4. Micro Economics

7/28/2019 4. Micro Economics

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What is Economics? Economics = the study of how people use

their scarce resources to satisfy their

unlimited wants.

How to allocate scarce resources among

competing needs.

The study of the production, distribution and

consumption of goods and services.

Types of economicsNormative - The economics of what

is. This is descriptive of fact andtheory without opinion.

Positive - The economics of whatshould be. This is economics whereones opinion is offered.

Micro Economics examines the factors thatinfluence individual economic choices.

Examines how markets coordinate the choicesof various decision-makers

Looks at specific economic unit

e.g. Price of specific product, employment ofspecific firm, etc

Macro Economics studies the performance ofthe economy as a whole

Focuses on the big picture

e.g. government, household, firms in thenation, etc.


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Need,WantandDemand

Demand, Wants, and Needs

Consumer demand and wants are not the same thing

Wants ignore the importance of ability to buy as

expressed by a persons budget

E.g. wanting expensive cars, designers clothing, long

holidays, want a CAT certificate (but do not want to

attend lectures or study at home), ...

Nor is demand the same as need

Need focuses on the willingness and again ignores the

ability to purchase

E.g. Need in-campus accommodation, need medical

treatment, need a car, ...

Needs - A needis something you have to

have, something you can't do without

i.e. I am hungry, I need food.

Wants - A wantis something you would

like to have. It is not absolutely

necessary, but it would be a good thing

to have. i.e. I want a hamburger, French

fries, and a soft drink.

Demands - Human wants backed by

buying power and willingness. i.e. I have

money to buy this meal.

Scarcity There is not enough of everything that

people want (and need) to go around.

Some people will get things and others will

not. That is a fact. The question is then, how

do we determine who gets what.

Scarcity is at the heart of economics. If there

were no scarcity, there would be no need for

economics.


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Scarcity refers to the fact that there is a

limited quantity of almost all things that

people want.

These things are called goods. Goods

are any items that are desired by

people. Most goods are available in

scarce quantities.

Economists assume that people act to

maximize their own happiness

This does not mean people are greedy -

some people get happiness from others

happiness

This happiness that economists assume

people maximize is called utility

We also assume all people act rationally

The reason that there is scarcity of

goods (and services) is that there is

scarcity of resources that are used to

make goods.

Resources are all the raw elements that

go into the production of a good orservice.

Workforce and their skills

Stock of capital assets

Limited natural resources


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Opportunity cost Scarcity forces us to make choices

Whenever you make a choice, you must passup another opportunity

Opportunity Cost is the next best alternativeforgone when using a resource

So your opportunity cost of seeing a moviemight be studying or going on a date or maybereading a book. But not all 3 -- only the oneyou value next best.

Utility Analysis Utilityis the sense of pleasure, or satisfaction, that comes

from consumption

The utility that a person derives from consuming a

particular good depends on persons tastes or preferences

for different goods and services likes and dislikes

Total Utility (TU) the total satisfaction that

people derive from spending their income and

consuming goods.

Marginal Utility (MU) - the change in total

utility when consumption of a good changes

by one unit.

Law of Diminishing Marginal Utility -

eventually, a point is reached where

the marginal utility obtained by

consuming additional units of a good

starts to decline, ceteris paribus.


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Example

If Im really hungry, I get a lot of satisfaction

from first slice of pizza.

If I keep eating pizza, the satisfaction from the

8th slice would be much less than that of the

first slice.

Utility Maximisation Suppose that we have the following bits of information

The price of pizza is $8

The rental price of a movie video is $4

After tax income equals $40 per week

To see you income is allocated between two goods soas to maximize utility, suppose we start with somecombination of pizzas and videos

If we can increase utility by reallocating ourexpenditures we will do so, and we will continue tomake adjustments as long as utility can beincreasedwhen no further utility-increasingmoves are possible, we have arrived at the

equilibrium combination

Pizza & Video Rentals

Marginal Marginal

Utility Utility

of Pizza of Videos

Pizza Total Marginal per Dollar Video Total Marginal per Dollar

Consumed Utility Utility Expended Rentals Utility of Utility of ExpendedPer Week of Pizza of Pizza (price=$8) per Week Videos Videos (price=$4)

(1) (2) (3) (4) (5) (6) (7) (8)

0 0 - - 0 0 - -1 56 1 402 88 2 683 112 3 884 130 4 1005 142 5 108

6 150 6 114

Pizza & Video Rentals

Marginal Marginal

Utility Utility

of Pizza of Videos


Consumed Utility Utility Expended Rentals Utility of Utility of ExpendedPer Week of Pizza of Pizza (price=$8) per Week Videos Videos (price=$4)

(1) (2) (3) (4) (5) (6) (7) (8)

0 0 - - 0 0 - -1 56 56 7 1 40 40 102 88 32 4 2 68 28 73 112 24 3 3 88 20 54 130 18 2 4 100 12 35 142 12 1 5 108 8 2

6 150 8 1 6 114 6 1

Suppose you start off spending your entire budget of $40 on pizza at a total utility of 142.

If you give up one pizza, you free up enough money to rent 2 videos and total utility

increases from 142 to 198.


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Marginal Marginal

Utility Utility

of Pizza of Videos


Consumed Utility Utility Expended Rentals Utility of Utility of Expended

Per Week of Pizza of Pizza (price=$8) per Week Videos Videos (price=$4)(1) (2) (3) (4) (5) (6) (7) (8)

0 0 - - 0 0 - -1 56 56 7 1 40 40 102 88 32 4 2 68 28 73 112 24 3 3 88 20 54 130 18 2 4 100 12 35 142 12 1 5 108 8 26 150 8 1 6 114 6 1

Reduce consumption of pizza to 3 units, you give up 18 units of utility from the 4th unit of

pizza but gain a total of 32 units of utility from the 3rd and 4th videos, another utility-

increasing move

Thus, by trial and error, we find that the utility-maximizing equilibrium condition is 3 pizzas

and 4 videos per week, for a total utility of 212 and an outlay of $24 on pizza and $16 onvideos

Pizza & Video Rentals Utility-Maximising Condition

Consumer equilibrium is achieved when the

budget is completely spent and the last dollar

spent on each good yields the same utility

Where MUp is the marginal utility of pizza,pp is

the price of pizza, MUv is the marginal utility of

videos, andpv the price of videos

v

v

p

p

PMU

P

MU

DEMANDANDSUPPY

Demand

Demandindicates how much of a good consumers are both

willing and able to buy at each possible price during a given

time period, other things constant

A person who wants something he/she cannot afford does

not demand the good in an economic sense; nomatter how badly he/she wants it.

E.g. DD for Pepsi, DD for Nissan cars, DD for child care

services, DD for residential apartments, ...


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Law of Demand says that quantity demanded

varies inversely with price, other things

constant

The higher the P, the smaller the quantity

demanded

The lower the P, the larger the quantity

demanded

E.g. the higher the fees of child care

services, the lower the quantity demanded

for child care services.

Demand Schedule & Demand Curve for Pizza

(b) Demand Curve

e

d

c

b

$0

$3

$6

$9

$12

$15

$18

8 14 20 26 32Millions of Pizzas per week

PriceperPizza

a

(a) Demand Schedule

Price per Quantity Demanded

Pizza per Week (millions)

a) $15 8

b) 12 14

c) 9 20

d) 6 26

e) 3 32

Demand and Quantity Demanded

Price

perquart

8 14 20 26 32

$15.00

12.00

9.00

6.00

3.00

0

a

b

c

d

eD

Millions of pizzas per week

Demand for pizza is not a specific

quantity, but rather the entire

relation between price and quantity

demanded, and is represented by

the entire demand curve

An individual point on the demand

curve shows the quantity demanded

at a particular price

Changes in demand

Change in Demand - a change in the desire ormeans to purchase the good, thus there is achange in quantity demanded at EVERY price.

Change in Demand - a shift of the demandcurve

A demand curve is drawn under theassumption of ceteris paribus.

When this assumption is relaxed, the entiredemand curves shifts


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Change in Demand vs. Change inQuantity Demanded

This is a very important distinction. In short - a

change in demand is a shift in the WHOLE

demand curve. People are willing to buy more

(or less) at every price.

Change in Quantity Demanded (DQd) -

movement along a demand curve

A change in quantity demanded can onlybe

caused by a change in the price of the good.

Changes in Quantity Demanded

Increase in Qd - a movement to the right along

a demand curve

Decrease in Qd - a movement to the left along

a demand curve

Increase in Demand

P

QdD

D

Increase in Quantity demanded

P

QdD

AB


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Increase in demand - demand curve

shifts to the right

Decrease in demand - demand curve

shifts to the left

1 Changes in Consumer IncomeGoods can be classified into 2 broad categories depending on how

the demand for the good responds to changes in money income

Normal goods: demand increases when income increases &

decreases when income decreases

E.g. Income increase, demand for fried chicken from KFC increases.

Inferior goods: demand decreases when income increases &

increases when income decreases

As income increases, consumers tend to switch from consuming

these goods to consuming normal goods

E.g. 2nd hand car, 2nd hand clothes, re-threaded tyre

2 Changes in the Prices of Related Goods

The Price of other goods & other factors are assumed constantalong a given demand curve

If 2 goods are substitutes, an increase in the Price of one shiftsthe demand for the other rightward

Conversely, if a decrease in the Price of one shifts the demandfor the other good leftward

E.g. Price of margarine increase, quantity demanded formargarine will fall, demand for butter will increase.

If 2 goods are complements, an increase in the Price of one

shifts the demand for the other leftward A decrease in the price of one shifts the demand for the other

rightward

E.g. Price of PCs increase, quantity demanded for PCs will fall,demand for printers will fall.

3 Changes in Consumer Expectations

If individuals expect income to increase in the future, currentdemand increases and vice versa

Eg If government servants expect a salary increment of 10% nextyear, their Demand for goods and services will increase.

If individuals expect prices to increase in the future, currentdemand increases and decreases if future prices areexpected to decrease

E.g. If consumers expect the price of Proton cars will fall in 3

months time, demand for proton cars now will fall.


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4 Changes in Consumer Tastes

Tastes are a persons likes and dislikes as a consumer Difficult to say what determines tastes but clearly they are important

And whatever factors change taste will clearly change

demand

E.g. More people prefers local fruits, then the demand for local

fruits will rise.

5 Availability of credit

If it is easier to borrow money (credit cards have lower

interest rates or are easier to obtain, etc.), do you think

people will buy more or less of a good at a given price?

Probably more. Since people can buy things that

couldnt buy before, their means have (in a sense)

increased. So an increase in the availability of credit will

increase demand.

Supply

Supplyindicates how much of a good producers are willingand able to offer for sale per period at each possible price,other things constant

Law of supplystates that the quantity supplied is usuallydirectly related to its price, other things constant

The lower the price, the smaller the quantity supplied

The higher the price, the greater the quantity supplied

Supply Schedule and Curve for Pizzas

12 16 20 24 28

$15

12

9

6

3

0

S


Price

Producers offer more for sale at higherprices than at lower prices the supplycurve slopes upward.

Supply Schedule

Price per Quantity Supplied

Pizza per Week (millions)

$15 28

12 24

9 20

6 16

3 12


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$15.00

12.00

9.00

6.00

3.00

0

12 16 20 24 28


Price

perquart

S

g

S'

h

Suppose a new high-tech

oven bakes pizza in half

the time, and this cause

the supply curve shifts

from S to S'.

1 Changes in Technology 2 Changes in the Prices of Relevant Resources

If the price of some relevant resource increases

supply decreases

shifts to the left

For example, if the price of mozzarella cheese falls, the costof pizza production declines supply increases shiftsto the right

3 Uncontrollable factors

Certain industries are particularly susceptible touncontrollable factors, such as changes in the weather

A good example is agriculture where bad whether candiminish or obliterate supply.

4 Changes in Producer Expectations

If suppliers expect higher prices in the future, they may beginto expand today

current SS shifts rightward

SS increases

Eg If a firm expects the chicken will rise in a few monthstime due to Eid celebration, the firm will start to raremore chicken now.


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5 Changes in the Number of Producers

If that number increases, supply increases

shifts to the right

If the number of producers decreases, supply will decrease

shift to the left

Eg As the number of pirated VCD producers fall, the

Supply of pirated VCD will fall.

6 Taxes and subsidies

Increase in tax on the good decreases

supply

Raises the cost of production

Decrease in tax on the good increases

supply

Lowers the cost of production

A subsidy is an amount the paid to the

producer for each unit of a good produced

Increase in Subsidy on the Good Increases

Supply

Lowers the costs of production

Decrease in Subsidy on the Good Decreases

Supply

Raises the costs of production

7 Availability of credit

If it is easier for the firm to borrow money, the

firm will be able to produce more

Thus Supply increases

If it is more difficult for the firm to borrow

money, the firm will have to produce less

Thus Supply decreases


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Equilibrium price Consumers want to pay as little as possible, but suppliers

want to charge as much as possible. The two sides of themarket have to compromise at some price betweenthese two extremes.

When the quantity that consumers are willing and ableto pay equals the quantity that producers are willing andable to sell, the market reaches equilibrium

Also called market price or market clearing price

The Market for Pizzas


$15.00

12.00

9.00

6.00

3.00

0

c

S

D

Surplus

Suppose the initial

price is $12, producers

supply 24 million pizzas

per week as shown by

the supply curve while

consumers demand

only 14 millionexcess quantity

supplied (or surplus) of

10 million pizzas per

week

14 20 24

Price


$15.00

12.00

9.00

6.00

3.00

0

c

S

D

Shortage

Alternatively, suppose

the price is initially $6

per pizza. At this price

consumers demand 26

million pizzas but

producers supply only 16

million an excessquantity demanded (or a

shortage) of 10 million

pizzas per week.

16 20 26

Price

The Market for Pizzas Disequilibrium Prices

Markets do not always reach equilibrium quickly.

Disequilibrium is usually temporary as the market gropes for

equilibrium

However, as a result of government intervention in markets,

disequilibrium can sometimes last a long time

To have an impact, a price floor must be set above theequilibrium price and a price ceiling must be set below theequilibrium price

Effective price floors and ceilings distort markets in that theycreate a surplus and a shortage, respectively

In these situations, various nonprice allocation devices emergeto cope with the disequilibrium resulting from the intervention


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Effects of a Price Floor

$2.50

14 19 24

S

D

Millions of gallons per month

Surplus

0

The federal government often regulates the prices

of agricultural commodities in an attempt to

ensure farmers a higher and more stable income

than they would otherwise earn.

To achieve higher prices, the federal

government sets aprice floor a minimumselling price that is above the equilibrium price

This surplus milk will spoil if it sets on store shelves. As

a result of this price support program, the government

spends billions of dollars buying and storing surplus

agricultural products.

$1.90

Effects of a Price Ceiling

$1000

$600

40 50 60

D

S

Thousands of rental units per month

0

Shortage

Sometimes public officials try to keep

prices below the equilibrium levels by

establishing aprice ceiling, or a maximum

selling price

A common example is rent control in

some cities. The market-clearing rent

is $1,000 per month with 50,000

apartments being rented.

Now suppose the government decides to

set a maximum rent of $600. At this

ceiling price, 60,000 rental units are

demanded, but only 40,000 are supplied

(a shortage).

CONSUMER

SURPLUS AND

PRODUCERSURPLUS

Consumer surplus measures the welfare that consumers

derive from their consumption of goods and services, or

the benefits they derive from the exchange of goods.

Consumer surplus is the difference between what

consumers are willing to pay for a good or service

(indicated by the position of the demand curve) and what

they actually pay (the market price). The level of consumer

surplus is shown by the area under the demand curve and

above the ruling market price

Producer surplus is a measure of producer welfare. It ismeasured as the difference between what producers are

willing and able to supply a good for and the price they

actually receive. The level of producer surplus is shown by

the area above the supply curve and below the market

price


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CO

NSUMERSURPLUSAND

PR

ODUCERSURPLUS

Elasticity 4 basic types used:

Price elasticity of demand

Price elasticity of supply

Income elasticity of demand

Cross elasticity of demand

We know, from the Law of Demand, that price

and quantity demanded are inversely related.

Now, we are going to get more specific in

defining that relationship

We want to know just how much will quantity

demanded change when price changes? That

is what elasticity of demand measures.

Price elasticity of demand (PED)

Elasticity of Demand (Ed) measures theresponsiveness of Qd of a good to a change inits P.

Ed = %D in Qd%D in P

Note that Dmeans change Also note that the law of demand implies Ed is

negative. We will ignore the negative sign onlywhen discussing elasticity of demand.


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Demand Curve for N

Take for example the calculation of

the price elasticity of demand for

N when the price ofN increase

from $1.40 to $1.60 each.

Arc elasticity

Price elasticity between a and b =

9.52 / 13.33 = 0.71

1.40

0

b

Thousands per day

D

$1.60 a

200220

Price

perN

Point elasticity

Price elasticity between a and b =

9.09 / 14.29 = 0.64

2/)pp(

p

2/)qq(

q

DE

D

D

Categories

The price elasticity of demand can be divided into three generalcategories

If the percent change in quantity demanded is smaller than thepercent change in price, demand is inelastic quantitydemanded is relatively unresponsive to a change in P

If the percent change in quantity demanded just equals thepercent change in price unit-elastic demand

If the percent change in quantity demanded exceeds the percent

change in price, demand is said to be elastic quantity is

responsive to changes in price

Inelastic absolute value between 0 and 1.0 unresponsive

Unit elastic absolute value equal to 1.0

Elastic absolute value greater than 1.0 responsive

P

0 Qd

Relatively

Inelastic

Relatively

Elastic

Constant Elasticity Demand Curves

Price

perunit

Price

perunit

Price

perunit

p

0 Quantityper period

Quantityper period

Quantityper period

E =D

(a) Perfectly elastic

$10

6

0 60 100

E =D 1

(c) Unit elastic

D

0

E =D 0

(b) Perfectly inelastic

D'

Q

D"

a

b

Demand curve in (a)

indicates consumers willdemand all that is offered

at the given price, p. If the

price rises above p,

quantity demanded drops

to zeroperfectly elasticdemand curve.

Demand curve in (b) is

vertical, quantity demandeddoes not vary when the price

changes no matter howhigh the price, consumers will

purchase the same quantity

perfectly inelastic demandcurve.

(c) shows a unit-elastic

demand curve where

any percent change in

price results in an

identical offsetting

percent change in

quantity demanded.


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Elasticity

If demand is priceelastic:

Increasing price wouldreduceTR (% Qd > % P)

Reducing price wouldincrease TR

(% Qd > % P)

If demand is priceinelastic:

Increasing price wouldincrease TR

(% Qd < % P)

Reducing price wouldreduceTR (% Qd < % P)

(a) Demand and Price Elasticity$100908070605040302010

ed

c

b

a

D

Inelastic ED < 1

Unit elastic ED = 1

Elastic ED > 1

0Quality per period

100 200 500 800 900 1,000

$25,000

Tota

lrevenue

0

Totalrevenue

(b) Total Revenue

TR = p x q

Price

perunit

Quantity per period 1,000500

Where demand is elastic, a

decrease in price will increase

total revenue because the gain in

revenue from selling more units

exceeds the loss in revenue from

selling at the lower price.

Where demand is inelastic, a price

decrease reduces total revenue

because the gain in revenue from

selling more units is less than the loss

in revenue at the lower price.

Demand, Price Elasticity and Total Revenue

1 Availability of Substitutes

The greater the availability of substitutes for a good and the closer the

substitutes, the greater the goods price elasticity of demand

E.g. sports shoes : Nike and Adidas

Tooth paste : Colgate and close-up, etc

Insulin has no substitutes if diabetic and demand is very

inelastic.

Habit forming goods such as cigarettes and drugs

Determinants of Price Elasticity of Demand 2 Proportion of Consumers Budget The less expensive a good is as a fraction of our

total budget, the more inelastic the demand forthe good is (and vice versa).

Example:

Price of cars go up 10% (from $20,000 to$22,000)

Price of box of matches goes up 10% (from $0.50

to $0.55) Demand is more effected by the price of cars

increasing. Matches are bought infrequently andthe price is only a very small part of totalspending few people will notice the rise.


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3. Necessities vs. Luxuries

The more necessary a good is, the more

inelastic the demand for the good (and vice

versa).

Example: Insulin

4. The importance of the good

Goods, which take a small part of consumers

total budget often, yield inelastic demand

schedule.

If the price of table salt falls by 2% per kilo,

few consumers would increase their rate of

consumption of salt.

5. The time period

the longer the time period the buyer can wait

before effecting a repeat purchase of the

good, the more elastic is the buyers demand

for that good.

The reason for this is that the longer time

period gives the buyer more time to find and

hence switch to substitute goods.

Demand is more elastic in the long run than in

the short run.

Other Elasticity Measures

1 Income Elasticity of Demand

The income elasticity of demandmeasures how responsive

demand is to a change in income

Measures the percent change in demand divided by the percent

change in income

Goods with income elasticities less than zero (-ve) are called inferior

goods demand declines when income increases

E.g. used clothing, recycled plastic containers, etc.

Normalgoods have income elasticities > zero demandincreases when income increases. (necessities vs luxuries)

E.g. furniture, clothing, electrical appliances, etc

Elastici ty Value Type of goods Example

Negative -ve Inferior Inter-city bus

Inelastic 0 - 1 Necessity Basic food stuffs

Elastic 1 Luxury Yatchs, sports cars


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2 Cross Elasticity of Demand

Cross elasticity of demand is defined as the percent change in the

demand of one good divided by the percent change in the price

of another good.

If an increase in the price of one good leads to an increase in the

demand for another good, their cross-price elasticity is positive

the two goods are substitutes. Eg Tea and coffee.

If an increase in the price of one good leads to a decrease in the

demand for another, their cross-price elasticity is negative the

two goods are complements.

Eg PCs and printers.

Perfect complements -1

Complements -ve

Unrelated goods 0

Substitutes +ve

Perfect substitutes +1

E1,2 = % D in Qd of Good 1

% D in P of Good 2

Note that the sign DOES matter for this

elasticity also!

Theprice elasticity of supplymeasures how responsive

producers are to a price change

Theprice elasticity of supplyequals the percent change in quantity

supplied divided by the percent change in price

Since the higher price usually results in an increasedquantity supplied, the percent change in price and thepercent change in quantity supplied move in the same

direction

the price elasticity of supply is usually a positivenumber

Price Elasticity of Supply Price Elasticity of Supply

p'

p

0 Quantity per period

S

q q'

If the price increases

fromp top', the

quantity supplied

increases from q to q'

The price elasticity of Es, is

WhereD q is the change inquantity supplied and D p is thechange in price.

Pricep

erunit


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The terminology for supply elasticity is the same as for

demand elasticity

If supply elasticity is less than 1.0, supply is inelastic

If it equals 1.0, supply is unit elastic

If it exceeds 1.0, supply is elastic

The next exhibit illustrates some special cases of supply

elasticity to consider

Categories of Supply ElasticityConstant-Elasticity Supply Curves

Price

peruni

Price

perunit

Price

perunit

p

0

E =S

(a) Perfectly elastic

$10

5

0 10 20

E =S 1

(c) Unit elastic

S

0

E =S 0

(b) Perfectly inelastic

S'

Q

S"

Quantity per periodQuantity per periodQuantity per period

At one extreme is the

horizontal supply curve.

Here producers will supply

none of the good at a price

below p, but will supply

any amount at a price of p,

as in (a).

The most unresponsive

relationship is where there

is no change in the quantity

supplied regardless of the

price, as shown in (b) where

the supply curve is perfectly

vertical.

Any supply curve that is

a straight line from the

origin such as shown in

(c) is a

unit-elastic supply

curve.

Determinants of Price Elasticity ofSupply

1. The existence of surplus capacity

If surplus capacity exists suppliers can more

easily react to price rises and supply will be

more elastic.

It is possible to produce more with the same

quantities of labor and capital, by extending

overtime, by keeping old machinery in use a

little longer, or by using or making a better use

of spare factory space.

2. Ease of entry into the market

elasticity may be influenced by the ease with

which firms can enter and leave the market.

Natural barriers: There may be limited

amount of land and skills so that it is difficult

to increase supply. Production may be very

expensive, as in the case of oil drilling for gas,

so that it is possible for relatively few firms

only.

Artificial barriers: Large monopolies


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Importance of Elasticity

Relationship between changes in price and

total revenue

Importance in determining what goods to tax

(tax revenue)

Influences the behaviour of a firm

COST Sunk Cost - A cost, once paid, that can never

be recovered.

For instance, you buy a license to sell food.Whether you sell the food or not - you havepaid for this cost and can not sell it or get yourmoney back in any way.

we are always concerned with future costsand benefits since the past cannot bechanged.

For instance, if you are in line at BML ATM and

the other line is going faster - should you

switch lines?

Yes. It doesnt matter how long you have

committed to one lane - your goal is to get

out fastest and you pick the lane thatfrom

that moment on, will suit you best in meeting

that goal. What is done - is done.

Total Fixed Cost (TFC) - costs which do not vary

with output.

the costs of fixed inputs (capital)

Total Variable Costs (TVC) - any cost that varies

with the quantity of output produced.

the costs of variable inputs (labor)

Total Cost (TC) - sum of all costs of production

TC = total fixed costs + total variable costs


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A Firms Short Run Costs

Cost Curves for a Firm

Output

Cost($ peryear)

100

200

300

400

0 1 2 3 4 5 6 7 8 9 10 11 12 13

VC

Variable costincreases withproduction and

the rate varies withincreasing &

decreasing returns.

TC

Total costis the vertical

sum of FCand VC.

FC50

Fixed cost does notvary with output

Marginal Cost (MC) - the additional cost of

producing one more unit of output.

Average Variable Cost (AVC) = TVC / Q

Average Fixed Cost (AFC) = TFC / Q

Average Total Cost (ATC) = TC / Q


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Cost Curves

0

20

40

60

80

100

120

0 12

Output (units/yr)

Cost($/unit)

MC

ATC

AVC

AFC

SummaryIn the short run, the total cost of any level of output is the sum of fixed

and variable costs: TC=FC+VC

Profit maximization point is when MC= MR

A firm may continue to produce as long as the MR exceeds its AVC, as in

doing so it will be making a contribution towards covering its fixed costs.

AFC is decreasing

AVC and ATC are U-shaped, reflecting increasing and then diminishing

returns.

Marginal cost curve (MC) falls and then rises, intersecting both AVC

and ATC at their minimum points.

Short-run and long-run production

decisions

In the short-run if:

TR > TVC continue production.

TR = TVC normal production.

TR < TVC cease production.

AR = Price =VC continue production.

In the short-run AR = AVC.

In the long-run AR = ATC.

In the long run, a firm will only continue inproduction if the price at which their product issold at least equals the average total cost ofproduction.

MARKET STRUCTURES


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Imperfect Competition

Market Structure Continuum

Pure

Competition

Pure

MonopolyMonopolistic

Competition Oligopoly

Fundamentally, there are two extremes to

the market structures. At one end, is the

perfect competition and the other is the

monopoly.

Characteristics of Perfect Competition

Large number of buyers and sellers.

Firms sell identical (homogenous) product.

No barriers to entry or exit.

Buyers and sellers have perfect information

Firms have no say in stating prices (Price Taker)

Perfect Comp. is our "Benchmark" Modelmeaning it is not very realistic, but will be used tocompare with more realistic models

DEMAND CURVE OF THE INDIVIDUAL

FIRM

Under perfect competition the firm is a price taker.

The demand curve for the firm is horizontal so that theprice equals AR which is the same as MR.

Imperfect Market

Imperfect competition is a market situationwhere individual firms have a measure ofcontrol over the price of the commodity in anindustry. a firm that can affect the market price of its

output can be classified as an imperfectcompetitor.

Normally, imperfect competition arises when anindustry's output is supplied only by one, or arelatively small number of f irms.


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Imperfect Market

An imperfect market is a situation where individual firms havesome measure of control or discretion over the price of thecommodity in an industry

This imperfect competition does not necessarily mean that afirm can arbitrarily put any price on its commodity

an imperfect competitor does not have absolute power overprice

Aside from discretion over price, imperfect competitors mayor may not have product differentiation/variation

Forms of imperfect competition

Monopoly

Oligopoly

Duopoly

Monopolistic competition

MONOPOLY

Monopoly exists when one producer suppliesthe entire market.

One large seller and many potential buyers.

No close substitutes exist.

High barriers to entry such as economies of

scale, legal protection etc The firm is a price setter(and thus quantity

taker) or a quantity setter (and price taker)

Long-run supernormal profits (due to thebarriers to entry) and subjected to regulationsby government and NGOs

Pure monopoly industry is thefirm!

Actual monopoly where firm has>25% market share

Natural Monopoly high fixed

costs gas, electricity, water,telecommunications, rail

Types of Monopoly


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1 Relatively Large Numbers: Small market share, Nocollusion & Independent actions2 Product Differentiation: Product Attributes, Services,Location, Brand Names and Pa ckaging3 Easy Entry and Exit: Firms are free to set up

business.4 Non-price Competition Advertising: Eachmonopolistic firm differentiates its products throughadvertisements

Monopolistic Competition

Oligopoly

Few large firms dominate the market.

They may produce homogeneous product (oil).

Cartels often form. (OPEC)

Complex use of product differentiation, barriersto entry and high level of influence on prices inthe market

Interdependence of firms i.e. how their rivals willreact.

2 to 6

Duopoly

Two usually large firms dominate.

Each producer has some control over price

and output, but most consider the possible

reactions of the competitor firm. Duopolists,

like oligopolist, can act competitively or

collusively.

Extensive non-price competition exists

Features of the four market structures

Type ofmarket

Numberof firms

Freedom ofentry

Nature of product Examples Implications fordemand curvefaced by firm

Perfectcompetition

Verymany Unrestricted

Homogeneous(undifferentiated)

Cabbages, carrots(approximately)

Horizontal:firm is a price taker

Monopolisticcompetition

Many /several

Unrestricted Differentiated Plumbers,restaurants

Downward sloping,but relatively elastic

Oligopoly Few RestrictedUndifferentiated

or differentiated

Cement

cars, electricalappliances

Downward sloping.Relatively inelastic

(shape depends onreactions of rivals)

Monopoly One Restricted orcompletely

blocked

UniqueLocal water

company, gas andelectricity in many

countries

Downward sloping:more inelastic thanoligopoly. Firm has

considerablecontrol over price

4. Micro Economics

Documents

Transcript of 4. Micro Economics