MICROECONOMICS

FOUNDATIONS

scarcity: any good or service that has a price, and is thus being rationed, is known as an
economic good

opportunity cost: the next best alternative foregone when an economic decision is made

FACTORS OF PRODUCTION:

- Land

- Labour

- Capital (physical capital: stock of manufactured resources / human capital: value of the
work force)

- Entrepreneurship: organising and risk taking factor of production

PPD

- show the concept of scarcity, choice and

opportunity cost

- show the maximum combinations of goods and

services that can be produced by an economy in a
given period of time

It is a curve because not all factors of production are

being used to output

z: most productive

z1: potential growth due to an improvement in the quantity or quality of factors of

production.

utility: measure of the useless and pleasure

total utility: total satisfaction gained from consuming a certain quantity of a product

marginal utility: extra utility the consumer gains from consuming one more unit of the
product

durable goods: consumed over time

non durable goods: consumed over a

short period of time

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 PLANNED ECONOMIES

planned economies: decisions on what to produce, how to produce, and who to produce
for are made by the government

- all resources are collectively owned

Government bodies arrange: production, set wages, and set prices through central planning

- all resources are collectively owned

example: in the 1980’s USSR and China were in planned economies

FREE MARKET ECONOMIES

free market economies: capitalism, where prices are used to ration goods and services

- all resources are privately owned

- demand and supply are left free to set wages and prices in the economy

- producers decisions are based upon the pro ts being made

- Government involvement is deemed essential

example: the USA

DISADVANTAGES OF FREE MARKETS DISADVANTAGES OF PLANNED MARKETS

Demerit goods will be over provided , driven by
high prices (high pro t motive)
Merit goods are under provided, only produced
for those who can a ord them
Resources may be used up too quickly -
environmental damage (pollution)
Some members of society will not be able to
take care of themselves (orphans, unemployed)
Large rms may grow and dominate industries,
leading to high prices, loss of e ciency and
excessive power
Total production, investment, trade and
consumption are too complicated to plan
e ciently // misallocation of resources of
resources, shortages, surpluses
No price system leads to lack of e ciency
Incentives will be distorted (motivation is
di cult) - output and quality will su er
dominance of the government may lead to a
loss of personal liberty and freedom of choice
governments do not share the same aims as the
majority of the population (corruption)

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 ECONOMIC GROWTH

national income: value of all the

goods and services produced in
an economy in a given time
period, normally one year

- can be measured by adding

activity along a, b or c

economic development: measure of welfare and well-well-being (health and social

indicators)

Measured by HDI: adds up real national income per head, adults literacy rate, average
years of schooling and life expectancy (value from zero to one)

1: high human development

0: low human development

sustainable development: development that meets and the needs of the present without
composing the ability of future generations to meet their own needs

DEMAND AND SUPPLY

market: buyers and seller come together to carry out an economic transaction

demand: quantity of a good or service that consumers are willing and able to purchase at a
given price in a given time period

law of demand: as the price of a product falls, the quantity demanded will increase, ceteris
paribus

ceteris paribus: an assumption that means ‘all other things being equal’ // when there is a
change in one factor, all other factors remain constant

INCREASE IN DEMAND WHY?

income e ect increase in income, increase in quantity

demanded
substitution e ect when the price of a product falls, the product
will become more attractive than the products
whose price has remained unchanged

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 NON PRICE TYPE EFFECT GRAPH
DETERMINANTS
OF DEMAND

income normal goods as income rise,

demand of the
product will rise

inferior goods as income rises,

demand will fall as
they start to buy
higher priced goods
(non organic food)

price of other products substitutes change in the price of

one of the products
will lead to a change in
the demand of another
product (milk)

complements products which are

often purchased
together (shampoo and
conditioner)

unrelated goods change in the price of -

one product will have
no e ect on the
demand for the other
product (toilet paper
and pencils)

Tastes/ Preferences - can either shift to the

left or right

OTHER FACTORS (a ecting demand) EFFECT

size of the population increase in population, will increase

demands for most products
change in age structure alter demand for certain products

government policy changes changes in direct tax, decrease disposable

income / policies would alter demand too
seasonal changes changes in pattern of demand in the economy

changes in income distribustion more equality = increase in demand for

necessity goods

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 movements along the demand curve: a change in price

shift out of the demand curve: change in any determinants of demand

Veblen goods:

supply: willingness and ability of producers to produce a quantity of a good or services at a

given price in a given time period

law of supply: as the price of a product rises, the quantity supplied of the product will
usually increase, ceteris paribus

NON PRICE EFFECT GRAPH

DETERMINANTS OF
SUPPLY

cost of factors of increase in cost of factor of

production production, will increase the
rm's costs, meaning they will
supply less

price of other products, if they could be producing

which the producer could something similar, they will. This will
produce instead of the increase the supply
existing products

state of technology improvements lead to an increase

in the supply curve

government intervention INDIRECT TAX:

shift the supply curve out by the

amount of tax
SUBSIDES:

shift the supply curve down by the

amount of the subsidy

movements along the supply curve: a change in price

shift out of the supply curve: change in any determinants of supply

supply is curve of a market is largely determined by the industry’s cost of production

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LINEAR DEMAND FUNCTION:

QD = a - bP

QD : the quantity demanded

a : quantity demanded when price is zero

b : slope of the curve

a and b: will be a ected by non price determinants of demand

LINEAR SUPPLY FUNCTION:

QS = c - dP

Qs : the quantity supplied

c : quantity supplied when price is zero

d : slope of the curve

c and d: will be a ected by non price determinants of supply (eg. costs of production)

MARKET EQUILIBRIUM

to nd equilibrium price: QS = QD

to nd equilibrium quantity: input equilibrium price into one of the equations

MARKET EQUILIBRIUM, THE PRICE MECHANISM AND MARKET

EFFICIENCY

equilibrium: a state of rest, self-perpetuating in the absence of any outside disturbance

MARKET EFFICIENCY (consumer and producer surplus)

consumer surplus: the extra satisfaction (utility) gained by consumers from paying a price
that is lower than that which they are prepared to pay a price that is lower than that which
they are prepared to pay

producer surplus: the excess of actual earning that a producer makes from a given
quantity of output, over the amount the producer would be prepared to accept for that
output

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 community surplus (total bene t to society)= consumer surplus + producer surplus

- community surplus is maximised at the equilibrium point = allocative e ciency because

it is the optimal combination for society

allocative e ciency: resources are allocated in the

most e cient way from society’s point of view

ELASTICITIES

elasticity of demand: measure of how much the demand for a product changes when
there is a change in one of the factors that determine demand

1) price elasticity of demand (PED)

2) cross elasticity of demand (XED)

3) income elasticity of demand (YED)

PRICE ELASTICITY OF DEMAND

elasticity of demand: measure of how much the demand for a product changes when
there is a change in one of the factors that determine demand

Range of values of PED

Perfectly inelastic

PED = 0

a change in the price of a product will have no

e ect on the quantity demanded at all

example: drug addiction / medication (in the short

term)

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 Perfectly elastic

PED = ∞

The smallest change in the price of a product will

eliminate all quantity demand

example: in any perfectly competitive market / rose

production in equator (short run)

Inelastic demand

0 < PED < 1

A change in price leads to a proportionately smaller

change in the quantity demanded

(as price raises =quantity demanded slightly

decreases - revenue of the rm will increase)

example: oil

Elastic demand

1 < PED < ∞

A change in price leads to a proportionately greater

change in the quantity demanded

(as price raises, quantity demanded falls - revenue

from rm will fall)

example: butter

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 Unit elastic demand

PED =1

A change in prices leads to a proportionately

opposite change in the quantity demanded

Revenue will stay the same

*ELASTICITY IS NOT THE SLOPE OF THE CURVE*

DETERMINANTS OF PED

DETERMINANTS WHY
Number and closeness of substitutes More substitutes: more elastic

Closer the substitutes: more elastic

Necessity of the product / how widely the More de ned: more elastic (eg. Meat into
product is de ned brands)

Necessary: inelastic demand

Time period Takes time for consumers to change their
consumption habits
Taxation (indirect tax) Increases price of all products (elasticities
change with products)

CROSS ELASTICITY OF DEMAND

cross elasticity of demand: measure of how much the demand for a product changes
when there is a change in the price of another product

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Range of values of XED

XED VALUE RELATIONSHIP EXAMPLE

positive substitutes
types of margarine
close substitutes: high value
negative complements
shampoo and conditioner
close complements: lower
value
zero unrelated houses and match sticks

- Firms need to be aware of XED for the products they produce in regard to a ‘rivals’
product.

INCOME ELASTICITY OF DEMAND

income elasticity of demand: measure of how much the demand for a product changes
when there is a change in the consumers income

Range of values of XED for normal goods

VALUE NAME EFFECT TYPE

0 < YED positive demand increases as normal goods

income increases
0 < YED < 1 income- %increase in Qd < normal goods
inelastic %increase in income
1 < YED income- %increase in Qd > % necessity goods: low income elasticity
elastic increase in income (demand for them changes little if income rises)

superior goods: high income elasticity

(demand for them changes signi cantly if
income rises)
YED < 0 negative demand decrease as inferior goods
income increased

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 Engel curve

Shows the relationship between income and the

demand for a product over time

ELASTICITY OF SUPPLY

price elasticity of supply: measure of how much the supply for a product changes when
there is a change in price of a product

RANGE OF VALUES OF PES

Perfectly inelastic

PES = 0

A change in price leads to a no e ect in quantity

supplied

example:

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Perfectly elastic

PES = ∞

A change in price leads to supply to fall to zero

example:

Inelastic supply

0 < PES < 1

A change in price leads to a proportionately

smaller change in supply

example:

Elastic supply

1 < PES < ∞

A change in price leads to a proportionately

greater change in supply

example:

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Unit elastic supply

PES = 1

A change in price leads to a proportionate change

in supply

example:

DETERMINANTS OF PES

DETERMINANTS HOW
how much costs as output increases prevent rise in cost

a) existence of space capacity - easily increase

output

b) mobility of factors of production - mobile =

elastic
time period longer time period = more elastic

ability to store stock able to react to price increases = elastic

PRIMARY COMMODITIES

Raw materials have inelastic demand

-have no/few substitutes

Manufactured goods are more elastic

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 INDIRECT TAXES, SUBSIDIES AND PRICE CONTROLS

indirect tax: a tax imposed on expenditure that is placed on the selling price of a product

Raises the rms cost and shifts the supply curve upwards by the amount of the tax.

speci c tax: xed amount of that that is imposed on a

product

percentage tax: tax is a percentage of the selling price

SPECIFIC TAX BURDEN

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The burden in indirect tax is shared

fairly evenly between consumers and
producers

PED = PES : tax burden shared equally

PED > PES : tax burden imposed on producer

PED < PES : tax burden imposed on the consumer

PED > PES PED < PES

This is why governments impose indirect tax on products with relatively inelastic demand
(cigarettes/alcohol)

SUBSIDIES

subsidies: amount of money paid by the government to a rm, per unit of output

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 Why do governments give subsidies?

1) lower prices of essential goods: increase the consumption due to the ‘lower price’

2) guarantee necessary products: essential goods to a society (coal/employment)

3) compete with overseas trade: protects the home industry

GOVERNMENT CONSIDERATION WHEN GIVING A SUBSIDY:

1) opportunity cost: in terms of other alternative spending projects

2) e ciency: whether the subsidy will ine cient since they don't have to compete with
overseas rms

3) taxpayers: the subsidy is funded by taxpayers who may not necessarily bene t

4) damage to foreign products: the rms overseas who are not receiving subsidies from
their government

PRICE CONTROLS

government intervention in the market in order to achieve di erent outcomes

MAXIMUM (LOW) PRICE CONTROLS

price ceilings: the government sets a maximum

price below the equilibrium price, which then
prevents the producers from raising the price
above it.

Maximum prices are set:

- protect consumers

- in markets where the product is viewed as a

necessity or a merit good (that would be under
provided in a free market)

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 Lead to shortages:

- excess demand may create problems

- shortages may lead to a black market

- queues may develop - leading to a discrimination onto who is allowed to buy

Reduce shortages:

shift the demand curve to the left, until equilibrium is

reached at the maximum price

- this would limit the consumption

shift the supply curve to the right until equilibrium is

reached at the maximum price

- the government could o er subsidies to the rms

in the industry to encourage them to produce
more

- the government could produce the product

themselves (increasing supply)

- if the government had stored the product

during food shortages to ensure low-cost food for the poor

MINIMUM (HIGH) PRICE CONTROLS

oor ceilings: prevents producers from reducing the

price below it

Maximum prices are set:

- to attempt to raise incomes for producers goods

that there government thinks are important
(agricultural products) - protected because they are
subject to large uctuations

- protect workers by setting a minimum wage

Leads to surplus:
- producers have a surplus (excess supply) so they may sell their goods for a lower price

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 Reduce surplus:
shifting the demand curve to the right

- destroy it: wasteful technique

- sell it abroad: leads to unfair dumping

- store: however it is expensive

Issues:

- opportunity cost when the government spends

money

- without minimum prices, it may lead to rms

being ine cient and wasting resouces

Maintaining minimum price: limit the supply

through quotas

Increase the demand for the product:

- advertising

- restricting supply through protectionist policies

(increases demand for domestic goods)

FIRM THEORY

COSTS, REVENUES AND PROFIT

Short run: period of time in which at least one factor of production is xed. All production
takes place in the short run

Long run: period of time in which all factors of production are variable, but the state of
technology is xed. All planning takes place in the long run

Fixed factor of production can be: element of capital, land, type of high skilled labour

Total product: total output that rm produces, using its xed and variable factors in a given
time period

Output in the SR can only be increased by applying more units of the variable factors to the
feed factors

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 Average product: the output that is produced, on average, by each unit of the variable
factor

TP: total output produced

V: number of units of that variable factor employed

Marginal product: the extra output that is produced by using an extra unit of the variable
factor

TP: change in total output

V: change in number of units of the variable factor

employed

LAW OF DIMINISHING RETURNS

The hypothesis of eventually diminishing marginal returns: As more of the variable

factors are added to a xed factor, the extra output from each additional unit of variable
factor added eventually falls, so the extra cost per unit of output eventually begins to rise

The hypothesis of eventually diminishing average returns: As more variable factor are
added to a xed factor, the output per unit of the variable factor will eventually falls, so the
cost per unit of output eventually rises

* The economic cost of producing a good is the opportunity cost of the rm’s production

(the next best alternative foregone when an economic decision is made)

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 Calculating the economic cost of production:

- The economic cost of producing a good is the opportunity cost of the rm’s production

- opportunity cost of the factors of production (resources) that have been used in
producing the good or service

1) Factors that are purchased from others and not already owned by the rm - explicit
costs

2) Factors already owned by the rm - implicit costs

explicit costs: any costs to a rm that involve the direct payment of money

implicit costs: the earnings that a rm could have had if it had employed its factors in
another use or if it had hired out or sold them to another rm

SHORT-RUN COSTS

Total costs: complete costs of producing output

Total cost can be calculated using 3 methods:

Total xed cost (TFC): total costs of the xed assets that a rm uses in a given time period
(a constant amount)

Total variable cost (TVC): total costs of the variables assets that a rm uses in a given time
period

(TVC increase as the rm uses more of the variable factor)

Total cost (TC): total costs of all the xed and variable factors used to produce a certain
output

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 Average costs: costs per unit of output

Average cost can be calculated using 3 methods:

Average xed cost (AFC): xed cost per unit of output

Average variable cost (AVC): variable cost per unit of output

AVC falls as output increases, then starts to rise again as the output continues to increase
(hypothesis of eventually diminishing average returns)

Average total cost (ATC): total cost per unit of output

Marginal cost (MC): increase in total cost of producing an extra unit of output

hypothesis of eventually diminishing marginal returns

The MC cuts the AVC and the ATC curves at their lowest
points

- AFC falls as output increases

- the di erence between ATC and AVC = AFC

- The vertical gap between ATC and AVC gets smaller as

output grows

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THE LONG RUN

- the planning stage

- only restricted by technology

- free to adjust the quantity of all factors of production

Costs when all the factors of production are increased in order to increase output

Curves represent all the possible

combinations of xed and
variable factors that could be
used to produce di erent levels
of output for this rm

LRAC curve is the boundary

between unit cost levels that are
attainable by the rm and unit
cost levels that are unattainable

Increasing returns to scale: long-run average costs are falling as output increases

increase in factors of production leads to a greater percentage increase in output -

reducing long-run average cost

Constant returns to scale: long-run average costs are constant as output increases

increase in factors of production leads to a same percentage increase in output -

long-run average cost remain the same

Decreasing returns to scale: long-run average costs are rising as output increases

increase in factors of production leads to a smaller percentage increase in output -

increasing long-run average cost

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 CHANGE IN LONG RUN

ECONOMIES OF SCALE

economies of scale: any decreases in long-run average costs that come when a rm alters
all its factors of production in order to increase its scale of output

economies of scale lead to the rm experiencing increasing returns to scale

ECONOMY OF SCALE HOW

SPECIALISATION managers have to take on many roles

- roles that are not for the best candidate

- may lead to higher unit cost

- as rms grow they can specialise in individual areas of

expertise
DIVISION OF LABOUR Breaking production process down into small activities so
that workers can perform repeatedly and e ciently

BULK BUYING As rms increase in scale, they can negotiate discounts

with their suppliers

- cost of their inputs is then reduced, which will reduce their

unit cost of production
FINANCIAL ECONOMIES banks charge lower interest to larger rms
- considered to be less of a risk

TRANSPORT ECONOMIES Bulk orders charged less for delivery costs

LARGE MACHINES Some machines are too large to be owned by small rms

PROMOTIONAL ECONOMIES the cost of promotion tend not to increase by the same
proportion as output

cost of promotion per unit of output falls

Diseconomies of scale: any increases in long-run average costs that come when a rm
alters all its factors of production in order to increase its scale of output

diseconomies of scale lead to the rm experiencing decreasing returns to scale

ECONOMY OF SCALE HOW

CONTROL AND COMMUNICATION As a rm grows in scale, the management will nd it harder to

PROBLEMS control and coordinate the activities of a rm

- Leads to ine ciency and increases unit costs of

production

ALIENATION AND LOSS OF Workers may lose a sense of belonging and loyalty

IDENTUTY - work less hard

- less productive

- force up unit costs of production

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 SHAPE OF THE CURVES

Short-run are U-shaped: hypothesis of diminishing returns

Short-run average variable: hypothesis of diminishing average returns / diminishing

marginal returns

Long run cost curve U-shape: existence of economies and diseconomies of scale

REVENUE THEORY

Total revenue: total amount of money that a rm receives from selling a certain amount of a
good or service in a given time period

Average revenue: revenue a rm receives per unit of its sales

Marginal revenue: extra revenue that a rm gains when it sells one more unit of a product
in a given time period

REVENUE CURVES AND OUTPUT

1) Revenue when price does not change with output

If a rm does not have to lower price as output increases and it wishes two sell more of its
product - perfectly elastic demand curve

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 2) Revenue when price falls as output increase

demand curve is downward sloping / elasticity of demand falls as output increase

Average revenue = price = demand

Marginal revenue is twice as steep as

average revenue

Marginal revenue is below average revenue

because to sell more products, the rm has
to lower the price of all products sold

TR drops: extra revenue gained from dropping price and selling more units is out < loss in
revenue from the units that were being sold at a higher price and now have to be sold at a
higher price

MR is negative: when price is lowered, total revenue will fall

A rm knowing whether their price is elastic or inelastic : know what pricing policy to adopt
to increase revenue

To increase revenue:

PED is elastic: lower its price

PED is inelastic: raise it’s price

PED is unity: leave price unchanged

(revenue already maximised)

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 PROFIT THEORY

Total pro t = total revenue - economic costs (explicit and implicit costs)

TR = TC: normal pro t (zero economic pro t)

TR > TC: abnormal pro t (economic pro t)

TR < TC: loss (negative economic pro t)

SHUT DOWN PRICE

shut down price: level of price that enables a rm to recover its variable cost in the short
run

- If a rm does not cover AVC it will shut down

- price = AVC: rm will shut down in the short run

example: ice cream store in Mostar

BREAK EVEN PRICE

break even price: price at which a rm is able to make normal pro t in the long-run

- If a rm does not cover ATC in the long-run, it will shut down for good

- price = ATC

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 PROFIT MAXIMISING LEVEL OF OUTPUT

MR > MC: Increase production

Firm makes a pro t on ever extra unit produced

MC = MR: pro t minimisation (loss maximisation)

The rm has made a loss on ever unit produced up to this level of output

MR < MC: decrease production

maximise pro t:
MC cuts MR from below

pro t maximising: MC=MR

MC curve cuts the AC curve at the lowest point on

the AC

Pro t per unit of producing: di erence between AR and

AC

*abnormal pro t depends on the position of the AC

curve

Other aims:
- Revenue maximisation: measure success by the amount of revenue that they make /
maximise their sales revenue by producing where the marginal revenue is zero

- Growth maximisation: achieve growth in the short run, rather than pro ts, in order to
gain a large market share and then dominate the market in the long run.

Growth through: quantity of sales, sales revenue, employment or the percentage of market
share

- Satis cing: perform satisfactorily rather than to a maximum level, in order to persue
other goals: pursuit of leisure, encourage development in the local community through
educational projects, reducing environmental e ects

Done to gain a good reputation in order to take people’s attention away from their product
(cigarettes and alcohol)

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 PERFECT COMPETITION

ASSUMPTIONS

- industry is made up of many rms

- each rm is small relative to the size of the industry (a rm cannot a ect the
output of the industry as a whole)

- all produce exactly identical products

- no barriers of entry or exit

- perfect knowledge of the market (consumers and producers)

example: tourist market in Thailand

Demand in the industry

rms are price takers

* Individual rms sell at the industry price

* if they sell at a lower price, the consumers will use buy it from another rm

* demand is perfectly elastic

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 Pro t maximisation

pro t is maximised: MC = MR
P = D = AR = MR

- the quantity of output from the rm is very small relative to the industry, so one rm will
not a ect the output of the industry

Short-run pro t and loss situations in perfect competition

Short-run abnormal pro ts: more than covering their total costs, including opportunity
costs

average cost is less average revenue

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 Short-run losses: not covering their total costs

cost per unit is greater than the price

- loss minimising

Movement from short-run to long-run in perfect competition:

other rms begin to react and the situation starts to change until an equilibrium point is
reached in the long-run

Short-run abnormal pro ts to long-run normal pro ts:

- a rm making abnormal pro ts in the short-run will not continue making abnormal pro ts
in the long-run

- rms are attracted too the abnormal pro ts

- perfect knowledge and no barriers to entry or exit the industry

- as more rms enter, the supply curve shift to the right

- will continue until abnormal pro ts become normal pro ts

- cover
opportunity costs

- no more abnormal pro t to attract more rms

- industry is in long-run equilibrium (no one will leave or enter)

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 Short-run losses to long-run normal pro ts:

- rms will start to leave the industry

- supply curve will start to shift to the left

- price will begin to rise

- demand curve shifts upwards

- process continues until normal pro ts are made ( price=costs )

- cover all costs / including opportunity costs

- normal pro ts mean that there is long-run equilibrium

Long-run equilibrium in perfect competition:

Long run: normal pro ts

Short-run abnormal pro ts / losses: rms will leave the industry until normal pro ts are
made

No incentives for other rms to leave or enter

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 productive e ciency: it produces its products at the lowest possible unit cost

produces at the most e cient at the lowest

average cost of production

MC = AC

combining their resources as e ciently as

possible and resources are not being wasted
by ine cient use

allocative e ciency: suppliers are producing the optimal mix of goods and services by
consumers

price: the value that the consumers place on a good

marginal cost: cost to society of all the resources used in producing tan extra unit of a good

price > marginal cost: consumers would value the good more than the cost to make it

MC = AR: allocative e ciency

MC: cost to producers

AR: value to consumers

impossible to make one person better o , without making someone else worse o

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 EFFICIENCY IN THE SHORT-RUN

Abnormal pro ts in the short run

- pro t maximising levels: MC = MR

- producing at allocative e ciency: MC = AR

- Not productive at most e cient level: MC = AC

Losses in the short-run

- producing at pro t maximising: MC=MR

- producing at allocative e ciency: MC = AR

- not producing at most e cient level: MC = AC

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 EFFICIENCY IN THE LONG-RUN

produce: lowest point of their long-run average cost curves

MC = AC

MONOPOLY

ASSUMPTIONS

- there is only one rm producing the product so the rm is the industry

- barrier to entry exists (stops new rms from entering the industry and maintains the
monopoly)

- Abnormal pro ts are made due to barriers to entry and exit

example: Microsoft on speci c software

- How much monopoly power does it have?

- To what extent is the rm a price setter?

- Depends on how many competing substitutes the rm has

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 SOURCES OF MONOPOLY POWER

a monopoly will continue to be the only producer in the industry if it is able to stop other
rms from entering the industry in someway.

Barriers of to entry:

1) economies of scale: rms gain cost advantages as their size increases / small rms
wanting to start will not bene t from these economies of scale will not have equal
economics of scale so its will not be able to compete and the infant industry would
make losses

2) natural monopoly: there only enough economies of scale to support one rm

- Monopolist industry has the demand curve D1.

- Long-run: cost curve is LRAC / position and shape are

set by the economies that they are experiencing

- Make abnormal pro ts because AR > AC for range of

output (if the monopoly is able to support the demand)

- Market will only support one rm

example: water supply in Malaysia

3) Legal barrier: Firm may be given a legal right to be the only producer / patents is a rm
which is given the right to be the only producer only after (usually) 20 years of ivention.
After patents expire, other producers are allowed to produce the goods

- Patents exits to encourage invention

- Encourage research and investment
- Copyrights/trademarks are intellectual property which refer to the creation of the mind
example: pharmaceutical industry / state postal industry

4) Brand loyalty: produces a product that has gained loyalty

5) Anti competitive behaviour: adopt restrictive practices, which should be legal or illegal /
eg. starting price wars / lowering their price when a new rm enters the industry

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 DEMAND CURVE AND PROFIT MAXIMISING LEVEL OF OUTPUT IN MONOPOLY

A monopoly can control either the level of

output of the price of the product (not both)

- In order to sell more, they need to lower their

price

- Monopolies have normal demand curves

Pro t maximising: MC = MR

POSSIBLE PROFIT SITUATIONS IN MONOPOLY

Abnormal pro ts in the short-run

- If they have e ective barriers of entry, other

rms cannot enter the industry / compete away
the pro ts being made

- Then, monopolist are able to make abnormal

pro ts in the long-run, till the barriers to entry
hold out

When monopolist produce something with little demand, it will not earn abnormal pro ts

Losses in the short-run

- Losses in the short-run: option of closing

down temporarily (if it is not covering variable
costs)

- Long-run losses: AC > AR

Firm will shut-down / rm is the industry so the
industry would cease to exist

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 REVENUE MAXIMISATION IN MONOPOLY

Monopoly chooses to maximise revenue, not

pro ts

Maximising pro ts: MC = MR

Revenue maximisation: MR = 0

EFFICENCY IN MONOPOLY

-Produces at the level of output where there is

neither productive e ciency nor allocative
e ciency

- Monopolies produce at pro t-maximising level

of output

- Most e cient level of output (allocative e cient)

not being achieved

ADVANTAGES AND DISADVANTAGES OF MONOPOLY IN COMPARISON WITH

PERFECT COMPETITION
ADVANTAGES of a monopoly DISADVANTAGES of a monopoly

Able to achieve economies of scale

Restrict output and charge a higher price than
- push MC curve down
perfect competition

- produce at higher output and lower price than - Higher prices and lower output exist in
perfect competition Monopoly

Monopolies produce where MC=MR

- They are productively and allocatively
- maximising pro ts ine cient
Higher levels of investment in research and The exercise anti competitive behaviour to keep
development
their monopoly power

- make abnormal pro ts which can be used to - act against the public interest

fund research
- governments have laws and policies to limit
- this would bene t consumers monopoly power

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 Economies of scale in Monopolies

MONOPOLISTIC COMPETITION

ASSUMPTIONS

- fairly large number of fries

- rms are small relative to the industry

- rms produce slightly di erentiated products

- rms are free to enter or leave the industry

Di erence from perfect competition is that monopolistic competition has product

di erentiation:

- brand name

- colour

- appearance

- packaging
- design

- quality of service

- skill levels

example: nail salons

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Lead to brand loyalty: producers have some element of independence when deciding on
price

- producers are (to some extent) price makers

- demand is relatively elastic

maximising pro t: MC = MR

SHORT-RUN PROFIT IN MONOPOLISTIC COMPETITION

Maximising pro ts by producing at the level:

MC = MR

as

Cost < Price

SHORT-RUN LOSSES IN MONOPOLISTIC COMPETITION

MC = MR

as

cost > price

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 LONG-RUN EQUILIBRIUM IN MONOPOLISTIC COMPETITION

If the rm is making pro ts or losses in the short-

run, due to freedom of entry and exit in the
industry, there will be long run equilibrium

Normal pro ts will be made

- maximising pro ts at MC = MR
cost (including opportunity costs) = price

Short-run abnormal pro ts: attracted to the industry / demand curve shifts the to left

Short-run losses: rms will leave the industry / remaining rms will experience demand
curve shifting to the right as they pick up consumers from leaving rms

PRODUCTIVE EFFCIENCY / ALLOCATIVE EFFIECENY IN MONOPOLISTIC

COMPETITION

SHORT RUN

productive e ciency: level of output where rm produces at the lowest possible cost per
unit

MC = AC

allocative e ciency: social optimum level of output

MC = AR

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 LONG RUN

Firm is producing at the pro t-maximising

level of output

-not at productive/allocative e ciency

MONOPOLISTIC COMPETITION IN COMPARISON TO PERFECT COMPETITION

ADVANTAGES DISADVANTGES

pro t maximisng not allocatively nor productively e cient

ine ciency is due to the consumers desire for pay slightly more
variety
consumers have the opportunity to make
choices

OLIGOPOLOY

ASSUMPTIONS

- only few rms dominate the industry

- large proportion of the industry’s output is shared by a small number of rms

- [some] produce high di erentiated products (shampoo brands)

- distinct barrier of entry

- interdependence (tends to make rms collude)

- price rigidity

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 CRx: ‘x’ represents the number of the largest rms / percentage of market hare by
the largest rms in the industry

higher the percentage: more concentrated the market power of the ‘x’ number rms

COLLUSIVE AND NON-COLLUSIVE OLIGOPOLY

collusive: rms in an oligopolistic market collude to charge the same prices fro their
product

Formal collusion (cartel): rms openly agree on the price that they will charge / could be
on market share or on marketing expenditure

- higher prices and less output for consumers

- against the interest of consumers

- Usually banned by governments (if they are discovered they may get penalised,
ned, etc.)

- formal collusion between governments is permitted (OPEC) which sets

production quotas and prices for the world market

Tacit collusion: charge the same prices without formal collusion (through adverts, charging
the same price as a dominant rm)

Collusive oligopoly shows price rigidity

- whether formally or tacit

- they’re making their share pf long-run monopoly pro ts

- try to keep the prices stable so situation continues

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 In both collisions, the process is the same

1) Behave as monopolist

2) Charge monopoly prices

3) Make monopoly pro ts

4) Share them according to market share

Non-collusive: rms in an oligopoly do not collude / must be aware of other rms when
making decisions and must be aware of their reactions

GAME THEORY

Assuming:

- it is a duopoly

- rms have equal costs

- identical products

- share market equally

- initially demand is the same

- useful for rms to

predict the outcomes
that will follow any set
of decisions

- the more rms in an

industry, the more
di cult it is to
estimate

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 Non-collusive - Kinked demand curve

Assume:

the only point the rm knows about it the

point it is at (point ‘a’)

Elastic above point ‘a’

-a small increase in price would lead to a

large fall in quantity demanded

Less elastic below point ‘a’

-If a rm were to lower their price, their
competitors would follow

-decrease in price is unlikely to lead to a

notice increase in quantity demanded

At point ‘a’: is kinked

- possess an MR curve that has a vertical section because MR curve will be 2x as steep as
the 2 parts of the demand curve

example: coca cola and pepsi

KINKED DEMAND CURVE AND PRICE RIGIDITY:

1) Firms are afraid to raise prices above the current market price, because other rms
will not / they will lose trade, sales and pro t

2) Firms are afraid to lower their prices below the current price, because other rms will
follow (undercutting them) - creating a price war that may harm all the rms involved

3) Shape of MR = if MC were to rise, then it would be possible for MC = MR, so the rms
being pro t maximisers would not change their prices or outputs

NON-PRICE COMPETITION
Firms in oligopolies tend to not compete in terms of price

1) brand names

2) packaging

3) special features

4) advertising

5) sales promotion

6) personal selling

7) publicity

8) sponsorship deals

9) special distribution features (free delivery)

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 They try to develop brand loyalty and make their demand fro their product less elastic

- may present a misuse of scare resources

- competition among companies results in greater choice for consumers

example: coca cola and pepsi / adidas and nike

PRICE DISCRIMINATIO

price discrimination: a producer sells the exact same product to di erent consumers at
di erent prices

CONDITIONS

1) producer must have the price setting ability

- most often found in monopolies or oligopolies

2) consumer must have di erent price elasticities of demand for the product (if not
the consumer will not be prepared to pay di erent prices
- inelastic demand: pay higher price

- elasticity signi es the importance of a product to consumers

3) producer must be able to separate the consumers

- TIME: train tickets during rush hours

- AGE: children tickets and cinemas

- GENDER: Ladies night

- INCOME: lawyers usually charge a higher price to the rich

- GEOGRAPHICAL DISTANCE: cost of transferring the product > di erence in prices

- TYPES OF CONSUMERS: charging tourists a higher price

LEVELS OF DISCRIMINATION

1) First-degree price discrimination

Each consumer pays exactly the price that s/he is

prepared to pay

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 pasar-malams work like this

Not 2 price discriminated: total revenue would be the ‘1’

Discrimination: consumer surplus is removed / total revenue = ‘1+2’

2) Second-degree price discrimination

A rm charges di erent prices to consumers depending on

how much they purchase

utilities companies work like this / gas or electricity

provider

3) Third-degree price discrimination

The consumers are identi ed in di erent market segments and separate price is
charged in each market segment that recognises the di erent price elasticities

- assume the rm is trying to maximise pro ts

- maximise pro ts when MC = MR

cinemas: students having a more elastic demand than inelastic demand with adults

ADVANTAGES AND DISADVANTAGES OF PRICE DISCRIMINATION

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 ADVANTAGES to the rm DISADVANTAGES to the rm

Gains a higher revenue from a given amount of

sales (due to erosion of consumer surplus)
Produce more of the product

- gain from economies of scale

- lowering average costs / prices in all market

segments
Drive competitors out of elastic market
- pro ts gained in inelastic segment to lower
prices in the elastic segment

- occurs in international trade

not allowed to sell below cost of production in forge in markets - dumping / only allowed to sell at
prices below the domestic market price

ADVANTAGES to the consumer DISADVANTAGES to the consumer

Allow some consumers to purchase a product Any consumer surplus that existed before price
that they would otherwise have to pay a higher discrimination will be lost
price for
- ‘subsidising’ the poorer consumers
Increases total output in a market so the some consumers will have to pay more than
product is available to more consumers the price they would have been charged in a
single, non discriminated market

Economies of scale mean lower unit costs, and

lower prices for consumers in all market
segments

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MARKET FAILURE

market failure: a market fails to allocate resources e ciently, or provide the quantity and
combination of goods and services mostly wanted by society

TYPES OF MARKET FAILURE

LACK OF PUBLIC GOODS

public goods: goods that are non-rivalrous and non-excludable so rms don’t have the
incentive to produce it

non-rivalrous: consumption of one person doesn’t reduce consumption by another

non-excludable: not possible to exclude someone from using the good

- goods that would otherwise not be provided at all in a free market

- the lack of public goods in a market

- goods that bene t a society

example: national defence, ood barriers

GOVERNMENT INTERVENTION
- provide the public good themselves through the money of the tax payers / fund
provision to spread the cost over a large number of people

- Subsidies private rms covering all costs to provide the good

example: roads, pavements, street lighting

UNDER SUPPLY OF MERIT GOODS

Merit goods: goods that are held desirable for the consumer, but which are under provided
by the market.

positive externalities / consumers with low incomes cannot a ord it / consumer ignorance
doesn’t know about the bene ts

- all public goods are merit goods

example: education, health care, sports facilities

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 GOVERNMENT INTERVENTION

government will attempt to increase the supply and consumption of the good depending on
how important the government thinks the good is

- Government will directly provide them

- Government will subside them until they are available at no direct cost to the consumer
(cost shared amongst tax payers)

OVER SUPPLY OF MERIT GOODS

Demerit goods: goods that are undesirable for consumers and are over provided by the
market

negative externalities / consumer ignorance about the harmful a ects

example: cigarettes, alcohol, hard drugs

GOVERNMENT INTERVENTION

- government could make laws / making them illegal / ban them completely

may lead to a black market - attracted by the chance to make pro ts by ful lling existing
demand

- tax the demerit goods

THE EXISTENCE OF EXTERNALITIES

An externality will occur when the production/consumption of a good or service has an
e ect upon a third party

Marginal social cost: MPC plus minus any external external costs or bene t of production

No externalities of production: MSC = MPS

- MPC is the private supply curve that is based

on the rm’s costs of production

No externalities of consumption: MSB = MPB

- MPB is the private demand curve that is based

on the utility/ bene t to the consumers

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 If no externalities exist: MSC = MPB

- socially e cient and maximum community surplus

If externalities exist: MSC ≠ MSB

- market failure and ine cient allocation of society’s resources

NEGATIVE EXTERNALITIES OF PRODUCTION

negative externality of production : the production of a good/service will create external

costs that are damaging to third parties / MSC > MPC

example: fossil fuel power houses

Free market: situation would continue because

pro t maximising rms will only take into
account their private costs of production

GOVERNMENT INTERVENTION

Tax the rm:

- Increase the rm’s private costs / shift

MPC upwards towards the points of social
e ciency

- Tax = external cost of production:

government has internalised the externality

- Tax ≠ external cost of production: reduce

deadweight burden / not eliminate it

Issues with tax:

- Di cult to measure the the externality of

production

- Taxes don’t actually stop the pollution

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 Pass laws:

- ban the polluting rms

- pass law relating measurable environmental standards in the rm’s production

- this increases their private costs

Issues:

- lead to job losses

- cost of setting policy may > than cost of pollution

Cap trade systems:

Tradable emission permits: market-based solutions to negative externalities of production

- Licence to create pollution up to a certain level

- Once they are issued: rms can trade, sell, and buy the permits on the market

Issues:

- di cult to measure pollution produced

- doesn’t reduce pollution

example: Kyoto protocol

POSITIVE EXTERNALITIES OF PRODUCTION

positive externality of production : the production of a good/service will create external

bene ts that are good for third parties / MSC < MPC

example: retraining for employees

Free market: it is up to the government to

rectify the situation

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 GOVERNMENT INTERVENTION

Subsidise the rms that o er training

- MPC curve would shift downwards by the subsidy

- if a full subsidy were given MPC = MSC at socially e cient point

Issue:

- di cult for the government to estimate the level of subsidy deserved by every rm

- cost of subsidy would imply an opportunity cost

Direct provision of training

- setting up centres

- lead to economic bene ts of improvement in quality of labour

Issue:

- costs would be high

- trainers lack expertises found in rms

- dissuade rms from o ering training alone

NEGATIVE EXTERNALITIES OF CONSUMPTION

negative externality of consumption : the consumption of a good/service will create

external costs to third parties MSB < MPB

example: cigarettes

The private utility is diminished by the negative

utility su ered by the third party

Free market: consumers will maximise their

private utility and consume at MSC = MPB

MSC > MSB: welfare loss to the society

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 GOVERNMENT INTERVENTION

Make it illegal / ban it

- Large a ect on rms producing the good /

shareholders and employment

- People are not likely to vote for this

example: Singapore smoking

Indirect tax

- Government could gain revenue

- They have inelastic demand (habit forming) so

taxes won’t do much

- Shift MSC curve upwards to MSC + tax / reducing consumption to socially e cient level

- may lead to a black market if tax is too high

example: Austrian smoker buy cigarettes in Slovakia / black market is formed

Provide education

- fund negative advertising

- a doubt on the e ectiveness of education

example: Malaysia smoking

POSITIVE EXTERNALITIES OF CONSUMPTION

positive externality of consumption : the consumption of a good/service will provide

external beni ts to third parties / MSB > MPB

example: education, health care

- A more productive work force

Free market: people will not consume enough

or it so the government has to intervene

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 GOVERNMENT INTERVENTION

Subsides

- shift the MSC downwards

- socially e cient level of consumption

- government may subside until it is free to

the consumer / no direct cost to consumer

Issue:

-developing countries are not able to funs

such schemes so they do not beni t from
positive externalities

example: NHS in the UK

Positive advertising

encourage people to consume more of the merit good

- shift MSB to the right, towards MSB curve : INCREASE WELFARE

Issue:

- high cost to advertising

- short-run bene ts are minimal

example: Singapore spitting

Pass laws:

- enforcing health care / vaccines

example: Italian preschools are vaccinations

COMMON ACESS RESOURCES AND SUSTAINABILITY

common access resources: resources that are not owned by anyone, do not have a price
and are available for anyone to use without payment. Their depletion leads to environmental
unsustainability.

example: sh in the open seas, ozone layer

- very di cult to exclude people from using them

- very expensive to exclude people from using them

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 Nature of resource: inability to charge for them may encourage overuse or over
consumption

- lead to depletion of the resource

marginal utility: extra satisfaction that a person gets by consuming one more unit of a
good or service

- It’s in the interest to each individual to take as many sh as they want, because each sh
adds marginal utility

Bene ts to the individual > external costs:incentive for individual to keep using the resource

Market-failure will take place due to over-consumption

sustainability: consumption needs of the present generation are met without reducing the
ability to meet the needs of future generations

FURTURE TREATS TO SUSTAINABILITY

Economic growth leads to environmental problems: over-exploitation of land, soil erosion,
land degradation

developing countries: weak regulations result in massive negative externalities and a treat
to sustainability / rely on common access resources to sustain themselves - due to over-
consumption less income

- loss of vegetation may result in ooding and landslides

- loss of forests: too many resources will be allocated to the production of these wood
products (seen through negative externalities)

GOVERNMENT INTERVENTION

-Cap trade systems: national targets for

emission reductions and encourage rms
to meet the targets for emission by creating
economic incentives

-Giving property rights to people /

regulation

-Clean technologies: governments can

subsides the development of clean
technologies / o er tax credits to rms
that invest in clean technology

example: German government with

electric cars

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 IMPERFECT COMPETITIO

IMPERFECT INFORMATION

Asymmetric information: where party in an economic transaction has access to more

information than the other party

- market will fail to reach allocative e ciency

- producer has more information than the consumer / charges a high price than is socially
e cient / too many resources have been allocated to the good

- consumer has more information / pays a lower price than the socially e cient price / too
few resources are allocated to the good

example: insurance

Adverse selection: buyers of insurance have more information about the themselves than
the seller / buyers of insurance know more about the state of their health than sellers of
insurance

Moral hazard : where one party takes risks, yet doesn’t face the full costs of these risks /
set limits to the issues that can go wrong

example: establishing franchises

GOVERNMENT INTERVENTION

- improve ow of information

- set regulations to producers of taking advantage of lack information / expensive and not
possible for all sectors of the economy

- consumers and producers value their right to make private decisions

- technology increases ow of information

IMPERFECT COMPETITION

monopolists: restrict the output in order to push up prices and maximise pro ts

- not producing at the socially e cient level of output

Any imperfect market will fail to produce

where MSC = MSB

-Pro t maximisation: MC = MR

-Loss of consumer surplus (dark blue)

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- Loss of producer surplus

- Community surplus is not maximised / welfare loss: situation of market failure

GOVERNMENT INTERVENTION

legal measures: make markets more competitive

- paw laws: do not permit mergers or take overs that give a rm / more than a certain
personage of the market

- set up regulatory bodies: investigate markets where monopoly power is felt / against the
interest of the public

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