MANAGERIAL ECONOMICS

Price Elasticity of Demand

In this chapter we look at the idea of elasticity of demand, in other words, how
sensitive is the demand for a product to a change in the products own price.
You will find that elasticity of demand is perhaps one of the most important
concepts to understand in your AS economics course
Defining elasticity of demand
Ped measures the responsiveness of demand for a product following a
cange in its o!n price.
The formula for calculating the co-efficient of elasticity of demand is:
Percentage change in quantity demanded divided y the percentage change in
price
Since changes in price and quantity nearly always move in opposite directions,
economists usually do not bother to put in the minus sign. We are concerned
with the co"efficient of elasticity of demand.
#nderstanding val$es for price elasticity of demand
If ed ! " then demand is said to be perfectly inelastic. This means that
demand does not change at all when the price changes # the demand
curve will be vertical
If ed is between " and $ %i.e. the percentage change in demand from &
to ' is smaller than the percentage change in price(, then demand is
inelastic. roducers )now that the change in demand will be
proportionately smaller than the percentage change in price
If ed ! $ %i.e. the percentage change in demand is e*actly the same as
the percentage change in price(, then demand is said to unit elastic. &
$+, rise in price would lead to a $+, contraction in demand leaving
total spending by the same at each price level.
If Ped % &, then demand responds more than proportionately to a
change in price i.e. demand is elastic. -or e*ample a .", increase in
the price of a good might lead to a /", drop in demand. The price
elasticity of demand for this price change is #$.+
'at Determines Price Elasticity of Demand(
Demand for rail services
&t pea) times, the demand for rail transport becomes inelastic # and higher
prices are charged by rail companies who can then achieve higher revenues
and profits
)e n$m*er of close s$*stit$tes for a good + $ni,$eness of te
prod$ct # the more close substitutes in the mar)et, the more elastic is
the demand for a product because consumers can more easily switch
their demand if the price of one product changes relative to others in
the mar)et. The huge range of pac)age holiday tours and destinations
ma)e this a highly competitive mar)et in terms of pricing # many holiday
ma)ers are price sensitive
)e cost of s!itcing *et!een different prod$cts # there may be
significant transactions costs involved in switching between different
goods and services. In this case, demand tends to be relatively inelastic.
-or e*ample, mobile phone service providers may include penalty
clauses in contracts or insist on $.-month contracts being ta)en out
)e degree of necessity or !eter te good is a l$-$ry # goods
and services deemed by consumers to be necessities tend to have an
inelastic demand whereas lu*uries will tend to have a more elastic
demand because consumers can ma)e do without lu*uries when their
budgets are stretched. I.e. in an economic recession we can cut bac) on
discretionary items of spending
)e . of a cons$mer/s income allocated to spending on te good #
goods and services that ta)e up a high proportion of a household0s
income will tend to have a more elastic demand than products where
large price changes ma)es little or no difference to someone0s ability to
purchase the product.
)e time period allo!ed follo!ing a price cange # demand tends to
be more price elastic, the longer that we allow consumers to respond to
a price change by varying their purchasing decisions. In the short run,
the demand may be inelastic, because it ta)es time for consumers both
to notice and then to respond to price fluctuations
'eter te good is s$*0ect to a*it$al cons$mption # when this
occurs, the consumer becomes much less sensitive to the price of the
good in question. 1*amples such as cigarettes and alcohol and other
drugs come into this category
Pea1 and off"pea1 demand - demand tends to be price inelastic at
pea) times # a feature that suppliers can ta)e advantage of when
setting higher prices. 2emand is more elastic at off-pea) times, leading
to lower prices for consumers. 3onsider for e*ample the charges made
by car rental firms during the course of a wee), or the cheaper deals
available at hotels at wee)ends and away from the high-season. Train
fares are also higher on -ridays %a pea) day for travelling between
cities( and also at pea) times during the day
)e *readt of definition of a good or service # if a good is broadly
defined, i.e. the demand for petrol or meat, demand is often fairly
inelastic. 'ut specific brands of petrol or beef are li)ely to be more
elastic following a price change
Demand c$rves !it different price elasticity of demand
-irms can use price elasticity of demand %12( estimates to predict:
The effect of a change in price on the total revenue 4 e*penditure on a product.
The li)ely price volatility in a mar)et following une*pected changes in supply #
this is important for commodity producers who may suffer big price movements
from time to time.
The effect of a cange in a government indirect ta- on price and quantity
demanded and also whether the business is able to pass on some or all of the
ta* onto the consumer.
Information on the price elasticity of demand can be used by a business as part
of a policy of price discrimination %also )nown as yield management(. This is
where a monopoly supplier decides to charge different prices for the same
product to different segments of the mar)et e.g. pea) and off pea) rail travel or
yield management by many of our domestic and international airlines
Supply and demand
In economics, supply and demand describes mar)et relations between
prospective sellers and buyers of a good. The supply and demand model
determines price and quantity sold in the mar)et. The model is fundamental in
microeconomic analysis of buyers and sellers and of their interactions in a
mar)et. It is used as a point of departure for other economic models and
theories. The model predicts that in a competitive mar)et, price will function to
equali5e the quantity demanded by consumers and the quantity supplied by
producers, resulting in an economic equilibrium of price and quantity. The model
incorporates other factors changing such equilibrium as reflected in a shift of
demand or supply.
Strictly considered, the model applies to a type of mar)et called perfect
competition in which no single buyer or seller has much effect on prices, and
prices are )nown. The quantity of a product supplied by the producer and the
quantity demanded by the consumer are dependent on the mar)et price of the
product. The law of supply states that quantity supplied is related to price. It is
often depicted as directly proportional to price: the higher the price of the
product, the more the producer will supply, ceteris paribus. The law of demand
is normally depicted as an inverse relation of quantity demanded and price: the
higher the price of the product, the less the consumer will demand, cet. par.
63et. par.6 is added to isolate the effect of price. 1verything else that could
affect supply or demand e*cept price is held constant. The respective relations
are called the 7supply curve7 and 7demand curve7, or 7supply7 and 7demand7 for
short.
The laws of supply and demand state that the equilibrium mar)et price and
quantity of a commodity is at the intersection of consumer demand and
producer supply. 8ere, quantity supplied equals quantity demanded %as in the
enlargeable -igure(, that is, equilibrium. 1quilibrium implies that price and
quantity will remain there if it begins there. If the price for a good is below
equilibrium, consumers demand more of the good than producers are prepared
to supply. This defines a shortage of the good. & shortage results in the price
being bid up. roducers will increase the price until it reaches equilibrium. If the
price for a good is above equilibrium, there is a surplus of the good. roducers
are motivated to eliminate the surplus by lowering the price. The price falls until
it reaches equilibrium.
)2E DEMAND SC2ED#LE
The demand schedule, depicted graphically as the demand curve, represents
the amount of goods that buyers are willing and able to purchase at various
prices, assuming all other non-price factors remain the same. The demand
curve is almost always represented as downwards-sloping, meaning that as
price decreases, consumers will buy more of the good.9$:
;ust as the supply curves reflect marginal cost curves, demand curves can be
described as marginal utility curves.9<:
The main determinants of individual demand are: the price of the good, level of
income, personal tastes, the population %number of people(, the government
policies, the price of substitute goods, and the price of complementary goods.
The shape of the aggregate demand curve can be conve* or concave, possibly
depending on income distribution.
&s described above, the demand curve is generally downward sloping. There
may be rare e*amples of goods that have upward sloping demand curves. Two
different hypothetical types of goods with upward-sloping demand curves are a
=iffen good %a sweet inferior, but staple, good( and a >eblen good %a good
made more fashionable by a higher price(.
MARGINAL RE3EN#E %MR(
In microeconomics, ?arginal @evenue %?@( is the e*tra revenue that an
additional unit of product will bring to a firm. It can also be described as the
change in total revenueAchange in number of units sold.
?ore formally, marginal revenue is equal to the change in total revenue over the
change in quantity when the change in quantity is equal to one unit %or the
change in output in the brac)et where the change in revenue has occurred(
This can also be represented as a derivative. %Total revenue( ! %rice
2emanded( times %Buantity( or . Thus, by the product rule:
.
-or a firm facing perfectly competitive mar)ets, price does not change with
quantity sold % (, so marginal revenue is equal to price. -or a
monopoly, the price received will decline with quantity sold % (, so
marginal revenue is less than price. This means that the profit-ma*imi5ing
quantity, for which marginal revenue is equal to marginal cost will be lower for a
monopoly than for a competitive firm, while the profit-ma*imi5ing price will be
higher. When marginal revenue is positive, rice elasticity of demand 912: is
elastic, and when it is negative, 12 is inelastic. When marginal revenue is
equal to 5ero, price elasticity of demand is equal to -$.
3ross elasticity of demand

In economics, the cross elasticity of demand and cross price elasticity of
demand measures the responsiveness of the quantity demand of a good to a
change in the price of another good.
It is measured as the percentage change in quantity demanded for the first
good that occurs in response to a percentage change in price of the second
good. -or e*ample, if, in response to a $", increase in the price of fuel, the
quantity of new cars that are fuel inefficient demanded decreased by .",, the
cross elasticity of demand would be -.",A$", ! -..
The formula used to calculate the coefficient cross elasticity of demand is
or:
Two goods that complement each other show a negative cross elasticity of
demand.
In the e*ample above, the two goods, fuel and cars%consists of fuel
consumption(, are complements - that is, one is used with the other. In these
cases the cross elasticity of demand will be negative. In the case of perfect
complements, the cross elasticity of demand is infinitely negative.
Where the two goods are substitutes the cross elasticity of demand will be
positive, so that as the price of one goes up the quantity demanded of the other
will increase. -or e*ample, in response to an increase in the price of
carbonated soft drin)s, the demand for non-carbonated soft drin)s will rise. In
the case of perfect substitutes, the cross elasticity of demand is equal to infinity.
Where the two goods are complements the cross elasticity of demand will be
negative, so that as the price of one goes up the quantity demanded of the
other will decrease. -or e*ample, in response to an increase in the price of fuel,
the demand for new cars will decrease.
Where the two goods are independent, the cross elasticity demand will be 5ero:
as the price of one good changes, there will be no change in quantity
demanded of the other good.
When goods are substitutable, the diversion ratio - which quantifies how much
of the displaced demand for product C switches to product i - is measured by the
ratio of the cross-elasticity to the own-elasticity multiplied by the ratio of product
i7s demand to product C7s demand. In the discrete case, the diversion ratio is
naturally interpreted as the fraction of product C demand which treats product i
as a second choice,9$: measuring how much of the demand diverting from
product C because of a price increase is diverted to product i can be written as
the product of the ratio of the cross-elasticity to the own-elasticity and the ratio
of the demand for product i to the demand for product C. In some cases, it has a
natural interpretation as the proportion of people buying product C who would
consider product i their Dsecond choice.7
1mpirical 2emand -unction
1mpirical estimation
2emand and supply relations in a mar)et can be statistically estimated from
price, quantity, and other data with sufficient information in the model. This can
be done with simultaneous-equation methods of estimation in econometrics.
Such methods allow solving for the model-relevant 6structural coefficients,6 the
estimated algebraic counterparts of the theory. The arameter identification
problem is a common issue in 6structural estimation.6 Typically, data on
e*ogenous variables %that is, variables other than price and quantity, both of
which are endogenous variables( are needed to perform such an estimation. &n
alternative to 6structural estimation6 is reduced-form estimation, which
regresses each of the endogenous variables on the respective e*ogenous
variables.
?acroeconomic uses of demand and supply
2emand and supply have also been generali5ed to e*plain macroeconomic
variables in a mar)et economy, including the quantity of total output and the
general price level. The &ggregate 2emand-&ggregate Supply model may be
the most direct application of supply and demand to macroeconomics, but other
macroeconomic models also use supply and demand. 3ompared to
microeconomic uses of demand and supply, different %and more controversial(
theoretical considerations apply to such macroeconomic counterparts as
aggregate demand and aggregate supply. 2emand and supply may also be
used in macroeconomic theory to relate money supply to demand and interest
rates.
2emand shortfalls
& demand shortfall results from the actual demand for a given product or
service being lower than the proCected, or estimated, demand for that product or
service. 2emand shortfalls are caused by demand overestimation in the
planning of new products and services. 2emand overestimation is caused by
optimism bias andAor strategic misrepresentation.
4#SINESS 5ORCAS)ING
-orecasting is the process of estimation in un)nown situations. rediction is a
similar, but more general term. 'oth can refer to estimation of time series,
cross-sectional or longitudinal data. Esage can differ between areas of
application: for e*ample in hydrology, the terms 6forecast6 and 6forecasting6 are
sometimes reserved for estimates of values at certain specific future times,
while the term 6prediction6 is used for more general estimates, such as the
number of times floods will occur over a long period. @is) and uncertainty are
central to forecasting and prediction. -orecasting is used in the practice of
2emand lanning in every day business forecasting for manufacturing
companies. The discipline of demand planning, also sometimes referred to as
supply chain forecasting, embraces both statistical forecasting and a consensus
process.
-orecasting is commonly used in discussion of time-series data.
3ategories of forecasting methods
)ime series metods
Time series methods use historical data as the basis of estimating future
outcomes.
?oving average
1*ponential smoothing
1*trapolation
Finear prediction
Trend estimation
=rowth curve

Ca$sal + econometric metods
Some forecasting methods use the assumption that it is possible to identify the
underlying factors that might influence the variable that is being forecast. -or
e*ample, sales of umbrellas might be associated with weather conditions. If the
causes are understood, proCections of the influencing variables can be made
and used in the forecast.
@egression analysis using linear regression or non-linear regression
&utoregressive moving average %&@?&(
&utoregressive integrated moving average %&@I?&(
e.g. 'o*-;en)ins
6$dgmental metods
;udgemental forecasting methods incorporate intuitive Cudgements,
opinions and probability estimates.
3omposite forecasts
Surveys
2elphi method
Scenario building
Technology forecasting
-orecast by analogy
Oter metods
Simulation
rediction mar)et
robabilistic forecasting and 1nsemble forecasting
@eference class forecasting
4#SINEES AND ECONOMIC 5ORCAS)ING
Economic forecasting is the process of ma)ing predictions about
the economy as a whole or in part
Input-output model
;ump to: navigation, search
This article is about the economic model. -or the computer interface, see
InputAoutput.
The Input-output model of economics uses a matri* representation of a nation7s
%or a region7s( economy to predict the effect of changes in one industry on
others and by consumers, government, and foreign suppliers on the economy.
This model, if applied on a region, is also )nown as the @egional Impact
?ultiplier System. Wassily Feontief %$G"+-$GGG( is credited with the
development of this analysis. -rancois Buesnay developed a cruder version of
this technique called Tableau Hconomique. Feontief won the Iobel ?emorial
ri5e in 1conomic Sciences for his development of this model.
Input-output analysis considers inter-industry relations in an economy, depicting
how the output of one industry goes to another industry where it serves as an
input, and thereby ma)es one industry dependent on another both as customer
of output and as supplier of inputs. &n input-output model is a specific
formulation of input-output analysis.
1ach column of the input-output matri* reports the monetary value of an
industry7s inputs and each row represents the value of an industry7s outputs.
Suppose there are three industries. 3olumn $ reports the value of inputs to
Industry $ from Industries $, ., and /. 3olumns . and / do the same for those
industries. @ow $ reports the value of outputs from Industry $ to Industries $, .,
and /. @ows . and / do the same for the other industries.
While the input-output matri* reports only the intermediate goods and services
that are e*changed among industries, row vectors on the bottom record the
disposition of finished goods and services to consumers, government, and
foreign buyers. Similarly, column vectors on the right record non-industrial
inputs li)e labor and purchases from foreign suppliers.
In addition to studying the structure of national economies, input-output
economics has been used to study regional economies within a nation, and as a
tool for national economic planning.
The mathematics of input-output economics is straightforward, but the data
requirements are enormous because the e*penditures and revenues of each
branch of economic activity has to be represented. The tool has languished
because not all countries collect the required data, data quality varies, and the
data collection and preparation process has lags that ma)e timely analysis
difficult. Typically input-out tables are compiled retrospectively as a 6snapshot6
cross-section of the economy, once every few years.
Esefulness
&n input-output model is widely used in economic forecasting to predict flows
between sectors. They are also used in local urban economics.
Irving 8oc) at the 3hicago &rea Transportation Study did detailed forecasting
by industry sectors using input-output techniques. &t the time, 8oc)0s wor) was
quite an underta)ing, the only other wor) that has been done at the urban level
was for Stoc)holm and it was not widely )nown. Input-output was one of the few
techniques developed at the 3&TS not adopted in later studies. Fater studies
used economic base analysis techniques.
Input-output models at JI code level compilations %eg, a city( are also available
through the I?F&I system.
Key Ideas
The inimitable boo) by Feontief himself remains the best e*position of input-
output analysis. See bibliography.
Input-output concepts are simple. 3onsider the production of the ith sector. We
may isolate %$( the quantity of that production that goes to final demand,ci, %.( to
total output, *i, and %/( flows *iC from that industry to other industries. We may
write a transactions tableau
)a*le7 )ransactions in a )ree Sector Economy
Economic
Activities
Inp$ts to
Agric$lt$re
Inp$ts to
Man$fact$ring
Inp$ts to
)ransport
5inal
Demand
)otal
O$tp$t
&griculture + $+ . <L G"
?anufacturing $" ." $" M" L"
Transportation $" $+ + " /"
Fabor .+ /" + " <"
4ASIC CONCEP) O5 PROD#C)ION )2EOR8
In microeconomics, roduction is simply the conversion of inputs into outputs. It
is an economic process that uses resources to create a commodity that is
suitable for e*change. This can include manufacturing, storing, shipping, and
pac)aging. Some economists define production broadly as all economic activity
other than consumption. They see every commercial activity other than the final
purchase as some form of production.
roduction is a process, and as such it occurs through time and space.
'ecause it is a flow concept, production is measured as a Nrate of output per
period of timeO. There are three aspects to production processes:
$. the quantity of the commodity produced,
.. the form of the good created,
/. the temporal and spatial distribution of the commodity produced.
& production process can be defined as any activity that increases the similarity
between the pattern of demand for goods, and the quantity, form, and
distribution of these goods available to the mar)et place
1fficiency and cross-efficiency
& production process is efficient if a given quantity of outputs cannot be
produced with any less inputs. It is said to be inefficient when there e*ists
another feasible process that, for any given output, uses less inputs. Some
economists %in particular Feibenstein( use the term P-efficiency to indicate that
production processes tend to be inherently inefficient due to satisficing
behaviour. The Nrate of efficiencyO is simply the amount of %or value of( outputs
divided by the amount of %or value of( inputs. If a production process uses +"
units of input %or Q+""" worth of inputs( to produce one unit of output it is more
efficient than a process that uses ++ units of input %or Q++"" worth of inputs( to
produce the same level of output. It is said to be $", more efficient %R++-
+"SA+"!$A$"!$",(.
-actors of production
The inputs or resources used in the production process are called factors by
economists. The myriad of possible inputs are usually grouped into four or five
categories. These factors are:
@aw materials
?achinery
Fabour services
3apital goods
Fand
1nterpreneur
In the Nlong runO all of these factors of production can be adCusted by
management. The Nshort runO however, is defined as a period in which at least
one of the factors of production is fi*ed.
& fi*ed factor of production is one whose quantity cannot readily be changed.
1*amples include maCor pieces of equipment, suitable factory space, and )ey
managerial personnel.
& variable factor of production is one whose usage rate can be changed easily.
1*amples include electrical power consumption, transportation services, and
most raw material inputs. In the short run, a firm0s Nscale of operationsO
determines the ma*imum number of outputs that can be produced. In the long
run, there are no scale limitations.
?any ways of e*pressing the production
relationship
The total, average, and marginal physical product curves mentioned above are
Cust one way of showing production relationships. They e*press the quantity of
output relative to the amount of variable input employed while holding fi*ed
inputs constant. 'ecause they depict a short run relationship, they are
sometimes called short run production functions. If all inputs are allowed to be
varied, then the diagram would e*press outputs relative to total inputs, and the
function would be a long run production function. If the mi* of inputs is held
constant, then output would be e*pressed relative to inputs of a fi*ed
composition, and the function would indicate long run economies of scale.
@ather than comparing inputs to outputs, it is also possible to assess the mi* of
inputs employed in production. &n isoquant %see below( relates the quantities of
one input to the quantities of another input. It indicates all possible combinations
of inputs that are capable of producing a given level of output.
@ather than loo)ing at the inputs used in production, it is possible to loo) at the
mi* of outputs that are possible for any given production process. This is done
with a production possibilities frontier. It indicates what combinations of outputs
are possible given the available factor endowment and the prevailing production
technology.
Isoquants
There are many ways of producing a given level of output. Tou can use a lot of
labour with a minimal amount of capital, or you could invest heavily in capital
equipment that requires a minimal amount of labour to operate, or any
combination in between. -or most goods, there are more than Cust two inputs.
-or e*ample in agriculture, the amount of land, water, and fertili5er can all be
varied to produce different amounts of a crop. &n isoquant, in the two input
case, is a curve that shows all the ways of combining two inputs so as to
produce a given level of output.
The marginal rate of technical substitution
Isoquants are typically conve* to the origin reflecting the fact that the two
factors are substitutable for each other at varying rates. This rate of
substitutability is called the Nmarginal rate of technical substitutionO %?@TS( or
occasionally the Nmarginal rate of substitution in productionO. It measures the
reduction in one input per unit increase in the other input that is Cust sufficient to
maintain a constant level of production. -or e*ample, the marginal rate of
substitution of labour for capital gives the amount of capital that can be replaced
by one unit of labour while )eeping output unchanged.
Isoquant

&n isoquant map where B/ U B. U B$. & typical choice of inputs would be labor
for input P and capital for input T. ?ore of input P, input T, or both is required to
move from isoquant B$ to B., or from B. to B/.
&( 1*ample of an isoquant map with two inputs that are perfect substitutes.
'( 1*ample of an isoquant map with two inputs that are perfect complements.
In economics, an isoquant %derived from quantity and the =ree) word iso
9meaning equal:( is a contour line drawn through the set of points at which the
same quantity of output is produced while changing the quantities of two or
more inputs. While an indifference curve helps to answer the utility-ma*imi5ing
problem of consumers, the isoquant deals with the cost-minimi5ation problem of
producers. Isoquants are typically drawn on capital-labor graphs, showing the
tradeoff between capital and labor in the production function, and the
decreasing marginal returns of both inputs. &dding one input while holding the
other constant eventually leads to decreasing marginal output, and this is
reflected in the shape of the isoquant. & family of isoquants can be represented
by an isoquant map, a graph combining a number of isoquants, each
representing a different quantity of output.
&n isoquant shows that the firm in question has the ability to substitute between
the two different inputs at will in order to produce the same level of output. &n
isoquant map can also indicate decreasing or increasing returns to scale based
on increasing or decreasing distances between the isoquants on the map as
you increase output. If the distance between isoquants increases as output
increases, the firm7s production function is e*hibiting decreasing returns to
scaleV doubling both inputs will result in placement on an isoquant with less than
double the output of the previous isoquant. 3onversely, if the distance is
decreasing as output increases, the firm is e*periencing increasing returns to
scaleV doubling both inputs results in placement on an isoquant with more than
twice the output of the original isoquant.
&s with indifference curves, two isoquants can never cross. &lso, every possible
combination of inputs is on an isoquant. -inally, any combination of inputs
above or to the right of an isoquant results in more output than any point on the
isoquant. &lthough the marginal product of an input decreases as you increase
the quantity of the input while holding all other inputs constant, the marginal
product is never negative since a logical firm would never increase an input to
decrease output.
Sapes of Iso,$ant C$rve7
If the two inputs are perfect substitutes, the resulting isoquant map generated
is represented in fig. &V with a given level of production B/, input P is effortlessly
replaced by input T in the production function. The perfect substitute inputs do
not e*perience decreasing marginal rates of return when they are substituted
for each other in the production function.
If the two inputs are perfect complements, the isoquant map ta)es the form of
fig. 'V with a level of production B/, input P and input T can only be combined
efficiently in a certain ratio represented by the )in) in the isoquant. The firm will
combine the two inputs in the required ratio to ma*imi5e output and minimi5e
cost. If the firm is not producing at this ratio, there is no rate of return for
increasing the input that is already in e*cess.
Isoquants are typically combined with isocost lines in order to provide a cost-
minimi5ation production optimi5ation problem.
MONOPOLIS)IC COMPE)E)ION
?onopolistic competition

?onopolistic competition is a common mar)et form. ?any mar)ets can be
considered monopolistically competitive, often including the mar)ets for
restaurants, cereal, clothing, shoes and service industries in large cities.
?onopolistically competitive mar)ets have the following characteristics:
There are many producers and many consumers in a given mar)et.
3onsumers perceive that there are non-price differences among the
competitors7 products.
There are few barriers to entry and e*it9$:.
roducers have a degree of control over price.
The characteristics of a monopolistically competitive mar)et are almost the
same as in perfect competition, with the e*ception of heterogeneous products,
and that monopolistic competition involves a great deal of non-price competition
%based on subtle product differentiation(. & firm ma)ing profits in the short run
will brea) even in the long run because demand will decrease and average total
cost will increase. This means in the long run, a monopolistically competitive
firm will ma)e 5ero economic profit. This gives the company a certain amount of
influence over the mar)etV because of brand loyalty, it can raise its prices
without losing all of its customers. This means that an individual firm7s demand
curve is downward sloping, in contrast to perfect competition, which has a
perfectly elastic demand schedule.
!!2efinition of monopolistic competition!! na lie
Short-run equilibrium of the firm under monopolistic competition
& monopolistically competitive firm acts li)e a monopolist in that the firm is able
to influence the mar)et price of its product by altering the rate of production of
the product. Enli)e in perfect competition, monopolistically competitive firms
produce products that are not perfect substitutes. &s such, brand P7s product,
which is different %or at least perceived to be different( from all other brands7
products, is available from only a single producer. In the short-run, the
monopolistically competitive firm can e*ploit the heterogeneity of its brand so as
to reap positive economic profit %i.e. the rate of return is greater than the rate
required to compensate debt and equity holders for the ris) of investing in the
firm(. Wne possible effect of advertising on a firm7s long run average cost curve
when earning an economic profit in the short run is to raise the curve.
Fong-run equilibrium of the firm under monopolistic competition
In the long-run, however, whatever distinguishing characteristic that enables
one firm to reap monopoly profits will be duplicated by competing firms. This
competition will drive the price of the product down and, in the long-run, the
monopolistically competitive firm will ma)e 5ero economic profit %i.e. a rate of
return equal to the rate required to compensate debt and equity holders for the
ris) of investing in the firm(.
Enli)e in perfect competition, the monopolistically competitive firm does not
produce at the lowest attainable average total cost. Instead, the firm produces
at an inefficient output level, reaping more in additional revenue than it incurs in
additional cost versus the efficient output level.
roblems
While monopolistically competitive firms are inefficient, it is usually the case that
the costs of regulating prices for every product that is sold in monopolistic
competition by far e*ceed the benefitsV the government would have to regulate
all firms that sold heterogeneous productsXan impossible proposition in a
mar)et economy. & monopolistically competitive firm might be said to be
marginally inefficient because the firm produces at an output where average
total cost is not a minimum. & monopolistically competitive mar)et might be said
to be a marginally inefficient mar)et structure because marginal cost is less than
price in the long run.
&nother concern of critics of monopolistic competition is that it fosters
advertising and the creation of brand names. 3ritics argue that advertising
induces customers into spending more on products because of the name
associated with them rather than because of rational factors. This is disputed by
defenders of advertising who argue that %$( brand names can represent a
guarantee of quality, and %.( advertising helps reduce the cost to consumers of
weighing the tradeoffs of numerous competing brands. There are unique
information and information processing costs associated with selecting a brand
in a monopolistically competitive environment. In a monopoly industry, the
consumer is faced with a single brand and so information gathering is relatively
ine*pensive. In a perfectly competitive industry, the consumer is faced with
many brands. 8owever, because the brands are virtually identical, again
information gathering is relatively ine*pensive. -aced with a monopolistically
competitive industry, to select the best out of many brands the consumer must
collect and process information on a large number of different brands. In many
cases, the cost of gathering information necessary to selecting the best brand
can e*ceed the benefit of consuming the best brand %versus a randomly
selected brand(.
1vidence suggests that consumers use information obtained from advertising
not only to assess the single brand advertised, but also to infer the possible
e*istence of brands that the consumer has, heretofore, not observed, as well as
to infer consumer satisfaction with brands similar to the advertised brand.9.:
1*amples
In many E.S. mar)ets, producers practice product differentiation by altering the
physical composition, using special pac)aging, or simply claiming to have
superior products based on brand images andAor advertising. Toothpastes and
toilet papers are e*amples of differentiated products.
OLIGOPOL8
&n oligopoly is a mar)et form in which a mar)et or industry is dominated by a
small number of sellers %oligopolists(. The word is derived from the =ree) for a
few over many. 'ecause there are few participants in this type of mar)et, each
oligopolist is aware of the actions of the others. The decisions of one firm
influence, and are influenced by the decisions of other firms. Strategic planning
by oligopolists always involves ta)ing into account the li)ely responses of the
other mar)et participants. This causes oligopolistic mar)ets and industries to be
at the highest ris) for collusion.
2escription
Wligopoly is a common mar)et form. &s a quantitative description of oligopoly,
the four-firm concentration ratio is often utili5ed. This measure e*presses the
mar)et share of the four largest firms in an industry as a percentage. Esing this
measure, an oligopoly is defined as a mar)et in which the four-firm
concentration ratio is above M",.9citation needed:
Wligopolistic competition can give rise to a wide range of different outcomes. In
some situations, the firms may collude to raise prices and restrict production in
the same way as a monopoly. Where there is a formal agreement for such
collusion, this is )nown as a cartel.
-irms often collude in an attempt to stabilise unstable mar)ets, so as to reduce
the ris)s inherent in these mar)ets for investment and product development.
There are legal restrictions on such collusion in most countries. There does not
have to be a formal agreement for collusion to ta)e place %although for the act
to be illegal there must be a real communication between companies( - for
e*ample, in some industries, there may be an ac)nowledged mar)et leader
which informally sets prices to which other producers respond, )nown as price
leadership.
In other situations, competition between sellers in an oligopoly can be fierce,
with relatively low prices and high production. This could lead to an efficient
outcome approaching perfect competition. The competition in an oligopoly can
be greater than when there are more firms in an industry if, for e*ample, the
firms were only regionally based and didn7t compete directly with each other.
The welfare analysis of oligopolies suffers, thus, from a sensitivity to the e*act
specifications used to define the mar)et7s structure. In particular, the level of
deadweight loss is hard to measure. The study of product differentiation
indicates oligopolies might also create e*cessive levels of differentiation in order
to stifle competition.
Wligopoly theory ma)es heavy use of game theory to model the behaviour of
oligopolies:
Stac)elberg7s duopoly. In this model the firms move sequentially %see
Stac)elberg competition(.
3ournot7s duopoly. In this model the firms simultaneously choose quantities
%see 3ournot competition(.
'ertrand7s oligopoly. In this model the firms simultaneously choose prices %see
'ertrand competition(.
2emand curve
&bove the )in), demand is relatively elastic because all other firm0s prices
remain unchanged. 'elow the )in), demand is relatively inelastic because all
other firms will introduce a similar price cut, eventually leading to a price war.
Therefore, the best option for the oligopolist is to produce at point 1 which is the
equilibrium point and, incidentally, the )in) point.
In an oligopoly, firms operate under imperfect competition and a )in)ed demand
curve which reflects inelasticity below mar)et price and elasticity above mar)et
price, the product or service firms offer, are differentiated and barriers to entry
are strong. -ollowing from the fierce price competitiveness created by this
stic)y-upward demand curve, firms utili5e non-price competition in order to
accrue greater revenue and mar)et share.
6Kin)ed6 demand curves are similar to traditional demand curves, as they are
downward-sloping. They are distinguished by a hypothesi5ed conve* bend with
a discontinuity at the bend - the 6)in).6 Therefore, the first derivative at that point
is undefined and leads to a Cump discontinuity in the marginal revenue curve.
3lassical economic theory assumes that a profit-ma*imi5ing producer with
some mar)et power %either due to oligopoly or monopolistic competition( will set
marginal costs equal to marginal revenue. This idea can be envisioned
graphically by the intersection of an upward-sloping marginal cost curve and a
downward-sloping marginal revenue curve %because the more one sells, the
lower the price must be, so the less a producer earns per unit(. In classical
theory, any change in the marginal cost structure %how much it costs to ma)e
each additional unit( or the marginal revenue structure %how much people will
pay for each additional unit( will be immediately reflected in a new price andAor
quantity sold of the item. This result does not occur if a 6)in)6 e*ists. 'ecause of
this Cump discontinuity in the marginal revenue curve, marginal costs could
change without necessarily changing the price or quantity.
The motivation behind this )in) is the idea that in an oligopolistic or
monopolistically competitive mar)et, firms will not raise their prices because
even a small price increase will lose many customers. 8owever, even a large
price decrease will gain only a few customers because such an action will begin
a price war with other firms. The curve is therefore more price-elastic for price
increases and less so for price decreases. -irms will often enter the industry in
the long run.
9edit: Wligopsonies
Wligopsony is a mar)et form in which the number of buyers is small while the
number of sellers in theory could be large. This typically happens in mar)ets for
inputs where a small number of firms are competing to obtain factors of
production. This also involves strategic interactions but of a different nature than
when competing in the output mar)et to sell a final output. Wligopoly refers to
the mar)et for output while oligopsony refers to the mar)et where these firms
are the buyers and not sellers %eg. a factor mar)et(. & mar)et with a few sellers
%oligopoly( and a few buyers %oligopsony( is referred to as a bilateral oligopoly.
1*amples
In the Enited Kingdom, the four-firm concentration ratio of the supermar)et
industry is YM.M, %.""<(9$:V the 'ritish brewing industry has a staggering L+,
ratio. In the E.S.&, oligopolistic industries include the beer, tobacco, accounting
and audit services, aircraft, military equipment, and motor vehicle industries.
?any media industries today are essentially oligopolies. Si* movie studios
receive G" percent of &merican film revenues, and four maCor music companies
receive L" percent of recording revenues. There are Cust si* maCor boo)
publishers, and the television industry was an oligopoly of three networ)s- &'3,
3'S, and I'3-from the $G+"s through the $GY"s. Television has diversified
since then, especially because of cable, but today it is still mostly an oligopoly
%due to concentration of media ownership( of five companies: 2isneyA&'3,
>iacomA3'S, I'3 Eniversal, Time Warner, and Iews 3orporation.9.:
In industriali5ed countries oligopolies are found in many sectors of the economy,
such as cars, auditing, consumer goods, and steel production. Enprecedented
levels of competition, fueled by increasing globalisation, have resulted in the
emergence of oligopoly in many mar)et sectors, such as the aerospace
industry. ?ar)et shares in oligopoly are typically determined on the basis of
product development and advertising. There are now only a small number of
manufacturers of civil passenger aircraft, though 'ra5il %1mbraer( and 3anada
%'ombardier( have fielded entries into the smaller-mar)et passenger aircraft
mar)et sector. & further instance arises in a heavily regulated mar)et such as
wireless communications. In some cases states have licensed only two or three
providers of cellular phone services.
W13 is another e*ample of an oligopoly, although on the level of national
bodies instead of corporate bodies. There are a few countries that try to control
the production of oil.
Isocost

In economics an isocost line represents a combination of inputs which all cost
the same amount. &lthough similar to the budget constraint in consumer theory,
the use of the isocost pertains to cost-minimi5ation in production, as opposed to
utility-ma*imi5ation. The typical isocost line represents the ratio of costs of
labour and capital, so the formula is often written as:
Where w represents the wage of labour, and r represents the rental rate of
capital. The slope is:
or the negative ratio of wages divided by rental fees.
The isocost line is combined with the isoquant line to determine the optimal
production point %at a given level of output(.
The cost function for a firm with two variable inputs
3onsider a firm that uses two inputs and has the production function -. This firm
minimi5es its cost of producing any given output y if it chooses the pair %5$, 5.(
of inputs to solve the problem
?in 5$,5.w$5$ Z w.5. subCect to y ! - %5$, 5.(,
where w$ and w. are the input prices. Iote that w$, w., and y are given in this
problem---they are parameters. The variables are 5$ and 5.. 2enote the
amounts of the two inputs that solve this problem by 5$[%y, w$, w.( and 5.[%y,
w$, w.(. The functions 5$[ and 5.[ are the firm7s conditional input demand
functions. %They are conditional on the output y, which is ta)en as given.(
The firm7s minimal cost of producing the output y is w$5$[%y,w$, w.( Z
w.5.[%y,w$, w.( %the value of its total cost for the values of 5$ and 5. that
minimi5e that cost(. The function T3 defined by
which is called the firm7s %total( cost function. %Iote that the hard part of the
problem is finding the conditional input demandsV once you have found these,
then finding the cost function is simply a matter of adding the conditional input
demands together with the weights w$ and w..(
Grapical ill$stration of te cost"minimi9ation pro*lem
The firm7s cost-minimi5ation problem is illustrated in the following figure. The
red curve is the y-isoquant: the set of all pairs %5$, 5.( of inputs that produce
e*actly the output y. The light blue area, above the y-isoquant, is the set of all
pairs %5$, 5.( of inputs that produce at least the output y: the set of feasible
input bundles for the output y. 1ach green line is a set of pairs %5$, 5.( of inputs
that are equally costly: an isocost line. The points on any given isocost line
satisfy the condition
w$5$ Z w.5. ! c
for some value of c. Isocost lines further from the origin correspond to higher
costs.
The cost-minimi5ation problem of the firm is to choose an input bundle %5$, 5.(
feasible for the output y that costs as little as possible. In terms of the figure, a
cost-minimi5ing input bundle is a point on the y-isoquant that is on the lowest
possible isocost line. ut differently, a cost-minimi5ing input bundle must satisfy
two conditions:
$. it is on the y-isoquant .. no other point on the y-isoquant is on a lower isocost
line.
In the figure, there is a single cost-minimi5ing input bundle, indicated by the
blac) dot. &nother e*ample of a firm7s cost-minimi5ation problem is given in the
following figure. In this case the isoquant does not have the 6typical6 conve*-to-
the-origin shapeV instead, it is bowed out from the origin. The cost-minimi5ing
bundle is, as before, the bundle on the isoquant that is on the lowest possible
isocost curve. This bundle is indicated by the large blac) dot. %Iote that the
point at which an isocost line is tangent to the isoquant ma*imi5es the cost of
producing the output y along the isoquant.(
)e case of smoot iso,$ants conve- to te origin
If the y-isoquant is smooth and the cost-minimi5ing bundle involves a positive
amount of each input, as in the first figure, we can see that at a cost-minimi5ing
input bundle an isocost line is tangent to the y-isoquant. Iow, the equation of an
isocost line is
w$5$ Z w.5. ! c
which we can rewrite as
5. ! cAw. %w$Aw.(5$
so that we see that is slope is w$Aw.. The absolute value of the slope of an
isoquant is the ?@TS, so we reach the following conclusion. If the isoquants are
smooth and conve* to the origin and the cost-minimi5ing input bundle %5$, 5.(
involves a positive amount of each input, then this bundle satisfies the following
two conditions:
- %5$, 5.( is on the y-isoquant %i.e. - %5$, 5.( ! y( and
- the ?@TS at %5$, 5.( is w$Aw. %i.e. ?@TS%5$, 5.( ! w$Aw.(.
The condition that the ?@TS be equal to w$Aw. can be given the following
intuitive interpretation. We )now that the ?@TS is equal to ?$A?.. So the
condition that the ?@TS be equal to w$Aw. is equivalent to the condition
w$Aw. ! ?$A?., or ?$Aw$ ! ?.Aw.: the marginal product per dollar is
equal for the two inputs. That is, the condition that ?@TS be equal to w$Aw. is
equivalent to the condition that at a cost minimi5ing bundle, a dollar spent on
each input must yield the same marginal output. This condition ma)es sense: if
a dollar spent on input $ yields more output than a dollar spent on input ., then
more of input $ should be used and less of input .. Wnly if a dollar spent on
each input is equally productive is the input bundle optimal.