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Transcript of Economics Study Notes
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WEEK 1(Chapter 1)
DEFINITION OF ECONOMICSAll economic questions arise because we want more than we can get.
SCARCITYInability to satisfy all our wants.
Because we face scarcity, we must make choices .The choices we make depend on the incentives we face . An incentive is a reward that
encourages an action or a penalty that discourages an action.
ECONOMICS is the social science that studies the choices that individuals, businesses, governments, and
entire societies make as they cope with scarcity and the incentives that influence and reconcilethose choices
ECONOMICS IS DIVIDED INTO MICRO AND MACROECONOMICSMicroeconomics Macroeconomics
The study of choices that individuals andbusinesses make, the way those choices
interact in markets, and the influence of governments.
The study of the performance of the nationaland global economies.
E.g. Why are people buy mobile phones? E.g. Why China economy grows so fast?
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TWO big questions summarize the scope of economicsHow do choices end up determining what ,how , and for whom goods and services get
produced?
When do choices made in the pursuit of self-interest also promote the social interest ?
What?Goods & Services are objects that people
value & produce to satisfy wants.What determines how much coal, cars or milk
to produce?
Self-interestsMaking choice in your self interests
Using time & resources in the way that benefityou & not concerning about others. E.g. Youorder pizza, you not concern that delivery guy
have too ride on rain to bring you pizza. How?
Gods & Services are produced by usingproductive resources called
FACTORS OF PRODUCTION theycategories into 4 categories:
Land gifts of nature (natural resources usedto produce Goods & Services)
Labour Human Capital knowledge & skillthat people obtain from education & work
experience. And time & effort used in producing Goods & Services.
Capital Tools, machines, buildings & ect.Use to produce Goods & Services (Not a
Financial Capital like Money, Shares)Entrepreneurship Human resource that
organises land, labour & capital to produceGoods & Services
Social InterestsSelf-interests promote Social Interest if they
lead to an outcome that uses resourcesefficiently & distributes Goods & Services
equally among individuals
For whom?Who gets Goods & Services that are produceddepends on the incomes people earn. Peoplecan earn income by selling services of the
factors of the production:Land earns Rent
Labour earns WagesCapital earns Interests
Entrepreneurship earns Profits
TRADE-OFF
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is choice we make in our decisions giving up one thing to get something elseGuns vs. Butter (if u wants more of one thing we have to exchange something else for it)
TRADE-OFF (WHAT? HOW? & FOR WHOM?)WHAT?
How individuals spend their money? How government spends tax? When business choose what
to produce E.g. Spend money or defence and cut from education, Gov. trade-off education for defence.HOW?
How goods & services get produced depends on the choice made by businessFOR WHOM?
For whom goods & services are proceed depends on distribution of buying power (payment,theft & tax).
Government redistribution of income from the rich to the poor creates big trade off betweenequity & efficiency. (E.g. Taxing Rich & give tax breaks to poor)
OPPORTUNITY COSTThe highest- valued alternative that we give up to get something is opportunity cost of the
activity chosen. No such idea as free stuff each and every choice has cost.E.g. If you enrolled in uni, the highest value alternative you chose if you were not at uni iswork therefore you lose money by not working, but getting greater job opportunities later.
Choosing at the MarginMARGIN
People make choices at the margin , which means that they evaluate the consequences of making incremental changes in the use of their resources.
MARGINAL BENEFITThe benefit from pursuing an incremental increase in an activity. E.g. Student average mark is
60%, to get higher mark student have too study extra night. Mark rises by 10% to 70% themarginal benefit from studding extra night is 10% NOT 70% because you already had 60%from studding 4 nights.MARGINAL COST
The cost in increase in activity E.g. By choosing to study extra one night it will cost extra onenight lost to spend doing other activities. To make a choice you compare marginal benefits oneextra night study with marginal cost. If marginal benefits exceeds the marginal costs you will
chose to study extra night. If not you dont. By choosing only actions that bring greater benefitsthan cost, we use resources in pest possible way.
RESPONDING TO INCENTIVESWhen we make choice we response to incentives, for any activity if marginal benefit exceeds
marginal cost, people have an incentive to do more of that activity. E.g. If you are told that thenext week home work will be on exam you have grater incentives to do work, rather than if youtold none of the next week work will be on exam.
If marginal cost exceeds marginal benefit, people have less incentive to do that activity.HUMAN NATURE
From economical point of view all people acting in self-interests as it bring most value for you based on your view of the value.
Positive Statement Normative Statement (cannot be tested)
Is about what is What ought to beWhat are the facts: can be true or false. E.g.
unemployment is 20%What is opinion: E.g. Australia is the best
country in world
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UNSCRAMBLING CAUSE & EFFECTEconomist particularly interested in positive statements about cause & effect. E.g. is computersgetting cheaper because people buying more of them or do they buy more computers because
they are getting cheaper? Or there is another factor that affects that.To answer questions like this economists create and test economic models
ECONOMIC MODELDescription of some aspects of the economic world that includes only those features that are
needed for the purpose at hand.E.g. economic model of the mobile phone network might include: price of calls, number of
users, volume of calls, model will ignore insignificant data like the ringtone types. The modeltested by comparing its predictions with the facts.
BUT TESTING AN ECONOMICAL MODEL IS DIFFICULT, SO ECONOMIST ALSOUSE:
Natural Experiment Statistical Investigations Economic ExperimentE.g. Tax study (Australian &
NZ economies are similar butthe tax is different, so
economist compare this twocountries to see the tax effect)
Looks at correlation of twovariables moving together
(same or opposite directions)E.g. cigarettes & cancer are
correlated but smoking causecancer hard to determine
E.g. In computer labanswering test questions
ECONOMIC AS POLICY TOOLTHE WAY TO APPROACH PROBLEMS IN ALL ASPECTS OF HUMAN LIVES.
THREE AREAS
Personal Economic Policy Business Economic Policy Government EconomicShould I buy this product or other one
Should Sony make only flatTV & Stop making mobile
phones
Should government lower tax?
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Chapter 2PRODUCTION POSSIBILITIES & OPPORTUNITY COST
PRODUCTION POSSIBILITIES FRONTIER (PPF)
Boundary between those combinations of goods & services that can be produced & those thatcannot. ( If want to produce more of something we have too decrease or stop productions of
something else ).PPF will focus on two goods at time & hold the quantities of all other goods & servicesconstant. Model economy in which everything remains the same except the two goods wereconsidering. Production efficiency producing goods & services at lowest production cost. Ondiagram it is point Z. 3 mill pizza & 9 mill cola.
TRADE-OFF ALONG THE PPFEvery choice along the PPF involves a tradeoff we trade off cola for pizza. E.g. If you want to
study more you tradeoff you sleep time. Every Tradeoff involve a cost: an opportunity costOPPORTUNITY COST
An action is the highest valued alternative sacrificed. We can produce more pizzas only if we produce less cola. The opportunity cost of producing additional cola is quantity of pizzas we
must sacrificed.
THE PPF & MARGINAL COSTCost of goods & services is the opportunity cost of producing ONE more unit of it.
This illustrates the marginal cost of pizza. As we move along the PPF in part (a), theopportunity cost of a pizza increases. The opportunity cost of producing one more pizza is themarginal cost (MC) of a pizza.
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In part (b) the bars illustrate the increasing opportunity cost of pizza. The black dots and theline MC show the marginal cost of pizza. The MC curve passes through the centre of each bar.
Preferences & Marginal Benefit
PREFERENCESPersons likes & dislikes, economists describe preferences by using: Marginal Benefits
MARGINAL BENEFITSOf a Goods & Services is benefit received from consuming ONE more unit of it. We measuringmarginal benefits by the amount person is willing to pay for an additional unit of a goods or service .
TO ILLUSTRATE THAT WE USE MARGINAL BENEFIT CURVE.MARGINAL BENEFIT CURVE
Shows the relationship between the marginal benefit of a good and the quantity of that goodconsumed. It is a general principle that the more we have of any goods, the smaller is itsmarginal benefit and the less we are willing to pay for an additional unit of it. We call thisgeneral principle the principle of decreasing marginal benefit . The reason why marginal
benefit from good or service decreases because consumer likes variety, consumer get tire of it& switches to something else. E.G. if Pizza was rare item and you can only obtain few pieces ayear you will be willing to pay high price for an addition slice. But if you eat pizza on daily
bases addition slice has almost no value to you.The MB curve slopes downward to reflect the principle of decreasing marginal benefit. At
point A, with pizza production at 0.5 million, people are willing to pay 5 cans of cola for a pizza. At point E , with pizza production at 4.5 million, people are willing to pay 1 can of colafor a pizza
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Allocative efficiencyWhen we cannot produce more of any one good without giving up some other good, we have
achieved production efficiency. We are producing at a point on the PPF . When we cannot produce more of any one good without giving up some other good that we value more highly ,we have achieved Allocative Efficiency .
This Illustrates allocative efficiency. The point of allocative efficiency is the point on the PPF at which marginal benefit equals marginal cost. This point is determined by the quantity at
which the marginal benefit curve intersects the marginal cost curve
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If we produce fewer than 2.5 million pizzas, marginal benefitexceeds marginal cost.We get more value from our resources by producing more pizzas.On the PPF at point A, we are producing too much cola, and weare better off moving along the PPF to produce more pizzas
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.
ECONOMIC GROWTHThe expansion of production possibilitiesan increase in the standard of living
Two key factors influence economic growth:Technological change Capital accumulation
is the development of new goods and of better ways of producing goods andservices
is the growth of capital resources, whichincludes human capital
THE COST OF ECONOMIC GROWTH To use resources in research and development and to produce new capital, we must decrease
our production of consumption goods and services. So, economic growth is not free. Theopportunity cost of economic growth is less current consumption.
WE produce pizzas or pizza ovens along PPF 0.By using some resources to produce pizza ovens today, the PPF shifts outward in the future.
ECONOMIC COORDINATIONFIRM MARKET PROPERTY RIGHTS MONEY
Is an economic unitthat hires factors of
production andorganizes those
factors to produce
and sell goods andservices.
arrangementthat enables buyers andsellers anddo business
with eachother
Are the socialarrangements that govern
ownership, use, anddisposal of resources,
goods or services. Money
is any commodity or token that is generallyacceptable as a means
of payment
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If we produce more than 2.5 million pizzas, marginal cost exceedsmarginal benefit.We get more value from our resources by producing fewer pizzas.On the PPF at point C , we are producing too many pizzas, and weare better off moving along the PPF to produce fewer pizzas
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CIRCULAR FLOWS THROUGH MARKETS
WEEK 2 Chapter 3
MARKET & PRICES
MarketIs any arrangement that enables buyers and sellers to get information and do business with each
other
Competitive marketIs a market that has many buyers and many sellers, so no single buyer or seller can influence
the price E.g. Item get produced if price is high enough to cover their opportunity costs
Money Price
The price of the good or service is number of dollars that is must be give up in exchange for it
Opportunity Cost & Relative Price
Opportunity cost of an action is highest value alternative forgone. E.g. if buy coffee, the highestvalued thing you forgone is chocolate you were planning to buy, the opportunity cost of coffee
is quantity of chocolate forgone. We can calculate quantity of chocolate forgone from themoney price of coffee & chocolate. If coffee = $2 & chocolate $1 than Opportunity Cost of
coffee is 2 chocolate. ($2 coff / $1 Choc) that = ratio of one price to another . Ratio of one priceto other called Relative Price
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Relative Price
Of a goodthe ratio of its money price to the money price of the next best alternative goodisits opportunity cost .
DEMAND
If you demand something, then you:1. Want it
2. Can afford it3. And have defendant plan to buy it
Wants are the unlimited desires or wishes people have for goods and services. Scarcityensure that most of our will never be satisfied. Demand reflects a decision about which
wants to satisfy.
Quantity demanded of a good or service is the amount that consumers plan to buy during a particular time period,
and at a particular price.Quantaty demand is measured as amount per unit of time. E.g. you buy a cup of coffee a day, 7
cups a week & 365 a year. The question is does quantity demand would change if pricechanges? This were law of demand come in place.
Law of Demand States:
Other things remaining the same, the higher the price of a good, the smaller is the quantitydemanded; and the lower the price of a good, the larger is the quantity demanded.
Why does higher price reduces quantity?Two reasons:
Substitution Effect & Income EffectSubstitution Effect Income Effect
When the relative price (opportunity cost)of a good or service rises, people seek
substitutes for it, so the quantity demandedof the good or service decreases.
When the price of a good or service risesrelative to income, people cannot afford all thethings they previously bought, so the quantitydemanded of the good or service decreases.
E.g. Energy bars price drops from $3 to$1.50 people substitute energy bar with an
energy drink, but with lowering of pricequantity demand increases. If roles
changed & energy bars cost increase from$3 to $6 than people will buy more energy
drinks & fewer energy bars
Demands Curves & Demand Schedule
The term demand refers to the entire relationship between the price of the good and quantitydemanded of the good
Demand curve
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The supply is more than just having the resources & the technologies to produce something.Resources & Technologies are the constraints that limit what is possible.
Resources and technology determine what it is possible to produce. Supply reflects a decisionabout which technologically feasible items to produce.
E.g. many things can be produced, but they are not produced unless it profitable to do so.
The quantity supplied of a good or service is the amount that producers plan to sell during agiven time period at a particular price. It is measured by as amount of units per time. E.g.
Toyota produces 1000 cars per day. The quantity supplied can be calculated as 1K a day, 7K aweek, 365K a year. To find out how does quantity supplied of goods change as it price change
and all other variables remain the same we look at law of supply.
The Law of Supply states:
Other things remaining the same, the higher the price of a good, the greater is the quantitysupplied; and the lower the price of a good, the smaller is the quantity supplied.
The reason why higher price increases quantity supplied because marginal cost of producing agood or service to increase as the quantity produced increases and firm only produces if can at
least cover marginal cost of production.WE CAN ILLUSTRATE THE LAW OF SUPPLY WITH SUPPLY CURVE & SUPPLY
SCHEDULE .
The term supply refers to the entire relationship between the quantity supplied and the price of a good
The supply curve shows the relationship between the quantity supplied of a good and itsprice when all other influences on producers planned sales remain the same.
CHANGE IN SUPPLYWhen some influence on selling plans changes (other than the price of the good), there is a
change in supply of that good.
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The quantity of the good that producers plan to sell changes at each and every price, so there isa new supply curve.
When supply increases , the supply curve shifts rightward .When supply decreases , the supply curve shifts leftward.
The five main factors that change supply of a good are prices of factors of
production
prices of related goods
produced
Expectedfuture prices
Number of suppliers
Technology state of nature
E.g. Price of jet fuel
increase, air travel
decrease
E.g. if priceexpected torise, thenreturn is
higher thantoday, so
supplydicreasestoday &
increases infuture
Larger amount of
firms greater is supply
New tech thatlower cost of production
goods &increasesupply
Bad weather smaller
supply of vegetables
Equilibriumis a situation in which opposing forces balance each other. Equilibrium in a market occurswhen the price balances the plans of buyers and sellers
equilibrium price equilibrium quantity price at which the quantity demanded equals
the quantity suppliedQuantity bought and sold at the equilibrium
price.
Price regulates buying and selling plans Price adjusts when plans dont matchPrice of goods regulate the quantity demanded
& suppledPrice changes when there is shortage or
surplusPrice high = quantity supplied exceed quantity
demanded and opposite.Shortage forces price up
Surplus forces price down
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PRICE ADJUSTMENTSShortage forces price up Surplus forces price down
At the equilibrium price, the price doesnt change until either demand or supply changes.
Predicting Changes in Price and Quantity
AN INCREASE IN DEMAND AN INCREASE IN SUPPLY
When demand increases the demand curveshifts rightward.The price rises, and the quantity suppliedincreases along the supply curve.
when supply increases the supply curveshifts rightwardThe price falls, and the quantity demandedincreases along the demand curve.
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Chapter 4
Price Elasticity of Demand
increase in supply brings increase in supply bringsA large fall in price
A small increase in the quantity demandedA small fall in price
A large increase in the quantity demanded
The contrast between the two outcomes in Figure 4.1 highlights the need for,A measure of the responsiveness of the quantity demanded to a price change
Elasticity is such a measurePRICE ELASTICITY OF DEMAND
Units-free measure of the responsiveness of the quantity demanded of a good to a change in its price when all other influences on buyers plans remain the same.
CALCULATING PRICE ELASTICITY OF DEMAND
This is a measure of the responsiveness of demand to changes in price. Price elasticity of demand may be calculated using the point method as follows:
For example, assume the price of particular newcar model rose from $20,000 to $25,000, resulting in demand falling from 10,000 to 5,000 newcar sales.
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If elasticity is greater than 1 (as in the above example), there is an ELASTIC demand; if elasticity equals 1 (or less) then demand is INELASTIC.
ELASTIC DEMAND INELASTIC DEMANDthe price elasticity of demand is less than 1
and the good has inelastic demandthe price elasticity of demand is less than 1and the good has inelastic demand
The degree of elasticity depends on theavailability of substitutes. Elastic demandtends to be for products often regarded asluxuries, including DVD equipment, cameras,and cars etc.
. Inelastic demand tends to be for essential products, which cannot be done without, suchas bread, milk, beer and cigarettes etc.
If the quantity demanded doesnt change when the price changes, the price elasticity of demandis zero and the good has a perfectly inelastic demand
Demand becomes less elastic as the price falls along a linear demand curve. At prices above themid-point of the demand curve, demand is elastic. At prices below the mid-point of the demand
curve, demand is inelastic.
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If the price falls from $15 to $10, the quantity demanded increases from 20 to 30 pizzas anhour.
The average price is $12.50 and the average quantity is 25 pizzas.The price elasticity is (10/25)/(5/12.5), which equals 1.
TOTAL REVENUE AND ELASTICITYThe total revenue from the sale of a good or service equals the price of the good multiplied by
the quantity sold.
When the price changes, total revenue also changes.But a rise in price doesnt always increase total revenue
The change in total revenue due to a change in price depends on the elasticity of demand
If demand is elastic, a 1% price cut increases the
quantity sold by more than1%, and total revenue
increases.
If demand is inelastic, a 1% price cut increases the
quantity sold by less than 1%,and total revenues decreases
If demand is unit elastic, a 1% price cut increases the
quantity sold by 1% , andtotal revenue remains
unchanged
TOTAL REVENUE TEST
method of estimating the price elasticity of demand by observing the change in total revenuethat results from a price change (when all other influences on the quantity sold remain the
same).If a price cut increases total
revenue, demand is elastic
If a price cut decreases total
revenue, demand is inelastic
If a price cut leaves total
revenue unchanged, demandis unit elastic.
DEMAND TOTAL REVENUE
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As the price falls from $25 to $12.50, thequantity demanded increases from 0 to 25
pizzas. Demand is elastic, and total revenueincreases.
At $12.50, demand is unit elastic and totalrevenue stops increasing.
As the price falls from $12.50 to zero, thequantity demanded increases from 25 to 50
pizzas. Demand is inelastic, and total revenuedecreases.
As the quantity increases from 0 to 25 pizzas,demand is elastic, and total revenue increases.
At 25, demand is unit elastic, and totalrevenue is at its maximum.
As the quantity increases from 25 to 50 pizzas,demand is inelastic, and total revenue
decreases
THE FACTORS THAT INFLUENCE THE ELASTICITY OF DEMAND
The closeness of substitutes The proportion of incomespent on the good
The time elapsed since a pricechange
The closer the substitutes for a good or service, the more
elastic are the demand for it.E.g. Necessities, such as food
Larger proportion of incomespends on good greater
elasticity of demand. E.g.Gum price increase barely
The more time consumershave to adjust to a price
change, or the longer that agood can be stored without
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or housing, generally haveinelastic demand. Luxuries,
such as exotic vacations,generally have elastic
demand.
noticeable, price in rentsignificantly noticeable
losing its value, the moreelastic is the demand for thatgood. E.g. When price of PC
fall demand increasedslightly, but as people become
more dependent on PCquantity increased
significantly. Demand become elastic
CROSS ELASTICITY OF DEMANDThe concept of cross elasticity of demand is used for measuring the responsiveness of quantity
demanded of a good to changes in the price of related goods. Cross elasticity of demand isdefined as:
"The percentage change in the demand of one good as a result of the percentage change in the price of another good".
Formula
Exy = % Change in Quantity Demanded of Good X
% Change in Price of Good Y
The numerical value of cross elasticity depends on whether the two goods in question aresubstitutes, complements or unrelated.
Types and Example:Substitute Goods
When two goods are substitute of each other,such as coke and Pepsi, an increase in the
price of one good will lead to an increase indemand for the other good. The numerical
value of goods is positive
Complementary Goods. However, in case of complementary goods such as car and petrol,cricket bat and ball, a rise in the price of one
good say cricket bat by 7% will bring a fall inthe demand for the balls (say by 6%). The
cross elasticity of demand which are
complementary to each other is, therefore,6% / 7% = 0.85 (negative).E.g. Coke and Pepsi close substitutes. increase
in the price of Pepsi good Y by 10% andincreases the demand for Coke good X by 5%,
the cross elasticity of demand would be:
Exy = %qx / %py = 0.2
Since Exy is positive (E > 0), therefore, Cokeand Pepsi are close substitutes.
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INCOME ELASTICITY OF DEMAND The income elasticity of demand measures how the quantity demanded of a good responds to a
change in income, other things remaining the same.
"The ratio of percentage change in the quantity of a good purchased, per unit of time to a percentage change in the income of a consumer".
Ey = Percentage Change in Quantity DemandPercentage Change in Income
Simplified formula:
Ey = q X P =changep Q
If the income elasticity of demand is greater than 1, demand is income elastic and the good is anormal good. If the income elasticity of demand is greater than zero but less than 1, demand isincome inelastic and the good is a normal good. If the income elasticity of demand is less than
zero (negative) the good is an inferior good.
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Increase quantity of pizza demanded when the price of burger (a substitute for pizza) rises.
The figure also shows the decrease in the quantityof pizza demanded when the price of a soft drink (a complement of pizza) rises.
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increase in demand bringsA large rise in price
A small increase in the quantity supplied
increase in demand bringsA small rise in price
A large increase in the quantity supplied
THE ELASTICITY OF SUPPLY
Measures the responsiveness of the quantity supplied to a change in the price of a good whenall other influences on selling plans remain the same.
Es = Percentage change in quantity suppliedPercentage change in price
FACTORS THAT INFLUENCE THE ELASTICITY OF SUPPLYResource substitution possibilities Time Frame for Supply Decision
The easier it is to substitute among theresources used to produce a good or service,
the greater is its elasticity of supply.
The more time that passes after a pricechange, the greater is the elasticity of supply.
Momentary supply is perfectly inelastic .The quantity supplied immediately following
a price change is constant.Short-run supply is somewhat elastic .
Long-run supply is the most elastic .
WEEK 3
FIRMInstitution that hires factors of production and organises them to produce and sell goods and
services
FIRMS GOALTo maximise profit, if failed then eliminated or bought out by other.
MEASURING A FIRMS PROFITAccountants measure a firms profit to ensure
that the firm pays the correct amount of taxand to show its investors how their funds are
being used
Economists measure a firms profit to enablethem to predict the firms decisions, and the
goal of these decisions is to maximise
economic profitProfit equals total revenue minus total cost Economic profit is equal to total revenue
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minus total cost, with total cost measured asthe opportunity cost of production.
FIRMS OPPORTUNITY COSTValue of the firms best alternative use of its resources
(Real alternative forgone (lost))
TWO TYPES OF OPPORTUNITY COST:Explicit costs Implicit costs
Amount paid for resources that could be spenddeferent resources to produce deferent goods
when it uses,1. Its own capital . (when instead it could
rented capital to another firm) Implicit rentalrate opportunity cost of use ur own capital.
2. Its owners time and financial resources .(Cost of owners resources )
Owner might supply both entrepreneurshipand labour. Return to entrepreneurship is
profit. Profit that an entrepreneur can expectto receive on average is called normal profit . Normal profit represe4nt the cost of forgone
alternative (running another firm)
ECONOMIC PROFITEquals a firms total revenue minus its total opportunity cost of production.
DECISION TIME FRAMESFirm makes many decisions to achieve its main objective: PROFIT MAXIMISATION
Some critical and irreversible and some easily reversedDECISIONS CAN BE PLACED INTO TWO TIME FRAMES
Short run Long runResources used in production are fixed.
Capital called firms plant is fixed. Short-rundecisions are easily reversed.
Is a time frame in which the quantities of allresourcesincluding the plant sizecan be
varied. Not easily reversed.
Firms technology, buildings and capital. E.g.In T-shirt firms plant machines to produce
shirts
E.g. T-shirt shop to buy more machines or hiremore staff
SUNK COSTWhen made Long Term decision the firm must live with it for some time. Cost incurred by the
firm and cannot be changed.If a firms plant has no resale value, the amount paid for it is a sunk cost.
Short-Run Technology Constraint Long-Run CostTo increase output in the short run, a
firm must increase the amount of labour employed.
Three concepts describe the
In the long run, all inputs are variable and all costsare variable.
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relationship between output and thequantity of labour employed:
1. Total product - total output producedin a given period using different
amounts of labour holding fixed allother factors of production.
THE PRODUCTION FUNCTIONBehaviour of long-run cost depends upon the firms
production function.The firms production function is the relationship between the maximum output attainable and the
quantities of both capital and labour.2. Marginal product - change in total product that results from a one-unit
increase in the quantity of labour employed, with all other inputs
remaining the same. Calculated: labour increase 2 to 3 workers, production
increase 10 to 13 shirts. Change in total product (3 shirt) divided by change inlabour (1) = marginal product of third
worker 3 shirts
3. Average product - total productdivided by the quantity of labour
employed. E.g. 3 workers, produce 13shirts 13/3=4.33 shirt per worker
As the size of the plant increases, the output that agiven quantity of labour can produce increases. But
as the quantity of labour increases, diminishingreturns occur for each plant
MARGINAL PRODUCT CURVE DIMINISHING MARGINAL PRODUCT OFCAPITAL
The increase in output resulting from a one-unitincrease in the amount of capital employed (number of machines), holding constant the amount of labour
employed.A firms production function exhibits diminishing
marginal returns to labour (for a given plant) as wellas diminishing marginal returns to capital (for aquantity of labour). For each plant, diminishing
marginal product of labour creates a set of short run,U-shaped costs curves for MC, AVC, and ATC.
E.g. The first worker hired produces 4units. The second worker hired produces
6 units of output and total product becomes 10 units.
The third worker hired produces 3 unitsof output and total product becomes 13
units
SHORT-RUN COST AND LONG-RUN COSTThe average cost of producing a given output varies
and depends on the firms plant. The larger the plant, the greater is the output at which ATC is at aminimum. The firm has 4 different plants: 1, 2, 3, or 4 machines. Each plant has a short-run ATC curve.The firm can compare the ATC for each output at
different plants.
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ATC1 is the ATC curve for a plant with 1 machineATC4 is the ATC curve for a plant with 4machinesThe long-run average cost curve is made up fromthe lowest ATC for each output level.So, we want to decide which plant has the lowestcost for producing each output level.Lets find the least-cost way of producing a givenoutput level.Suppose that the firm wants to produce 13 T-shirts aday.
Almost all production processes are likethe one shown here and have:
Increasing marginal returns occur when marginal product of worker
increase marginal product of previousworker. E.g. if only one worker he haveto do everything, if hire another one we
can dived and specialise workers
13 T-shirts a day cost $7.69 each on ATC1.13 T-shirts a day cost $6.80 each on ATC2.13 T-shirts a day cost $7.69 each on ATC3.13 T-shirts a day cost $9.50 each on ATC4.
Diminishing marginal returns occursmarginal product of worker less thatmarginal product of previous worker.E.g. because more workers use the samemachine and have to wait for their turn,therefore reducing productivity.
LONG-RUN AVERAGE COST CURVE(LRAC)
Is the relationship between the lowest attainableaverage total cost and output when both the plant
and labour are varied.The long-run average cost curve is a planning curvethat tells the firm the plant that minimises the cost of
producing a given output range.Once the firm has chosen its plant, the firm incursthe costs that correspond to the ATC curve for that
plantLAW OF DIMINISHING RETURNSAs a firm uses more of a variable input
with a given quantity of fixed inputs, themarginal product of the variable input
eventually diminishes.
ECONOMIES AND DISECONOMIES OFSCALE
Economies of scale features of a firms technologythat make ATC fall as output increases. E.g. if Ford
produces 100 p/week each worker have too do many
tasks and the capital (machines) but if Ford makes10K cars a week each worker specialises in one task
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and becomes proficient
Diseconomies of scale features of a firmstechnology that make ATC rise as output increases.Constant returns to scale are features of a firms
technology that keep ATC constant as outputincreases
AVERAGE PRODUCT CURVE Illustrates economies and diseconomies of scale
Average product curve and itsrelationship with the marginal product
curve.When marginal product exceeds average
product, average product increases.
When marginal product is belowaverage product, average productdecreases.
When marginal product equals average product, average product is at its
maximum.Short-Run Technology Constraint
MINIMUM EFFICIENT SCALEthe smallest quantity of output at which the long-run
average cost reaches its lowest level.If the long-run average cost curve is U-shaped, theminimum point identifies the minimum efficient
scale output level.
To produce more output in the shortrun, the firm must employ morelabour, which means that it must
increase its costs . We describe the way
a firms costs change as total productchanges by using three cost conceptsand three types of cost curve:
Total costis the cost of all resources used. We
divide TC into two categories:Total fixed cost (TFC)
Is the cost of the firms fixed inputs.Fixed costs do not change with output.
Total variable cost (TVC)Is the cost of the firms variable inputs.Variable costs do change with output
That is: TC = TFC + TVC
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E.g. Machine Rent (TFC) $25 p/day,TVC number of workers 3 x by $25,therefore if Sam produces 13 Shirts aday and have 3 workers TVC = $75 is
TFC + TVC=TC (25+75=100)
total cost curves
Total fixed cost is the same at eachoutput level. Total variable cost
increases as output increases. Total cost,which is the sum of TFC and TVC alsoincreases as output increases. The totalvariable cost curve gets its shape from
the total product curve.The TP curve becomes steeper at low
output levels and less steep at highoutput levels.
In contrast, the TVC curve becomes lesssteep at low output levels and steeper at
high output levels.MARGINAL COST
MC=TC/QIncrease in total cost those resultsfrom a one-unit increase in total
product.Over the output range with increasingmarginal returns, marginal cost falls asoutput increases. Over the output range
with diminishing marginal returns,marginal cost rises as output increases.
AVERAGE COSTAverage cost measures can be derivedfrom each of the total cost measures:
Average fixed cost (AFC=TFC/Q)Average variable cost (AVC=TVC/Q)
Average total cost (ATC=TC/Q)Total cost: TC = TFC + TVC
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AFC curve shows that average fixedcost falls as output increases.
AVC curve is U-shaped. As outputincreases, average variable cost falls to a
minimum and then increases.MC curve is very special.
The range of outputs over which AVC isfalling, MC is below AVC.
The range of outputs over which AVC isrising, MC is above AVC.
The output at which AVC is at theminimum, MC equals AVC. Similarly,the range of outputs over which ATC is
falling, MC is below ATC.The range of outputs over which ATC is
rising, MC is above ATC.At the minimum ATC, MC equals ATC.
Why the ATC Is U-ShapedAVC curve is U-shaped because:
Initially, marginal product exceedsaverage product, which brings rising
average product and falling AVC.Eventually, marginal product falls below
average product, which brings fallingaverage product and rising AVC. TheATC curve is U-shaped for the samereasons. In addition, ATC falls at lowoutput levels because AFC is falling
steeply.
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COST CURVES AND PRODUCTCURVES
SHIFTS IN COST CURVESThe position of a firms cost curves
depend on two factorsTechnology
An increase in productivity shifts theaverage and marginal product curves
upward and the average and marginalcost curves downward .
Prices of factors of productionAn increase in a fixed cost shifts the
(TC ) and average total (ATC ) curvesupward but does not shift the (MC )
curve .An increase in a variable cost shifts the
(TC ), (ATC ), and (MC ) curvesupward
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COMPACT GLOSSARY OF COSTTerm Symbol Definition EquationFixed Cost Cost that is independent of the
output levelVariable Cost Cost that varies with the output
level, cost of variable inputTotal Fixed Cost TFC Cost of fixed inputsTotal Variable Cost TVC Cost of variable inputsTotal Cost TC Cost of all inputs TC=TFC+TVCTotal Product(output)
TP Total Quantity Produced (Q)
Marginal Cost MC Change in total cost resulting froma one unit increase in total product
MC=TC/Q
Average Fixed Cost AFC Total fixed cost per unit of output AFC=TFC/QAverage Variable
Cost
AVC Total variable cost per unit of
output
AVC = TVC/Q
Average Total Cost ATC Total cost per unit of output ATC=AFC+AVC
WEEK 4
PERFECT COMPETITIONMany firms sell identical goods & services
No restriction to enter market New & old firms have same price
Everyone well informed about prices
HOW PERFECT COMPETITION ARISESWhen firms minimum efficient scale is small relative to market demand so there is room for
many firms in the industry.And when each firm is perceived to produce a good or service that has no unique
characteristics, so consumers dont care which firm they buy from.E.g. Food industry
PRICE TAKERSIs firm that cant influence the market price because it produces an insignificant part of the
market
Each firms output is a perfect substitute for the output of the other firms, so the demand for each firms output is perfectly elastic.
ECONOMIC PROFIT AND REVENUEGoal of each firm is to maximise economic profit, which is equal:
Total Revenue Total Cost . Total Cost is opportunity cost of production, which includesnormal profit .
Total Revenue (TR=P x Q)Marginal Revenue (MR=TR / Q) change in TR that result from one unit increase in Q sold
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a) Shows that market demandand market supply determinethe market price that the firm
must take.
(b) Shows the firms totalrevenue curve (TR).
(c) Shows the marginalrevenue curve (MR). The firm
can sell any quantity itchooses at the market price,so marginal revenue equals
price and the demand curvefor the firms product is
horizontal at the market price.
The demand for a firms product is perfectly elastic because one firms T-shirt is a perfectsubstitute for the T-shirt of another firm .
The market demand is not perfectly elastic because a T-shirt is a substitute for some othergood .
A perfectly competitive firms goal is to make maximum economic profit , given theconstraints it faces.
So the firm must decide:1. How to produce at minimum cost.
(operating with plant that minimises long run average cost by being on its long run average costcurve)
2. What quantity to produce. (firm output)3. Whether to enter or exit a market.
PROFIT-MAXIMISING OUTPUT
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A perfectly competitive firm chooses the output that maximises its economic profit.One way to find the profit-maximising output is to look at the firms total revenue and
total cost curves.
MARGINAL ANALYSISFirm can use marginal analysis to determine the profit-maximising output which
compares Marginal Revenue (MR) & Marginal Cost (MC)
TEMPORARY SHUTDOWN DECISIONIf the firm makes an economic loss it may decide to exit the market or to stay in the market.
If the firm decides to stay in the market, it must decide whether to produce something or to shutdown temporarily.
The decision will be the one that minimises the firms loss
Loss Comparison
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a show TR & TCb shows TR-TC=Economic Profit (EP)At low output levels Economic Loss it cantcover its fixed costs.
At intermediate output levels = EP
At high output levels = Economic Lossnowthe firm faces steeply rising costs because of diminishing returns.
The firm maximises EP when it produces 9T-shirts a day
If MR > MC, economic profit increasesif output increases.
If MR < MC, economic profitdecreases if output increases.
The profit maximizing level of output isthat where MR = MC.
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The firms loss = Total fixed cost (TFC) + Total variable cost (TVC) - Total revenue (TR).Economic loss = TFC + TVC TR
TFC + (AVC - P) Q
If the firm shuts down, Q is 0 and the firm still has to pay its TFC. So the firm incurs an
economic loss equal to TFC. This economic loss is the largest that the firm must bear
The Shutdown PointThe price and quantity at which it is indifferent between producing and shutting down
This point is where AVC is at its minimumIt is also the point MC curve crosses the AVC curve
At the shutdown point, the firm is indifferent between producing and shutting downtemporarily.
The firm incurs a loss = to TFC from either action .
THE FIRMS SUPPLY CURVEA perfectly competitive firms supply curve shows how the firms profit-
maximising output varies as the market price varies, other things remaining thesame.
Because the firm produces the output at which marginal cost equals marginalrevenue, and because marginal revenue equals price, the firms supply curve is
linked to its marginal cost curve.
But at a price below the shutdown point, the firm produces nothing.
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shows the shutdown pointMinimum AVC is $17 a T-shirt. If the price is
$17, the profit-maximising output is 7 T-shirts aday. The firm incurs a loss equal to TFC. Thefirm is at the shutdown point. If the price is
between $17 and $20.14, the firm produces thequantity at which marginal cost equals price. Thefirm covers all its variable cost and at least part
of its fixed cost.It incurs a loss that is less than TFC
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Short-run market supply curveShows the quantity supplied by all firms in the market at each price when each firms plant and
the number of firms remain the sameThe quantity supplied by the market at any given price is the sum of the quantities supplied
by all the firms in the market at that price .At a price equal to minimum AVC, the shutdown price, some firms will produce the shutdown
quantity and others will produce zero.
The market supply curve is perfectly elastic
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If price equals minimum AVC, $17 in thisexample, the firm is indifferent between producingnothing and producing at the shutdown point, T.
If the price is $25, the firm produces 9 T-shirts aday, the quantity at which P = MC. If the price is $31, the firm produces 10 T-shirts aday, the quantity at which P = MC.
The blue curve in part (b) traces the firms short-run supply curve
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Short-run equilibrium
Short-run market supply and market demanddetermine the market price and output
Change in DemandAn increase in demand bring a rightward shiftof the market demand curve: The price rises
and the quantity increases.
A decrease in demand bring a leftward shift of the market demand curve: The price falls and
the quantity decreases
Three Possible Short-Run Outcomes
Output, Price, and Profit in the Long Run
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At $17 all firms are indifferent between shutting or not as none make profit. As price goes up quantity& profits increases.
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In short-run equilibrium, a firm may make an economic profit , break even , or incur an economic loss .
Only one of them is a long-run equilibrium because firms can enter or exit the marketENTRY AND EXIT
New firms come into market the number of firms increases and firm. Firms enter anindustry in which existing firms make an
economic profit
Firms exit an industry in which they incur aneconomic loss.
A CLOSER LOOK AT ENTRY A CLOSER LOOK AT EXITWhen the market price is $25 a T-shirt, firms
in the market are making economic profit
New firms have an incentive to enter themarket as long as firms are making economic
profits.When they do, the market supply increases
and the market price falls. In the long run, themarket supply increases, the market price falls
and firms make zero economic profit.
When the market price is $17 a T-shirt, firmsin the market are incurring an economic loss
Firms have an incentive to exit the market aslong as they are incurring economic losses.
When they do, the market supply decreasesand the market price rises. In the long run, themarket supply decreases, the market price rises
until firms make zero economic profit
CHOICES, EQUILIBRIUM, AND EFFICIENCY
We can describe an efficient use of resources in terms of the choices of consumers andfirms coordinated in market equilibrium.
Choices Equilibrium and EfficiencyA consumers demand curve shows how the
best budget allocation changes as the price of good changes.
So consumers get the most value out of their resources at all points along their demand
curves.With no external benefits, the market demand
curve is the marginal social benefit curve
In competitive equilibrium, resources are usedefficientlythe quantity demanded equals thequantity supplied, so marginal social benefit
equals marginal social cost.
The gains from trade for consumers ismeasured by consumer surplus the area
below demand, above price and to the left of the quantity transacted in the market.The gains from trade for producers is
measured by producer surplus the areaabove the supply curve, below price and to theleft of the quantity transacted in the market.
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Total gains from trade equal total surplus consumer surplus plus producer surplus.
WEEK 5 (Chapter 10)
MONOPOLYThat produces a good or service for which no close substitute exists
In which there is one supplier that is protected from competition by a barrier preventing theentry of new firms.
HOW MONOPOLY ARISES No close substitutes Barriers to entry
Monopoly sells a good that has no closesubstitutes.
market in which competition and entry arerestricted by the granting of a:
1 Public franchise (Australia Post).2 Government licence controls entry in professions such as law, medicine, and
dentistry.3 Patent or copyright (pharmaceuticals).
MONOPOLYS GOAL AND CONSTRAINTSTo maximise economic profit
Economic profit (EP) is = total revenue - minus total cost.EP=TR TC
Total revenue Total costamount received from selling the firms
product.opportunity cost of the firms production,
which includes the cost of the labour, capital,land (raw materials), and entrepreneurship
used by the firm
A monopoly faces two sets of constraints in the pursuit of maximum profit.Market Demand Technology and Cost
Monopoly is the only seller in a market, thedemand curve that it faces is the market
demand curve.Monopoly sells a good or service that has noclose substitute, so the demand curve for the
firms good or service slopes downward.The lover the price the large quantity demand
and greater quantity monopoly sells.To sell large Q must set lower P
To produce its good or service, a monopolymust set up its production plant and equipment
and hire the labour and other resourcesneeded. Because a monopoly experiences
economies of scale, it has a high fixed cost of its plant and a low marginal cost. The greater
the quantity produced, the more units over which the monopoly spreads its high fixedcost, so the lower is its average total cost of
production
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A SINGLE-PRICE MONOPOLYS OUTPUT AND PRICE
Demand curve, D, facing amonopoly electricity
producer. The ATC curveshows the ATC of producinga kilowatt hour of electricity,which is the TC of operating
the plant, divided by thenumber of units produced.
ATC=TC/Q
Monopolys economic profit.Economic profit = TR-TC.
The blue rectangle shows themonopolys profit if it
produces 2 megawatt hours.The price charged by amonopoly exceeds theaverage total cost of producing the good .
Producer surplus made by amonopoly electricity
producer. The monopolys profit is shown by the blue
rectangle. The monopoly sellsfor a price that exceeds ATC
PRICE AND MARGINAL REVENUETotal revenue (TR) Marginal revenue (MR)
TR=P x Q MR= TR / QFor a single-price monopoly, marginalrevenue is less than price at each level of
output. That is, MR < P .
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Economic Profit = TR-TCAs output increases, economic profit increases at small output levels, reaches a maximum, and
then decreases.
MARGINAL REVENUE EQUALS MARGINAL COST
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Illustrates the relationship between price andmarginal revenue and derives the marginalrevenue curve.Suppose Paula, a hairdresser in Augathella,
has a monopoly and sets a price of $16 andsells 2 units. Now suppose the firm cuts the price to $14 tosell 3 units. It loses $4 of total revenue on the2 units it was selling at $16 each. And it gains$14 of total revenue on the 3rd unit. So totalrevenue increases by $10, which is marginalrevenueThe marginal revenue curve, MR, passesthrough the red dot midway between 2 and 3units and at $10.You can see that MR < P at each quantity
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COMPARING PRICE AND OUTPUT
Efficiency Comparison
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Paulas marginal revenue (MR) andmarginal cost (MC).
When Paulas increases outputfrom 2 to 3 haircuts, MR is $10 and
MC is $8. MR exceeds MC by $2and Paulas economic profitincreases by that amount. If Paulas
increases output from 3 to 4haircuts, MR is $6 and MC is $8.
MC exceeds MR by $2, soeconomic profit decreases by thatamount. The monopoly producesthe profit-maximising quantity,
where MR = MC.The monopoly produces the output
at which MR equals MC and setsthe price at which it can sell that
quantity.The ATC curve tells us the average
total cost.Economic profit is the profit per unit multiplied by the quantity producedthe blue rectangle.
Price and quantity produced in competitiveequilibrium .
A single-price monopoly produces 3,000haircuts an hour and sells them at $14 ahaircut.
Compared with competition, monopoly produces a smaller output and charges a
higher price
Efficiency of perfect competition.The market demand curve is the marginalsocial benefit curve, MSB, and the market
supply curve is the marginal social cost curve,MSC.So competitive equilibrium is efficient:MSB = MSC.
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GAINS FROM MONOPOLYThe main reason why monopoly exists is that it has potential advantages over a
competitive market.Incentives to innovation Economies of scale and economies of scope
Firms developing new product or processobtain exclusive right of product or process
Increase in the range of goods producedlowers average total cost
NATURAL MONOPOLY REGULATIONRegulation Social interest theory Capture theory
rules administrated by agovernment agency to
influence prices, quantities,entry
political and regulatory process relentlessly seeks outinefficiency and regulates to
eliminate deadweight loss
regulation serves the self-interest of the producer, who
captures the regulator
Two theories about howregulation works are: =>
Efficient Regulation of a Natural Monopoly
E.g. Distribution of Electricity-natural monopolyWhen demand and cost conditions create natural monopoly, the quantity produced is less than
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Consumer surplus is the area below thedemand curve and above the price.Under competition total surplus is maximised and the quantity produced is efficientThe inefficiency of monopoly.Because price exceeds marginal social cost,marginal social benefit exceeds marginalsocial cost. A deadweight loss arises.
Some of the lost consumer surplus (bluerectangle) goes to the monopoly as producer surplus. This portion of the loss of consumer surplus is not a loss to society.
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the efficient quantity. How can government regulate natural monopoly so that it produces theefficient quantity.
Marginal cost pricing ruleis a regulation that sets the price equal to the monopolys marginal cost. The quantity
demanded at a price equal to marginal cost is the efficient quantity.Two possible ways of enabling a regulated monopoly to avoid an economic loss are:
Average Cost Pricing Government Subsidysets the price equal to average total cost. Themonopoly produces the quantity at which the
ATC curve cuts the demand curve.The monopoly makes zero economic profit
breaks even
Direct payment to a firm equal to its economicloss. To pay a subsidy, the government must
raise the revenue by taxing some other activity. But taxes themselves generate
deadweight loss
Which is the better option, average cost pricing or marginal cost pricing with agovernment subsidy?
The answer depends on the relative magnitudes of the two deadweight losses.The smaller deadweight loss is the second-best solution to regulating a natural monopoly.
Price Cap Regulation
Price ceiling, e.g. the Australia Post stamp price. The rule specifies the highest price that
the firm is permitted to charge. This type of regulation gives the firm an incentive tooperate efficiently and keep costs under
control.Unregulated, a natural monopoly profit-
maximises .A price cap sets the maximum price.
The firm has an incentive to minimise costand produce the quantity on the demand curve
at the price cap.The price cap regulation lowers the price and
increases the quantity
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Chapter 15
Monopolistic competition1 A large number of firms compete.
2 Each firm produces a differentiated product.3 Firms compete on product quality, price, and marketing.
4 Firms are free to enter and exit the industry
Each firm has only a smallmarket share and therefore
has limited market power toinfluence the price of its
product
Each firm is sensitive to theaverage market price, but no
firm pays attention to theactions of others. So no onefirms actions directly affect
the actions of others
Collusion, or conspiring to fix prices, is impossible
PRODUCT DIFFERENTIATIONif the firm makes a product that is slightly different from the products of competing firms
E.g. Running ShoesProduct differentiation enables firms to compete in three areas: quality, price, marketing, and
brandingQuality includes design,reliability, and service
Because firms producedifferentiated products, thedemand for each firms
product is downward sloping.But there is a tradeoff
between price and quality
Because products aredifferentiated a firm must
market its product. Marketingtakes the two main forms:advertising and packaging
ENTRY AND EXITThere are no barriers to entry in monopolistic competition, so firms cannot make an
economic profit in the long run.Producers of audio and video equipment, clothing, jewellery, computers, and sporting goods
operate in a monopolistically competitive environment.
FIRMS SHORT-RUN OUTPUT ANDPRICE DECISION
LONG RUN: ZERO ECONOMICPROFIT
A firm that has decided the quality of its
product and its marketing program producesthe profit-maximising quantity at which itsmarginal revenue equals its marginal cost
(MR = MC).Price is determined from the demand curve for the firms product and is the highest price thatthe firm can charge for the profit-maximising
quantity.
In the long run, economic profit induces entry.
And entry continues as long as firms in theindustry earn an economic profitas long as
(P > ATC). In the long run, a firm inmonopolistic competition maximises its profit
by producing the quantity at which itsmarginal revenue equals its marginal cost, MR
= MC
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As firms enter the industry, each existing firmloses some of its market share. The demand
for its product decreases and the demandcurve for its product shifts leftward.
The decrease in demand decreases the quantity
at which MR = MC and lowers the maximum price that the firm can charge to sell this
quantity.Price and quantity fall with firm entry until P= ATC and firms earn zero economic profit.
The firm in monopolistic competition operateslike a single-price monopoly. The firm
produces the quantity at which MR equals MCand sells that quantity for the highest possible price. It earns an economic profit (as in this
example) when P > ATC.
PROFIT MAXIMISING MIGHT BE LOSSMINIMISING
A firm might incur an economic loss in theshort run. Here is an example. At the profit-maximising quantity, P < ATC and the firm
incurs an economic loss.
MONOPOLISTIC COMPETITION AND PERFECT COMPETITION Two keydifferences between monopolistic competition and perfect competition are:
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Excess capacity Mark-upA firm has excess capacity if it produces lessthan the quantity at which ATC is a minimum
A firms mark-up is the amount by which its price exceeds its marginal cost
E.g. Real estate u can get more customers if udrop a price. But then u occur loses
MONOPOLISTIC COMPETITION EFFICIENT?
Price = marginal social benefit (MSB).The firms marginal cost = marginal social cost (MSC).
Under monopolistic competition price exceeds marginal cost, so marginal social benefitexceeds marginal social cost.
So the firm in monopolistic competition in the long run produces less than the efficientquantity
WEEK 6 (Chapter 16)Oligopoly
Is a market structure in which: Natural or legal barriers prevent the entry of
new firmsA small number of large firms compete
Because an oligopoly market has a smallnumber of firms, the firms are interdependent
Interdependence: With a small number of firms, each firms profit depends on every
firms actions.and face a temptation to
Cartel: A cartel is an illegal group of firmsacting together to limit output, raise price, andincrease profit.Firms in oligopoly face the temptation to form
a cartel, but aside from being illegal, cartelsoften break downcooperate.
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An oligopoly situation where there is a naturalduopolya market with two firms.
THE KINKED DEMAND CURVE MODELKey assumption:
In the kinked demand curve model of oligopoly, each firm believes that if it raises its price, itscompetitors will not follow, but if it lowers its price all of its competitors will follow
This means the firm faces two different demand curves and their associated marginal revenuecurves
Above the kink, demand is relatively elastic because all other firms prices remainunchanged. Below the kink, demand is
relatively inelastic because all other firms prices change in line with the price of the firm
shown in the figure. The kink in the demandcurve means that the MR curve is
discontinuous at the current quantityshown by that gap AB in the figure. Fluctuations inMC within the discontinuous portion of theMR curve leave profit-maximising quantityand price unchanged. For example, if costs
increased so that the MC curve shifted upwardfrom MC0 to MC1, the profit-maximising
price and quantity would not change.
Game theoryis a tool for studying strategic behaviour, which is behaviour that takes into
account the expected behaviour of others and the mutual recognition of interdependence.
All games have four features:
Rulesthe actions the players may take, and the consequences of those actionsPrisoners Dilemma game, two prisoners (Art and Bob) have been caught committing a petty
crime. Each is held in a separate cell and hence they cannot communicate with each other.If one of them confesses, he will get a 1-year sentence for cooperating while his accomplice
gets a 10-year sentenceIf both confess each receives 3 years in jail.
If neither confesses, each receives a 2-year sentenceStrategies
are all the possible actions of each player Art and Bob each have two possible actions:
Confess to crime or Deny committed crime.With two players and two actions for each player,
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there are four possible outcomes:1. Both confess.
2. Both deny.3. Art confesses and Bob denies.4. Bob confesses and Art denies.
PayoffsEach prisoner can work out what happens to himcan work out his payoffin each of the
four possible outcomes.We can tabulate these outcomes in a payoff matrix.
Payoff matrix is a table that shows the payoffs for every possible action by each player for every possible action by the other player.
A dominant strategy is a strategy which is best no matter what the other player does. In thegame above this is for both players to confess.
Formulas
Average Total Cost (ATC) = Total Cost / Q (Output is quantity produced or 'Q')
Average Variable Cost (AVC) = Total Variable Cost / Q Average Fixed Cost
(AFC) = ATC - AVC
Total Cost (TC) = (AVC + AFC) X Output (Which is Q)
Total Variable Cost (TVC) = AVC X Output
Total Fixed Cost (TFC) = TC - TVC
Marginal Cost (MC) = Change in Total Costs / Change in Output
Marginal Product (MP) = Change in Total Product / Change in Variable Factor
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Marginal Revenue (MR) = Change in Total Revenue / Change in Q
Average Product (AP) = TP / Variable Factor
Total Revenue (TR) = Price X Quantity
Average Revenue (AR) = TR / Output
Total Product (TP) = AP X Variable Factor
Economic Profit = TR - TC > 0
A Loss = TR - TC < 0Break Even Point = AR = ATC
Profit Maximizing Condition = MR = MC
Explicit Costs = Payments to non-owners of the firm for the resources theysupply