of products will not purchase at a higher price than equilibrium price

Imperfect Consumers not fully aware of COP

Imperfect Production methods and prices Cost structures differ as some firms enjoy more favourable locations / rentals

Imperfect

Firms curve

P = AR = MR

P > MR Cannot increase both output and price at the same time as curve is downward sloping

P > MR Some degree of control over own prices No single equilibrium price in market no market

P > MR Firm increases price other firms will not Firm decreases price other firms follow

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demand curve

Examples

Stock market Forex market Agricultural products: many farmers in LDCs

Utilities Starhubs EPL coverage SMRT for NS and EW lines

Bubble tea

may lead to price war Price rigidity: menu costs, fear of harming firms image (fall in price fall in quality) UK brewery industry Taxi companies OPEC Mobile service provision

Firms SR equilibriu m Firms LR equilibriu m LR equilibriu m curve

Supernormal, normal / subnormal profits MC = MR and MC must be rising Normal / supernormal profits Firm will shut down if subnormal profits Normal profits Normal / supernormal

Normal profits New firms will enter industry to erode supernormal profits

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Productive efficiency

Efficient Firm produces at MES

Inefficient unless by coincidence

Allocative efficiency

Efficient P = MC

Inefficient Inefficient unless by coincidence Will settle at LRAC that is not necessarily at MES Firms POV: all points on LRAC Societys POV: MES Inefficient P > MC Could be seen as premium society pays for product differentiation

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2. Analysis of Imperfect Market Structures Type Monopoly Economic Allocative inefficiency: P > efficiency MC, output below optimum Productive inefficiency X-inefficiency but increasingly reduced due to globalisation, reduced customs duties and barriers to trade Dynamic efficiency: r+d Variety of Unique products Possible innovation and new products: BTE stimulus to the creativity required to destroy barriers monopoly profits stimulates new entrants producing new and competing products R+d and Profits lead to unequal new income distribution: dollar profits votes + shift of consumer surplus to producer Supernormal profits plough into r+d better quality products + better methods of production lower AC but there is no Monopolistic Competition Allocative inefficiency: P > MC Productive inefficiency: do not utilise optimal plant capacity, do not exhaust potential for further EOS because all small firms Dynamic inefficiency: no r+d Large variety increase in consumer welfare Oligopoly Allocative inefficiency: P > MC, output below optimum Productive inefficiency Dynamic efficiency: r+d

Differentiated

More equity: no redistribution of income from consumers to shareholders Normal profits: no additional profits to plough into r+d

Supernormal profits ploughed into r+d

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guarantee that monopolies will do this

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Theory vs empirical evidence

MES high IEOS lower MC than PC industry lower P and higher o/p but monopolies charge high prices by restricting output

Wasteful competition Advertising provides better consumer information which helps move market structure closer to PC model but loss of consumer sovereignty

P/R/C MCp c Pc Pm

MC m

Practise price discrimination MR AR [has both costs and 0 Q Q Q benefits] c m Natural monopolies Perfectly contestable markets: costs of entry and exit by potential rivals are zero, and when such entries can be made very rapidly eg. deregulation of airline industry in 1978 Hit and run competition: market contestable for certain seasons eg. parcels service during festivals Reduces wasteful

High price rigidity: price stability Wasteful competition: more likely to engage in extensive advertising encourages price competition, with increased sales volume and reaping of EOS, price reduce further But possible monopoly power through collusion But multiple branding gives consumers misguided information in thinking products are from different firms

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competition (instead of extensive advertising, money can be spent to produce more goods)

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3. Price Discrimination Producer sells specific commodity to different buyers at two or more different prices Same consumer charged different prices for same product for reasons not associated with cost differences Conditions Possible Seller has control over market supply Market segmentation and identifiable groups + no resale Profitable: each market as different PED First degree Practice of charging each customer his reservation price Captures all consumer surplus as revenue Eg. auction sites Impractical to charge each customer a different price Firm usually does not know the reservation price of each customer: consumers do not tell and producers may not want to spend time and resources to find out Second degree Charge different prices for different blocks of the same product to the same buyer Eg. photocopying shops Third degree Sells same product at different prices to different customers Conditions Two or more markets which can be separated PED of each market must be different

Higher price charged in market with more price inelastic demand Cost: loss of consumer surplus 41

Benefits Firm: higher profits and may use these profits from one market to withstand possible price war in breaking into another market Consumer Consumer may not have been able to afford good otherwise Higher profits may be reinvested into r+d better quality products + better methods of production Provision of goods that would otherwise not be produced due to high costs if production and consumption of good is one that confers positive externalities on society Additional profits might exceed losses such that firm will still continue producing the good

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Discuss the view that the profit motive will always lead to a few large firms dominating the market for each and every type of product. [15m] 1) Barriers to entry Few large firms merge greater market share reap EOS fall in LRAC fall in price ward off rivals / block new entrants (natural BTE) able to maintain supernormal profits If plough into r+d better methods of production further fall in AC - make more profits But some industries have low BTE (technology easily replicated) low sunk cost eg. retail, grocery 2) Market size Small: eg. Singapore television broadcasting Mediacorp vs. Mediaworks Firms will eat into each others market share erode profits so to keep profits just let one firm dominate Market big: eg. US then can afford to have few large firms 3) Nature of product Large firms: unique products with no close substitutes Small firms: availability of substitutes, prestige market / services, localized demand, perishables, limited MES fashion, specialization, personalized services 4) Government Intervention / publics desire Few large firms will help to reduce price increase in consumer surplus increase in consumer welfare Supernormal profits plough into r+d to produce better quality products Will still have competition unlike monopoly still have the incentive to be more cost-efficient / innovative

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Explain what is meant by productive and allocative efficiency. [10m] 1. Allocative efficiency Definition: situation in which it is impossible to change the allocation of resources in such a way as to make someone better off without making someone else worse off Assumption: no externalities / public goods P = MC right amount + type of good produced to maximize societal welfare Pric e S (MC)

D (MB) Quantity If MB < MC,0 last unit of good less than opportunity cost of producing that unit society benefits from not producing that last unit If MB > MC, last unit of good more than opportunity cost of producing that unit society benefits from producing that last unit Assumption aside, MSB = MSC Perfect competition: firm price taker MR = MC = P allocatively efficient P/R/ C

MC MR

P1

Q1

Quantit y

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2. Productive efficiency Long run concept Firms POV Any given level of firms output produced at lowest possible AC all points on LRAC curve are productively efficient Societys POV LRAC minimum firm is at optimum size / MES all IEOS exploited P/R/ C LRA C

P1

MR

Q1

Quantit y

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A firm should be encouraged to maximize profits because this makes it efficient. Discuss whether this argument is true for a firm operating in an imperfect market. [15m] *When comparing efficiency, only talk about long run 1) Allocative efficiency: P > MC true for all imperfect markets because they are price setters deadweight loss to society allocatively inefficient 2) Productive efficiency: Not operating at MES (where LRAC cuts MC) not fully exploited all IEOS productively inefficient P/R/C Triangle = DWL MC LRAC

Pm Pc

MR

AR

PC industry needs to Qm at MES because it needs to be as costbe Qc 0 Quantity effective as possible price taker cannot pass cost increase to consumers Vs. imperfect market need not be at MES because price setter can pass cost increase to consumers 3) X-inefficiency Monopoly: lax in cost control no existing competition can pass cost increase as price increase But monopoly can also be cost efficient due to fear of new entrants Globalisation and international competition If market is contestable Force monopoly to be cost efficient Oligopoly more likely to be cost-efficient compared to monopoly but wastage of resources large scale advertising / promotion increase cost for firm and opportunity cost to society as the money could have been used to produce more goods 4) Dynamic efficiency

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Supernormal profits in long run able to invest in r+d better methods of production fall in AC in very long run Vs. PC industry: no dynamic efficiency

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Distinguish between monopolistic competition and oligopoly. [10m] Type Number of sellers Nature of product Monopolistic competition Many one firms action less likely to affect others Differentiated eg. retail: restaurants affect demand curve demand price elastic Oligopoly A few large firms interdependence one firms action likely to evoke responses from rivals Homogeneous / differentiated eg. mobile service provision, petrol companies / taxi companies, OPEC kinked demand curve P/R/C

P/R/C

Pe AR 0 Quantit y AR Quantit 0 y Firm increase price: rivals will not follow quantity demanded for firms product falls more than proportionately demand price elastic Firm reduces price: rivals likely to follow price war + quantity demanded for firms product increases less than proportionately demand price inelastic Larger scale

Nonpricing competiti on Likelihoo d of colluding BTE

Smaller scale

Less

More: large market share High natural: high sunk cost eg. utilities, telecomm TFC very huge LRAC keeps falling enjoys huge EOS very low

Low / no low sunk cost + technology easily replicated long run normal

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profits

LRAC new entrants cannot produce at such low LRAC Artificial: patents Ensure supernormal profits in long run

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Explain why oligopoly is a common market structure in many economies. [15m] 1) Firms want to be big to maximize profits Merger of small firms EOS fall in LRAC fall in price ward off rivals + block new entrants Monopoly attracted by supernormal profits monopoly loses its power 2) Society may desire oligopolies Oligopoly competition greater innovation through r+d which monopolistic competition cannot afford since it only makes normal profits Vs. monopoly lax X-inefficiency 3) Governments intervention Singapore government face of international competition in a free market, local firms have to be big eg. banking go regional liberalization and deregulation of industries: mobile service industry, taxi companies Firms prefer operate in oligopolistic structure rather than monopolistic: monopolies more closely watched by government vs. oligopolies harder to observe whether they are colluding 4) Some industries due to huge sunk cost oligopolistic / even natural monopoly eg. utilities, telecommunications, transport, TV broadcasting in Singapore since market size is too small one single player most efficient

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