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(a) The firm is an economic agent which wishes to maximise profits subject to

its demand and cost function. It will try to get on the highest isoprofit as
this depicts higher level of profits. However the firm is constrained by its
demand curve.
Given the profit maximising nature of the firm, it will try to restrict quantity in
order to charge a higher price (hence get a higher profit) and convert the
maximum consumer surplus into producer surplus. As a result, price is always
greater than the marginal cost for a firm producing a differentiated product such
as cereals. This can be shown below.

PP

QP

However, the degree by which the firm can reduce quantity to increase price
depends on certain factors such as price elasticity of demand, availability of
substitutes, market power and advertising.
The extent by which price deviates from the marginal cost depends most
importantly on price elasticity of demand which gives or takes power to/from
firms to extract consumer surplus to turn it into producer surplus.
Price elasticity of demand measures the responsiveness of a change in quantity
demanded to a change in price. From the above, we know that the firm will
operate where MRT=MRS, that is,
1/ = (p-mc)/p,
Where (p-mc)/p is the mark-up of the firm and it can be seen that if the firm has
no power at all (perfectly competitive market), where PED is infinite, the firm
cannot charge aprice above marginal cost. Hence mark-up is equal to zero. From
the above, we can deduce that the mark up is inversely related to the price
elasticity of demand.

A firm selling cereal will have some power over its product since the latter is
differentiated. The firm will have some bargaining power with its customers to be
able to set price above marginal cost without losing all customers. This is
because some customers have a strong preference and brand loyalty for a
particular cereal that they will stick to it even if the price is raised, unlike in the
perfectly market, where if price is raised, the firm loses all its customers. The
firm faces a less elastic demand curve which gives the firm the power to restrict
quantity to increase price without experiencing an infinite fall in quantity
demanded.
Advertising also influences the degree to which the firm can price above
marginal cost. Agrresive advertising creates brand loyalty, increasing demand
and making it steeper. Advertising on the health benefits that a particular cereal
offers can shift the demand, increasing the ability of the firm to price above MC,
extracting more consumer surplus. This can be shown diagrammatically:

A survey conducted by Schonfeld and Associate also revealed that advertising on


breakfast cereals in the US is about 5.5% of total sales revenue and the highest
market share is owned by those companies that spend heavily on advertising.

(b) Economies of scale refer to reductions in the long run average costs of a
firm when it grows in size or expands output. Being a profit maximiser, the
firm will produce where the highest attainable isoprofit curve is tangential
to the demand curve. This can be shown below:

The profit maximising output in this diagram is Q* for which a price of P* has
been set. However, this is not the socially optimal output as consumers value the
last unit produced more than the extra cost in producing that last unit. Some
consumers, QA-Q*, are not able to have the good although they value the good
more that the marginal cost. This means that allocative efficiency is not
achieved, and the firm is deliberately restricting quantity in order to charge a
higher price.

There are two reasons why the firm charges this price and not the socially
optimal output and will never produce at QA, unless there is some government
intervention in terms of subsidy for example.
Firstly, the firm never produces at QA because if it does so, it will be on a lower
isoprofit curve, meaning that it gains lower profit for each unit sold than the
profit it gains when it is producing Q*. However the firm wants to attain the
highest indifference curve as it wants higher level of welfare which corresponds
to higher level of profits. Hence the firm reaches the higher isoprofit, producing
Q*.
Secondly, the firm will also never produce QA as the producer maximises gains
from trade(producer surplus) at Q*. At Q*, producer surplus is equal to P*Eba,
while consumer surplus is represented by a smaller area which is CEP*.
If the firm starts producing at QA, it loses a bigger amount of surplus represented
by the area P*EDPA and gains a smaller area of BDF. The firm faces a net loss of
surplus.
When government intervenes through a subsidy in the market, it can make a
deal with the producer to charge a price equal to PA, but the government subsidy
guarantees the producer a price of P*, such that the difference between P* and
PA is the subsidy per unit.
This can be represented on a supply-demand diagram.
Price
S

S1

P*
PM
PA

D
Quantity
QM

QA

(c) To explain this behaviour, a model needs to be developed in which the


employer chooses a wage based on is knowledge of how the employee will
respond in terms of effort and in turn, the employee chooses an effort
level to satisfy her employer and a level of effort where she does not
exhaust herself.
However, the employer will never know what effort level will be provided by the
worker. The worker does not get paid for the actual work he does but for the time
he spends in the job. This is due to the following factors:
Lack of information- workers often work in group such that it is not always
possible to determine how much each worker has produced.
Division of labour- the firm never knows how much each worker has
contributed to the final output and what was their effort level in producing the
good.
Service based economy- in many developed countries, workers are
increasingly employed in service oriented industries and since it is not possible
to measure the exact output per worker in such an industry, a piece rate system
cannot be used.
Incompleteness of job contract- an employment contract does not stipulate
everything that a worker needs to do. Hence employers pay a higher wage than
the reservation wage to incentivise the workers to do almost what is expected
from them and perform well in unforeseen events that the contract does not
mention.
The employees effort is essential to the business as it helps generate output and
hence profit increases, ceteris paribus. If the worker is offered a higher wage, he
is more incentivised, he has altruistic feelings and reciprocity for the employee,

he therefore works harder, produces more output and hence this action
generates higher profits for the owner.
The only variable that the employer can play with is therefore the wage to
incentivise the worker and extract the maximum effort from the worker, given
the wage level. This can be modelled by the best response curve of the worker
which shows the relationship between effort and wage.

As shown above, if the worker is paid the reservation wage, he is likely not to
exert any effort in the job. However, if the employer starts increasing the wage
level, from the diagram it can be seen that the effort level also increases. This is
because the employment rent is higher as wage increases. The employee is
motivated to exert some effort so that she does not lose her job. This is therefore
beneficial to the business as more effort means higher output and higher profits.

(d) To determine where employment level and wage level will be determined,
two concepts are required: wage curve and the profit curve.
The wage curve is derived from the best response curve of the worker and it
depicts the relationship between the firm and the employees. It shows the wage
at each level of employment to provide workers with the incentive to exert effort
in the job.
On the other hand, the profit curve gives the wage to be paid to workers when
the profit maximising price is chosen. A firm with market power can set its price
where the highest isoprofit is tagential to the demand curve. This profit
maximising price in turn depends on the costs and the price elasticity of
demand. In other words, the price is set such that the markup is inversely
proportional to elasticity.
Assuming that the only factor that affects cost is the wage cost, if the firm has
market power, that is, it does not face a cut throat competition from competitors,
this means the firm enjoys a relatively lower price elasticity of demand. This
leads to a higher markup and a higher price and thus a lower real wage. As such
the profit curve depicts the relationship between the wage and the price that
results when the firm chooses the profit maximising price.
Put together, the wage curve and the profit curve determine the Nash
equilibrium, where employers pay a wage consistent with their profit maximising
objective and employees offer the maximum effort given the wage level.

This can be shown below:

Point A is termed as the Nash equilibrium as it is the real wage that motivates
workers to provide the maximum effort at that wage and it also matches the
level of competition in the economy.

However, despite A being a Nash equilibrium, the labour market does not clear
and unemployment still exists. However if everyone had a job, employment rent
would be zero and no one would have incentive to work and everyone would be
unemployed. Hence the existence of unemployment is a Nash equilibrium.