Lecture Notes, Lectures 1-8 Lecture Notes, Lectures 1-8: Prices and Markets (RMIT) Prices and Markets (RMIT)

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Lecture notes, lectures 1-8
Prices and markets (RMIT)
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PRICES AND MARKETS
Topic 1 : Markets
“Economics is concerned with the efficient use of limited

productive resources for the purposes of attaining the
maximum satisfaction of our material wants.”
Jackson, page 3
Macroeconomics deals with this problem at the aggregate

level. Microeconomics (this course) deals with the problem
at the level of individual units - such as consumers, firms,
owners of resources.
1-1
Why is the study of economics important?
• to provide a basic understanding of the economic aspects

of society’s current problems and issues and the
economic consequences of policies
• to place business managers in a better position to

formulate strategies
• to provide individuals with knowledge to assist in a

range of personal/financial decisions
Jackson pages 4-5
1-2
Positive Economics:
deals with facts and theories
Normative Economics:
involves value judgements and relates to policy
1-3
Prices and Markets: lecture overheads vm081 1

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MARKETS: an overview
Definition of a market using the concepts of demand and
supply substitutability.
Classification of market structure using the concepts of
concentration, product differentiation and barriers to entry.
Market conduct and its relationship to market structure.
1-overview
Users of the Market Concept

• firms: to identify their competition
• competition regulators: eg. Australian Competition and Consumer
Commission, Competition Commission of Singapore,
Competition Policy Advisory Group (Hong Kong), Federal Trade
Commission (USA), …
1-4
The Australian Competition and Consumer Commission

(ACCC) and Mergers
The ACCC needs to assess whether “a merger would have the effect, or be
likely to have the effect, of substantially lessening competition....
In analysing the likely effect of a merger or acquisition, the Commission
has…a five stage evaluation process…
The first step is to define the relevant market, in its product, functional,
geographic and time dimensions…..
Market definition is an integral part of competition analysis. It identifies the
sellers and buyers who effectively constrain the price and output decisions
of the merged firm. It identifies the relevant area of competition.”
ACCC Merger Guidelines, Sections 5.1, 5.25, 5.26 and 5.35
1-5
Market Definition
A market includes all sellers who are in, or potentially in,
competition (that is, selling closely substitutable products)
selling to a common group of buyers.
Two main elements of this definition:
• demand substitutability
• supply substitutability
1-6

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Elements of Demand Substitutability
• The Product Level

The firms must be selling products which are closely
substitutable in consumers’ eyes - that is, products with a
high cross elasticity of demand.
• The Geographic Dimension

The firms must be selling to a common group of buyers -
international, national, state, local?
• The Functional Level

Is the market at the manufacturing, wholesale or retail
level?
Elements of Supply Substitutability

• current suppliers
Firms currently supplying products that are considered to
be close substitutes for each other, and so part of the
same market.
• potential suppliers
Firms that have the ability to quickly and easily move
into supplying these products, if given the incentive.
1-7
Market Structure
“the competitive environment in the market”
Characteristics of Market Structure
• Concentration
The number and size distribution of firms in a market
(measured by market shares or concentration ratio)
• Product Differentiation
Physical (real) or subjective (perceived or imagined)
differences in consumers’ minds between rival firms’
products
• Barriers to Entry
The extent to which it is difficult for new firms to enter a
market and compete with existing firms
(eg. patent rights, economies of scale)
1-8

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Concentration:
Size Distribution of Firms
40
35
% Share of Market Sales
30
25
20
15
10
0
1 2 3 4 5 6 7 8
Firms
1-9
Barriers to Entry:
Unit Cost Economies of Scale
$
CN
CE Unit
Cost
O QN QE Output
QE - CE: output and unit cost for existing firms in the

market
QN - CN: output and unit cost for new firm trying to
enter the market
1-10

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Market Structure
Selling side of Market
1. Pure/Perfect Competition
• Large number of sellers
• Homogeneous product Pure
• Low barriers to entry Perfect
• Perfect knowledge
• Perfect mobility of factors of production
2. Monopolistic Competition
• Large number of sellers
• Differentiated products
• Low barriers to entry
3. Oligopoly
• Few sellers
• High barriers to entry
• Differentiated or homogeneous products
4. Monopoly
• Single seller
• High barriers to entry
1-11

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Basic Conditions
⇓
Market Structure
⇓
Market Conduct
⇓
Market Performance
1-12
Market Conduct
“firms policies in regard to their operation in the market”
For example: price setting

product range
co-operation with rivals
advertising
research, innovation
legal tactics
1-13

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PRICES AND MARKETS
Topic 2 : Demand, Supply and Elasticity
Derivation of a Demand Curve

• factors influencing demand
• movements and shifts in the curve
• different concepts of demand
• market demand
• factors determining the shape of the demand curve
Derivation of a Supply Curve
• factors influencing supply
• movements and shifts in the curve
Market Equilibrium
Consumer and Producer Surplus
Elasticity of Demand
• measurement
• determinants
• elasticity and revenue
Elasticity of Supply
Other Demand Elasticities
• cross price
• income
2-overview
Definition of Demand
Demand may be defined as “the number of units of a
particular good or service that consumers are willing to
purchase during a specified period and under a given set of
conditions”.
Demand for a good is a function of, or is influenced by
• its own price
• prices of competitive goods
• prices of complementary goods
• expectations of price changes
• incomes
• tastes and preferences
• advertising expenditure, etc.
2-1

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Demand Curve
Suppose the observed price and quantity demanded of
good X is:
P Q Point
$10 10 E
$8 14 F
$6 19 G
$4 25 H
where P is price in dollars and
Q is quantity demanded in units.
E
10 •
F
8 •
G
6 •
H
4 • Demand
2
Q
10 14 19 25
2-2
Linear Demand Function:

QD = 100 - 2P
Find two points on the line by choosing any two prices - say,
if P = 0, QD = 100 (A) and
if P = 30, QD = 40 (B) Note: By using P = 0
you will be able to
P determine the horizontal
50 intercept. To find the
vertical intercept,
calculate P using Q = 0.
B In this case,
30 0 = 100 - 2P.
So 2P = 100
Demand and P = 50 at this point.
A
0 Q
40 100
2-3

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Shift in the Demand Curve

P
d2
d1
Q
Demand curve has shifted out from d1 to d2.
This may be due to an increase in income, an increase in the
price of a substitute good or a change in tastes, to name a
few.
2-4
Different Concepts of Demand
• individual’s demand for the commodity

• demand for the commodity produced by a single firm
• entire market demand for the commodity
2-5
Derivation of the Market Demand Curve

PX
PX PX
$10
$7
dA dB DX
QX
6 9 6 10 12 19
Individual A’s Individual B’s Market Demand Curve

demand curve demand curve
2-6

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Factors that determine the shape of the demand curve
1. Functional Factors
• income effect
• substitution effect
2. Non-Functional Factors
• bandwagon effect
• snob effect
• conspicuous consumption
2-7
Supply Function
Some of the factors which influence the supply of a good are:
• selling price of the good
• price of other goods substitutable on the supply side
• prices of raw materials and inputs
• taxes
• subsidies
• technology
• price of labour
• price of capital
• profit expectations
2-8
$ Supply Curve
Supply
P0 A
Q
Q0
A movement along the supply curve is in response to a
change in price.
Some factors that may cause the supply curve to shift are
changes in the price of resources, changes in technology, or
subsidies, to name a few.
2-9

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Market Equilibrium
P
S
P0
D
Q
Q0
Market equilibrium is achieved at the price where quantity

demanded is equal to quantity supplied. In the above
diagram, this is at the price P0 and the quantity Q0.
2-10
Using Qd = 100 - 2P (demand curve, from 2-3)

and Qs = -20 + 2P (supply curve)
P
50 Supply
30
Demand
10
Q
-20 0 40 100
2-11

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Calculation of Market Equilibrium
Qd = 100 – 2P (demand curve)

Qs = -20 + 2P (supply curve)
Equilibrium is where
Qd = Qs
100 – 2P = -20 + 2P
100 = -20 + 4P
120 = 4P
30 = P (equilibrium price)
Calculate equilibrium quantity by substituting into the

demand equation,
Qd = 100 – 2 (30) = 100 – 60 = 40
or calculate equilibrium quantity using the supply equation
Qs = -20 + 2 (30) = -20 + 60 = 40
2-12
Market Forces
P
S
A B
P1
P0
E F
P2
D
Q
Q0
A – B : Excess supply, or surplus, when price = P1

E – F : Excess demand, or shortage, when price = P2
• If excess supply exists, that is at the prevailing price

quantity supplied is greater than quantity demanded, there
is downward pressure on price.
• If excess demand exists, that is, at the prevailing price
quantity demanded is greater than quantity supplied, there
is upwards pressure on price.
2-13

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A Shift in the Demand Curve

P
S
P0
P1 D0
D1
Q1 Q0 Q
Initial equilibrium is at P0 – Q0. Suppose there is a decrease

in the level of income, or a decrease in the price of a
substitute good. Demand curve shifts from D0 to D1, and the
new equilibrium is at P1 – Q1.
2-14
A Shift in the Supply Curve

Returning to overhead 2-11, suppose there is a decrease in the labour costs such
that the supply curve shifts down to Qs = 0 + 2P.
P
Supply
50
New Supply
30
Pe New Equilibrium
10 Demand
Q
-20 0 40 Qe 100
Calculation of New Market Equilibrium

Qd = Qs
100 – 2P = 0 + 2P
100 = 4P
25 = P (new equilibrium price)
and 50 = Q (new equilibrium quantity)
2-15

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Consumer Surplus
Consumer Surplus is the difference between what a consumer
is willing to pay for a good (as shown by the demand curve)
and what they actually pay when buying it (the market price).
P
For the demand curve
35 QD = 70 - 2P
If P = 20, Q = 30 and
CS = 12 (35 - 20)(30)
20
= 12 (15)(30)
= 225
D
Q
30 70
2-16
Producer Surplus
Producer Surplus is the amount producers receive (the market
price) over and above the minimum price that would be
required to induce them to supply the good (as shown by the
supply curve).
P
For the supply curve
S QS = 0 + 1.5P
If P = 20, Q = 30 and
PS = 12 (20)(30)
20 = 300
Q
30
2-17

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Elasticity of Demand
This measures the responsiveness of quantity demanded of a

good to a change in one of the determinants of demand for
that good (assuming all other determinants remain constant).
εd =
% change in quantity demanded (Q)
% change in one of the factors (X)
Point Elasticity
ε =
∆Q
∆X
•
X
Q
Arc Elasticity (or midpoint formula)

ε
=
∆Q
(Q 2 + Q1 )/2
100 ÷
∆X
(X 2 + X 1 )/2
100
which rearranged becomes

X +X
ε =
∆Q
∆X
•
2 1
Q 2 + Q1
2-18
Own Price Elasticity

This measures the responsiveness of quantity demanded of a
particular good to a change in the price of that good (ie, its
own price).
εp =
% change in quantity demanded (Q)
% change in own price (P)
or
∆Q P2 + P1
εp =
∆P
•
Q 2 + Q1
2-19

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Own Price Elasticity of Demand - An Example
Week 1: price = $4.00, sales = 8,100 kg.

Week 2: price = $4.50, sales = 6,900 kg.
εp =
− 1,200
0.50
•
4.50 + 4.00
6,900 + 8,100
− 1,200 8.50
= •
0.50 15,000
= -1.36
This means that for a 1% increase (decrease) in price,

quantity demanded has decreased (increased) by 1.36%.
2-20
Summary of own price elasticities
εp > 1 elastic demand
εp < 1 inelastic demand
εp = ∞ perfectly elastic demand
εp = 0 perfectly inelastic demand
εp = 1 unitary elastic demand
2-21
Determinants of Price Elasticity of Demand

• Number and closeness of substitute goods
• The extent to which a good is considered to be a necessity
• The proportion of income spent on the product
• The strength of the non-functional effects
2-22

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Elasticity and a Linear Demand Curve

Price Quantity Total Revenue
(P) (Q) (TR)
10 0 0
9 1 9 elastic
8 2 16 demand
7 3 21
6 4 24
unitary
5 5 25
elasticity
4 6 24
3 7 21 inelastic
2 8 16 demand
1 9 9
0 10 0
P
10 elastic demand
Price: $8→$7
unitary elasticity Quantity: 2→3
5 inelastic
demand εp =
1
•
15
−1 5
D = -3
0 Q
5 10
TR
Price: $4→$3
Quantity: 6→7
εp = 1
•
7
−1 13
TR = -0.54
Q
5 10
2-23

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Linear Demand Curve

Effect of a Price Change on Total Revenue
P εP→ ∞
εP = 1
εP > 1
εP < 1 εP→ 0

D
Q
TR
TR
Q
Price Fall Price Rise
εP> 1 TR↑ TR↓

εP= 1 TR constant TR constant
εP< 1 TR↓ TR↑
where Total Revenue (TR) = PxQ

2-24
Elasticity of Supply
εS = % change in quantity supplied

% change in price
The elasticity of supply will be greater the longer the time

period under consideration.
2-25

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Cross Price Elasticity of Demand

(between commodities X and Y)
ε =
% change in quantity demanded of X
% change in price of Y
∆Q PY + PY
ε XY = ∆PY
X •
2
QX + QX
1
2 1
Substitutes - positive sign (ie, εXY > 0)

Complements - negative sign (ie, εXY < 0)
2-26
Cross Price Elasticity of Demand - Example 1

Month 1: price of bananas = $2.50 per kg. sales of apples = 530 kg.
Month 2: price of bananas = $3.00 per kg. sales of apples = 600 kg.
εcross = 70
0.50
•
3.00 + 2.50
600 + 530
70 5.50
= •
0.50 1130
= +0.7
This means that for a 1% increase (decrease) in the price of bananas,
the quantity of apples demanded increased (decreased) by 0.7%.
2-27
Cross Price Elasticity of Demand - Example 2

Month 1: price of gas = $1.05 per unit sales of gas stoves = 700
Month 2: price of gas = $1.20 per unit sales of gas stoves = 600
εcross = − 100
0.15
•
1.20 + 1.05
600 + 700
− 100 2.25
= •
0.15 1300
= -1.15
This means that for a 1% increase (decrease) in the price of gas, the
quantity demanded of gas stoves decreased (increased) by 1.15%.
2-28

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Some Problems with the use of Cross Elasticity of Demand in

Practice
• There is no absolute standard for judging what is a ‘high’

or a ‘low’ elasticity of demand
• Cross elasticity of demand can change over time
• Not enough cross elasticity data are available to make it
generally applicable.
2-29
Income Elasticity
εy =
% change in quantity demanded of X
% change in income
∆Q Y2 + Y1
εy= ∆Y
•
Q 2 + Q1
εy > 0 normal good (both necessity and luxury)

εy < 0 inferior good
2-30
Income Elasticity of Demand - An Example

Year 1: average weekly earnings = $300 no. of new cars demanded = 5000
Year 2: average weekly earnings = $310 no. of new cars demanded = 5140
εincome =
140
10
•
310 + 300
5140 + 5000
140 610
= •
10 10,140
= +0.84
This means that for a 1% increase (decrease) in average weekly
earnings, the quantity demanded of new cars increased (decreased)
by 0.84%.
2-31

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Summary: Own Price, Cross Price and Income

Elasticities
own price sign < 0 follows the Law of Demand

>0 only in exceptional
circumstances,
eg., conspicuous
consumption
size > 1 elastic

<1 inelastic
(Refer to determinants on
overhead 2-22)
cross price sign < 0 complements

>0 substitutes
size measures the degree of

complementarity or
substitutability
income sign < 0 inferior good

>0 normal good
size For a normal good this

determines its position in the
spectrum of necessity through
to luxury.
2-32

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PRICES AND MARKETS
Topic 3 : Applications of Demand and Supply
Price Controls
• price ceiling
• price floor
Deadweight Loss
Taxes on Consumers and Producers
3-overview
“A price ceiling is the maximum legal price a seller may

charge for a product or service.”
(Jackson page 168)
P
S
Pe
price
Pc
ceiling
QS Q
Qe QD
where PC is the maximum legal price
3-1
Price Ceiling
• why impose a price ceiling?
• who gains and who is disadvantaged?
• circumventing the scheme
• black markets
• rationing
3-2

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Price floors “are minimum prices fixed by government that

are above equilibrium prices.”
(Jackson page 170)
P
S
price
Pf
floor
Pe
Q
QD Qe QS
where Pf is the minimum legal price

3-3
Price Floor
• why impose a price floor?
• who gains and who is disadvantaged?
• circumventing the scheme
• government measures to support the outcome
3-4
W Minimum Wage
SL
minimum
Wm
wage
We
DL
L
LD Le LS
where Wm is the minimum wage rate and LS – LD is the

resulting excess supply of labour, or unemployment
3-5

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Effect of Price Ceiling on Consumer and Producer Surplus

P
Supply
A
Pe B
C E
Pc Pc
F
Demand
Q0 Qe Q
Original: Consumer Surplus = areas A and B

Producer Surplus = areas C, E and F
After introduction of Price Ceiling
Consumer Surplus = areas A and C
Producer Surplus = area F
Deadweight Loss = areas B and E
where deadweight loss is net loss in total surplus
(ie, combined consumer and producer surplus)
3-6
Effect of Price Floor on Consumer and Producer Surplus

P
Supply
A
Pf Pf
Pe C B
E
F
Demand
Q
Q0 Qe
Original: Consumer Surplus = areas A, B and C
Producer Surplus = areas E and F
After introduction of Price Floor
Consumer Surplus = area A
Producer Surplus = areas C and F
Deadweight Loss = areas B and E
3-7

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Consumer and Producer Surplus, and a Price Ceiling
Using the demand and supply curves from overheads 2-16

and 2-17, ie. QD = 70 - 2P and QS = 0 + 1.5P. Impose a price
ceiling of $10 and consider the effect on the consumer
surplus and the producer surplus.
Supply
35
A
27.5
B
C
20
D E
Price
10
F Ceiling
Demand
Q
15 30 70
3-8

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A unit tax imposed on the producer will shift the supply

curve upwards.
P
S1
S0
P1 TAX
P0
Q
Q0
3-9
Effect of Imposing Tax on Producer
P
S1
A B S0
PM tax
Pc E1
P0 C E0
Pp F
D
Q1 Q
Q0
where P0Q0 original market equilibrium

PcQ1 market equilibrium after imposition of tax
PcE1CP0 consumers’ share of tax burden
P0CFPp producers’ share of tax burden
3-10

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Case 1
P
S1
A TAX S0
Pc
Pe
B
Pp
C
D
Q
Q1 Qe
Where S0 is the original supply curve
S1 is the supply curve after the imposition of the tax
Pe is the equilibrium price, prior to the tax
Pc is the price paid by consumers after the
imposition of the tax
Pp is the amount per unit received by the producers
after payment of the tax
ABC deadweight loss
3-11
Case 2
S1
TAX
S0
A
Pc
Pe B
D
Pp
C
Q
Q1 Qe
Summary - Burden of the Tax
The share of the tax burden between producers and consumers is
determined by the elasticities of demand and supply.
Inelastic Elastic
Demand → consumer → producer
Supply → producer → consumer
3-12

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Extreme Cases for Demand Elasticity

Perfectly Inelastic Demand – burden falls on consumer
P D
S1
S0
P1 B TAX
P0 A
Q
Q0
Perfectly Elastic Demand – burden falls on producer
P
S1
S0
TAX
P0 B
A D
Q
Q1 Q0
3-13
Extreme Cases for Supply Elasticity
Perfectly Elastic Supply – burden falls on consumer
P
P1 B
S1 = P0 + T
TAX A
P0 S0
D
Q0 Q
Q1
Perfectly Inelastic Supply – burden falls on producer
P S
P0 A
P2
D
Q
Q0
3-14

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A Tax on the Consumer
A unit tax imposed on the consumer will shift the demand

curve (faced by the producer) downwards.
P0
TAX
P1
D0
D1
Q
Q0
After the imposition of the tax, for consumers to demand Q0
units of the good, the price (not including tax) would need to
be P1, so that the total cost to the consumer remained at P0
per unit.
3-15
Effect of Imposing Tax on Consumer

P
Pc
Pe
Pp
TAX
D0
D1
Q
Q1 Qe
Where D0 is the original demand curve

D1 is the demand curve after the imposition of the
tax
Pc is the price paid by consumers (including tax)
Pp is the amount per unit received by the
producers
3-16

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Tax on Consumer v. Tax on Producer
S1
S0
A
Pc
Pe
Pp
B
D0
D1
Q
Q1 Qe
The relative tax burden is unaffected by whether it is imposed

on the producer or the consumer.
D0 (S0) is the original demand (supply) curve

D1 (S1) is the demand (supply) curve after the
imposition of the tax
AB is the amount of the tax
Pc is the price paid by consumers (including tax)
Pp is the amount per unit received by the
producers
3-17

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PRICES AND MARKETS
Topic 4: Production and Costs
Production and Costs

• the firm
• opportunity cost, accounting and economic profit
• short run output and the law of diminishing returns
• short run costs
• relationship between short run production and costs
• long run average cost curve
• economies and diseconomies of scale
4-overview
The Firm
A firm is an organisation that employs factors of production
to produce or provide goods and/or services.
There are different types of business enterprises:
eg. sole proprietorship
partnership
company
4-1
Scarcity and Choice

unlimited wants
+
scarce resources
↓
need for choice
How do we evaluate whether the chosen allocation of

resources is efficient?
4-2

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Definition of Opportunity Cost
The opportunity cost of using something in a particular

venture or activity is the benefit foregone, or opportunity lost,
by not using it in its best alternative use.
Real Opportunity Cost :

the maximum quantity of output the inputs required to
produce a good or service could have produced in their next
best alternative use.
Money Opportunity Cost :

the maximum value which a particular input could realise in
its next best alternative use.
4-3
Costs
Explicit costs:
explicit payments for hiring or purchasing resources used by
the firm, eg. wages, rent, cost of raw materials.
Implicit costs:
opportunity cost of resources owned and used by the firm but
not explicitly paid for by the firm as costs, eg. the opportunity
cost of the proprietor’s labour.
4-4
Profit
Accounting Profit
= total revenue - total explicit costs
Economic Profit
= total revenue - opportunity costs of all the resources used
by the firm
= total revenue - (total explicit costs + total implicit costs)
Normal profit is earned when economic profit is equal to
zero, or normal profit = zero economic profit
4-5

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Example: Suppose an individual runs their own business

with the following revenue and costs for the year:
Sales Revenue: $800,000
Cost of Materials,
Rent and Labour: $750,000
Accounting Profit: $50,000
Salary Foregone:
Economic Profit:
4-6
Short Run v. Long Run

Short Run: period in which the quantity of at least one input is fixed.
Typically there are fixed and variable factors of production.
Long Run: period in which all factors of production are variable.

4-7
Short Run Production

Assume only one variable input which is labour (L).
Total Product or Output is denoted by either TP or Q.
Q
average product of labour : APL =
L
∆Q
marginal product of labour : MPL =
∆L
where ∆ represents “the change in”
4-8
Example: Pat has started up a document preparation service for lecturers. She has
leased office space, two computers and a photocopier. The duration of the lease is one
year (fixed factor). In addition to herself, Pat will be using casual labour and can vary
the labour units on a daily basis (variable factor). (Note: To keep the example simple,
we will ignore any other costs.) The tasks involved are to type, proofread, and
photocopy documents, answer the phone and deal with the lecturers directly. On a
weekly basis, Pat working on her own (ie, L = 1 or 1 labour unit, which could equal 40
hours) can prepare 200 documents (or Q = 2, where output is measured in hundreds of
documents). Increasing the labour units to two means that one person can focus on the
typing of the documents (uninterrupted) and output increases to 700 documents. The
effect on output, as further units of labour are added, is shown in the following table.
4-9

lOMoARcPSD|3607735
Short Run Production – Calculations

L Q APL MPL
0 0
1 2 2.0 (12 ) 2.0 (12 )
2 7 3.5 (72 ) 5.0 (15 )
3 15 5.0 (153 ) 8.0 (81 )
4 19 4.8 4.0
5 20 4.0 1.0
6 18 3.0 -2.0
4-10
Short Run Production Curves

output C
TP
A
B
AP
labour
0 L1 L2 L3
MP
Law of Diminishing Returns
“as successive units of a variable resource (say, labour) are
added to a fixed resource (say, capital), beyond some point
the extra, or marginal, product attributable to each additional
unit of the variable resource will decline.”
(Jackson page 240)
4-11

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output Relationship between MP and AP
AP
MP
L
L2
An illustration with exam marks
mark 1 mark 2 mark 3 mark 4 Average Mark
58 59 63 60
58 59 63 68 62
58 59 63 52 58
58 59 63 60 60
4-12
Costs of the Firm in the Short Run

total fixed cost (TFC): associated with the fixed factor(s) of production
total variable cost (TVC): associated with the variable factor(s) of production
total cost (TC) = TFC + TVC
4-13
Variable Costs - Assume PL = 10

L Q TVC AVC MC
0 0 0
 10 
1 2 10 5.00 5.00   where
2
 10  total variable cost
2 7 20 2.86 2.00   TVC = LxPL
5
 10  average variable cost
3 15 30 2.00 1.25  
8 TVC
AVC =
 10  Q
4 19 40 2.11 2.50  
4 marginal cost
TVC
 10  MC =
5 20 50 2.50 10.00   Q
1
4-14

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Fixed Costs
TFC
Q TFC AFC where average fixed cost (AFC) =
Q
0 20 $
2 20 10.00
7 20 2.86
15 20 1.33
19 20 1.05
20 20 1.00 AFC
Q
4-15
Calculation of Costs
L Q TVC TFC TC AVC AFC ATC MC
0 0 0 20 20
 10 
1 2 10 20 30 5.00 10.00 15.00 5.00  
2
 10 
2 7 20 20 40 2.86 2.86 5.71 2.00  
5
 10 
3 15 30 20 50 2.00 1.33 3.33 1.25  
8
 10 
4 19 40 20 60 2.11 1.05 3.16 2.50  
4
 10 
5 20 50 20 70 2.50 1.00 3.50 10.00  
1
where: average total cost (ATC), or average cost (AC)

TC (TFC + TVC)
= = = AFC + AVC
Q Q
∆TC ∆TVC
marginal cost (MC) = =
∆Q ∆Q
4-16

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Graphing the Total Cost Curves

$ TC
TVC
TFC
Q
where TC = TVC + TFC
4-17
Graphing the Average and Marginal Curves

$
MC
ATC
AVC
B
A
C
Q
Q1 Q2
Note: Since ATC = AVC + AFC, the vertical distance

between ATC and AVC represents AFC.
4-18

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Relationship between Production and Costs

L Q APL AVC MPL MC
0 0
1 2 2.0 5.00 2.0 5.00
2 7 3.5 2.86 5.0 2.00
3 15 5.0 2.00 8.0 1.25
4 19 4.8 2.11 4.0 2.50
5 20 4.0 2.50 1.0 10.00
Notice that when AP ↑ ( ↓ ), AVC ↓ ( ↑ )

and when MP ↑ ( ↓ ), MC ↓ ( ↑ )
This can also be shown by the following:
Q TVC L
PL • L
APL = AVC = = = PL  
L Q Q Q
∆Q ∆TVC P • ∆L  ∆L 
MPL = MC = = L = PL  
∆L ∆Q ∆Q  ∆Q 
4-19
Long Run Average Cost (LRAC) Curve

$
LRAC
Q
Q1 Q2
There are economies of scale up to Q1, and diseconomies of
scale for output larger than Q2. The horizontal section of the
curve between Q1 and Q2 reflects constant returns to scale.
Q1 is the minimum efficient scale.
Economies (diseconomies) of scale are where average, or per
unit, cost decreases (increases) as the level of output
increases.
Minimum Efficient Scale (MES) is the smallest level of
output at which a firm can minimise long run average costs
(ie, at output Q1).
4-20

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Economies and Diseconomies of Scale

These could originate from technical, production,
management or money related factors. Some examples are
given below:
Economies:
• labour specialisation
• managerial specialisation
• efficient capital
• bulk buying
• supporting facilities
Diseconomies:
• over-specialisation of labour
• managerial problems
• access to materials
• access to skilled labour
4-21
Alternative Shapes
$ Economies Diseconomies typical depiction
of the long run
average cost
LRAC curve.
Q
Q1
$
LRAC limited economies
available before
diseconomies set in
– consistent with
monopolistic
Q competition
Q1
$
LRAC
extensive economies
available before
diseconomies set in
– consistent with
oligopoly and
monopoly
Q
Q1
4-22

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Relationship between LRAC and short run ATC

$
SRATC1
SRATC2 SRATC4
CA1 SRATC3
CA2
Q
QA
Plant 2 can produce QA more cheaply than can Plant 1 (CA2 is

less and CA1). So, in the long run, Plant 2 would be chosen
ahead of Plant 1 if this were the desired output.
The “outer envelope” of the short run ATC curves forms the
LRAC curve.
4-23
Long Run Average Cost

Assuming a virtually unlimited number of plant sizes, the
LRAC curve takes on a smoother shape.
$
LRAC
Q
4-24

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PRICES AND MARKETS
Topic 5: Perfect Competition
Perfect Competition
• market structure and revenue
• rules for profit maximisation
• characteristics of Pure and Perfect Competition
• short run profit maximisation by the firm
• short run supply curves of the firm and the market
• long run equilibrium of the firm
• long run adjustment
• assessment
5-overview
Market Structure
One classification:
• Perfect competition
• Monopoly
• Monopolistic competition
• Oligopoly
Another classification:
• Price takers
• Price makers
5-1
Demand curve faced by a perfectly competitive firm:

P
0 Q
Demand curve faced by a firm that is a price maker (ie, under
monopolistic competition, oligopoly, or monopoly):
P
0 Q
5-2

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Revenue
Total Revenue (TR) = P x Q
TR PxQ
Average Revenue (AR) = = = P
Q Q
Marginal Revenue (MR) is the change in total revenue as

output changes by one unit.
∆TR
MR =
∆Q
5-3
Example for Perfect Competition (Price Taker)

Assume that the selling price of a unit of the good is $5.
Q TR AR MR
0 0
1 5 5 5
2 10 5 5
3 15 5 5
4 20 5 5
$5 D = P = AR = MR
5-4

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Rules for Profit Maximisation
MR = MC
P
MC
g
a MR
h
b
Q
Short Run: P ≥ AVC

Long Run P ≥ ATC
(Note: At the output at which MR = MC, marginal cost must

be cutting marginal revenue from below.)
5-5
Characteristics of Pure Competition

• low concentration
• homogeneous product
• low barriers to entry
Characteristics of Perfect Competition

• low concentration
• homogeneous product
• low barriers to entry
• perfect knowledge of market conditions
• perfect mobility of factors of production
5-6

lOMoARcPSD|3607735
Demand Curve facing a Firm

P P
PE D = MR
Q q
Market Firm
5-7
Short Run Profit Maximisation

P
MC
ATC
AVC
P4 A D4 = MR4
C4 B
Q
Q4
5-8
Short Run Loss Minimisation

P
MC
ATC
AVC
C2 B
P2 D2 = MR2
A
CV2
F
P0 D0 = MR0
Q
Q0 Q2
5-9

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Profit Maximising Outcomes Summarised

P
MC ATC
AVC
P3 D3 = MR3
P1 D1 = MR1
Q
Q1 Q3
When MR = MC at price:
above P3 firm is maximising profit
P3 firm is at break-even point
between P3 and P1 firm is minimising loss
P1 firm is at shut-down point
below P1 firm should not produce
5-10
Numeric Example 1
Using cost curves from Jackson pages 274 and 276,
and P = MR = $110
TP TVC TC AVC ATC MC TR TPrft
0 0 100 0 -100
1 90 190 90.0 190.0 90 110 -80
2 170 270 85.0 135.0 80 220 -50
3 240 340 80.0 113.3 70 330 -10
4 300 400 75.0 100.0 60 440 40
5 370 470 74.0 94.0 70 550 80
6 450 550 75.0 91.7 80 660 110
7 540 640 77.1 91.4 90 770 130
8 650 750 81.3 93.8 110 880 130
9 780 880 86.7 97.8 130 990 110
10 930 1030 93.0 103.0 150 1100 70
5-11

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Numeric Example 2
Using cost curves from Jackson pages 274 and 276,
and P = MR = $80
TP TVC TC AVC ATC MC TR TPrft

0 0 100 0 -100
1 90 190 90.0 190.0 90 80 -110
2 170 270 85.0 135.0 80 160 -110
3 240 340 80.0 113.3 70 240 -100
4 300 400 75.0 100.0 60 320 -80
5 370 470 74.0 94.0 70 400 -70
6 450 550 75.0 91.7 80 480 -70
7 540 640 77.1 91.4 90 560 -80
8 650 750 81.3 93.8 110 640 -110
9 780 880 86.7 97.8 130 720 -160
10 930 1030 93.0 103.0 150 800 -230
Question: What would be the optimal output if price

increased to $83?
5-12
Firm’s Short-Run Supply Curve
P
MC
B
P3
AVC
P2
P1 A
P0
Q
Q1 Q2 Q3
The firm’s short run supply curve is the marginal cost
curve above AVC.
The short run market supply curve is derived from the
horizontal summation of the individual firms’ supply curves.
5-13

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Long Run Equilibrium

P
MC
ATC
PE D = MR
E
Q
QE
At the long run equilibrium, point E,
the firm is earning zero economic profit.
P = MR = MC = ATC
5-14
Efficiency Measures
At this long run equilibrium, point E, the firm achieves:
Productive Efficiency: minimum AC
and
Allocative Efficiency: P = MC
Note: When P > MC under-allocation

and P < MC over-allocation
of resources to this product, from society’s viewpoint.
5-15
Long Run Adjustment

P P
MC
ATC S1
b B
P2
P1 a A
D2
D1
q Q
q1 q2 Q1 Q2
FIRM MARKET
Initially the market is in equilibrium at point “A” (intersection of D1 and S1) and
the firm at point “a”. Suppose then that the demand curve shifts up to D2.
5-16

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Long Run Adjustment - continued

P P
MC
ATC
S1
S2
b B
P2
P1 a C
A
D2
D1
q Q
q1 q2 Q1 Q2 Q3
FIRM MARKET
As a result of above normal profits and low barriers to entry,

new firms are attracted into the market. The supply curve
shifts out to S2 and the price moves back down to P1.
The firm's output falls back to q1.
5-17
Long Run Adjustment – Fall in Demand

P P
MC
ATC
S4
1st
S1
2nd
P1 C A
a 1st 2nd
P4
b B
D1
1st D4
2nd 2nd 1st
q Q
q4 q1 Q5 Q4 Q1
FIRM MARKET
Demand curve shifts down to D4. Price falls to P4. As a
result of below normal profits, some firms exit the market.
The supply curve contracts back up to S4 and the price moves
back up to P1. The firm's output increases back up to q1.
5-18

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Assessment of Perfect Competition
Merits
(1) Most efficient in allocating resources to maximise consumer welfare.
• productive efficiency: min AC
• allocative efficiency: P = MC
• maximum consumer surplus
• speed of resource reallocation
(2) Political Appeal: no power groups
Criticisms
(1) Little financial resources for research and development
(2) Less product variety than under monopolistic competition or oligopoly
5-19
Consumer Surplus in a Competitive Market

P
A
S
B
Pc
Q
Qc
5-20

lOMoARcPSD|3607735
PRICES AND MARKETS
Topic 6 : Monopoly
Monopoly
• market structure and revenue
• rules for profit maximisation
• characteristics of monopoly
• barriers to entry
• natural monopoly
• price, output and profit maximising behaviour
• comparison with perfect competition and assessment
• regulation of monopolies
• price discrimination
6-overview
Demand curve faced by a perfectly competitive firm:

P
0 Q
Demand curve faced by a firm that is a price maker (ie, under

monopolistic competition, oligopoly, or monopoly):
0 Q
6-1

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Revenue
Total Revenue (TR) = P x Q
TR PxQ
Average Revenue (AR) = = = P
Q Q
Marginal Revenue (MR) is the change in total revenue as

output changes by one unit.
∆TR
MR =
∆Q
6-2
Example - Demand curve faced by a firm that is a price

maker (ie, under monopolistic competition, oligopoly or
monopoly).
Assume QD = 5 - 0.5P
Q P TR AR MR
0 10 0
1 8 8 8 8
2 6 12 6 4
3 4 12 4 0
4 2 8 2 -4
5 0 0 0 -8
10 P > MR
D = AR
MR
Q
2.5 5
6-3

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Marginal Revenue and the

Downward Sloping Demand Curve
P
slope = -b
Demand Curve
slope = -2b
Marginal Revenue
Q
A B C
where AB = BC
The Marginal Revenue line is twice as steep as the
Demand Curve.
You need to be able to remember this fact and use it, but you
are not required to be able to prove it. The following is for
those interested in the proof.
Demand Curve : P = a -bQ
TR = PQ = (a - bQ)Q = aQ - bQ2
MR = dTR/dQ = a - 2bQ
6-4
Rules for Profit Maximisation

MR = MC
Short Run: P ≥ AVC
Long Run P ≥ ATC
(Note: At the output at which MR = MC, marginal cost must
be cutting marginal revenue from below.)
P
G MC
A
F
B MR
Q* Q
Q1 Q2
6-5

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Output Range
A monopolist (or any other price maker) will not produce an
output corresponding to the inelastic range of a linear
downward sloping demand curve.
P
Elastic
Unit Elastic
Inelastic
D Q
$ MR
TR
Q
Q1
6-6
Characteristics of Monopoly
(1) high concentration (single seller)
(2) high barriers to entry
• economies of scale
• ownership of raw materials
• patents
• licensing regulations
6-7
$ Economies of Scale
C1
LRAC
C2
Q
0 Q1 Q2
Where economies of scale are substantial and demand is

limited, this may result in a natural monopoly.
(ie, The market is too small for two firms.)
6-8

lOMoARcPSD|3607735
$
MC
P1 A
ATC
C1 B
MR
Q
0 Q1
MR = MC at output Q1, where

Total Profit = P1ABC1
ie, Total Rev (P1AQ10) - Total Cost (C1BQ10)
6-9
$
ATC
MC
AVC
C2 B
P2
A
V2
E
D
MR
Q
0 Q2
MR = MC at Q2 where Total Loss = C2BAP2

ie, Total Rev (P2AQ20) - Total Cost (C2BQ20)
However, Total Revenue exceeds Total Variable Cost
(V2EQ20) by the amount P2AEV2.
6-10

lOMoARcPSD|3607735
Numeric Example 1
P Q TC TVC AVC MC TR MR
500 0 100 0 0
450 1 340 240 240.0 240 450 450
400 2 560 460 230.0 220 800 350
350 3 810 710 236.7 250 1050 250
300 4 1110 1010 252.5 300 1200 150
250 5 1480 1380 276.0 370 1250 50
200 6 1940 1840 306.7 460 1200 -50
150 7 2510 2410 344.3 570 1050 -150
100 8 3210 3110 388.8 700 800 -250
6-11
Numeric Example 2
P Q TC TVC AVC MC TR MR
100 0 300 0
90 10 550 250 25.0 25 900 90
80 20 750 450 22.5 20 1600 70
70 30 970 670 22.3 22 2100 50
60 40 1250 950 23.8 28 2400 30
50 50 1550 1250 25.0 30 2500 10
40 60 2010 1710 28.5 46 2400 -10
30 70 2660 2360 33.7 65 2100 -30
20 80 3540 3240 40.5 88 1600 -50
6-12
Assessment of Monopoly
(1) Price, output and resource allocation – comparison
with perfect competition. (see Cases A and B)
(2) Income distribution – Monopoly profits tend to
concentrate in higher income groups.
(3) Technological progress: dynamic efficiency.
Monopolists have more financial resources than
perfectly competitive firms for technological
advancement. But monopolists' incentives for such
advancement may or may not be strong.
6-13

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Comparison with perfect competition – Case A

$
MC AC
A
PM
PC E
D
B
MR
Q
QM QC
Assumption: MC (the monopolist's marginal cost curve) is
identical to the supply curve of the perfectly competitive market.
Outcomes – Perfect Competition to Monopoly:
• price higher (PM above PC)
• output lower (QM less than QC)
• consumer surplus decreased by PMAEPC
• deadweight loss of AEB
(ie, loss of satisfaction QMAEQC – resources saved QMBEQC)
• neither allocative nor productive efficiency achieved
6-14
Comparison with perfect competition – Case B

$ MC1
PM1 MC2
E1
PC E2
PM2 AC2
MR
Q
QM QC QM2
Assumptions: (1) MC1 is identical to supply curve of
perfectly competitive market; (2) AC2 and MC2 reflect
economies of scale of the monopolist.
Outcomes – Perfect Competition to Monopoly:
- price lower (PM2 below PC)
- output higher (QM2 greater than QC)
- consumer surplus increased by PCE1E2PM2
- still neither allocative nor productive efficiency achieved
6-15

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Government Regulation and Intervention

- competition policy
- encourage new entrants
- legal action
- imposition of price ceiling
6-16
Monopoly Regulation – Price Ceiling (Case 1)

$
MC
AC
A
PM
E
PC
PT T
B D
MR
Q
QM QC
Price ceiling set at PC.
Now for monopolist, MR = MC at QC.
Consumer surplus is increased by PMAEPC.
Allocative efficiency is achieved.
Deadweight loss of AEB is eliminated.
Monopolist still earns a profit of PCETPT.
6-17
Monopoly Regulation – Price Ceiling (Case 2)

$
PM
A B AC
PC MC
E D
MR
Q
0 QM QC
Two-part pricing
(a) price equal to MC
(b) fixed fee such that the loss (BE)x(0QC) will be covered
6-18

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Price Discrimination
Price discrimination is selling the same product to different
buyers at different prices, not because of difference in cost.
Conditions making price discrimination possible:
(1) markets (or sub-markets) separate, and resale not
possible
(2) different elasticities of demand in different markets
(or sub-markets)
(3) monopoly control
6-19
Third Degree Price Discrimination

$
P1
P2
MC = ATC
D2
D1 MR1 MR2
Q
Q1 0 Q2
Assumption: MC constant and equal to ATC
In Market 1, profit maximising price and output are P1 and
Q1. In Market 2, they are P2 and Q2.
6-20

lOMoARcPSD|3607735
PRICES AND MARKETS
Topic 7 : Monopolistic Competition and Oligopoly

Monopolistic Competition and Oligopoly
Characteristics of monopolistic competition
Short run profit maximisation
Long run equilibrium
Assessment of monopolistic competition
Product Differentiation and Advertising
Characteristics of oligopoly
Game theory
Four models of oligopoly
- kinked demand curve
- price leadership
- collusive pricing
- cost-plus pricing
Non-price competition
Assessment of oligopoly
7-overview
Characteristics of Monopolistic Competition

(1) low concentration
• many firms with small market share
• no collusion and firms not interdependent
(Refer to concentration data in Figure 12.1 in Jackson, page 349)
(2) differentiated products
• demand for an individual firm’s product is not
perfectly elastic
(3) non-price competition
eg, quality, advertising, packaging
(4) low barriers to entry
7-1

$
MC
ATC
A
P1
C1 B D
MR
Q
Q1
MR = MC at output Q1 and price P1
Total Profit = P1ABC1
7-2

lOMoARcPSD|3607735

$
MC
ATC
AVC
B
C2
P2 A
V2
D
MR
Q
Q2
MR = MC at Q2 and P2 Total Loss = C2BAP2
P (= P2) > AVC (= V2), so short run production worthwhile.
7-3
Long Run Equilibrium

$
MC
AC
E
PE
MR
Q
QE
Low barriers to entry mean that it is easy for new firms to
enter the market, when attracted by positive economic profits.
Long run equilibrium occurs when economic profit is zero.
There is no further incentive for new firms to enter, nor for
existing firms to exit.
7-4
Assessment of Monopolistic Competition

Compare with perfect competition
- price - higher
- output - lower
- allocative efficiency - not achieved
- productive efficiency - not achieved
Excess Capacity v. Variety
7-5

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Assessment Diagram
$
MC
AC
P1 E1
E2
P2 D2 = MR2
D1
MR1
Q
Q1 Q2
Long Run Equilibrium: For purpose of comparison,
assume same LRAC under the two market structures.
Monopolistic Competition: P1-Q1 (point E1)
Perfect Competition: P2-Q2 (point E2)
7-6
Product Differentiation
Real and/or perceived differences created by factors such as
quality, advertising, packaging, service and location.
Advantages
• variety - provides choice
• leads to innovation, and product development
Disadvantages
• too much choice → confusion
• superficial product changes rather than real
7-7
Advertising
Firm
Advantages
• influences consumer preferences
(increased market share and size of market)
• reduces substitutability
• increases market power
Disadvantages
• increases cost of production
Society
Advantages
• provides information
• promotes competition
• supports national communication
Disadvantages
• persuasive advertising → waste of resources
• promotes market power
• media bias
7-8

lOMoARcPSD|3607735
Characteristics of Oligopoly
(1) high concentration
• small number of large firms
(Refer to concentration data in Figure 13.1 in Jackson, page 367.)
(2) mutual interdependence
(3) standardised or differentiated products
(4) high barriers to entry
eg, economies of scale, high set up costs, patents,
control of raw materials and heavy advertising
expenditure
(5) non-price competition
(6) competition or collusion
7-9
Game theory provides a framework for analysing the

strategies that oligopolists may choose, based on assumptions
made about their rivals’ behaviour. It can be used to explain
both competitive and collusive behaviour.
7-10
Duopoly Game – Payoff Matrix

SPIN
P = $1000 P = $1500
SPLASH 14 10
P = $1000 14 25
25 20
P = $1500 10 20
Assume two washing machine manufacturers in the market –

Splash and Spin.
Assume two possible pricing strategies - $1000 or $1500.
Payoffs – outcomes for the two firms for each combination of
strategies – assume these figures represent profit in $m.
MAXIMIN - firms maximise the minimum expected
payoff
7-11

lOMoARcPSD|3607735
Duopoly Game – Example 2

FIZZ
Advertise Not Advert
SPARKLE Advertise 6 7
22 20
7 8
Not Advert 15
14
Assume only two soft drink firms in the market.

They each need to decide whether or not to advertise in the
next time period.
Benefits of advertising are attracting new customers
(increasing total size of market), increasing market share
and brand loyalty.
However advertising adds to the cost of
producing the good.
7-12
Oligopoly: Some Models of Price-Output Behaviour

Diversity and Mutual Interdependence
→ no single model of oligopoly
Models
• kinked demand curve
• price leadership
• collusive pricing
• cost-plus pricing
Possible Outcomes
• inflexible prices
• firms changing price together
7-13

lOMoARcPSD|3607735
Deriving the Kinked Demand Curve

$
PA
P0
D2
D1
Q
QA2 QA1 Q0
D1: assume that if this firm changes price, its competitors will
do likewise (ie, react)
D2: assume that if this firm changes price, its competitors will
not follow (ie, no reaction)
7-14
The Kinked Demand Curve Model

$
MC
A
B
P0
C1
C2 D
Q
Q0
MR
Assumption: Other firms will follow price cut,

but not price rise.
7-15

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The Price Leadership Model

Typically a “dominant” firm starts price changes, which are
then followed by other firms.
• dominant - oldest, largest, most respected, or most
efficient
• no collusion
• price changes infrequent
• intended price changes signalled
7-16
Collusion
“Collusion occurs when firms in an industry reach an overt
(open) or covert (secret) agreement to fix prices, divide up or
share the market, or in other ways restrict competition among
themselves.” Jackson pages 375-6
Incentive to collude:
• remove uncertainty
• avoid price war
• increase profits
• hinder new entrants
7-17
Cartel (Explicit Collusion)
“Groups of firms that agree either formally or informally to

set prices and output levels of particular products among
members.” Jackson page 377
• control of price and output

• share of output
• incentive to cheat
7-18

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Difficulties for Collusion

• different costs
• differentiated products
• number of firms
• cheating
• recession
• legal obstacles
7-19
Cost-Plus Pricing
Cost-plus pricing, also known as mark-up pricing, involves a
simple formula:
P = unit cost (1 + x%)
Cost-plus pricing is not inconsistent with explicit collusion or
price leadership.
7-20
Non-Price Competition
• common under oligopoly - slower to match than price changes
• importance of quality
• advertising for differentiated products and standardised
products (goodwill)
7-21
Assessment of Oligopoly
Negatives
• efficiency - allocative and productive
• collusion
Positives
• economies of scale
• innovation
7-22

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PRICES AND MARKETS
Topic 8 : Market Failure
Market Failure
• Sources: externalities
public goods and services
“other”
• Solutions: government intervention - taxes, subsidies, legislation,
government provision of goods and services
8-overview
Generally, competition promotes efficiency and maximises

consumer welfare. Hence economists generally advocate
competition. But competition, working through the market,
does not always deliver socially optimal results. This is due
to market failure.
8-1
Shortcomings of the Market

Five problem areas
(1) externalities
(2) public goods and services
(3) information
(4) monopolies
(5) non-market goals
8-2
Externalities
• costs or benefits that fall on third parties, without their
consent and without working through the market
mechanism
• also known as external costs or external benefits,
spillovers, and external economies or external
diseconomies
Cost examples: smoke from a factory causing damage to
nearby residents and property, pollution from cars
Benefit examples: keeping a beautiful garden, keeping good
health, education, car maintenance
8-3

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External Costs or Diseconomies

P
Sa
f
c S
P0
Pe b
a
D
Q
Q0 Qe
S supply according to marginal private costs
Sa supply according to marginal social costs
Pe,Qe equilibrium price and output
P0,Q0 socially optimal price and output
cbf society’s loss due to external costs
8-4
Policy Implications of External Costs

• internalise
(by banning activity generating external diseconomy)
• levy tax
• create property rights
8-5
External Benefits or Economies

P
k
S
P0 h
Pe
g
Da
j
D
Q
Qe Q0
D demand according to marginal private benefit
Da demand according to marginal social benefit
Pe,Qe equilibrium output
P0,Q0 socially optimal output
gkh society’s loss due to missed opportunities
8-6

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Policy Implications of External Benefits

• government production
• subsidise buyers
• subsidise producers
• create property rights
8-7
Public Goods
Characteristics:
• joint consumption (or non-rivalry)
An extra consumer can enjoy consumption of a good without
creating cost or reducing anyone else’s benefit. Typically the
good or service is large and “indivisible”.
• exclusion principle not applicable
Once the good or service is provided, individuals cannot be
excluded from consuming it.
Examples:
lighthouse, defence, the legal system, environmental
protection
8-8
Free Rider Problem

Since consumers cannot be excluded from consuming the
good or service, then they are able to receive the benefits
without contributing directly to its cost. This is known as the
free rider problem.
If left to itself, the market will not provide public goods,
except where the provision can be financed by income from
advertising.
8-9

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Quasi-Public Goods
Characteristics:
• joint consumption up to the level of capacity
• exclusion principle is applicable
These goods and services can be provided through the market
system. However, where there are substantial spillover
benefits, the government may become involved in the
provision.
Examples:
education, streets and highways, police and fire protection,
museums and libraries
8-10
Information
Where there is a lack of perfect or complete information, and
the outcome of this can have serious consequences for the
consumer, there is a case for government intervention.
Examples
• houses
• cars
• pharmaceuticals
8-11
Monopolies
As we saw in Topic 6, monopolies usually cause inefficient
allocation of resources if they are not appropriately regulated.
8-12
Non-Market Goals
Some goals considered desirable by society may not be
achieved by pure market forces, such as universal education
up to a certain age, a “fair” distribution of income, protection
of the disadvantaged. Also, some goods could be harmful.
Hence some government intervention is necessary.
8-13

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Prices and markets (RMIT)

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PRICES AND MARKETS

“Economics is concerned with the efficient use of limited

Macroeconomics deals with this problem at the aggregate

Why is the study of economics important?

• to provide a basic understanding of the economic aspects

• to place business managers in a better position to

• to provide individuals with knowledge to assist in a

Jackson pages 4-5

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Users of the Market Concept

The Australian Competition and Consumer Commission

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Elements of Demand Substitutability

• The Product Level

• The Geographic Dimension

• The Functional Level

Elements of Supply Substitutability

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QE - CE: output and unit cost for existing firms in the

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Selling side of Market

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For example: price setting

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PRICES AND MARKETS

Topic 2 : Demand, Supply and Elasticity

Derivation of a Demand Curve

Prices and Markets: lecture overheads vm081 1

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Linear Demand Function:

Prices and Markets: lecture overheads vm081 2

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Shift in the Demand Curve

Different Concepts of Demand

• individual’s demand for the commodity

Derivation of the Market Demand Curve

Individual A’s Individual B’s Market Demand Curve

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Factors that determine the shape of the demand curve

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Market equilibrium is achieved at the price where quantity

Using Qd = 100 - 2P (demand curve, from 2-3)

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Calculation of Market Equilibrium

Qd = 100 – 2P (demand curve)

Calculate equilibrium quantity by substituting into the

A – B : Excess supply, or surplus, when price = P1

• If excess supply exists, that is at the prevailing price

Prices and Markets: lecture overheads vm081 6