THE PRICE SYSTEMAND THE THEORY OF

THE FIRMSUPPLEMENT

KALAIYARASI DANABALAN

A’ LEVEL (ECONOMICS)

TOPIC COVERED• Law of Diminishing Marginal Utility

• Budget lines

• Short-run and long-run production and cost functions

• Demand and supply for labour

• Wage determination

• Types of cost, revenue and profit

• Growth and survival of firms

• Differing objectives of a firm

• Different market structures

• Contestable markets

• Conduct and performance of firms

LAW OF DIMINISHING MARGINAL UTILITY• As a consumer consumes more and more units of a specific commodity,

utility from the successive units goes on diminishing

• Utility – satisfaction

• Total Utility – The sum total of satisfaction which a consumer receives by consuming the various unity of the commodity. The more unit of a commodity he/ she consumes, the greater will be his/ her total utility

• Marginal Utility - The amount by which total utility rises with consumption of an additional unit of a good, service, or activity, all other things unchanged, is marginal utility.

LAW OF MARGINAL UTILITY

UNITS TOTAL UTILITY

MARGINAL UTILITY

1ST glass 20 20

2nd glass 32 12

3rd glass 40 8

4th glass 42 2

5th glass 42 0

6th glass 39 -3

EQUIMARGINAL PRINCIPLE

• Economics assumes that consumer have limited incomes, behave in a rational manner and seek to maximize their total utility.

• A consumer is said to be in equilibrium, assuming a given level of income, when it is not possible to switch any expenditure from, product A to Product B increase total utility.

• The fundamental principle of demand is that an increase in the price of a good will lead to reduction in its demand. DD curve downward sloping

EXERCISE Quantity Consumed (bottles) Total Utility

0 0

1 20

2 35

3 45

4 53

5 58

6 54

a.) Calculate the marginal utilityb.) Sketch the total utility and marginal utility curves. (x-axis = quantity consumed & y-axis = utility.c.) if the price of good X increase from $1 to $2 per bottle, how might it affect consumption. Explain your answer using the data above.

BUDGET LINE

• All consumers are controlled in what they are able to buy because of their income & price of goods they wish to buy.

• These 2 important underpinning principles of consumer behavior are brought together in the idea of budget line.

• For a consumer who buys only two goods, the budget constraint can be shown with a budget line. A budget line shows graphically the combinations of two goods a consumer can buy with a given budget.

BUDGET LINE• Rose Bole has only $100 to spend on her two

passions in life: buying books and attending movies.

• If all books cost $5.00 and all movies cost $2.50 the graph below shows the options open to Rose.

• . Spending money on a product means that money cannot be used to purchase another product. In the case of books versus movies, the tradeoff is a straight line because one more book always costs two movies, regardless of how many books Rose has already.

• Substitution Effect & Income effect

PRINCIPLES OF PRODUCTION & THE PRODUCTION FUNCTION

• Producers need all of the factors of production in order to make their products for sale in markets which are mainly in developed economies.

• Their task is to combine the production factors in an effective way to be efficient, competitive and profitable in the world market.

• They have to make concerns the relative mixture of labour and capital.

• The task for the firm is to find the least cost / most efficient combination of labour and capital for the production of a given quantity of output.

SHORT-RUN AND LONG-RUN PRODUCTION AND COST FUNCTIONS

SHORT RUN

• period of time when at least one of the factors of production is fixed. Usually labour is the easiest factor to change. Thus in short run a firm can increase production only by employing more labour because no more land or capital is available. Thus, labour is the variable factor in the short run.

Production Function

• The relationship between the quantity of factor inputs (labour/ workers) & total quantity of output.

• Law of Increasing Returns

As more units of variable factor are added to a fixed factor, output will first rise more than proportionately. Thus, the firm experiences increasing returns.

• Law of Diminishing Return

as more units of a variable factor are added to a fixed factor, there will come a point when output will rise less than proportionately.

TOTAL PRODUCT (TP)= ∑ Marginal Product

MARGINAL PRODUCT (MP) = ∆TP / ∆L

AVERAGE PRODUCT (AP) = TP / L

The function shows the regions of increasing marginal product, decreasing marginal product, and negative marginal product

Marginal Product and Average Product

EXERCISE• Find AP and MP.

• Sketch the curve.

LABOUR TOTAL PRODUCT

AVERAGE PRODUCT

MARGINAL PRODUCT

0 0

1 3

2 8

3 14

4 19

5 23

6 26

7 28

8 29

PRODUCTION IN THE LONG RUN• All factors are variable, and firms are therefore able to adjust their input of all

factors of production. The process of change of input of all factors of production is the change in the scale of production.

• When a firm changes it inputs but the change in output is more than the change input, the firms is said to be experiencing increasing returns to scale. On the other hand, when a firm’s output experiences a less proportionate increase as compared to the increase in input, it is said to be diminishing returns to scale.

• In the long run all the factors of production are Variable and a firm can expand or decrease the level of output by varying its variable factors.

• There is no time dimension as to determine whether it is short run or long run. When the firm can alter it fixed factors, it is said to be a long run.

LONG RUN TOTAL COST (LRTC)

LONG RUN AVERAGE COST (LRAC)

ISOQUANTS AND ISOCOSTS

ISOQUANTS- allow us to show all of the various combinations of capital and labor that can be used to produce a level of output.

ISOCOST - line allows us to represent the quantities of labor and capital that can be purchased at given input prices, given an amount of total cost.

THE LABOUR MARKET

DEMAND FOR LABOUR (DERIVED DEMAND)

• The firm’s demand for labour is due to its decision to produce certain goods and services.

• Labour is essential for the production of goods or services.

• The firms wishing to hire labour is operating in a competitive market. There are many buyers & sellers of labour, and no single firm / worker can affect the wage that is paid.

• The firm is profit maximizer. Its DD & SS of labour are based on it maximizing the difference between total revenue & total cost.

Marginal Revenue Product of Labour (P.77)

• The amount that an additional unit of a factor adds to a firm’s total revenue during a period. The amount that an additional unit of a factor adds to a firm’s total revenue during a period of the factor.

• We find marginal revenue product by multiplying the marginal product (MP) of the factor by the marginal revenue (MR).

MRP=MP×MR

In a perfectly competitive market, the marginal revenue a firm receives equals the market-determined price P. Therefore, for firms in perfect competition, we can express marginal revenue product as follows:

MRP=MP×P

FACTORS AFFECTING CHANGES OF LABOUR DEMAND

• Changes in the Use of Other Factors of Production

As a firm changes the quantities of different factors of production it uses, the marginal product of labour may change.

• Changes in Technology

Technological changes can increase the demand for some workers and reduce the demand for others.

• Changes in Product Demand

An increase in the demand for a product increases its price and increases the demand for factors that produce the product and vice-versa.

• Changes in the Number of Firms

If more firms employ the factor, the demand curve shifts to the right

SUPPLY OF LABOUR

• the total number of hours that labour is able and willing to supply at a particular wage rate.

• the more work a person does, the greater his or her income, but the smaller the amount of leisure time available. An individual who chooses more leisure time will earn less income than would otherwise be possible. The more leisure people demand, the less labour they supply.

• Labour supply curves are derived from the 'labour-leisure' trade-off. More hours worked earn higher incomes but necessitate a cut in the amount of leisure that workers enjoy.

FACTORS AFFECTING SUPPLY FOR LABOUR

• Changes in Preferences –(Attititude) If people decide they value leisure more highly, they will work fewer hours at each wage, and the supply curve for labour will shift to the left.

• Changes in Income - An increase in income will increase the demand for leisure, reducing the supply of labour.

• Changes in the Prices of Related Goods and Services - Several goods and services are complements of labour. If the cost of child care (a complement to work effort) falls and supply of labour tend to fall.

• Changes in Population – Increase of life expectancy, labour supply increase in labour market at a given wage rate.

• Changes in Expectations - One change in expectations that could have an effect on labour supply is life expectancy. Another is confidence in the availability of Social Security.

• Labour Participation rate - early retirement and higher education reduce labour participation.

• Immigration and emigration - Where there are labour shortages, Immigrants moved from their countries, often to work relatively low payment industries and the public services. This increased the labour supply. Emigration from these countries in turn relieved pressures in their labour markets

WAGE DETERMINATION UNDER FREE MARKET FORCES

• The determinants of employing the addition to labour depends on the Marginal Revenue Product (MRP) of the worker.

• MRP = MPP X P

• The firm only employs however up to the point where MRP=MC, not lower, in economic theory.

• The change of labour demand and labour supply will reflect in wage and quantity of labour.

ROLE OF TRADE UNIONS AND GOVERNMENT IN WAGE DETERMINATION

• Trade unions – organisations that seek to represent labour in their work place. They were set up & continue to exist because labours have very little power to influence conditions of employment, including wages.

• Through collective bargaining with employers, they act on behalf of their members to:

Increase the wages of their members

Improve working conditions

Maintain pay differentials between skilled & unskilled workers

Fight job losses

Provide a safe working environment

Secure additional working benefits.

Prevent unfair dismissals.

MONOPSONY IN THE LABOUR MARKET

• There is single / dominant labour buyer.

• Monopsony is the buyer’s counterpart of monopoly. Monopoly means a single seller; Monopsony means a single buyer.

• The monopoly buyer determine the price which is paid for the services of the workers that are employed.

• It’s dealing with imperfection rather than competitive market.

• The graph shows how the monopsonist can affect the market equilibrium.

• The wage that the monopsonist pays to hire labour- Wm

• Below the wage that should be paid if they were paying the full value of their marginal revenue product – Wmp. The level of employment- Lm.

• The power of employer in the labour market is of over-riding importance & the employer can set a low wage because of this buying power.

THEORY OF THE FIRM

The firm’s Costs of Production

• Firm- describe a unit of decision making which has particular objectives such as profit maximization, the avoidance of risk-taking and achieving its own long-term growth.

• This term used for national or multinational corporations with many plants and business establishments.

• All firms are headed by an entrepreneur.

• An entrepreneur must consider all the costs of the factors of production involved in the final output.

• Production may create costs for other people but these are not necessarily taken into account by the firm.

• Profit = Expenses – firm’s income/ sales revenue.

= Total revenue – Total cost

• The entrepreneur may have capital that could have been used elsewhere at no risk and would have earned an income.

Short Run Cost

• Fixed cost – the costs that independent of output.

• Variable cost – costs that are incurred directly in the production process.

• TC = TFC+TVC

INDICATE WHETHER EACH ONE IS LIKELY TO BE FIXED OR VARIABLE IN THE SHORT RUN.

• The rent of a factory

• Taxes paid on business premises

• Workers’ pay

• Electricity charges

• Raw materials

• Advertising expenditure

• Interest on loans

• Management salaries

• Transport costs

• Depreciation on fixed capital

Economies of Scale

• Where an output growth leads to a reduction in the unit costs.

• Internal economies of scale - the benefits that accrue to a firm as a result of its decision to produce on a larger scale.

• Diseconomies of scale – if the output is less than proportional, the firm will see diminishing returns to scale.

• There are some of the advantages firms may apply in a particular production.

1. Technical economies

2. Purchasing economies

3. Marketing economies

4. Managerial economies

5. Financial economies

6. Risk-bearing economies

THE GROWTH OF FIRMS

Business growth is strongly linked with the search of profit but the motives behind a firm’s growth may include

• The desire to achieve a reduction in ATC over time through the benefits of economies of scale.

• To achieve a bigger market share, which would boost sales revenue and profits.

• To diversify the product range.

• To capture the resources of another business.

Firms can grow internally or externally.

PERFECT COMPETITION

• There are a large number of firms in the industry.

• The firms are usually small in size and with small market shares.

• Due to their small outputs they cannot affect the whole industry output and thus are ‘price takers’.

• All firms produce identical or homogeneous products

• There are no barriers to entry or exit.

• Producers and consumers have perfect knowledge of the market i.e. prices and products.

• There is prefect resource mobility i.e. all the resources can be switched/allocated in the most profitable manner.

Firm is price taker, thus it has to adopt the prevalent price in the industry.

• If they increase their price then the consumer will switch to another firm as the all the firms produce homogenous products and moreover, consumers have perfect knowledge of producers who can supply goods at lower prices. The demand curve for a firm in perfect competition is perfectly elastic because a firm can sell any quantity at the industry price.

The industry will face normal demand and supply curve.

• suppliers are willing to supply more at higher prices and consumers are willing to buy more at lower prices. Thus the price in the industry is the equilibrium point.

Profit maximization level of output for a firm is where MC=MR

3 TYPES OF PROFIT

• Abnormal profit

It may be due to some cost advantages due to technological changes or some production innovation. This means the firm will be covering more than the economic cost (total cost + opportunity cost).

AC lower than MR

• Zero Profit

AC= MR

• Loss

when a firm may not be able to cover its Total cost due to some inefficiency in their production process.

AC higher than MR.

PROFIT MAXIMIZATION IN THE LONG RUN

• there are no barriers to entry in a perfectly competitive market, the moment a firm starts making abnormal profits, more firms will be attracted by that and will start entering the industry. This will lead to an increase in supply, which will lead to a fall in industry prices.

• The firm is a price taker and thus prices for it will also fall and the demand curve will shift downwards.

• And in the long run its abnormal profits will vanish and the firm will have normal profits only.

MOVING FROM SHORT RUN ABNORMAL PROFIT TO LONG RUN NORMAL PROFIT

• the industry price is P and the firm takes its price from the industry price. The firm is making abnormal profits by producing at q (Profit Maximisation level) and is having an abnormal profit P-C.

• Now look at the industry graph, more firms are attracted, which results in a increase in supply (shift of supply curve from S to S1). This leads to a lower in the industry price to P1. The firm has to take this price P1 and its demand curve shifts downwards i.e. D1=AR1=MR1

• At this point the existing firms will not leave the industry as they can cover their economic cost and new firms will stop entering the industry as there is no more abnormal profits. The industry has reached long term equilibrium.

MOVING FROM SHORT RUN ABNORMAL PROFIT TO LONG RUN NORMAL PROFIT

• In the short run a firms in a perfectly competitive market might make losses.

• The firms will start shut down as there is no sunk cost. The supply in the industry will go down pushing the prices up and the firms will start making normal profits in the long run.

ADVANTAGES OF PERFECT COMPETITION• P = MC; Production is at minimum AC; only normal profits will be made in the long run.

No supernormal profits, so consumers gain from low prices.

• If consumer’s tastes change, the resulting price change will lead firms to respond. An increase in consumer demand will call forth-extra supply.

• Perfect competition is said to lead to consumer sovereignty. Consumers through the market determine what and how much is to be produced. Firms cannot manipulate the market.

• They cannot control price. The only thing they can do to increase profit is to become more efficient, which also benefits the consumer. If a firm is efficient it will earn supernormal profits (in the short run).

• Competition between firms acts as a spur to efficiency. There is no point in advertising as all the products are the same.

• The desire for supernormal profits and the desire to avoid a loss will encourage the development of new technology.

DISADVANTAGES OF PERFECT COMPETITION

• Firms may not be able to afford research and development. Investment may be considered a waste of money, as one’s rivals will copy new production techniques. The product is homogeneous.

• The lack of variety is a disadvantage to the consumer. Under monopolistic competition and oligopoly there is often intense competition over the quality and design of the product. This can lead to pressure on firms to improve their products. This doesn’t exist in perfect competition. There is therefore a lack of competition over product design and specification

MONOPOLISTIC COMPETITION

• It is a market with many competing firms where each firm has a little bit of market share. Firms have the ability to set their own prices.

• Many, many firms produce in a monopolistically competitive industry.

• Each firm produces a product that is differentiated (i.e., different in character) from all other products produced by the other firms in the industry.

• There is free entry and exit of firms in response to profits in the industry.

• Consumer and producer have imperfect knowledge of the market.

• Examples, car mechanics, salons, plumbers and jewelers.

• Toothpastes and toilet papers are examples of differentiated products.

SHORT RUN PROFIT AND LOSSthe short run a monopolistically competitive firm will produce at the profit maximising level MC=MR where the AC is below the AR curve. If the firm’s AC is above the AR curve, the firm will experience losses.

MONOPOLY

• situation in which a single company or group owns all or nearly all of the market for a given type of product or service.

Monopoly – Assumptions

• There is only one seller in the market.

• Barriers to entry exists.

• Due to the fact that monopolist is the industry, it is the price maker.

• Monopolist is able to make abnormal profits.

• Economies of scale are the benefits of producing in large quantities. A firm producing in large quantities has lower average cost of production as compared to a firm which produces less quantities

NATURAL MONOPOLIES

• This is where the market structure of monopoly is the 'natural' state of affairs in an industry. This tends to happen in industries where the sunk costs are absolutely huge. The utilities are considered to be natural monopolies, despite the advent of competition.

Monopoly Diagram

Abnormal Profit in short run and long run Loss

PROBLEMS OF MONOPOLY

• Higher Prices - Firms with monopoly power can set higher prices than in a competitive market.

• Allocative Inefficiency - A monopoly is allocatively inefficient because in monopoly the price is greater than MC. (P > MC). In a competitive market the price would be lower and more consumers would benefit. A monopoly results in dead-weight welfare loss indicated by the red triangle.

• Productive Inefficiency - A monopoly is productively inefficient because output does not occur at the lowest point on the AC curve.

• X – Inefficiency. – It is argued that a monopoly has less incentive to cut costs because it doesn’t face competition from other firms.Therefore the AC curve is higher than it should be.

• Supernormal Profit.- A Monopolist makes Supernormal Profit Qm * (AR – AC ) leading to an unequal distribution of income.

• Higher Prices to suppliers - A monopoly may use its market power and pay lower prices to its suppliers. E.g. Supermarkets have been criticized for paying low prices to farmers.

• Diseconomies of scale - It is possible that if a monopoly gets too big it may experience diseconomies of scale. – higher average costs because it gets too big.

• Lack of incentives. A monopoly faces a lack of competition and therefore, it may have less incentive to work at product innovation and develop better products.

• Charge higher prices to suppliers - Monopolies may use their supernormal profits to charge higher prices to suppliers.

ADVANTAGES OF MONOPOLY• Economies of scale

If there are significant economies of scale, a monopoly can benefit from lower average costs. This can lead to lower prices for consumers. For natural monopolies and industries with significant economies of scale, monopolies can be more efficient.

• Research & Development

Monopolies make supernormal profit which can be invested in Research & Development. This is important for industries like medical drugs.

• A Firm may gain monopoly power because it is the most efficient.

• The promise of abnormal profit, protected perhaps by patent may encourage the development of new monopoly industries producing new products;

• There are those who maintain that a monopolist has gained his status by being the most efficient in the industry. Indeed ‘Natural monopolies’ must also be mentioned here.

OLIGOPOLY

• An oligopoly market exists when barriers to entry result in a few mutually dependent companies controlling a substantial portion of a market

• Few firms dominate an industry.

• Large proportion of industry's output is shared by a few firms.

• High barriers to entry may be due to economics of scale, legal barriers, aggressive tactics such as advertising or high startup costs

• Products may be identical or differentiated.

• Firms are interdependent and take careful notice of each other's actions.

http://www.youtube.com/watch?v=ElBF2D7IHAI

THE KINKED DEMAND CURVE MODEL

• This model suggests that prices will be fairly stable and there is little incentive to change prices. Therefore, firms compete using non-price competition methods.

• This assumes that firms seek to maximise profits

• If they increase price, then they will lose a large share of the market because they become uncompetitive compared to other firms, therefore demand is elastic for price increases.

• If firms cut price then they would gain a big increase in market share, however it is unlikely that firms will allow this. Therefore other firms follow suit and cut price as well. Therefore demand will only increase by a small amount: Demand is inelastic for a price cut.

• Therefore this suggests that prices will be rigid in oligopoly

• Lets assume that a firm is selling at price P. The firm as options.

• If the firm increase the Price: If the firm increase the price above its present price P, it is more likely that other firms will not increase their prices. The firm will end up losing customer to other firms. The firm will lose relatively large demand as compared to the price increase. Thus, a firm will face a relatively elastic demand curve above the point 'a'.

• If the firm lowers the Price: If the firm lowers the price, it will start a price war and other firms will lower their prices too. It is more likely that the competitors will set their prices even lower than the firm. The firm will not see much increase in its demand even with a relatively high price cut. Thus, the firm will face less elastic demand below the point 'a'.

• The firm would be better off concentrating on non-price competition to increase revenue. This may include :-

Advertising and promotion

Product innovation – the attempt to make the product more appealing to consumers.

Brand proliferation- where the firm produces lots of brands to saturate the market and to leave no gaps for rivals

Market segmentation – Producers may decide that there are markets where the consumers have different characteristics and needs, and these market niches will be catered for through product innovation.

ASSIGNMENT

Question 1

a.) Explain the link between a consumer’s expenditure and the equi-marginal principle of utility.

b.) Analyse what is meant by economic efficiency and assess whether efficiency is always achieved in a market.

Question 2

The market is the fairest means of wage determination.

To what extent do you support this opinion?