Introduction to Applied Economics
- Scarcity: a condition where there are insufficient
What is Economics?
- study on how societies choose to use scarce
productive resources that have alternative uses ,
to produce commodities of various kinds, and to
distribute them among different groups
(Samuelson and Nordhaus)
- study of how individuals and society in general
make choices that involve the use of scarce
resources from among alternative wants that
need to be satisfied (Sicat)
- is a social science that studies the optimum
allocation, over time, of scarce human and non-
human resources among their alternative uses
in order to satisfy unlimited human wants and
needs (Villegas)
- is a study of how society allocates scarce
resources to satisfy unlimited human wants and
needs
Definition and keywords:
- comes from the Greek word “OIKONOMIA”
which means management of the household
- is a study of wealth
- Use of wealth for production and
consumption
- is a study of making choices
• Opportunity cost: best forgone
alternative use of a resource
- is as a study of allocation
• Allocation of scarce resources to answer
unlimited human wants
Economics is…
- Is a social science because its central subject is
man and how he interacts with the other
elements of society
- It is also a pure because it is a systematic body
of knowledge which utilizes the scientific
approach (econometrics) in explaining how
society allocates scarce resource among
alternative wants that need to be satisfied.
Resources and the study of economics
Resources - natural, human, and man-made wealth that
can provide satisfaction through the production of goods
and services.
• Natural Resources - forms of wealth derived
from nature, including land, forests, mountains,
rivers, and seas.
• Human Resources - labor , muscular or brain
power of the people to create things
• Physical Resources - man-made things used in
the production of goods and services.
Raw materials: inputs of production subject to further
processing and transformation
Factor inputs: transforming inputs that process the raw
materials and intermediate inputs into final goods and
services
Resources are limited: time-consuming, competing
uses
Scarcity as a source of economic problem:
resources to satisfy all the needs and wants of a
population
- Economic goals: material survival, stability and
growth
- Scarcity vs. Shortage vs. Surplus
Allocation of resources:
Allocation
- Social mechanism of distributing limited
resources to meet expanding human wants
• Market system as an allocation mechanism
• Market: a place where buyers and
sellers transact on the purchase or sale
of a good or service
• Price as cost (sacrifice) and benefit
(satisfaction)
• The problem of scarcity is addressed
through the changes in price and the
corresponding responses of the buyers
and sellers
Basic Economic Problems/Questions:
- These problems need to be answered in order to
cope with constraints and limitations
1. What to produce and how much
2. How to produce
3. For whom to produce
- How these questions are answered depends on
the nature of the economic system
Economic Systems
1. Traditional Economy
• Decisions are based on traditions and
practices
• Methods are stagnant; not progressive
• Traditional societies exist in primitive and
backward civilizations
• What to produce: what the culture tells them
• How to produce: hand-crafted
• For whom: for themselves
2. Command Economy
• Authoritative system/Centrally Planned
• Decision making is centralized in the
government or a planning committee
• Decisions are imposed on people who do
not have a say in what goods are to be
produced
• Holds true in dictatorial, socialist, and
communist nations
• Communism is an example
3. Market Economy
• Most democratic form of economic system
• Based on the workings of demand and
supply, decisions are made on what goods
and services to produce.
• People’s preferences are reflected in the
prices they are willing to pay in the market --
this becomes the basis of the producers’
decisions on what goods to produce
4. Mixed Economy
• Basic economic questions are answered by
combining traditional, state-run and private
enterprises
• No real disadvantage: inclination
Economics as a Applied Science
• Economics is a social science and it deals with
how people interact with one another to sustain,
stabilize and develop the material dimension of
a society
• Many of the principles, laws and theories
developed in economics can be applied to a
number of  fields
Decisions arising from Economic Analysis
• Marginal Benefit – additional benefit derived
from an additional activity
• Marginal Costs – additional cost incurred from
an additional production of a good or service
• MB>MC = Net MB positive = Total Net Benefit
increasing
• MB<MC = Net MB negative = Total Net Benefit
decreasing
• MB=MC = Net MB zero = Total Net Benefit
maximum
Types of Benefits and Costs:
1. Explicit costs: easily recognized since they are
expressed in monetary terms and may involve
actual financial outlays
2. Implicit costs: may not have to incur any
monetary expense; opportunity costs
1. Explicit benefits: can be measured in monetary
terms or levels of satisfaction or utility
2. Implicit benefits: non-measurable
Variations in Benefits and Costs due to Stage of
Recognition:
1. Spatial Dimensions in the Issue of Recognition
• Implicit benefits and implicit costs are
harder to recognize because of the
spatial consideration of the decision
maker who may not be aware of the
social or public effect of his actions
• Exclusion of implicit social benefits and
implicit social costs will lead to improper
allocation of resources with its
accompanying consequences
2. Temporal Dimension in the Issue of Recognition
• Present benefits and present costs are
readily realized while future benefits and
future costs (which are implicit benefits
and implicit costs) are too distant in time
to affect the awareness of the decision
maker
• Exclusion of future benefits and future
costs will lead to improper allocation of
resources with its accompanying
consequences
- Even if the decision maker recognizes the
implicit benefits and implicit costs of his action,
the differences between marginal benefits and
marginal costs can still persist
- The proper pricing and valuation of these implicit
costs may have an effect on the optimal decision
3. Spatial Dimension in the Issue of Valuation
• Even if the decision maker has
recognized the social benefits and social
costs of his action, various individuals
may have different valuation of these
social impacts
4. Temporal Dimension in the Issue of Valuation
• Discount rate: rate which a stream of
future values is reduced to make them
comparable with present values
Economics as a Applied Science
• Social, economic and business issues arise due
to the differences in marginal costs and marginal
benefits
• These imbalances result in the improper
allocation of resources and manifest in various
problems and issues in society
• These are due to the non recognition as well as
the differences in valuing the implicit
components of the benefits and costs
Economic Challenges in the Philippines (21st
Century)
• Poverty and Unequal Distribution of Income
• Absolute Poverty: lack of income to buy
the basic food and necessities
• Poverty Threshold: income needed to
purchase the minimum nutritional
requirements and other basic
necessities for daily survival
• Poverty Incidence: proportion of
households in the country with family
income lower than the poverty threshold
• Relative Poverty: the structure on how
the national income is being distributed
among households in an economy
• Lorenz Curve: shows the share of the
various household groups on the total
national income
• Gini Coefficient: measure of income
inequality derived from the Lorenz
Curve (Perfect equality = 0; Perfect
inequality = 1)
• Demographic Changes and its Economic
Implications
• Population growth, is it good or bad?
• Economics of Childbirth: looks at the
benefits and costs of having a child
• Low Investment in Human Resource
Development
• Knowledge capital: heavy investments
in higher education, science and
technology, and research and
development
• Weak Infrastructure (How to finance? Borrowing,
taxation, PPP)
• Pursuing Food Security
• Food security vs. food self-sufficiency
• Slow Adaptation of Modern Technology
• Labor intensive technology vs. Capital
intensive technology
• Environmental Sustainability and the Country’s
Development Thrust
• The environment is part of natural
resources where we derive income from
the utilization of its wealth. 
• However, excessive use of our natural
resources may compromise its ability to
provide income and other benefits in the
future.
CORONA VIRUS THREAT
Application of Demand and Supply Analysis
What is a Demand Curve?
A schedule of the willingness and capacity of a
consumer to buy a commodity at alternative
prices at a given point in time ceteris paribus
(other things constant)
The only factor that influences the level of
demand or consumption is the price of the
commodity itself
Other Factors Affecting the Demand of a Commodity
• Income
- a higher level of income will give a
person a higher capacity to consume
• Prices of Other Commodities
- If the other good is a substitute, the
increase in the price of the substitute
good may increase the demand for the
commodity
- If the other good is a complementary
good, a decrease in its price will have a
positive impact on the demand of the
good
• Expectation
- If you believe that the price of gasoline
will increase tomorrow, there is a
tendency for consumers to increase
their consumption today
• Taste
- Shaped by cultural values, peer
pressure or the power of advertising
• Market
- Population and demographic changes
Why is the Demand Curve Downward Sloping?
• Substitution Effect
- Decision of a consumer to substitute an
expensive good with cheaper goods
when there is a price change
• Income Effect
- An increase in purchasing power will
enable the customer to buy more of the
good and vice versa
Principle of Diminishing Marginal Utility
- This implies that the additional satisfaction
(utility) provided by an additional commodity
consumed is lower than the additional
satisfaction given by the previous level of
consumption of the commodity
- The optimal demand for a commodity is attained
when its price is equal to the marginal utility
derived from the last unit consumed
Changes in Demand Curve
• Movement along the demand curve
- Change in quantity demand resulting from the
change in the price of the commodity
- As the price of a commodity decreases, the
movement along the curve will lead to an
increase in the quantity demand and vice versa
• Shifts in demand curve
- Changes in demand curve cased by any of the
other factors beside the price of the commodity
- A positive effect will shift the demand curve to
the right (increase in the demand for a
commodity)
- A negative effect will shift the demand curve to
the left (decrease in the demand for the
commodity)
Shifts in demand curve to the right:
What is a Supply Curve?
- A schedule showing a direct or positive
relationship between the price of the commodity
and the level of output that the seller is willing to
supply at a given point in time ceteris paribus
- As the price of the commodity increases, there
will be more sellers that will be willing to supply
the good
Other Factors Affecting Supply of a Commodity
• Price of Production Inputs
- The production of any commodity will require the
use of 2 major inputs – intermediate inputs or
raw materials and factor inputs (land, labor,
capital and entrepreneurship)
- When the price of production inputs increases,
there will be an increase in the cost of
production and sellers will be reluctant to
maintain their previous level of supply
• Taxes
- An increase in sales tax, real estate tax and
other business taxes can increase the cost of
supplying a commodity which will in turn
discourage sellers from increasing their supply
- Change in the price of the commodity
- An increase in the price of the commodity will
increase the quantity supplied as shown by
movement northeast along the supply curve and
vice versa

• Technology
- Labor-intensive technology is used if the cost of
labor is relatively cheap; Capital-intensive
technology is used if wages are high
- Improvements in technology can lower
production cost and encourage firms to supply
more

• Expectation
- If there is an expectation that the price of rice
will increase next season, this will encourage
farmers to plant more rice now in anticipation of
higher price in the future. This expectation can
also discourage rice dealers to sell rice currently
and some of them will keep a higher inventory of
rice currently so they can sell it in the future with
higher returns.
Why is the Supply Curve Upward Sloping?
• Variations of the unit cost of production
• Shift in the supply curve
- Changes in other factors affecting supply except
the price of the commodity
- A positive effect will shift the supply curve to the
right (increase in the supply of a commodity)
- A negative effect will shift the supply curve to the
left (decrease in the supply of the commodity)
Shifts in supply curve to the left:

Determination of the Prices of Commodity

• Equilibrium Price
- When buyers and sellers transact in the market
- Who can supply the good, if the market price is and they agree on the price of the commodity
6?; if the market price is 16? and the amount to be sold and bought

- The previously ineffective producers at lower • Disequilibrium

prices have become more efficient and - Cases when there are disagreements among
competitive as the price of the commodity buyers and sellers on the price and quantity
increases (excess demand and excess supply)

Principle of Diminishing Marginal Productivity & Market Equilibrium

Increasing Marginal Costs

- A fixed factor input (capital, land) is mixed with a

variable factor input (labor), the employment of
additional labor will increase the total production
but at a decreasing rate

- As the firm employs additional variable inputs, it

also increases its total cost of production. Since
each additional variable input is less productive
than the previous ones, they become costlier to Excess Demand and Excess Supply
employ (increasing marginal costs with the
increase in output production)

• Profit – difference between total revenue and total

costs
• Maximum Profit – attained when the difference
between total revenue and total costs is the widest
or marginal revenue is equal to marginal costs
(marginal profit is zero)

- As long as marginal profit is positive, there is

motivation to increase production as this will
increase profit

Changes in Supply Curve

• Movement along the supply curve
Shift in the Demand Curve to the Right Shift of the Demand Curve to the Right and Shift of
the Supply Curve to the Left (unequal proportion)

Shift in the Demand Curve to the Left Other Applications of Supply and Demand Analysis

• Price Ceiling
- Government imposed price control (prices
cannot go higher than the mandated price
ceiling)
- See graph 2.15

• Price Floor
- Government imposed price control (prices
cannot go lower than the mandated price floor)
- See graph 2.16

Shift in the Supply Curve to the Right

Graph 2.15 Price Ceiling (Excess Demand) and Graph
2.16 Price Floor (Excess Supply)

Shift in the Supply Curve to the Left

• Applications in the Labor Market
- Those buying labor services are the firms and
firms will hire laborers if the monetary value of
the labor productivity (marginal benefit) is equal
to the wage rate (marginal cost)
- The laborers are the ones supplying the labor
services and to them, the wage rate is the
opportunity cost of leisure
- See graph 2.17

Graph 2.17 Determination of the Wage Rate in the

Shift in the Demand Curve to the Right and Shift in Labor Market
the Supply curve to the Right (equal proportion)

• Minimum Wage as Price Floor

- If the equilibrium price in graph 2.17 is
considered too low by the laborers, they may
demand the government to impose a minimum
wage
- See graph 2.18

Graph 2.18 Minimum Wage as Price

 Floor
• Application in the Foreign Exchange Market
- Demand for USD is influenced by demand for
imports. At higher USD price, imports becomes
expensive and our demand for USD decreases
- Supply of USD is based on the inflows of USD
brought by exports and remittances. At higher
USD price, it motivates exporters and Filipinos
to work overseas
- See graph 2.19
Graph 2.19 Determination of the
Exchange Rate
• Labor Migration and the OFWs
- Supply of OFWs increases when foreign wage
rate increases or when the exchange rate
increases even if the foreign wage rate does not
change
- Demand for OFWs increases when foreign wage
rate decreases
- Even at lower foreign wage rate, there will be
more OFWs willing to go abroad because the
peso value of their foreign wage is still high with
the depreciated peso
- See graph 2.20
Graph 2.20 Market for OFW Services
• Determination of Rent
- Rent refers to the price of using land in the
process of production
- Supply curve of land is vertical because land is
fixed and cannot be increased with increase in
rent or price of land
- Low demand of land Do = idle
- High demand of land D1 = agriculture
- Very high demand of land D2 = business, high
rises and condominiums
- Co = cost of putting land in productive use
- See graph 2.21
Contemporary Economic Issues Facing
the Filipino Entrepreneur
• There are 4 types of Market Structures based on the
Market Power of the actors in any transaction
• Market Power
- The ability of any actor or group of actors in the
market to significantly influence the price in the
market and the quantity to be produced and sold
- Aim of every actor is to enhance its market
power
Perfect Competition
• A market structure where no single seller or
buyer has power to determine the price and the
level of output in the market
• Large number of buyers and sellers
• Suppliers sell similar or undifferentiated products
• Free entry and exit
• Mobility of resources
• Perfect information
• Ideal market structure since it leads to an
efficient use of resources
Monopoly
• A market structure characterized by a single
seller in the market
• Exact opposite of a perfect competition
• Enormous market power
• Unique product
• Huge profit (limiting production and setting
higher price)
• Restrictions to entry (scale barriers and legal
barriers)
• If there is only a single buyer, the market is
known as a monopsony
Oligopoly
• A market structure characterized by few sellers
producing similar and differentiated products
• Imperfect competition (there is competition
among the few sellers, but it is imperfect since
the excess profit is only reduced but not
eliminated)
• Interaction of these few sellers:
 • As a result, some of these firms locate their
- Independent actions – mimics a competitive manufacturing plants in regions or countries
market where labor is relatively inexpensive
- Collusion – forming a cartel and monopolizing
the market Taxes
- Since collusion is not allowed here, firms opt to • Taxes can increase the cost of business
react to their fellow firms decisions or follow the operations and can threaten the profitability
industry leader of business enterprises at their initial stage of
operations
Monopolistic Competition • In order to attract pioneer, foreign and local
firms to establish their presence in the
• This market structure has the elements of both country, governments can give tax incentives
competitive and monopolistic markets
• Imperfect competition
• Competitive (numerous sellers and buyers
that can freely enter and exit the market)
• Monopolistic (product although similar, can
be differentiated through advertising and
packaging, which leads to brand loyalty)

Market Structures an Implications for Entrepreneurs

• If you have limited resources and productive

capacity…
• The firm may enter the perfectly competitive
market, but the ability to expand and find a niche
is very limited
• Thus, a monopolistically competitive market is
better, although the firm must be cautious of
potential rivals
• Difficult in entering the monopolistic and
oligopolistic market

Investment and Interest Rate

• External funds can be sourced from the capital

market
- Demand curve for funds shows and indirect
relationship between interest rate and the
amount being borrowed
- Supply of funds (savings) is positively
related with the interest rate
- If the price of capital is high, it may
discourage potential entrepreneurs to
engage in business and existing
entrepreneurs may postpone their
expansion and investment plans, and vice
versa

Rentals and the Cost of Business Operations

• It may not be wise for a small and beginning

enterprise with limited resources to locate its
office in high-end commercial districts because
rental rates can eat up a huge part of its
revenues
• BUT there are several benefits of having an
office in those areas
- Gives legitimacy and prestige
- Savings – attracting a lot of customers,
accessible to workers and near to clients
and service providers
- Commercial districts are well planned and
designed for business with their good
infrastructure and adequate support services

Minimum Wage

• Example of floor price that prevents the market

to seek its equilibrium condition because of a
government policy
• For labor intensive industries, minimum wage
can discourage firms to hire additional workers,
since the wage rate has become prohibitive.
Elasticity of Demand and Supply
Price Elasticity of Demand
• Elasticity
• Responsiveness
• Price elasticity of demand
• Consumers’ responsiveness to a change in
price
• Percentage change in quantity demanded
divided by percentage change in price
Measures Responsiveness to Price Changes
Why use percentages?
It is because when using absolute changes, our choice
of units would arbitrarily affect our impression of buyer
responsiveness:
• With a P1 reduction in the price of a hand
sanitizer, consumers increase their
consumption from 6 to 10 bottles (a 1 unit
price change causes a 4 unit quantity
change)
• If we change the monetary unit from pesos
to centavos, now it appears that it takes a
price change of 100 centavos to cause the 4
unit quantity change
Examples:
1. If the price of Alcohol is increased by 10%, the
quantity demanded decreased by 20%. Then the
coefficient for price elasticity of the demand of
Alcohol is:
Ed = percentage change in Qd / percentage change in
Price = (20%) / (10%) = 2
2. If the quantity demanded of face mask has
decreased from 1000 units to 900 units as price
increased from P2 to P4 per unit, the coefficient
for Ed is:
|Ed| = (900-1000)/(4-2)x(3/950)
= 0.16
Categories of ED
Price Elasticity along a Linear Demand Curve
• Elasticity typically varies over different price
ranges of the same demand curve.
Determinants of Elasticity
Availability of substitutes
elastic = many close substitutes
less elastic/ inelastic = few substitutes to none
Time horizon
elastic = long run
less elastic/ inelastic = short run periods
Product category
elastic = broader classification of the product or
service
less elastic/ inelastic = narrow product/ service
classification
Necessities vs luxuries
elastic = luxuries
less elastic/ inelastic = necessities
Purchase size
elastic = bigger purchase size that could affect
the budget
less elastic/ inelastic = small purchase /
irrelevant to income
Total Revenue Test
Total revenue (TR) is calculated by multiplying price (P)
per unit and quantity (Q) of the good sold.
• TR = P x Q
The total revenue test is a method of estimating the price
elasticity of demand. As Ed will impact the total revenue,
we can estimate the Ed by looking at the movement of
the total revenue.
Total Revenue Test
• Ed > 1, total revenue will decrease as price
increases. P and TR moves in opposite
directions.

Producers can increase total revenue ( TR = Price x

Quantity) by lowering the price. Therefore,
most department stores will have sales to attract
customers.

• Ed < 1, total revenue will increase as price Short-Run

increases.

P and TR moves in the same direction. Producers can

increase total revenue by raising the price. Inelastic
demand for agricultural products helps to explain why
abundant crops lower the prices and total revenues for
farmers.

Total revenue = price * quantity demanded at this

price
• TR= p * q
• As p decreases
• If D elastic, TR increases
• If D inelastic, TR decreases
• If D unit elastic, TR unchanged

Price Elasticity of Supply

Now, we compare the immediate market period, the

short-run, and long-run.

Immediate Market Period

Long-Run

Elasticity of Supply
Elasticity of Supply Examples
1. If the price of Product A increased by 10%, the
quantity supplied increases by 5%. Then the
coefficient for price elasticity of the supply of
Product A is:
Es = percentage change in Qs / percentage change in
Price = (5%) / (10%) = 0.5
2. If the quantity supplied of Product B has
decreased from 1000 units to 200 units as price
decreases from P4 to P2 per unit, the coefficient
for Es is:
Es = (200-1000)/(2-4) x (400/3) = 2
Characteristics & Determinants
Characteristics:
Es approaches infinity, supply is perfectly elastic.
Producers are very sensitive to price change.
Es > 1, supply is elastic. Producers are relatively
responsive to price changes.
Es = 1, supply is unit elastic. Producers’ response and
price change are in same proportion.
Es < 1, supply is inelastic. Producers are relatively
unresponsive to price changes.
Es approaches 0, supply is perfectly inelastic. Producers
are very insensitive to price change.
It is impossible to judge elasticity of a supply curve by its
flatness or steepness. Along a linear supply curve, its
elasticity changes.
Determinants:
1. Time lag: How soon the cost of increasing
production rises and the time elapsed since the
price change influence the Es. The more rapidly
the production cost rises and the less time
elapses since a price change, the more inelastic
the supply. The longer the time elapses, more
adjustments can be made to the production
process, the more elastic the supply.
2. Storage possibilities: Products that cannot be
stored will have a less elastic supply. For
example, products usually have inelastic supply
due to the limited shelf life of the vegetables and
fruits.
Cross Price Elasticity of Demand
• measures the degree of responsiveness of
quantity purchased of one good as the price
of another good changes
Example:
Interpretation: the cross price elasticity of demand for
good X with respect to Y is equal to 4. In general, a 1%
increase (decrease) in the price of good Y, results in
a 4% decrease (increase) in the quantity demanded of
good X.
What is the relation between goods X and Y?
If Exy > 0 (e.g., Exy = 1.5 ) then X and Y are substitutes
If Exy < 0 (e.g., Exy = -.5 ) then X and Y are
complements
If Exy = 0 (e.g., Exy = 0 ) then X and Y are independent
of each other.
Income Elasticity of Demand
• measures the degree of responsiveness of
quantity demanded (q) to changes in the
level of income of consumer (y)
Classification of goods and income elasticities:

If n > 0 (e.g., Ey=2) then the good is a normal good

Specifically,
if 0<Ey<1 (e.g., Ey=0.8) then the good is normal and is
considered a
necessity e.g rice, and other basic goods
if Ey>1 (e.g. Ey= 1.5 ,. then the good is normal and is
considered a luxury e.g jewelry appliance, etc.
if Ey<0 (e.g. Ey= -0.75) then the good is inferior., eg
salt, sardines, dried fish

Note: the inferiority or normality of a good is relative to

income levels, i.e, at low incomes, a commodity may be
normal (increase in income, increase in quantity
demanded) but at high income levels, the same
commodity may turn out to be inferior.

Price Ceiling and Price Floor
Why governments Control Prices?
• The market price moves to the level at which
the quantity supplied equals the quantity
demanded. BUT this equilibrium price does
not necessarily please either buyers or
sellers.
• Therefore, the government intervenes to
regulate prices by imposing price controls,
which are legal restrictions on how high or
low a market price may go.
• Price ceiling is the maximum price sellers
are allowed to charge for a good or service.
• Price floor is the minimum price buyers are
required to pay for a good or service.
Price Ceilings
• Price ceilings are typically imposed during
crises—wars, harvest failures, natural
disasters—because these events often lead
to sudden price increases that hurt many
people but produce big gains for a lucky few.
Examples:
• U.S. Government imposed ceilings on
aluminum and steel during World War II
• Rent control in New York
The Market for Apartments in the absence of
Government Controls
The Effects of Price Ceiling
How Price Ceilings Causes Inefficiency
• Inefficiently Low Quantity
• Inefficient Allocation to Customers
• Wasted Resources
• Inefficiently Low Quality
• Black Markets
How Price Ceilings Causes Inefficiently Low Quality
How Price Ceilings Cause Inefficiency
• Price ceilings often lead to inefficiency in the
form of inefficient allocation to consumers:
people who want the good badly and are
willing to pay a high price don’t get it, and
those who care relatively little about the
good and are only willing to pay a low price
do get it.
• Price ceilings typically lead to inefficiency in
the form of wasted resources: people
expend money, effort and time to cope with
the shortages caused by the price ceiling.
• Price ceilings often lead to inefficiency in
that the goods being offered are of
inefficiently low quality: sellers offer low-
quality goods at a low price even though
buyers would prefer a higher quality at a
higher price.
• A black market is a market in which goods
or services are bought and sold illegally—
either because it is illegal to sell them at all
or because the prices charged are legally
prohibited by a price ceiling.
Price Floors
• Sometimes governments intervene to push
market prices up instead of down.
• The minimum wage is a legal floor on the
wage rate, which is the market price of
labor.
 • Just like price ceilings, price floors are
intended to help some people but generate
predictable and undesirable side effects.
The Market for Butter in the Absence of Government
Controls
The Effects of a Price Floor
Price Floors and School Launches
• When you were in grade school, did your
school offer free or very cheap lunches? If
so, you were probably a beneficiary of price
floors.
• During the 1930s, when the U.S. economy
was going through the Great Depression,
prices were low and farmers were suffering.
To aid, the U.S. government imposed price
floors on agricultural products like beef,
sugar, pork, etc.
• Price floors are meant to create a surplus.
Government reduces supply by paying
farmers not to grow crops and also buys the
surplus, thus taking excess surplus off the
market.
• The government then gives away this
excess surplus to schools as free or cheap
lunches.
How a Price Floor Causes Inefficiency
• The persistent surplus that results from a
price floor creates missed opportunities—
inefficiencies—that resemble those created
by the shortage that results from a price
ceiling. These include:
o Inefficiently low quantity
o Inefficient allocation of sales among
sellers
o Wasted resources
o Inefficiently high quality
o Temptation to break the law by
selling below the legal price
A Price Floor Causes Inefficiently Low Quantity
How a Price Floor Causes Inefficiency
• Price floors lead to inefficient allocation of
sales among sellers: those who would be
willing to sell the good at the lowest price
are not always those who actually manage
to sell it.
• Price floors often lead to inefficiency in that
goods of inefficiently high quality are offered:
sellers offer high-quality goods at a high
price, even though buyers would prefer a
lower quality at a lower price.
Ceilings, Floors and Quantities
• A price ceiling pushes the price of a good
down.
• A price floor pushes the price of a good up.
• Both floors and ceilings reduce the quantity
bought and sold.
• If sellers don’t want to sell as much as
buyers want to buy, it’s the sellers who
determine the actual quantity sold, because
buyers can’t force unwilling sellers to sell
and vice versa.
Controlling Quantities
• A quantity control, or quota, is an upper limit
on the quantity of some good that can be
bought or sold. The total amount of the good
that can be legally transacted is the quota
limit.
• An example is the taxi medallion system in
New York.
• A license gives its owner the right to supply
a good.
• The demand price of a given quantity is the
price at which consumers will demand that
quantity.
• The supply price of a given quantity is the
price at which producers will supply that
quantity.
The Market for Taxi Rides in Absence of
Government Controls
 creates persistent surplus. Price floors lead to
inefficiencies in the form of inefficiently low
quantity, inefficient allocation of sales among
sellers, wasted resources, and inefficiently high
quality. It also encourages illegal activity and
black markets. The most well-known kind of
price floor is the minimum wage, but price floors
are also commonly applied to agricultural
products.

4. Quantity controls, or quotas, limit the quantity of

Effect of a Quota on the Market for Taxi Rides
a good that can be bought or sold. The quantity
allowed for sale is the quota limit. The
government issues licenses to individuals, the
right to sell a given quantity of the good.
Economists say that a quota drives a wedge
between the demand price and the supply price;
this wedge is equal to the quota rent. Quantity
controls encourage illegal activity.

The Anatomy of Quantity Controls

• A quantity control, or quota, drives a wedge

between the demand price and the supply
price of a good; that is, the price paid by
buyers ends up being higher than that
received by sellers.
• The difference between the demand and
supply price at the quota limit is the quota
rent, the earnings that accrue to the license-
holder from ownership of the right to sell the
good. It is equal to the market price of the
license when the licenses are traded.

The Cost of Quantity Controls

• Some mutually beneficial transactions don’t
occur.
• Incentives for illegal activities.

SUMMARY
1. Even when a market is efficient, governments
often intervene to pursue greater fairness or to
please a powerful interest group. Interventions
can take the form of price controls or quantity
controls, both of which generate predictable and
undesirable side effects.

2. A price ceiling, a maximum market price below

the equilibrium price, benefits successful buyers
but creates persistent shortages. Price ceilings
lead to inefficiencies in the form inefficiently low
quantity, inefficient allocation to consumers,
wasted resources, and inefficiently low quality. It
also encourages illegal activity as people turn to
black markets to get the good.

3. A price floor, a minimum market price above the

equilibrium price, benefits successful sellers but
 Perfect Competition

Assumptions:
• Large number of Buyers & Sellers.
• Homogeneous product.
• Free entry & exit to industry.
• No govt. regulation.
• Price takers
• Perfect Knowledge of market conditions.
• Perfect mobility of factors of production.

- A perfectly competitive market is where

agents in the market (buyer & seller) are
price taker.
- Price taking behaviors: agents believe that
the market price is given and their actions
do not influence the market price.

Examples of Perfect Competition:

- Financial markets - (stock exchange, currency market),
agriculture

Perfect Competition

What is a Market Structure?

- The competitive environment in the market
for any product is the market structure faced
by the firm

It is measured in terms of: Equilibrium of firm in short run

• the number of the actual buyers and sellers
plus potential entrants
• Barriers to entry and exit
• Capital requirements
• Price vs Non-price competition
• Potential entrants pose a sufficiently credible
threat of entry to affect price/output
decisions of incumbents

Factors that Shape the Competitive Environment

• Product Differentiation
o R&D, innovation, and advertising are
important in many markets.
• Production Methods
o Economies of scale can preclude small-
firm size.
• Entry and Exit Conditions
o Barriers to entry and exit can shelter
incumbents from potential entrants.
• Buyer Power
o Powerful buyers can limit seller power.

Market Classification based on the nature of

competition
Profit Maximization for a Perfectly Competitive Firm

• All firms maximization for a Perfectly

Competitive Firm

MR = MC
 • Since the perfectly competitive firm is a price
taker, marginal revenue equals price.

MR = P

• Therefore, profits will be maximized where

MR (= P) = MC or P = MC

Profit Maximization Pricing and Output Decisions (Perfect Competition)

- All firms can maximize profits (or minimize
losses) by comparing marginal revenue Loss Minimization and Shutdown Condition
(MR) with marginal cost (MC) - If there are ∏, then it means TR>TC and
max condition holds: MR=MC
• If MR > MC, profits are increasing - If there are losses or TR<TC and P<AC, firm
• If MR < MC, profits are decreasing has 2 options
• Therefore, profits must be maximized where MR=MC i. Produce in the short run in spite
of losses
- Since the perfectly competitive firm is price ii. Shutdown and do not produce
taker, marginal revenue equals price. even in the short run

MR= P Option 1: Firm will continue to produce in spite of losses

as long as:
- Therefore, profits will be maximized where i. TR >TVC
ii. P>AVC
MR (=P) = MC or P = MC Why?
• If firm shuts down, losses=TFC; you still
Is the firm making a profit? have to pay fixed costs even at zero output
• If TR>TVC(or P>AC), the variable costs are
- For a price taker, price is also equal to the recovered plus a part of the fixed cost.
average revenue and we need to compare Therefore, losses are minimized by
average total cost with price in order to tell continuing to produce.
whether the firm is making a profit.
- If P > ATC , the firm is making a profit that Option 2: If TR<TVC, firm should shutdown even in the
is, it is selling its output at mere than its cost. SR
Why?
• If firm continues producing, then losses are
equal to:

TFC+part of TVC (or AFC+part of AVC)

If P < ATC, the firm is losing money • If firm shuts down, then losses = TFC only.
Therefore, losses are again minimized by
shutting down shop.

If P > ATC, the firm is having economic profits

MONOPOLY Characteristics
• One firm in industry
• Profit-maximiser
If P = ATC, the firm is at break even condition • Faces market demand curve
• One product
• No close substitutes
• Price-maker
• No restrictions on resources
• Blockaded entry and/or exit
• Imperfect dissemination of information
• Opportunity for economic profits in long-run
equilibrium.

Typical Industries under Monopoly
• Power Distribution Utilities
• Gas
• Water
• Public Transport
• Telecommunications
Monopoly Graph:
Profit Maximization in Monopoly Markets
Price/Output Decisions
• A monopoly firm is the market.
• Market and firm demand curve
slopes downward.
• Monopoly demand curve is always
above the marginal revenue curve,
P = AR > MR.
• Monopoly position allows above-
normal profits.
P > AC in long-run equilibrium.
• Set Mπ = MR - MC = 0 to maximize
profits.
• MR=MC at optimal output.
Social Costs of Monopoly
• Monopoly Underproduction
- Monopolists produce too little output.
Monopolists charge prices that are too high.
• Deadweight Loss from Monopoly
- Monopoly markets creates a loss in social
welfare due to the decline in mutually
beneficial trade activity.
- There is also a wealth transfer problem
associated with monopoly.
- Under monopoly, consumer surplus is
transferred to producer surplus.
Social benefits from Monopoly
• Economies of Scale
- Monopoly is sometimes the natural result of
vigorous competitive forces.
- In natural monopoly, LRAC declines
continuously and one firm is most efficient.
- Some real-world monopolies are
government-created or government-
maintained.
• Invention and Innovation
- Public policy sometimes confers explicit
monopoly rights to spur productivity.
-
Sources of Monopoly Power
• Natural monopoly (public utilities best example,
railway tracks), economies of scale,
• Capital requirements on production or big sunk
costs on entry
• Patents (20 years), trade secrets (Coke)
• Exclusive or unique assets (minerals, talent)
• Locational advantage (popcorn shop in cinema –
but in general you pay rent for these
• advantages)
• Regulation (TV, taxi, telephone in the past)
• Collusion by competitors
What can Monopolist do to create strategic entry
barriers?
• Excessive patenting and copyright
• Limit pricing (set price below monopoly price)
• Extensive advertising to create brand name to
raise cost of entry
• Create intentionally excess capacity as a
warning for a price war
Oligopoly
Market Characteristics
• Few sellers.
• Homogenous or unique products.
• Blockaded entry and exit.
• Imperfect dissemination of information.
• Opportunity for above-normal (economic) profits
in long-run equilibrium.
Examples:
• National markets for aluminum, cigarettes,
electrical equipment, filmed entertainment,
ready-to-eat cereals, etc.
• Local retail markets for gasoline, food,
specialized services, etc.
Cartels and Collusion
• Overt and Covert Agreements
o Cartels operate under formal
agreements.
 Powerful cartels function as a
monopoly.
o Collusion exists when firms reach
secret, covert agreements.
• Enforcement Problem
o Cartels are typically rather short-lived
because coordination problems often
lead to cheating.
o Cartel subversion can be extremely
profitable.
o Detecting the source of secret price
concessions can be extremely difficult.
Oligopoly Output-Setting Models

• Cournot Oligopoly
• Cournot equilibrium output is found by
simultaneously solving output-reaction curves
for both competitors.
• Cournot equilibrium output exceeds monopoly
output but is less than competitive output. Monopolistic Competition

- The market consists of a number of mono-

product firms;
- The products are viewed by the buyers as close
though not perfect substitutes for one another;
- Therefore, each of the sellers is a monopolist of
its particular product variant with a limited
degree of monopoly power.
- Such a monopolist is enjoying a monopoly
power and making economic profit during only a
short period of time from the introduction of an
unique product or technology
- until such a technology becomes available to
rivals, or
- until a new “more innovative” product is
introduced by a rival.
Stackelberg Oligopoly

• Stackelberg model posits a first-mover

advantage.
• Price wars severely undermine profitability for
both leading and following firms.
• Price signaling can reduce uncertainty in
oligopoly markets.
• Price leadership occurs when firms follow the
industry leader’s pricing policy.

Short-run Monopoly Equilibrium

Monopolistically competitive firms take
full advantage of short-run monopoly.

- Price leader sets the price at P2

- Profit is maximised at Q1
- The follower(s) will supply the
- combined output of Q4-Q1
- At P3-Follows will supply
- everything
- At P1 – the leader will supply everything at no
economic profit

Oligopoly Price-Setting Models Entry of new firms offering

product substitutes shifts the
• Bertrand Oligopoly: Identical Products demand and MR curves)
- The Bertrand model focuses upon the price
reactions.
- The Bertrand model predicts a competitive
market price/output solution in oligopoly
markets with identical products.
 Long-run equilibrium same costs, lower demand and
excess capacity – low output high price decision With
differentiated products, P=AC at a point above minimum
LRAC. P > MR = MC.