Fundamental of Economics-GEN-201-Touhid Sir

NPI University of Bangladesh
Sub: Fundamental of Economics

Course Code: GEN-201
Department: EEE
Fundamental of Economics
Economics Lecture Notes – Chapter 1
THE CENTRAL PROBLEM OF ECONOMICS will be

taught in economics tuition in the first week of term 1.
Students can refer to Economics – A Singapore Perspective for the diagrams. The book is available
in the major bookstores in Singapore.
1 INTRODUCTION
Economics is the study of how society allocates limited resources to the production of goods and
services to satisfy unlimited human wants.
There are two main branches of economics: microeconomics and macroeconomics. Microeconomics
deals with the analysis of individual parts of the economy. It concerns factors determining the
behaviour of a consumer, the behaviour of a firm, the demand for a good, the supply of a good, the
price of a good, the quantity of a good, the performance of a market, etc. Macroeconomics deals with
the analysis of the whole economy. It concerns factors determining aggregate variables such as
aggregate demand, aggregate supply, national output, unemployment, inflation, the balance of
payments, etc. As opposed to microeconomics which focuses on the individual parts of the economy,
macroeconomics looks at the big picture of the economy.
Economists often distinguish between positive economics and normative economics. Positive
economics is concerned with facts. It tells us what was, what is or what will be. Disagreement over
positive economics can be settled by an appeal to facts. In other words, positive economics is
verifiable.
Consider the following statement:
‘A decrease in personal income tax will lead to a rise in unemployment.’
In the above statement, both personal income tax and unemployment are measurable and hence the
statement is verifiable. Therefore, the statement is a positive statement. It is important to take note
that a positive statement can be true or false. What makes the statement a positive statement is not
that it is true but that it is verifiable. In fact, the statement is false.
Normative economics is concerned with value judgments. It tells us what should be. Disagreement
over normative economics cannot be settled by an appeal to facts. In other words, normative
economics is not verifiable.
Consider the following statement:
‘A redistribution of income from the rich to the poor will increase social welfare.’
In the above statement, although redistribution of income is measurable, social welfare is not and
hence the statement is not verifiable. Therefore, the statement is a normative statement. It is important
to take note that a normative statement can be true or false. Although the statement is true, what
makes it a normative statement is not that it is true but that it is not verifiable.
2 FACTORS OF PRODUCTION
In order to produce goods and services, an economy needs to have resources. The larger the amount
of resources an economy has, the larger will be the amount of goods and services it can produce.
Resources can be divided into four categories known as the four factors of production: land, labour,
capital and enterprise.
Land
Land refers to the gifts of nature that are used to produce goods and services. It includes plots of land,
natural resources, fishes in the sea and trees in the forests.
Labour
Labour refers to the physical and mental effort that people devote to the production of goods and
services.
Capital
Capital refers to the goods that are produced for use in the production of other goods. It includes
factories and machinery.
Enterprise
Enterprise refers to the ability and the willingness to take risk.
Note: Students should not mix up capital in economics, which is known as physical capital, and
capital in business, which is known as financial capital. Although financial capital refers to the money
needed to start a business, physical capital refers to factories and machinery.
Factors of production will be discussed in greater detail in economics tuition by the

Principal Economics Tutor.
3 SCARCITY, CHOICE AND OPPORTUNITY

COST
Although resources are limited, human wants are unlimited, and this gives rise to scarcity. Scarcity is
the situation where limited resources are insufficient to produce goods and services to satisfy unlimited
human wants. Scarcity necessitates choice. In other words, due to scarcity and hence the inability to
produce all goods and services, society must choose what goods and services to produce. The
opportunity cost of a course of action is the benefit forgone by not choosing its next best alternative.
When a choice is made, an opportunity cost is incurred. In other words, when society chooses what
goods and services to produce, it is choosing what goods and services not to produce.
4 THE PRODUCTION POSSIBILITY CURVE

4.1 The Production Possibility Curve, Scarcity, Choice and Opportunity cost
The production possibility curve (PPC) shows all the possible combinations of two goods that can be
produced in the economy when resources are fully and efficiently employed, given the state of
technology, assuming the economy can only produce the two goods.
Possible Combinations of Good Y and Good X
Combination Good X Good Y
A 0 50
B 10 48
C 20 45
D 30 40
E 40 33
F 50 23
In the above table, A, B, C, D, E and F are the possible combinations of good Y and good X that the
economy can produce using its resources fully and efficiently.
Production Possibility Curve

The PPC reflects scarcity, choice and opportunity cost. Although the points inside and on the PPC are
attainable, the points outside the PPC are not. Scarcity is reflected by the unattainable points that lie
outside the PPC, such as point G and point H. The PPC is a series of points rather than a single point.
Choice is reflected by the need for society to choose among the series of points on the PPC, such as
point C and point D. The PPC is downward sloping. Opportunity cost is reflected by the negative slope
of the PPC which indicates that an increase in the production of one good will lead to a decrease in
the production of the other good.
4.2 Movements along versus Shifts in the Production Possibility Curve
A change in the tastes and preferences of society will lead to a movement along the PPC which reflects
a change in choice. The tastes and preferences of society may change due to several factors such as
technological advancements and campaigning. For example, the inventions of smartphones and
tablets have led to a change in the tastes and preferences of society from print publications to digital
publications. Healthy living campaigns have led to a change in the tastes and preferences of society
from non-diet soft drinks to diet soft drinks.
An increase in the production capacity in the economy will lead to an outward shift in the PPC resulting
in a decrease in scarcity, and vice versa. When the PPC shifts outwards, some of the points which
were previously unattainable will become attainable. The production capacity in the economy may
increase due to an increase in the quantity or the quality of the factors of production in the economy.
For example, education and training which will lead to greater human capital will increase the skills
and knowledge of labour and hence the production capacity in the economy. Research and
development which will lead to technological advancement will increase the efficiency of capital and
hence the production capacity in the economy.
Note: When the economy moves into a recession, the PPC will not shift, at least not immediately.
Rather, the economy will move from a point on the PPC to a point inside the PPC, assuming resources
are initially fully and efficiently employed.
A decrease in investment expenditure will not lead to a leftward shift in the PPC. Rather, it will cause
the PPC to shift outwards at a slower rate as firms are still producing new capital. However, if the
amount of new capital falls below the level necessary to replace the amount of worn-out capital, the
PPC will shift inwards.
The production possibility curve will be discussed in greater detail in economics tuition by the Principal
Economics Tutor.
4.3 Shape of the Production Possibility Curve
The PPC is concave to the origin because the opportunity cost of producing each good increases as
its quantity increases as resources are not equally suitable for producing different goods. As the
economy produces more and more of a good, it has to use resources that are less and less suitable
for producing the good to actually produce the good. This means that increasingly more units of
resources are needed to produce each additional unit of the good. Therefore, increasingly more units
of other goods have to be forgone to produce each additional unit of the good resulting in an increase
in the opportunity cost.
4.4 Economic Efficiency
Due to the problem of scarcity, all economies must make three fundamental economic decisions: what
and how much to produce, how to produce and for whom to produce. In making these three
fundamental economic decisions, the objective is to maximise the welfare of society. Efficiency is one
of the criteria used to determine whether this objective is achieved.
Productive Efficiency
The economy is productively efficient when it is impossible to increase the production of some goods
without decreasing the production of other goods, given the quantity and the quality of the factors of
production in the economy. This occurs when the economy is producing on the PPC where resources
in the economy are fully and efficiently employed. Resources in the economy are efficiently employed
when all firms are productively efficient and are fully employed when there is no unemployment of
resources.
Allocative Efficiency
The economy is allocatively efficient when it is impossible to change the allocation of resources in a
way that will increase the welfare of society. This occurs when the economy is producing at the point
on the PPC that is tangent to the social indifference curve where the marginal rate of transformation
is equal to the marginal rate of substitution. Productive efficiency is a necessary condition for allocative
efficiency. In other words, for the economy to be allocatively efficient, it must be productively efficient.
Note: The economy is economically efficient when it is productively efficient and allocatively efficient.
This means that an economy which is productively efficient but allocatively inefficient is not
economically efficient. Apart from the level of the economy, efficiency can also be discussed at the
level of the firm and the level of the market which will be done in Chapter 6 and Chapter 7.
Students are not required to explain the concepts of marginal rate of transformation and marginal rate
of substitution in the examination as they are not in the Singapore-Cambridge GCE ‘A’ Level
Economics syllabus.
5 ECONOMIC SYSTEM
As discussed previously, all economies face the problem of scarcity and hence are required to make
the three fundamental economic decisions of what and how much to produce, how to produce and for
whom to produce. However, economies vary in the way they make these three fundamental economic
decisions in terms of the degree of government intervention. An economic system is a way of making
the three fundamental economic decisions of what and how much to produce, how to produce and for
whom to produce. There are three types of economic systems: the market system, the command
system and the mixed system.
5.1 The Market System
The market system is an economic system in which the three fundamental economic decisions of what
and how much to produce, how to produce and for whom to produce are made by private individuals
with no government intervention. The market system is also known as the free market system, the free
enterprise system and the laissez-faire system. The market system was first advocated by Adam Smith
in his famous book, ‘An Inquiry into the Nature and Causes of the Wealth of Nations’, which was
published in 1776. He argues that the pursuit of self-interest will lead to the benefit of society.
In the market system, all the factors of production in the economy are owned by private individuals.
All economic decisions are made by private individuals. Private individuals can engage in productive
activities, choose what to buy, where to work, etc. There is total economic freedom and the role of the
government is confined to the provision of national defence, maintaining law and order, issuing
currency, etc. Private individuals pursue self-interest. Firms seek to maximise profit, consumers seek
to maximise satisfaction and owners of factors of production seek to maximise factor income.
Competition exists in all economic activities. Firms compete for resources and sales, consumers
compete for goods and services and owners of factors of production compete for employment of their
resources.
In the market system, the three fundamental economic decisions of what and how much to produce,
how to produce and for whom to produce are made by private individuals with no government
intervention.
What and How Much to Produce?
The types and amounts of goods to produce are jointly determined by consumers and firms through
the price mechanism. The price mechanism refers to the system in a market economy whereby
changes in price due to shortages and surpluses equate quantity demanded and quantity supplied.
Consumers indicate to firms the types and amounts of goods that they want by the prices that they
are able and willing to pay for them. Firms that seek to maximise profit will only produce the types and
amounts of goods that consumers are able and willing to pay for. Therefore, prices signal the types
and amounts of goods that are in demand and hence, the profitability of producing these goods. This
signalling role of prices is the essence of the price mechanism.
How to Produce?
The profit motive of firms implies that they will choose the least-cost method to produce any amount
of output and this is determined by relative factor prices. If labour is cheaper than capital, firms will
use more labour and less capital in production. However, if capital is cheaper than labour, firms will
use more capital and less labour in production. Therefore, relative factor prices determine the ways in
which goods are produced.
For Whom to Produce?
The market system distributes goods to consumers with the ability and the willingness to pay for the
goods and this is determined by their preferences and income levels.
5.2 The Command System
The command system is an economic system in which the three fundamental economic decisions of
what and how much to produce, how to produce and for whom to produce are made by the government
with no involvement of private individuals. The command system is also known as the centrally
planned system. The command system was first advocated by Karl Marx in his famous book, ‘Das
Kapital’, which was published in 1867. He argues that capitalism will fall which will lead to the rise of
socialism and eventually to communism.
In the command system, all the factors of production in the economy are owned by the government.
All economic decisions are made by the government. Private individuals cannot engage in productive
activities, choose what to buy and where to work, etc. There is no economic freedom. Private
individuals cannot pursue self-interest and competition does not exist.
In the command system, the three fundamental economic decisions of what and how much to produce,
how to produce and for whom to produce are made by the government with no involvement of private
individuals. In other words, economic decision-making is centralised. To do this, the government must
choose the combination of goods that it thinks will maximise the welfare of society, direct resources to
produce the goods by planning the output level of each industry, decide on the method of production
and how the goods are to be distributed. The government can distribute goods directly which is usually
done through the issue of rationing coupons, or it can decide on the distribution of income, in which
case, it will decide who should be paid what.
5.3 The Mixed System
The mixed system is an economic system in which the three fundamental economic decisions of what
and how much to produce, how to produce and for whom to produce are partly made by private
individuals and partly made by the government. Therefore, a mixed economy is comprised of the
private sector and the public sector. In reality, every economy is a mixed economy. Due to the flaws
of both the market system and the command system, all economies in the world are a mixture of both
economic systems. Even command-oriented economies such as North Korea and Cuba rely on the
market system to some extent and market-oriented economies such as Singapore and Hong Kong
have some degree of government intervention.
In the mixed system, some of the factors of production in the economy are owned by private individuals
and some are owned by the government. Economic decisions are partly made by private individuals
and partly made by the government. Although private individuals can engage in productive activities,
choose what to buy and where to work, they are restricted by the government. Although there is
economic freedom, it is restricted by the government. Although private individuals can pursue self-
interest, they are restricted by the government. Although competition exists, it does not happen in all
forms of economic activities.
In the mixed system, the three fundamental economic decisions of what and how much to produce,
how to produce and for whom to produce are partly made by private individuals and partly made by
the government.
5.4 Advantages and Disadvantages of Economic Systems
Advantages of the Market System and Disadvantages of the Command System
In the market system, allocative efficiency may be achieved as private individuals themselves are in
the best position to know what they want. There will be incentive for workers to work hard and for firms
to be efficient as they will be rewarded with high income and profit. There will fast decision-making as
each private individual only needs to make economic decisions pertaining to their interest. There will
be liberty as private individuals are allowed to choose their ways of life.
The advantages of the market system are the disadvantages of the command system.
Advantages of the Command System and Disadvantages of the Market System
In the command system, allocative efficiency may be achieved as externalities will be taken into
consideration by the government. There will be no unemployment as the government will provide a
job for every private individual. The distribution of income will be equitable as no private individuals
will earn very high or very low income. Public goods will be produced by the government through
taxation. There will be no private firms with substantial market power which can charge high prices.
The advantages of the command system are the disadvantages of the market system.
DEMAND AND SUPPLY will be taught in economics

tuition in the second and third weeks of term 1.
1 INTRODUCTION
In Chapter 1, we learnt that the allocation of resources in the market system is determined by the
market forces of demand and supply. Therefore, to have a good understanding of the allocation of
resources in the market system, we need to understand the concepts of demand and supply. Indeed,
as demand and supply are two fundamental economic concepts which permeate the study of
economics, a good understanding of the concepts is essential for understanding economics. To draw
an analogy, the importance of demand and supply in economics is equivalent to the importance of the
four mathematical operations of addition, subtraction, multiplication and division in mathematics. This
chapter provides an exposition of the concepts of demand and supply.
2 DEMAND
2.1 Relationship between Price and Quantity Demanded
The demand for a good is the quantity of the good that consumers are willing and able to buy at each
price over a period of time, ceteris paribus. The quantity demanded of a good refers to the quantity of
the good that consumers are willing and able to buy. The law of demand states that there is an inverse
relationship between price and quantity demanded. When the price of a good falls, the quantity
demanded will rise. Conversely, when the price of a good rises, the quantity demanded will fall. The
demand curve of a good shows the quantity demanded of the good at each price over a period of time,
ceteris paribus. The demand curve is downward sloping due to the law of demand.
Demand Curve
In the above diagram, when the price (P) is P0, the quantity demanded (Q) is Q0. A fall in the price
from P0 to P1 leads to an increase in the quantity demanded from Q0 to Q1.
The law of demand can be explained with the concept of diminishing marginal utility. Utility refers to
the satisfaction obtained by consumers from consuming a good. Marginal utility is the additional
satisfaction resulting from consuming one more unit of a good. The more a consumer has of a good,
the less they will value it at the margin and this is known as diminishing marginal utility. Due to
diminishing marginal utility, consumers will only increase the consumption of a good if the price falls.
The law of demand can also be explained with the concepts of substitution effect and income effect.
When the price of a good falls, the real income of consumers will rise as they will be able to buy a
larger amount of goods and services with the same amount of nominal income. This will induce them
to buy more of the good. This effect is known as the income effect of a price fall. Furthermore, when
the price of a good falls, the good will become relatively cheaper than other goods. This will induce
consumers to substitute the good for other goods. This effect is known as the substitution effect of a
price fall.
Note: Ceteris paribus is Latin which means other things being equal.
The demand curve of a consumer is downward sloping due to the law of demand. The market demand
curve is the horizontal summation of the demand curves of all the consumers in the market and hence
is also downward sloping.
Students are not required to explain the inverse relationship between price and quantity demanded in
the examination unless the question specifically asks so.
2.2 Movements along versus Shifts in the Demand Curve
A change in quantity demanded occurs when quantity demanded changes due to a change in price.
This is shown by a movement along the demand curve.
In the above diagram, the quantity demanded (Q) increases from Q0 to Q1 due to a fall in the price (P)
from P0 to P1. This is called an increase in quantity demanded.
A change in demand occurs when quantity demanded changes due to a change in a non-price
determinant of demand. In other words, quantity demanded changes at the same price. This is shown
by a shift in the demand curve.
In the above diagram, the quantity demanded (Q) increases from Q0 to Q1 at the same price (P0) due
to a change in a non-price determinant of demand. This is called an increase in demand.
Note: Students should not mix up a change in quantity demanded which is shown by a movement
along the demand curve and a change in demand which is shown by a shift in the demand curve as
failure to do so will lead to a great loss of marks in the examination.
2.3 Non-price Determinants of Demand
Tastes and Preferences
A change in tastes and preferences towards a good will lead to an increase in the demand and vice
versa. Tastes and preferences are affected by a number of factors such as technological
advancements and campaigning. For example, the inventions of smartphones and tablets have led to
a change in tastes and preferences from print publications to digital publications. Healthy living
campaigns have led to a change in tastes and preferences from non-diet soft drinks to diet soft drinks.
These have increased the demand for digital publications and diet soft drinks and decreased the
demand for print publications and non-diet soft drinks.
Prices of Substitutes and Complements
Substitutes are goods which are consumed in place of one another such as Coke and Pepsi. A rise in
the prices of substitutes for a good will induce consumers to buy less of the substitutes resulting in an
increase in the demand for the good and vice versa. For example, if the price of Pepsi rises, consumers
will buy less Pepsi and more Coke. Complements are goods which are consumed in conjunction with
one another such as car and petrol. A fall in the prices of complements for a good will induce
consumers to buy more of the complements resulting in an increase in the demand for the good and
vice versa. For example, if the prices of cars fall, consumers will buy more cars and more petrol.
Substitutes and complements will be explained in greater detail in Chapter 3.
Number of Substitutes and Complements
An increase in the number of substitutes for a good will lead to a decrease in the demand for the good
and vice versa. For example, if scientists found out that milk could be used as a substitute for shampoo,
the demand for shampoo would decrease. An increase in the number of complements will lead to an
increase in the demand for a good and vice versa. For example, if more models of digital cameras are
introduced onto the market, the demand for memory cards will increase.
Level of Income
When consumers’ income rises, the demand for some goods will increase and these goods are called
normal goods. A normal good is a good whose demand rises when consumers’ income rises. There
are two types of normal goods: necessity and luxury. A necessity is a good whose demand rises by a
smaller proportion when consumers’ income rises. Examples of necessities include agricultural
products and stationery. A luxury is a good whose demand rises by a larger proportion when
consumers’ income rises. Examples of luxuries include private cars and branded watches. When
consumers’ income rises, the demand for some goods will decrease and these goods are called
inferior goods. An inferior good is a good whose demand falls when consumers’ income rises. Inferior
goods are typically relatively low in quality. Examples of inferior goods include public transport and
Daiso Products.
Distribution of Income
If income is redistributed from the rich to the poor, the demand for luxuries which are typically
consumed by the rich will fall as the rich will become less rich. The demand for inferior goods which
are typically consumed by the poor will also fall as the poor will become less poor. However, the
demand for necessities will increase as both the rich and the poor will buy more necessities.
Expectations of Price Changes
If consumers expect the price of a good to rise, they will bring forward the purchase to avoid paying a
higher price in the future. If the good can be resold such as residential properties, consumers will also
buy the good to sell it at a higher price later. When these happen, the demand for the good will
increase. Conversely, if consumers expect the price of a good to fall, they will put off the purchase to
enjoy a lower price in the future which will lead to a decrease in the demand.
Size of the Population
An increase in the size of the population will lead to an increase in the demand for certain goods and
services. With the exception of a few countries such as Japan, most countries have been experiencing
an increase in the size of the population.
Structure of the Population
If the population is greying, the demand for pharmaceutical products will increase. An example is
Singapore. If the birth rate rises, the demand for infant products will increase.
Government Policies
The government is the biggest spender in every economy. Therefore, if the government increases
expenditure on goods and services, the demand for certain goods and services will increase and vice
versa. The government can also affect private expenditure by changing interest rates and tax rates.
For example, if the government cuts income taxes, consumers will experience a rise in their disposable
incomes which will lead to an increase in the demand for certain goods and services.
Weather Conditions
In winter, the demand for coats and sweaters will increase and the demand for ice creams will
decrease. The opposite is true in summer.
Note: The non-price determinants of demand will be discussed in greater detail in economics
tuition by the Principal Economics Tutor.
3 SUPPLY
3.1 Relationship between Price and Quantity Supplied
The supply of a good is the quantity of the good that firms are willing and able to sell at each price
over a period of time, ceteris paribus. The quantity supplied of a good refers to the quantity of the good
that firms are willing and able to sell. The law of supply states that there is a direct relationship between
price and quantity supplied. When the price of a good falls, the quantity supplied will fall. Conversely,
when the price of a good rises, the quantity supplied will rise. The supply curve of a good shows the
quantity supplied of the good at each price over a period of time, ceteris paribus. The supply curve is
upward sloping due to the law of supply.
Supply Curve
In the above diagram, when the price (P) is P0, the quantity supplied (Q) is Q0. A rise in the price
from P0 to P1 leads to an increase in the quantity supplied from Q0 to Q1.
The law of supply can be explained with the concept of profit maximisation. A rise in the price of a
good will increase the profitability of selling the good. Therefore, firms which are profit-oriented will sell
more of the good. The law of supply can also be explained with the concept of diminishing marginal
returns. Suppose that a firm employs two factor inputs: capital and labour. Although labour is a variable
factor input, capital is a fixed factor input. As the quantity of capital is fixed in the short run, the firm
can increase production only by employing more labour. However, as each additional unit of labour
will have less capital to work with, it will add less to total output than the previous additional unit and
this is known as diminishing marginal returns. Due to diminishing marginal returns, to produce each
additional unit of output, more units of labour will be required which will lead to an increase in marginal
cost. Marginal cost is the additional cost resulting from producing one more unit of output. Therefore,
firms will increase the production of a good only if the price rises.
Note: The supply curve of a firm is upward sloping due to the law of supply. The market supply curve
is the horizontal summation of the supply curves of all the firms in the market and hence is also upward
sloping.
Students are not required to explain the direct relationship between price and quantity supplied in the
examination unless the question specifically asks so.
3.2 Movements along versus Shifts in the Supply Curve.
A change in quantity supplied occurs when quantity supplied changes due to a change in price. This
is shown by a movement along the supply curve.
In the above diagram, the quantity supplied (Q) increases from Q0 to Q1 due to a rise in the price (P)
from P0 to P1. This is called an increase in quantity supplied.
A change in supply occurs when quantity supplied changes due to a change in a non-price determinant
of supply. In other words, quantity supplied changes at the same price. This is shown by a shift in the
supply curve.
In the above diagram, the quantity supplied (Q) increases from Q0 to Q1 at the same price (P0) due to
a change in a non-price determinant of supply. This is called an increase in supply.
Note: Students should not mix up a change in quantity supplied which is shown by a movement along
the supply curve and a change in supply which is shown by a shift in the supply curve as failure to do
so will lead to a great loss of marks in the examination.
3.3 Non-price Determinants of Supply
Cost of Production
A rise in the cost of production will lead to a decrease in supply and vice versa. When the cost of
production rises, firms will increase the price at each quantity to maintain profitability. In other words,
they will reduce the quantity supplied at each price which will lead to a decrease in supply. The
converse is also true. There are several factors that can lead to a change in the cost of production.
For example, a fall in factor prices such as wages will lead to a fall in the cost of production and vice
versa. Subsidy will decrease the cost of production and tax will have the opposite effect. Labour
productivity refers to output per hour of labour. When labour productivity rises, which may be due to
an increase in the skills and knowledge of labour or the efficiency of capital, firms will need a smaller
amount of labour to produce any given amount of output. Therefore, the cost of production will fall.
Production Capacity
If the production capacity in the industry increases, which may occur due to an increase in the number
of firms in the industry or an expansion of the production capacities of the existing firms, the supply of
the good will increase. The converse is also true.
Expectations of Price Changes
If firms expect the price of a good to rise, they will hoard some of the output that they currently produce
to sell it at a higher price in the future. This will lead to a fall in the supply of the good. The converse
is also true.
Profitability of Goods in Joint Supply
Goods in joint supply refer to goods that are produced in the same production process. An example is
petrol and diesel. In the process of refining crude oil to produce petrol, other grade fuels such as diesel
are also produced. Therefore, if the demand for petrol increases which will lead to an increase in the
profitability, more petrol will be produced. When this happens, the supply of diesel will also increase.
The converse is also true.
Profitability of Substitutes in Supply
Substitutes in supply refer to goods that are produced using the same factor inputs. An example is
potatoes and tomatoes. If the demand for tomatoes increases which will lead to an increase in the
profitability, some farmers who are currently producing potatoes will switch to the production of
tomatoes which will lead to a decrease in the supply of potatoes. The converse is also true.
Disasters (Natural and Man-made)

Natural disasters such as floods and earthquakes, and man-made disasters such as wars which may
kill workers and destroy factories and machinery, may lead to a decrease in the supply of certain goods
including agricultural products.
Weather Conditions
When weather conditions become less favourable, the supply of agricultural products will fall as
harvests will decrease. The converse is also true. In the event of severe weather conditions, the supply
of air travel will fall as airlines will be forced to cancel flights.
Note: The non-price determinants of supply will be discussed in greater detail in economics tuition
by the Principal Economics Tutor.
4 EQUILIBRIUM
4.1 Equilibrium Price and Equilibrium Quantity
An equilibrium is a state where there is no tendency to change. The equilibrium of a market is

determined by the market forces of demand and supply. If consumers demand more of a good than
what firms supply at a particular price, the quantity demanded will exceed the quantity supplied. The
resultant shortage will push up the price. This is because when firms do not produce enough to sell,
they can raise the price without losing sales. Therefore, they will do so to increase their profits. A rise
in the price of the good will incentivise firms to increase the production due to the higher profitability
and consumers to decrease the consumption due to the higher relative price and the lower real
income. Therefore, the quantity supplied will rise and the quantity demanded will fall. The price will
continue rising until the quantity demanded is equal to the quantity supplied, at which point the
shortage is eliminated and an equilibrium is established.
In the above diagram, given the demand (D) and the supply (S), the equilibrium price and the
equilibrium quantity are PE and QE. At a price below PE, such as P1, the quantity demanded (QD) is
greater than the quantity supplied (QS) and this results in a shortage (QD – QS). As the price rises, the
quantity demanded falls and the quantity supplied rises and this process continues until the price rises
to PE where the quantity demanded and the quantity supplied are equal at QE. Similarly, if firms supply
more of a good than what consumers demand at a particular price, the quantity supplied will exceed
the quantity demanded. The resultant surplus will push down the price. This is because when firms
cannot sell all the output that they produce, their stocks will build up. Therefore, they will lower the
price to reduce their stocks. A fall in the price of the good will incentivise firms to decrease the
production due to the lower profitability and consumers to increase the consumption due to the lower
relative price and the higher real income. Therefore, the quantity supplied will fall and the quantity
demanded will rise. The price will continue falling until the quantity demanded is equal to the quantity
supplied, at which point the surplus is eliminated and an equilibrium is established.
In the above diagram, given the demand (D) and the supply (S), the equilibrium price and the
equilibrium quantity are PE and QE. At a price above PE, such as P2, the quantity supplied (QS) is
greater than the quantity demanded (QD) and this results in a surplus (QS – QD). As the price falls, the
quantity demanded rises and the quantity supplied falls and this process continues until the price falls
to PE where the quantity demanded and the quantity supplied are equal at QE. At PE, the quantity
demanded is equal to the quantity supplied. There is neither surplus nor shortage and hence there is
no incentive for firms to change the price.
4.2 Effects of a Change in Demand on Price and Quantity
Increase in Demand
An increase in demand will lead to a rise in price and quantity.
In the above diagram, an increase in the demand (D) from D0 to D1 leads to a rise in the price (P) from
P0 to P1 and a rise in the quantity (Q) from Q0 to Q1. Given the demand (D0) and the supply (S0), the
price and the quantity are P0 and Q0. When the demand increases from D0 to D1, although the quantity
demanded rises at the same price (P0), the quantity supplied remains at Q0 and this results in a
shortage. When firms do not produce enough to sell, they can raise the price without losing sales.
Therefore, they will do so to increase their profits. As the price rises, the quantity demanded falls and
the quantity supplied rises and this process continues until the price rises to P 1 where the quantity
demanded and the quantity supplied are equal at Q1.
Decrease in Demand
A decrease in demand will lead to a fall in price and quantity.
In the above diagram, a decrease in the demand (D) from D0 to D1 leads to a fall in the price (P) from
P0 to P1 and a fall in the quantity (Q) from Q0 to Q1. Given the demand (D0) and the supply (S0), the
price and the quantity are P0 and Q0. When the demand decreases from D0 to D1, although the quantity
demanded falls at the same price (P0), the quantity supplied remains at Q0 and this results in a surplus.
When firms cannot sell all the output that they produce, their stocks will build up. Therefore, they will
lower the price to reduce their stocks. As the price falls, the quantity demanded rises and the quantity
supplied falls and this process continues until the price falls to P1 where the quantity demanded and
the quantity supplied are equal at Q1.
Note: When demand changes, price and quantity will change in the same direction.
4.3 Effects of a Change in Supply on Price and Quantity
Increase in Supply
An increase in supply will lead to a fall in price and a rise in quantity.
In the above diagram, an increase in the supply (S) from S0 to S1 leads to a fall in the price (P) from
P0 to P1 and a rise in the quantity (Q) from Q0 to Q1. Given the demand (D0) and the supply (S0), the
price and the quantity are P0 and Q0. When the supply increases from S0 to S1, although the quantity
supplied rises at the same price (P0), the quantity demanded remains at Q0 and this results in a surplus.
When firms cannot sell all the output that they produce, their stocks will build up. Therefore, they will
lower the price to reduce their stocks. As the price falls, the quantity demanded rises and the quantity
supplied falls and this process continues until the price falls to P1 where the quantity demanded and
the quantity supplied are equal at Q1.
Decrease in Supply
A decrease in supply will lead to a rise in price and a fall in quantity.
In the above diagram, a decrease in the supply (S) from S0 to S1 leads to a rise in the price (P) from
P0 to P1 and a fall in the quantity (Q) from Q0 to Q1. Given the demand (D0) and the supply (S0), the
price and the quantity are P0 and Q0. When the supply decreases from S0 to S1, although the quantity
supplied falls at the same price (P0), the quantity demanded remains at Q0 and this results in a
shortage. When firms do not produce enough to sell, they can raise the price without losing sales.
Therefore, they will do so to increase their profits. As the price rises, the quantity demanded falls and
the quantity supplied rises and this process continues until the price rises to P1 where the quantity
demanded and the quantity supplied are equal at Q1.
Note: When supply changes, price and quantity will change in opposite directions.
4.4 Effects of Simultaneous Changes in Demand and Supply on Price and Quantity
Same Directional Changes in Demand and Supply
Suppose that demand and supply rise simultaneously. An increase in demand will lead to a rise in
price and quantity. An increase in supply will lead to a fall in price and a rise in quantity. Therefore,
quantity will rise and price will be indeterminate. In this case, the effect on price will depend on the
relative changes in demand and supply. If the increase in demand is greater than the increase in
supply, price will rise.
In the above diagram, given the demand (D0) and the supply (S0), the price (P) and the quantity (Q)
are P0 and Q0. A larger increase in the demand from D0 to D1 and a smaller increase in the supply
from S0 to S1 lead to a rise in the price from P0 to P1 and a rise in the quantity from Q0 to Q1. However,
if the increase in supply is greater than the increase in demand, price will fall.
In the above diagram, given the demand (D0) and the supply (S0), the price (P) and the quantity (Q)
are P0 and Q0. A larger increase in the supply from S0 to S1 and a smaller increase in the demand
from D0 to D1 lead to a fall in the price from P0 to P1 and a rise in the quantity from Q0 to Q1.
Similarly, when demand and supply fall simultaneously, quantity will fall and price will be indeterminate.
The effect on price will depend on the relative changes in demand and supply. If the decrease in
demand is greater than the decrease in supply, price will fall. However, if the decrease in supply is
greater than the decrease in demand, price will rise.
Different Directional Changes in Demand and Supply
The above analysis is based on the assumption that demand and supply change in the same direction.
However, if demand and supply change in opposite directions, the analysis will be a little more
complicated. As the analysis of such a case involves the concepts of price elasticity of demand and
price elasticity of supply which have not been covered, it will be explained in Chapter 3.
Note: The effects of simultaneous changes in demand and supply on price and quantity will be
discussed in greater detail in economics tuition by the Principal Economics Tutor.
5 SURPLUS
5.1 Consumer Surplus
Consumer surplus is the difference between the maximum amount that consumers are willing and
able to pay for a good and the amount that they actually pay.
In the above diagram, consumers are willing and able to pay $10 for the first unit of the good, $9 for
the second unit, $8 for the third unit and $7 for the fourth unit. Suppose that consumers buy 4 units of
the good. When the quantity demanded is 4 units, the price is $7. In this case, although the maximum
amount that consumers are willing and able to pay is $34 ($10 + $9 + $8 + $7 = area of trapezium),
the amount that they actually pay is $28 ($7 x 4 = area of rectangle). Therefore, the consumer surplus
is $6 ($34 – $28 = area of trapezium – area of rectangle) and is represented by the area below the
demand curve and above the price.
Consumers pursue self-interest by maximising utility through maximising consumer surplus. Recall
that consumer surplus is the difference between the maximum amount that consumers are willing and
able to pay for a good and the amount that they actually pay. This means that consumer surplus of a
unit of a good occurs when the maximum price that consumers are willing and able to pay for it is
higher than the price they actually pay. Recall that the demand for a good is the quantity of the good
that consumers are willing and able to buy at each price over a period of time, ceteris paribus. The
demand curve shows the quantity demanded at each price and is downward sloping due to the law of
demand. It follows that the demand curve shows the maximum price that consumers are willing and
able to pay at each quantity. Consumers seek to maximise utility which refers to the satisfaction
obtained from consuming a good. To maximise utility, consumers will maximise consumer surplus by
consuming up to the point where the maximum price that they are willing and able to pay is equal to
the price they actually pay.
In the above diagram, given the demand curve (D) and the price (P0), the maximum price that
consumers are willing and able to pay for each unit of the good is higher than the price they actually
pay from the first unit to Q0. Therefore, consumers will maximise consumer surplus by consuming the
quantity (Q0) as each unit of the good from the first unit to Q0 produces a consumer surplus. The
consumer surplus is represented by the shaded area.
Note: Consumer surplus will be discussed in greater detail in economics tuition by the Principal
Economics Tutor.
5.2 Producer Surplus
Producer surplus is the difference between the minimum amount that firms are willing and able to
receive for a good and the amount that they actually receive.
In the above diagram, firms are willing and able to receive $4 for the first unit of the good, $5 for the
second unit, $6 for the third unit and $7 for the fourth unit. Suppose that firms produce 4 units of the
good. When the quantity supplied is 4 units, the price is $7. In this case, although the minimum amount
that firms are willing and able to receive is $22 ($4 + $5 + $6 + $7 = area of trapezium), the amount
that they actually receive is $28 ($7 x 4 = area of rectangle). Therefore, the producer surplus is $6
($28 – $22 = area of rectangle – area of trapezium) and is represented by the area below the price
and above the supply curve.
Firms pursue self-interest by maximising profit through maximising producer surplus. Recall that
producer surplus is the difference between the minimum amount that firms are willing and able to
receive for a good and the amount that they actually receive. This means that producer surplus of a
unit of a good occurs when the minimum price that firms are willing and able to receive from it is lower
than the price they actually receive. Recall that the supply of a good is the quantity of the good that
firms are willing and able to sell at each price over a period of time, ceteris paribus. The supply curve
shows the quantity supplied at each price and is upward sloping due to the law of supply. It follows
that the supply curve shows the minimum price that firms are willing and able to receive at each
quantity. Firms generally seek to maximise profit which is the excess of total revenue over total cost.
To maximise profit, firms will maximise producer surplus by producing up to the point where the
minimum price that they are willing and able to receive is equal to the price they actually receive.
In the above diagram, given the supply curve (S) and the price (P0), the minimum price that firms are
willing and able to receive from each unit of the good is lower than the price they actually receive from
the first unit to Q0. Therefore, firms will maximise producer surplus by producing the quantity (Q0) as
each unit of the good from the first unit to Q0 produces a producer surplus. The producer surplus is
represented by the shaded area.
ELASTICITY OF DEMAND AND SUPPLY will be

taught in economics tuition in the fourth and fifth weeks
of term 1.
1 INTRODUCTION
In Chapter 2, we learnt that a fall in price will lead to an increase in quantity demanded and vice versa.
However, given any change in price, in addition to the direction of the change in quantity demanded,
economists are interested to find the magnitude of the change. In other words, they are interested to
find the degree of responsiveness of consumers to a change in price. To measure this, they use the
concept of price elasticity of demand. Furthermore, economists are also interested to find the degree
of responsiveness of consumers to a change in income and a change in the prices of related goods.
To measure this, economists use the concepts of income elasticity of demand and cross elasticity of
demand. This chapter provides an exposition of the concepts of price elasticity of demand, income
elasticity of demand, cross elasticity of demand and price elasticity of supply.
2 PRICE ELASTICITY OF DEMAND

2.1 Measurement and Interpretation of Price Elasticity of Demand
The price elasticity of demand (PED) for a good is a measure of the degree of responsiveness of the
quantity demanded to a change in the price, ceteris paribus.
The PED for a good is calculated by dividing the percentage change in the quantity demanded by the
percentage change in the price.
% Δ Quantity Demanded
PED = ————————————–
% Δ Price
Due to the law of demand, the PED for a good is always negative. However, the common practice
among economists is to omit the negative sign.
If the PED for a good is greater than one, the demand is price elastic which means that a change in
the price will lead to a larger percentage/proportionate change in the quantity demanded. A good with
a price elastic demand has a relatively flat demand curve. If the PED for a good is less than one, the
demand is price inelastic which means that a change in the price will lead to a smaller
percentage/proportionate change in the quantity demanded. A good with a price inelastic demand has
a relatively steep demand curve. If the PED for a good is equal to one, the demand is unit price elastic
which means that a change in the price will lead to the same percentage/proportionate change in the
quantity demanded. The demand curve for a good with a unit price elastic demand is a rectangular
hyperbola.
Special cases:
If the PED for a good is zero, the demand is perfectly price inelastic which means that a change in the
price will not lead to any change in the quantity demanded. A good with a perfectly price inelastic
demand has a vertical demand curve. If the PED for a good is infinity, the demand is perfectly price
elastic which means that a rise in the price will lead to an infinite decrease in the quantity demanded.
In theory, this means that the quantity demanded will fall from infinity to zero. A good with a perfectly
price elastic demand has a horizontal demand curve.
Note: It is important to understand that the concept of elasticity is about relative changes and not
about absolute changes. This is because although price is measured in dollars, quantity demanded is
measured in units. Due to the difference in the units of measurement, we can only compare the
changes in price and quantity demanded in relative terms. For example, it is wrong to say, ‘If demand
is price elastic, a fall in price will lead to a large increase in quantity demanded.’. The correct way to
say it is, ‘If demand is price elastic, a fall in price will lead to a larger percentage/proportionate increase
in quantity demanded.’. Students should not confuse relative changes with absolute changes.
2.2 Applications of Price Elasticity of Demand
The concept of PED allows a firm to determine how to change price to increase total revenue.
If the demand for the good produced by a firm is price elastic, the firm can decrease the price to
increase the total revenue as the quantity demanded will increase by a larger percentage.
In the above diagram, the initial total revenue is area A plus area B and the new total revenue is area
B plus area C. Area C is the gain in revenue resulting from the increase in the quantity demanded (Q)
from Q0 to Q1 and area A is the loss in revenue resulting from the fall in the price (P) from P 0 to P1.
Since area C is greater than area A, the gain in revenue exceeds the loss and hence the total revenue
rises.
If the demand for the good produced by a firm is price inelastic, the firm can increase the price to
increase the total revenue as the quantity demanded will decrease by a smaller percentage.
In the above diagram, the initial total revenue is area B plus area C and the new total revenue is area
A plus area B. Area A is the gain in revenue resulting from the rise in the price (P) from P 0 to P1 and
area C is the loss in revenue resulting from the decrease in the quantity demanded (Q) from Q0 to Q1.
Since area A is greater than area C, the gain in revenue exceeds the loss and hence the total revenue
rises.
If the demand for the good produced by a firm is unit price elastic, the firm cannot change the price to
increase the total revenue as the quantity demanded will change by the same percentage.
In addition to firms, the concept of price elasticity of demand may be useful to the government. The
main source of revenue for the government is tax revenue. If the government imposes a tax on a good,
the cost of production will rise which will lead to a decrease in the supply. When this happens, the
price will rise which will lead to a fall in the quantity demanded. If the demand for the good is price
elastic, the quantity demanded is likely to fall by a large extent. As the tax revenue is the product of
the tax per unit of the good and the quantity, a large decrease in the quantity demanded is likely to
limit the amount of tax revenue which the government is able to collect. Therefore, if the government
wants to collect a large amount of tax revenue from imposing a tax on a good, it should do so for a
good with a price inelastic demand. Examples of goods with a price inelastic demand include tobacco
and alcohol due to their addictive nature. The government may also impose a tax on a good to reduce
the consumption. This is generally a good which society deems undesirable and the government thinks
people should be discouraged from consuming, commonly known as a demerit good. Examples of
demerit goods include tobacco and alcohol. However, due to the addictive nature of tobacco and
alcohol which makes the demand price inelastic, a tax on these goods is likely to lead to a small
decrease in the quantity demanded. Therefore, for a tax on tobacco and alcohol to be effective for
reducing the consumption, the government should ensure that it is sufficiently high.
Note: When we are discussing the effects of a tax on a good on the consumption or tax revenue, it
is wrong to say, ‘If the demand for the good is price elastic, the quantity demanded will fall by a larger
percentage/proportion.’. The correct way to say it is, “If the demand for the good is price elastic, the
quantity demanded will fall by a large extent.’. This is because we are not comparing the changes in
the price and the quantity demanded.
Note: The applications of price elasticity of demand will be discussed in greater detail in economics
2.3 Determinants of Price Elasticity of Demand

Number of Substitutes
The PED for a good will be higher the larger the number of substitutes. Conversely, the PED for a
good will be lower the smaller the number of substitutes. For example, the demand for a brand of
smartphones is likely to be price elastic due to the large number of substitute brands in the market
such as Huawei, Oppo, Apple, Samsung, LG, HTC, etc. The number of substitutes for a good depends
partly on how narrowly, and for that matter, how broadly the good is defined. The more broadly a good
is defined, the smaller the number of substitutes and hence the less price elastic the demand for the
good. Conversely, the more narrowly a good is defined, the larger the number of substitutes and hence
the more price elastic the demand for the good. For example, although the demand for food is price
inelastic due to the high degree of necessity and lack of substitutes, the demand for beef is likely to
be price elastic due to the large number of substitutes such as mutton, pork, chicken, duck and fish.
Closeness of Substitutes
The PED for a good will be higher the closer the substitutes. Conversely, the PED for a good will be
lower the further the substitutes. For example, the demand for housing is price inelastic due to lack of
close substitutes, apart from the high degree of necessity. In contrast, the demand for the mobile
network services provided by an operator in Singapore such as SingTel is likely to be price elastic due
to the presence of close substitutes which include the mobile network services provided by other
operators such as M1 and StarHub.
Degree of Necessity
The PED for a good will be higher the lower the degree of necessity. Conversely, the PED for a good
will be lower the higher the degree of necessity. A good that is essential has a high degree of necessity
and hence has an inelastic demand. For example, the demand for public transport is price inelastic
due to the high degree of necessity as it is essential, apart from lack of close substitutes. A good that
is not essential but addictive also has a high degree of necessity and hence also has an inelastic
demand. For example, the demand for tobacco is price inelastic due to the high degree of necessity
as a result of the addictive nature, apart from lack of close substitutes.
Proportion of Income Spent on the Good
The PED for a good will be higher the larger the proportion of income spent on the good. Conversely,
the PED for a good will be lower the smaller the proportion of income spent on the good. For example,
the demand for private cars is likely to be price elastic due to the large proportion of income spent on
the good as private cars are generally expensive. In contrast, the demand for stationery is likely to be
price inelastic due to the small proportion of income spent on the good as it is generally cheap, apart
from the high degree of necessity.
Time Period
The PED for a good will be higher the longer the time period under consideration. Conversely, the
PED for a good will be lower the shorter the time period under consideration. This is because
consumers need time to find substitutes and adjust their consumption patterns. For example, given
any increase in the price of petrol, the quantity demanded is likely to fall by a small extent in the short
run as most people are likely to continue to drive their cars to carry out their normal daily activities.
However, the quantity demanded will fall by a larger extent in the long run as more fuel-efficient cars
can be developed and people can switch to smaller cars which consume less fuel.
Note: Students should avoid arguing that the demand for a good is likely to be price elastic due to
the low degree of necessity. This is because saying this would suggest that the demand for most
goods is likely to be price elastic as there are more non-essential goods than essential goods.
Students should avoid arguing that the demand for a good is likely to be price inelastic due to the small
number of substitutes. This is because the substitutes for the good may be close which is likely to
make the demand for the good price elastic.
Note: The determinants of price elasticity of demand will be discussed in greater detail in economics
3 INCOME ELASTICITY OF DEMAND

3.1 Measurement and Interpretation of Income Elasticity of Demand
The income elasticity of demand (YED) for a good is a measure of the degree of responsiveness of
the demand to a change in income, ceteris paribus.
The YED for a good is calculated by dividing the percentage change in the demand by the percentage
change in income.
% Δ Demand
YED = ———————–
% Δ Income
If the YED for a good is positive, the good is a normal good. A normal good is a good whose demand
rises when consumers’ income rises. There are two types of normal goods: necessity and luxury. A
necessity is a normal good with a YED between zero and one. In other words, the demand for a
necessity is income inelastic. An example of a necessity is agricultural products. A luxury is a normal
good with a YED greater than one. In other words, the demand for a luxury is income elastic. An
example of a luxury is private cars. If the YED for a good is negative, the good is an inferior good. An
inferior good is a good whose demand falls when consumers’ income rises. An example of an inferior
good is public transport.
3.2 Applications of Income Elasticity of Demand
The concept of YED allows a firm to determine the future size of the market for the good and hence
its production capacity. Suppose that the YED for a good is positive. If a firm predicts an economic
expansion which is a period of time during which national income is rising, it should increase its
production capacity in order to be able to meet the higher demand when the economic expansion
comes. Furthermore, the higher the YED is, the larger will be the increase in the demand and hence
the larger the extent the firm should increase its production capacity. Conversely, if the firm predicts
an economic contraction which is a period of time during which national income is falling, it should
decrease its production capacity to minimise excess capacity when the economic contraction comes.
The concept of YED may enable a firm to determine how to formulate its marketing strategy. Suppose
that a firm sells two goods. Further suppose that one of the goods is a normal good and the other good
is an inferior good. If the economy is expanding and hence national income is rising, the firm should
focus its marketing strategy on the normal good. Conversely, if the economy is contracting and hence
national income is falling, the firm should focus its marketing strategy on the inferior good.
Note: It is important to note increasing production capacity is not the same as increasing production.
Increasing production capacity does not lead to an increase in current output. Rather, it enables the
firm to increase future output.
3.3 Determinants of Income Elasticity of Demand
Degree of Luxury
The YED for a good will be higher the more luxurious the good. Conversely, the YED for a good will
be lower the less luxurious the good. For example, high-end private cars such as BMW cars are likely
to be a luxury and hence the YED is likely to be greater than one which means that the demand is
likely to be income elastic. Mid-range private cars such as Honda Civic cars are likely to be a necessity
and hence the YED is likely to be between zero and one which means that the demand is likely to be
income inelastic. Low-end private cars such as Chery QQ cars may be an inferior good and hence the
YED may be less than zero.
Level of Income
The YED for a good will be higher the lower the level of income. Conversely, the YED for a good will
be lower the higher the level of income. For example, to high income individuals, due to their high
levels of income, private cars are likely to be a necessity and hence the YED is likely to be between
zero and one which means that the demand is likely to be income inelastic. In contrast, to low income
individuals, due to their low levels of income, private cars are likely to be a luxury and hence the YED
is likely to be greater than one which means that the demand is likely to be income elastic.
Note: The determinants of income elasticity of demand will be discussed in greater detail in
economics tuition by the Principal Economics Tutor.
4 CROSS ELASTICITY OF DEMAND

4.1 Measurement and Interpretation of Cross Elasticity of Demand
The cross elasticity of demand (XED) for a good with respect to another good is a measure of the
degree of responsiveness of the demand for the first good to a change in the price of the second good,
ceteris paribus. Let the two goods be good A and good B.
The XED for good A with respect to good B is calculated by dividing the percentage change in the
demand for good A by the percentage change in the price of good B.
% Δ Demand for Good A

XEDAB = ————————————–
% Δ Price of Good B
If XEDAB is positive, good A and good B are substitutes. Substitutes are goods which are consumed
in place of one another such as Coke and Pepsi. If the price of good B rises, consumers will buy less
of it. Since good A and good B are substitutes, they will buy more good A. If XEDAB is negative, good
A and good B are complements. Complements are goods which are consumed in conjunction with
one another such as car and petrol. If the price of good B rises, consumers will buy less of it. Since
good A and good B are complements, they will buy less good A.
4.2 Applications of Cross Elasticity of Demand
The concept of XED allows a firm to determine how a change in the price of a related good produced
by another firm will affect the demand for its good. For example, if a rival firm decreases its price, the
demand for the good produced by the first firm will fall due to the positive XED between substitutes.
To avoid a decrease in sales, the firm may need to decrease its price. However, if this is likely to lead
to a price war, the firm may consider engaging in non-price competition such as product promotion
and product development instead of decreasing its price. If a rival firm increases its price, the demand
for the good produced by the first firm will increase if it keeps its price constant. However, the firm may
not experience an increase in sales if it has no or little excess capacity.
The concept of XED may enable a firm that produces two or more goods which are complements to
increase total revenue. For example, a telecommunications firm may reduce the price of its mobile
devices even if the demand is price inelastic. Although the revenue from the sale of its mobile devices
will fall as the quantity demanded will rise by a smaller proportion, the demand and hence the revenue
from the provision of its mobile network services will rise due to the negative XED between mobile
network services and mobile devices. Therefore, the total revenue of the telecommunications firm may
increase.
4.3 Determinants of Cross Elasticity of Demand
The XED between two goods will be higher the more closely they are related. For example, the XED
between Coke and Pepsi is higher than that between coffee and tea as Coke and Pepsi are closer
substitutes than coffee and tea are.
5 PRICE ELASTICITY OF SUPPLY

5.1 Measurement and Interpretation of Price Elasticity of Supply
The price elasticity of supply (PES) of a good is a measure of the degree of responsiveness of the
quantity supplied to a change in the price, ceteris paribus.
The PES of a good is calculated by dividing the percentage change in the quantity supplied by the
percentage change in the price.
% Δ Quantity Supplied
PES = ————————————
% Δ Price
Due to the law of supply, the PES of a good is always positive.
If the PES of a good is greater than one, the supply is price elastic which means that a change in the
price will lead to a larger percentage/proportionate change in the quantity supplied. A good with a price
elastic supply has a relatively flat supply curve. If the PES of a good is less than one, the supply is
price inelastic which means that a change in the price will lead to a smaller percentage/proportionate
change in the quantity supplied. A good with a price inelastic supply has a relatively steep supply
curve. If the PES of a good is equal to one, the supply is unit price elastic which means that a change
in the price will lead to the same percentage/proportionate change in the quantity supplied.
Special Cases: If the PES of a good is zero, the supply is perfectly price inelastic which means that a
change in the price will not lead to any change in the quantity supplied. A good with a perfectly price
inelastic supply has a vertical supply curve. If the PES of a good is infinity, the supply is perfectly price
elastic which means that a fall in the price will lead to an infinite decrease in the quantity supplied. In
theory, this means that the quantity supplied will fall from infinity to zero. A good with a perfectly price
elastic supply has a horizontal supply curve.
5.2 Determinants of Price Elasticity of Supply
Production Time and ‘Stockability’ of the Good
When the price of a good rises, firms can increase the quantity supplied in two ways: increase
production and draw from stock. Therefore, if the production time of a good is long and if it cannot be
stocked in large quantities, the supply is likely to be price inelastic, and vice versa. The ‘stockability’
of a good depends on the size of the good and whether it is perishable. Goods that are small in size
and non-perishable can be stocked in large quantities, and vice versa. For example, the production
time of agricultural products is long due to the long gestation period and they cannot be stocked due
to the perishable nature. Therefore, the supply of agricultural products is price inelastic. In contrast,
with today’s production technology, most manufactured goods are mass produced on assembly lines
which are highly automated. Therefore, the production time of manufactured goods is likely to be short
and hence the supply is likely to be price elastic. Different types of manufactured goods, however,
have different production times. The supply of luxuries is likely to be price inelastic as the production
time is likely to be long because they are typically high quality goods that normally undergo stringent
quality control. In contrast, the supply of necessities and inferior goods is likely to be price elastic as
the production time is likely to be short due to the limited focus on the quality.
Excess Capacity
Given any increase in the price of a good, the lower the output level and hence the larger the amount
of excess capacity, the slower the marginal cost of production will rise as firms increase output. The
slower the marginal cost of production for a good rises as firms increase output in response to a rise
in the price, the larger the increase in output. Therefore, the lower the output level of a good and hence
the larger the amount of excess capacity, the more price elastic the supply. Conversely, the higher the
output level of a good and hence the smaller the amount of excess capacity, the less price elastic the
supply.
Definition of the Good
The more broadly a good is defined, the less price elastic the supply. Conversely, the more narrowly
a good is defined, the more price elastic the supply. For example, the supply of a crop is more price
elastic than the supply of crops as a whole as it is easier to obtain factor inputs from within the
agricultural sector to produce a crop than to obtain factor inputs from other industries to produce crops
as a whole.
Time Period
The longer the time period after an increase in the price of a good, the more price elastic the supply
as firms are able to increase the production by a larger amount with more time. Time period can be
divided into the immediate run, the short run and the long run. The immediate run is the time period
that is so short that the output level is fixed. The supply of the good is perfectly price inelastic, assuming
firms do not keep stock of the good. The short run is the time period during which at least one of the
factor inputs used in the production process is fixed. In the short run, when the price of a good rises,
firms can increase the production only by employing more of the variable factor inputs used in the
production process. The long run is the time period after which all the factor inputs used in the
production process are variable. The supply of a good is more price elastic in the long run than in the
short run as firms can increase the production by employing more of all the factor inputs used in the
production process.
Mobility of Factors of Production
The ease with which factors of production can be moved from the production of one good to another
will influence the price elasticity of supply of a good. The supply of a good will be more price elastic
the higher the mobility of factors of production. Conversely, the supply of a good will be less price
elastic the lower the mobility of factors of production. For example, if a manufacturing firm in the city
is able to swiftly employ rural farmers to increase output, the supply of the good is likely to be price
elastic.
6 LIMITATIONS OF THE CONCEPTS OF

ELASTICITY OF DEMAND
Irrelevant and Unreliable Data
The data that are used to calculate elasticities of demand may be irrelevant or unreliable. Data from
past records may no longer be relevant to calculating elasticities of demand as some of the
determinants of demand may have changed. Although data from current market surveys are relevant
to calculating elasticities of demand, they may not be reliable as the respondents may not be truthful
in their responses. Furthermore, if the sample sizes of the market surveys are small, the results may
not be reliable as they may not be reflective of the actual markets for the goods.
Unrealistic Assumption
The assumption of ceteris paribus that is made in calculating elasticities of demand is unlikely to hold
in reality. In reality, many factors such as the level of income, the price of the good and the prices of
related goods are changing simultaneously.
Omission of Total Cost
Although PED may be useful for increasing total revenue, this is not true for increasing profit due to
the omission of total cost. For example, if demand is price elastic, a fall in price will lead to a larger
proportionate increase in quantity demanded resulting in an increase in total revenue. However, if total
cost rises by a larger extent, profit will fall.
Omission of Production Capacity
PED and XED do not take production capacity into consideration. For example, if demand is price
elastic, a fall in price will lead to a larger proportionate increase in quantity demanded resulting in an
increase in total revenue. However, total revenue will not rise if there is no excess capacity to increase
production.
Note: The limitations of the concepts of elasticity of demand will be discussed in greater detail in
economics tuition by the Principal Economics Tutor.
7 EFFECTS OF ELASTICITY ON PRICE AND

QUANTITY
When demand increases, price and quantity will rise. If supply is price elastic, the increase in price is
likely to be small and the increase in quantity is likely to be large.
In the above diagram, due to the elastic supply which gives rise to the relatively flat supply curve (S0),
an increase in the demand (D) from D0 to D1 leads to a large rise in the quantity (Q) from Q0 to Q1 and
a small rise in the price (P) from P0 to P1. However, if supply is price inelastic, the increase in price is
likely to be large and the increase in quantity is likely to be small.
In the above diagram, due to the inelastic supply which gives rise to the relatively steep supply curve
(S0), an increase in the demand (D) from D0 to D1 leads to a large rise in the price (P) from P0 to P1 and
a small rise in the quantity (Q) from Q0 to Q1.
When supply decreases, price will rise and quantity will fall. If demand is price elastic, the increase in
price is likely to be small and the decrease in quantity is likely to be large.
In the above diagram, due to the elastic demand which gives rise to the relatively flat demand curve
(D0), a decrease in the supply (S) from S0 to S1 leads to a large fall in the quantity (Q) from Q0 to
Q1 and a small rise in the price (P) from P0 to P1. However, if demand is price inelastic, the increase
in price is likely to be large and the decrease in quantity is likely to be small.
In the above diagram, due to the inelastic demand which gives rise to the relatively steep demand
curve (D0), a decrease in the supply (S) from S0 to S1 leads to a large rise in the price (P) from P0 to
P1 and a small fall in the quantity (Q) from Q0 to Q1.
Based on the above analysis, we can see that a large rise in price may be due to four factors. Apart
from a large increase in demand and a large decrease in supply, a large rise in price may also be due
to an inelastic demand and an inelastic supply. Similarly, a large increase in quantity may be due to
four factors. Apart from a large increase in demand and a large increase in supply, a large increase in
quantity may also be due to an elastic demand and an elastic supply.
In Chapter 2, we learnt that when demand and supply change simultaneously in the same direction,
although quantity will be determinate, the effect on price will depend on the relative changes in demand
and supply. For example, when demand and supply rise simultaneously, although quantity will rise,
price will fall if the increase in supply is greater than the increase in demand. However, if the increase
in demand is greater than the increase in supply, price will rise. Similarly, when demand and supply
fall simultaneously, although quantity will fall, price will rise if the decrease in supply is greater than
the decrease in demand. However, if the decrease in demand is greater than the decrease in supply,
price will fall. One thing we can see here is that when demand and supply change simultaneously in
the same direction, a consideration of the relative price elasticities of demand and supply is not
necessary. This is because if the increase in demand is greater than the increase in supply, or the
decrease in supply is greater than the decrease in demand, a shortage will occur at the initial price
which will lead to a rise in price, regardless of the price elasticities of demand and supply. Conversely,
if the increase in supply is greater than the increase in demand, or the decrease in demand is greater
than the decrease in supply, a surplus will occur at the initial price which will lead to a fall in price,
regardless of the price elasticities of demand and supply.
The above analysis is based on the assumption that demand and supply change simultaneously in
the same direction. However, if demand and supply change simultaneously in opposite directions, a
consideration of the relative price elasticities of demand and supply will be necessary, in addition to a
consideration of the relative changes in demand and supply. Suppose that demand rises and supply
falls simultaneously. An increase in demand will lead to a rise in price and quantity. A decrease in
supply will lead to a rise in price and a fall in quantity. Therefore, price will rise and quantity will be
indeterminate. In this case, one may think that if the increase in demand is greater than the decrease
in supply, quantity will rise and vice versa. However, this is erroneous. To determine the effect on
quantity, one should not only consider the relative changes in demand and supply. This is because
the relative price elasticities of demand and supply will also have an effect on quantity and to
understand this, we can simply consider the case of Certificate of Entitlement (COE) in Singapore. As
the supply of COEs in Singapore is determined by the Land Transport Authority (LTA) based on traffic
conditions, it is perfectly price inelastic which gives rise to a vertical supply curve. If the demand rises,
even if the increase is large, the quantity will not rise. However, if the supply falls, even if the decrease
is small, the quantity will fall. Therefore, even if the increase in the demand is greater than the decrease
in the supply, the quantity will fall. This example shows that if demand and supply change
simultaneously in opposite directions, the directional change in quantity will depend on two factors:
the relative price elasticities of demand and supply and the relative changes in demand and supply.
Suppose that demand increases and supply decreases simultaneously. Further suppose that demand
is price elastic and supply is price inelastic. When demand is price elastic, a decrease in supply is
likely to lead to a large decrease in quantity. When supply is price inelastic, an increase in demand is
likely to lead to a small increase in quantity. Therefore, quantity is likely to fall, assuming the changes
in demand and supply are equal.
In the above diagram, an increase in the demand (D) from D0 to D1 and the same decrease in the
supply (S) from S0 to S1 lead to a rise in the price (P) from P0 to P1 and a fall in the quantity (Q) from
Q0 to Q1. If the decrease in supply is greater than the increase in demand, quantity is likely to fall by a
large extent. However, if the increase in demand is greater than the decrease in supply, quantity may
rise. In this case, quantity will be indeterminate.
Suppose that demand increases and supply decreases simultaneously. Further suppose that demand
is price inelastic and supply is price elastic. When demand is price inelastic, a decrease in supply is
likely to lead to a small decrease in quantity. When supply is price elastic, an increase in demand is
likely to lead to a large increase in quantity. Therefore, quantity is likely to rise, assuming the changes
in demand and supply are equal.
In the above diagram, an increase in the demand (D) from D0 to D1 and the same decrease in the
supply (S) from S0 to S1 lead to a rise in the price (P) from P0 to P1 and a rise in the quantity (Q) from
Q0 to Q1. If the increase in demand is greater than the decrease in supply, quantity is likely to rise by
a large extent. However, if the decrease in supply is greater than the increase in demand, quantity
may fall. In this case, quantity will be indeterminate.
Note: If demand and supply are both price elastic or price inelastic, the effect of a simultaneous
increase in demand and a decrease in supply on quantity will depend to a large extent on the relative
changes in demand and supply. If the increase in demand is greater than the decrease in supply,
quantity is likely to rise. However, if the decrease in supply is greater than the increase in demand,
quantity is likely to fall.
PRODUCTION AND COSTS will be taught

in economics tuition in the eighth and ninth weeks of
term 1.
1 INTRODUCTION
Production is the process by which factor inputs are transformed into output. An increase in the
quantity of factor inputs will lead to an increase in output. The theory of production is the study of how
the output level changes as the quantity of factor inputs changes. To increase output, firms need to
employ more factor inputs which will lead to an increase in costs. The theory of costs is the study of
how the cost of production changes as the output level changes. When a firm expands its scale of
production, its average cost will usually fall and this phenomenon is called internal economies of scale,
or simply known as economies of scale. However, when the scale of production of a firm reaches a
certain size, a further expansion may lead to a rise in its average cost and this phenomenon is called
internal diseconomies of scale, or simply known as diseconomies of scale. A firm may experience a
fall or rise in its average cost when the industry expands, even though its scale of production remains
unchanged, and these phenomena are called external economies of scale and external diseconomies
of scale respectively. This chapter provides an exposition of the theory of production and the theory
of costs.
2 THE SHORT-RUN THEORY OF PRODUCTION

2.1 Marginal Returns
If a firm wants to increase output, it can almost immediately employ more labour. However, it will not
be able to employ more capital in the same time frame as acquisition of capital takes time. In
economics, we distinguish between two types of factor inputs: variable factor input and fixed factor
input. Variable factor inputs are factor inputs whose quantities can be changed in the short run. An
example is labour. Fixed factor inputs are factor inputs whose quantities are fixed in the short run. An
example is capital.
The short run is the time period during which at least one of the factor inputs used in the production
process is fixed. It does not correspond to any specific number of weeks, months or years as it varies
from firm to firm and from industry to industry. For example, a web hosting firm may take only a few
weeks or even days to increase its production capacity by purchasing more servers. However, an oil
refining firm may take many years to increase its production capacity due to the long time period
needed to build oil refineries.
Suppose that a firm employs two factor inputs: capital and labour. In this case, the fixed factor input is
capital and the variable factor input is labour. As the quantity of capital is fixed in the short run, the
firm can increase output only by employing more labour.
Example
Capital Labour Total Output Additional Output
5 0 0 —
5 1 3 3
5 2 7 4
5 3 12 5
5 4 18 6
5 5 22 4
5 6 24 2
5 7 24 0
5 8 23 -1
5 9 20 -3
In the above table, from the first unit of labour to the fourth, each additional unit of labour is adding
more to total output than the previous additional unit and hence the firm is experiencing increasing
marginal returns. Increasing marginal returns occur when each additional unit of a variable factor input
(e.g. labour) is adding more to total output than the previous additional unit. This occurs due to under-
utilisation of the fixed factor inputs (e.g. capital). However, from the fifth unit of labour onwards, each
additional unit of labour is adding less to total output than the previous additional unit and hence the
firm is experiencing diminishing marginal returns. Diminishing marginal returns occur when each
additional unit of a variable factor input (e.g. labour) is adding less to total output than the previous
additional unit. This occurs due to over-utilisation of the fixed factor inputs (e.g. capital). Diminishing
marginal returns set in when the fifth unit of labour is employed. Furthermore, the seventh unit of labour
is actually redundant. Total output even falls when the eighth unit of labour is employed.
The law of diminishing marginal returns states that if an increasing quantity of a variable factor input
is used with a constant quantity of fixed factor inputs, an output level point will be reached beyond
which each additional unit of the variable factor input will add less to total output than the previous
additional unit. To put it somewhat differently, the law of diminishing marginal returns states if a firm
increases output continually in the short run, it is a matter of time that diminishing marginal returns will
set in. If the firm starts with a small quantity of fixed factor inputs, diminishing marginal returns will set
in earlier. If the firm starts with a large quantity of fixed factor inputs, diminishing marginal returns will
set in later.
Note: Marginal returns will be discussed in greater detail in economics tuition by the
2.2 Total Product, Marginal product and Average product (Optional but good to know)
Total Product
Total product (TP) is the total output produced with a given amount of factor inputs.
The total product curve is S-shaped.
Total Product Curve

In the above diagram, the TP curve shows how total output varies with the quantity of labour, given
the quantity of capital. From the first unit of labour to QL0, the firm is experiencing increasing
marginal returns and hence total output is rising at an increasing rate when the quantity of labour
increases. After QL0, the firm is experiencing diminishing marginal returns and hence total output is
rising at a decreasing rate when the quantity of labour increases. After QL2, the problem of
diminishing marginal returns becomes so severe that additional units of labour actually lead to a fall
in total output.
Marginal Product
Marginal product (MP) is the additional output resulting from employing one more unit of labour.
Marginal product is calculated by dividing the change in total output by the change in the quantity of
labour.
ΔTP
MP = ——–
ΔQL
The marginal product curve is inverted-U-shaped.
Marginal Product Curve
In the above diagram, from the first unit of labour to QL0, the firm is experiencing increasing marginal
returns and hence MP is rising. After QL0, the firm is experiencing diminishing marginal returns and
hence MP is falling. After QL2, the problem of diminishing marginal returns becomes so severe that
additional units of labour actually lead to negative MP.
Average Product
Average product (AP) is the output per unit of labour.
Average product is calculated by dividing total output by the quantity of labour.
TP
AP = ——–
QL
The average product curve is inverted-U-shaped.

To understand the shape of the average product curve, we need to understand the relationship
between average value and marginal value which can be illustrated with the following example.
Assume that the average height of a particular class of students is 1.7 metres. Further assume that a
new student joins the class. If the height of the new student, which is the marginal height, is higher
than the average height of 1.7 metres, the average height of the class will rise. However, if the height
of the new student is lower than the average height, the average height of the class will fall. Therefore,
when the marginal value is higher than the average value, the average will rise and vice versa. This
applies to the relationship between average product and marginal product.
Average Product Curve
In the above diagram, from the first unit of labour to QL1, MP is higher than AP and hence AP is
rising. After QL1, MP is lower than AP and hence AP is falling. The above analysis does not only
explain why the AP curve is inverted-U-shaped, it also explains why the MP curve cuts the AP curve
at the maximum point.
Note: Students are not required to draw the product curves in the examination as they have been
removed from the Singapore-Cambridge GCE ‘A’ Level Economics syllabus. Nevertheless, it is good
for them to have a basic understanding of the product curves in order to have a better understanding
of the cost curves.
3 THE LONG-RUN THEORY OF PRODUCTION

3.1 The Least-cost Combination of Factor Inputs (Optional but good to know)
The long run is the time period after which all the factor inputs used in the production process are
variable. In the long run, if a firm wants to increase output, not only can it employ more labour, it can
also employ more capital whose quantity is fixed in the short run. Like the short run, the long run does
not correspond to a specific number of weeks, months or years as it varies from firm to firm and from
industry to industry.
The least-cost combination of factor inputs is used when the last dollar of each factor input employed
produces the same additional output. If a firm employs two factor inputs, labour (L) and capital (K), the
least-cost condition can be expressed as MPL/PL = MPK/PK, where MP denotes marginal product and
P denotes price.
Suppose that MPL/PL is twice MPK/PK. In other words, the additional output produced by the last dollar
of labour employed is twice the additional output produced by the last dollar of capital employed. In
this case, the firm can reduce the total cost of producing the same amount of output by employing
more labour and less capital. For example, if the firm employs one more dollar of labour and two dollars
less of capital, although total cost will fall by one dollar, total output will remain constant which will lead
to a fall in the total cost of producing the same amount of output. However, as the quantity of labour
increases, MPL will fall due to diminishing marginal returns. Similarly, as less capital is employed,
MPK will increase. This process will continue until MPL/PL = MPK/PK. In other words, the additional
output resulting from employing the last dollar of labour is equal to the additional output resulting from
employing the last dollar of capital.
Note: Students are not required to explain the least-cost combination of factor inputs in the
examination as it has been removed from the Singapore-Cambridge GCE ‘A’ Level Economics
syllabus. Nevertheless, it is good for them to have a basic understanding of the least-cost combination
of factor inputs in order to have a better understanding of ‘The Long-run Theory of Production’.
3.2 Returns to Scale
When the quantities of all the factor inputs used in the production process are increased by the same
proportion in the long run, the scale of production expands. An increase in the scale of production will
lead to one of three scenarios: increasing returns to scale, constant returns to scale or decreasing
returns to scale.
Increasing Returns to Scale
Increasing returns to scale occur when the same percentage/proportionate increase in the quantities
of all the factor inputs used in the production process leads to a larger percentage/proportionate
increase in total output.
Constant Returns to Scale
Constant returns to scale occur when the same percentage/proportionate increase in the quantities of
all the factor inputs used in the production process leads to the same percentage/proportionate
Decreasing Returns to Scale
Decreasing returns to scale occur when the same percentage/proportionate increase in the quantities
of all the factor inputs used in the production process leads to a smaller percentage/proportionate
Example
Capital Labour Percentage Total Percentage Returns to

increase in output increase in scale
the quantities total output
of all factor
inputs
20 4 — 100 — —
40 8 100 250 150 IRS

60 12 50 420 68 IRS
80 16 33.33 560 33.33 CRS
100 20 25 672 20 DRS
120 24 20 780 16 DRS
From the output level 100 to the output level 420, the firm is experiencing increasing returns to scale
(IRS). Increasing returns to scale occur due to greater division of labour and the use of larger
machines. Division of labour is the process whereby each job is broken up into its component tasks
and each worker is assigned one or a few component tasks of the job. An expansion of the scale of
production may enable the firm to engage in greater division of labour and hence greater specialisation
which will lead to higher labour productivity resulting in increasing returns to scale. Furthermore, larger
machines are often more efficient than smaller machines as they generally make more efficient use of
materials and labour. Therefore, an expansion of the scale of production may enable the firm to use
larger machines that are often more efficient than smaller machines which will also lead to higher
labour productivity resulting in increasing returns to scale. From the output level 420 to the output level
560, the firm is experiencing constant returns to scale (CRS). From the output level 560 to the output
level 780, the firm is experiencing decreasing returns to scale (DRS). Decreasing returns to scale
occur due to greater division of labour. When division of labour increases to a high degree, workers
may become demotivated as performing the same task all the time may lead to boredom. This is
especially true if the task is mundane. If this happens, labour productivity will fall which will lead to
decreasing returns to scale.
Note: Returns to scale will be discussed in greater detail in economics tuition by the Principal
Economics Tutor.
4 THE SHORT-RUN THEORY OF COSTS
4.1 Fixed Costs, Variable Costs, Explicit Costs and Implicit Costs
Fixed costs are costs that do not vary with the output level. Examples of fixed costs include rent and
interest payments on loans. An increase in the output level will not lead to an increase in fixed costs.
Fixed costs will be incurred even if the firm shuts down production. Variable costs are costs that vary
directly with the output level. Examples of variable costs include the cost of labour and the costs of
materials. An increase in the output level will lead to an increase in variable costs as more variable
factor inputs are needed to produce more output. Variable costs will not be incurred if the firm shuts
down production.
Explicit costs are costs that involve monetary payments. Examples of explicit costs include the cost of
labour and the costs of materials. Implicit costs are costs that do not involve monetary payments.
Examples of implicit costs include the cost of the owner’s labour and the cost of the owner’s financial
capital. Profit is the excess of total revenue over total cost. Accounting profit is the excess of total
revenue over accounting costs. Accounting costs are costs computed by accountants which include
only explicit costs. Economic profit is the excess of total revenue over economic costs. Economic costs
are costs computed by economists which include both explicit costs and implicit costs. As economic
costs are higher than accounting costs, economic profit, which is the profit that economists are
concerned with, is lower than accounting profit.
Note: Fixed costs and variable costs will be discussed in greater detail in economics tuition by the
4.2 Total Cost, Marginal Cost, Average Cost, Average Variable Cost and Average Fixed Cost
Total Cost
Total cost (TC) is the cost of the factor inputs required for the production of an amount of output.
In the short run, total cost is the sum of total fixed cost (TFC) and total variable cost (TVC) and is
positively related to the output level. The total cost curve is inverse-S-shaped.
Total Cost Curve
In the above diagram, as fixed costs do not vary with the output level, the TFC curve is horizontal.
However, as more variable factor inputs are needed to produce more output, the TVC curve is upward-
sloping. As TC is the sum of TFC and TVC, the TC curve is geometrically similar to the TVC curve,
except that the former is higher than the latter by TFC at each output level. From the first unit of output
to Q0, the firm is experiencing increasing marginal returns. Recall that this means each additional unit
of the variable factor input is adding more to total output than the previous additional unit. Therefore,
each additional unit of output requires fewer units of the variable factor input to produce and this makes
the TC curve and the TVC curve rise at a decreasing rate. After Q0, the firm is experiencing diminishing
marginal returns. Recall that this means each additional unit of the variable factor is adding less to
total output than the previous additional unit. Therefore, each additional unit of output requires more
units of the variable factor input to produce and this causes the TC curve and the TVC curve to rise at
an increasing rate.
Marginal Cost
Marginal cost (MC) is the additional cost resulting from producing one more unit of output.
Marginal cost is calculated by dividing the change in total cost by the change in total output.
ΔTC
MC = ——–
ΔQ
The marginal cost curve is U-shaped or Nike-shaped which some like to call it.
Marginal Cost Curve
In the above diagram, from the first unit of output to Q0, the firm is experiencing increasing marginal
returns and hence MC is falling. After Q0, the firm is experiencing diminishing marginal returns and
hence MC is rising.
Average Cost
Average cost (AC) is the cost per unit of output.
Average cost is calculated by dividing total cost by total output.
TC
AC = ——–
The average cost curve is U-shaped.
Recall from Section 2.2 that to understand the shape of the average cost curve, we need to understand
the relationship between average value and marginal value which can be illustrated with the following
example.
Assume that the average height of a particular class of students is 1.7 metres. Further assume that a
new student joins the class. If the height of the new student, which is the marginal height, is higher
than the average height of 1.7 metres, the average height of the class will rise. However, if the height
of the new student is lower than the average height, the average height of the class will fall. Therefore,
when the marginal value is higher than the average value, the average will rise and vice versa. This
applies to the relationship between average cost and marginal cost.
Average Cost Curve
In the above diagram, from the first unit of output to Q2, MC is lower than AC and hence AC is falling.
After Q2, MC is higher than AC and hence AC is rising. The above analysis does not only explain
why the AC curve is U-shaped, it also explains why the MC curve cuts the AC curve at the minimum
point.
Average Variable Cost
Average variable cost (AVC) is the variable cost per unit of output.
Average variable cost is calculated by dividing total variable cost by total output.
TVC
AVC = ——–
The average variable cost curve is U-shaped.
The relationship between average value and marginal value applies to average variable cost and
marginal cost.
Average Variable Cost Curve
In the above diagram, from the first unit of output to Q1, MC is lower than AVC and hence AVC is
falling. After Q1, MC is higher than AVC and hence AVC is rising. The above analysis does not only
explain why the AVC curve is U-shaped, it also explains why the MC curve cuts the AVC curve at
the minimum point.
Average Fixed Cost
Average fixed cost (AFC) is the fixed cost per unit of output.
Average fixed cost is calculated by dividing total fixed cost by total output.
TFC
AFC = ——–
The average fixed cost curve is a rectangular hyperbola.
Average Fixed Cost Curve
In the above diagram, as TFC is constant, AFC falls when the output level increases.
The following diagram shows the relationships between the marginal cost curve, the average cost
curve, the average variable cost curve and the average fixed cost curve.
In the above diagram, from the first unit of output to Q0, MC is falling due to increasing marginal returns,
and is rising thereafter due to diminishing marginal returns. From the first unit of output to Q1, MC is
lower than AC and AVC and hence AC and AVC are falling. After Q1, MC is higher than AVC and
hence AVC is rising. After Q2, MC is higher than AC and hence AC is rising. As AC is the sum of AVC
and AFC, the vertical distance between the AC curve and the AVC curve is equal to AFC. As AFC
falls when the output level increases, the vertical distance between the AC curve and the AVC curve
narrows as the output level increases.
5 THE LONG-RUN THEORY OF COSTS
5.1 Long-run Average Cost
The long-run average cost (LRAC) curve shows the lowest average cost of production at each output
level when all the factor inputs used in the production process are variable in the long run. Each point
on the LRAC curve is a point of tangency to the AC curve with the lowest average cost of producing
the corresponding output level.
As fixed factor inputs in the short run become variable in the long run, a firm can choose the quantity
of fixed factor inputs that achieves the lowest average cost of producing any output level. Suppose
that a firm can choose among three quantities of fixed factor inputs: small quantity, medium quantity
and large quantity. For simplicity, one can think of a small quantity of fixed factor inputs as a small
factory, a medium quantity as a medium factory and a large quantity as a large factory.
In the above diagram, the average cost (AC) curves that correspond to the three quantities of fixed
factor inputs are AC0, AC1 and AC2, where AC0 corresponds to the small quantity, AC1 corresponds
the medium quantity and AC2 corresponds to the large quantity. As a larger scale of production enables
the firm to produce a larger amount of output, AC1 is on the right of AC0 and AC2 is on the right of AC1.
Furthermore, AC1 is lower than AC0 as the expansion of the scale of production from the small quantity
of fixed factors to the medium quantity enables the firm to reap more economies of scale. However,
AC2 is higher than AC1 as the expansion of the scale of production from the medium quantity of fixed
factors to the large quantity causes the firm to experience diseconomies of scale. Economies of scale
and diseconomies of scale will be explained in greater detail in Section 5.2. If the firm wants to produce
an output level below Q’, the lowest-average-cost quantity of fixed factor inputs will be the small
quantity that corresponds to AC0. If the firm wants to produce an output level between Q’ and Q”, the
lowest-average-cost quantity of fixed factor inputs will be the medium quantity that corresponds to
AC1. If the firm wants to produce an output level above Q”, the lowest-average-cost quantity of fixed
factor inputs will be the large quantity that corresponds to AC2. Therefore, the LRAC curve is the bold
curve in the diagram.
The above analysis is based on the assumption that the firm can choose among only three quantities
of fixed factor inputs: small quantity, medium quantity and large quantity. However, if we assume that
fixed factor inputs are continuously divisible and hence the firm can choose among an infinite number
of quantities of fixed factor inputs, we will get a U-shaped LRAC curve. For simplicity, one can think of
the ability to choose among an infinite number of quantities of fixed factor inputs as the ability to choose
a factory of any size.
U-shaped LRAC Curve
In the above diagram, the assumption that fixed factor inputs are continuously divisible leads to a U-
shaped LRAC curve. The falling portion of the U-shaped LRAC curve is due to economies of scale
and the rising portion is due to diseconomies of scale. Although the LRAC curve is U-shaped in theory,
some empirical studies have shown that the LRAC curve has a relatively large flat portion. In other
words, these empirical studies have shown that the LRAC curve is saucer-shaped. This may be due
to limited forces inducing economies of scale and limited forces inducing diseconomies of scale
existing simultaneously and offsetting each other which leads to constant long-run average cost.
Saucer-shaped LRAC Curve
In the above diagram, the LRAC curve is saucer-shaped, which has been shown by some empirical
studies. The falling portion of the saucer-shaped LRAC curve is due to economies of scale, the flat
portion is due to constant long-run average cost, and the rising portion is due to diseconomies of scale.
Note: Students are allowed to use either the U-shaped LRAC curve or the saucer-shaped LRAC
curve in the examination.
5.2 Internal Economies of Scale and Internal Diseconomies of Scale
Internal Economies of Scale
When a firm expands its scale of production, its average cost will usually fall. Internal economies of
scale (IEOS), or simply known as economies of scale (EOS), refer to the decrease in average cost
when the scale of production expands. Economies of scale are shown by a downward movement
along the long-run average cost curve. Unless otherwise stated, economies of scale refer to internal
economies of scale which are different from external economies of scale which will be explained in
greater detail later. There are several sources of economies of scale.
Technical Economies of Scale
Recall that division of labour is the process whereby each job is broken up into its component tasks
and each worker is assigned one or a few component tasks of the job. An expansion of the scale of
production may enable the firm to engage in greater division of labour and hence greater specialisation
which will lead to higher labour productivity resulting in increasing returns to scale. Furthermore, larger
machines are often more efficient than smaller machines as they generally make more efficient use of
materials and labour. Therefore, an expansion of the scale of production may enable the firm to use
larger machines that are often more efficient than smaller machines which will also lead to higher
labour productivity resulting in increasing returns to scale. Recall that increasing returns to scale occur
when the same percentage/proportionate increase in the quantities of all the factor inputs used in the
production process leads to a larger percentage/proportionate increase in total output. When this
happens, the percentage/proportionate increase in total output will be greater than the
percentage/proportionate increase in total cost resulting in a fall in average cost.
Managerial Economies of Scale
Larger firms may be able to afford to create more specialised departments where specialists perform
specific administrative functions. These specific administrative functions include human resource,
purchasing, finance and marketing. Greater specialisation in these areas of expertise will lead to
greater efficiency resulting in a fall in average cost.
Organisational Economies of Scale

Larger firms are able to spread overheads such as marketing cost and training cost over a larger
amount of output. Spreading overheads will lead to lower overheads per unit of output resulting in a
fall in average cost. For example, as the cost of an advertisement is independent of the amount of
output produced, larger firms that produce a larger amount of output have a lower marketing cost per
unit of output.
Purchasing Economies of Scale
Larger firms produce a larger amount of output. Therefore, they require a larger amount of factor
inputs. It follows that larger firms are able to obtain a higher trade discount for the larger amount of
factor inputs that they purchase which will lead to a fall in their average costs.
Financial Economies of Scale
Larger firms are generally perceived to be more financially stable. Greater financial stability is
commonly associated with lower default risk. Therefore, larger firms generally are able to obtain loans
at lower interest rates which will lead to a fall in their average costs.
Container Principle
A container costs less per unit of output the larger the size. The cost of a container depends directly
on the amount of materials used to make it and hence the surface area. However, the capacity of a
container depends directly on the volume. Therefore, larger containers have a bigger volume relative
to surface area and hence larger firms that use larger containers have a lower container cost per unit
of output which will lead to a fall in their average costs.
Internal Diseconomies of Scale
When the scale of production of a firm reaches a certain size, a further expansion may lead to a rise
in its average cost. Internal diseconomies of scale (IDOS), or simply known as diseconomies of scale
(DOS), refer to the increase in average cost when the scale of production expands. Diseconomies of
scale are shown by an upward movement along the long-run average cost curve. Unless otherwise
stated, diseconomies of scale refer to internal diseconomies of scale which are different from external
diseconomies of scale which will be explained in greater detail later. There are several sources of
diseconomies of scale.
Technical Diseconomies of Scale
When division of labour increases to a high degree, workers may become demotivated as performing
the same task all the time may lead to boredom. This is especially true if the task is mundane. If this
happens, labour productivity will fall which will lead to decreasing returns to scale. Recall that
decreasing returns to scale occur when the same percentage/proportionate increase in the quantities
of all the factor inputs used in the production process leads to a smaller percentage/proportionate
increase in total output. When this happens, the percentage/proportionate increase in total output will
be smaller than the percentage/proportionate increase in total cost resulting in a rise in average cost.
Managerial Diseconomies of Scale

When more specialised departments are created, coordination of the departments in the firm may
become difficult. This is especially true if a system of coordination is not put in place. If this happens,
efficiency in the various departments will fall which will lead to a rise in average cost.
Note: Internal economies and diseconomies of scale will be discussed in greater detail in economics
5.3 External Economies of Scale and External Diseconomies of Scale
External Economies of Scale
A firm may experience a fall in its average cost when the industry expands, even though its scale of
production remains unchanged. External economies of scale (EOS) refer to the decrease in average
cost when the industry rather than the scale of production expands. External economies of scale are
shown by a downward shift in the long-run average cost curve. There are several sources of external
economies of scale.
When the industry expands, the demand for factor inputs will increase which will allow firms that supply
factor inputs to the industry to expand their scales of production. When this happens, they may reap
more economies of scale and hence charge lower prices to firms in the output industry. If this happens,
as firms in the output industry will pay lower prices for the factor inputs that they purchase, their
average costs will fall.
When an industry is small, training schools may find it unprofitable to design and conduct training
courses to cater for the industry. However, when the industry expands, these training courses may
become profitable to design and conduct. If this happens, firms in the industry will experience a fall in
their training costs which will lead to a fall in their average costs.
An expansion of the industry may induce the government to improve the infrastructure such as the
transportation network to support the industry. If this happens, firms in the industry will experience a
fall in their transportation costs which will lead to a fall in their average costs.
When the industry expands, specialist firms which supply components to the industry may be set up.
If this happens, as these specialist firms use dedicated machinery to produce the components, the
costs of production will be lower which will lead to lower prices. As a result, firms in the industry will
experience a fall in their average costs.
An expansion of the industry may lead to an increase in the number of researchers from both academia
and industry who will devote their researches to the industry. If this happens, the researches
conducted by these researchers will be published in research journals and be made accessible to
interested parties for a fee. If the researches lead to better production technologies in the industry,
average cost will fall.
External Diseconomies of Scale
A firm may experience a rise in its average cost when the industry expands, even though its scale of
production remains unchanged. External diseconomies of scale (DOS) refer to the increase in average
cost when the industry rather than the scale of production expands. External diseconomies of scale
are shown by an upward shift in the long-run average cost curve. There are several sources of external
diseconomies of scale.
When the industry expands, the demand for factor inputs will increase which will lead to a rise in the
prices. When this happens, as firms in the industry will pay higher prices for factor inputs, their average
costs will rise.
An expansion of the industry may exert a strain on the infrastructure such as the transportation network
which will lead to congestion. If this happens, firms in the industry will experience a rise in their
transportation costs which will lead to a rise in their average costs.
5.4 Economies of Scope
When the types of goods produced increase, average cost will usually fall. Economies of scope refer
to the decrease in average cost due to an increase in the size of the firm associated with an increase
in the types of goods produced rather than an increase in the scale of producing any one good.
Economies of scope occur due to several reasons. For example, an increase in the types of goods
produced will lead to a fall in the research and development cost per unit of output if the technologies
that are used to produce the goods are related. An increase in the types of goods produced will also
lead to a fall in the marketing cost per unit of output if the goods use the same branding.
5.5 Minimum Efficient Scale
The minimum efficient scale (MES) is the lowest output level at which economies of scale are fully
reaped. With a saucer-shaped LRAC curve, the minimum efficient scale is the output level at which
the long-run average cost curve (LRAC) stops falling. With a U-shaped LRAC curve, the minimum
efficient scale is the output level which corresponds to the lowest point on the LRAC curve.
In the above diagram, with a saucer-shaped LRAC curve, the minimum efficient scale is Q0.
In the above diagram, with a U-shaped LRAC curve, the minimum efficient scale is Q0.
The size of a firm is often measured by its long-run output level which depends to a large extent on
the minimum efficient scale. If the minimum efficient scale is low, the firm will tend to be small.
Conversely, if the minimum efficient scale is high, the firm will tend to be large. However, the long-run
output level of a firm does not depend entirely on its minimum efficient scale. A firm with a higher
minimum efficient scale in a smaller market may have a long-run output level lower than that of a firm
with a lower minimum efficient scale in a larger market. In other words, the long-run output level of a
firm also depends on the size of the market in which the firm operates.
In a market with a low demand, a monopoly may emerge naturally if it can reap very substantial
economies of scale due to very high capital costs. The very substantial economies of scale, coupled
with a low market demand, lead to a high minimum efficient scale relative to the market demand
resulting in the long-run average cost curve falling over the entire range of market demand. In such a
market, a single firm can meet the market demand at an average cost which allows it to make
supernormal profit. However, with two or more firms, all firms will make subnormal profit as there is
simply no price that will allow any firm to cover its average cost. A monopoly that emerges in this way
is known as a natural monopoly. An example of a firm with the characteristics of a natural monopoly
is an electricity utility firm. Monopoly will be explained in greater detail in Chapter 5.
MARKET STRUCTURE will be taught in the

first, second, third and fourth weeks of term 2
in economics tuition.
1 INTRODUCTION
Economists are interested to study the behaviour of firms such as whether they will charge a high or
low price, whether they will make a large or small amount of profit and whether they will produce
efficiently. The answers to these questions will depend on the market structure. Market structure refers
to the characteristics of a market such as the number of firms, the nature of their products, the
availability of knowledge and the extent of barriers to entry which affect the behaviour of the firms in
the market. For example, a firm that faces competition from many firms is likely to charge a low price,
make a small amount of profit and produce efficiently. The converse is also true. To maximise profit,
a firm may not charge the same price for each unit of a good and this practice is known as price
discrimination. Price discrimination affects the firm, consumers and society as a whole. Although firms
generally seek to maximise profit, some firms seek to maximise market share, sales revenue and long-
run profit. This chapter provides an exposition of the four types of market structures: perfect
competition, monopoly, monopolistic competition and oligopoly, price discrimination and the
alternative objectives of firms.
2 PERFECT COMPETITION
2.1 Characteristics of Perfect Competition
Large Number of Small Firms
In perfect competition, there are a large number of small firms each with a small market share.
Homogeneous Products
In perfect competition, firms sell homogenous products that are perfect substitutes.
Perfect Knowledge
In perfect competition, consumers and firms have perfect knowledge about the price, quality,
availability and production technology of the product.
Price-takers
Due to small market share, product homogeneity and perfect knowledge, perfectly competitive firms
are price-takers in the sense that they are unable to influence the market price by changing their output
levels. Therefore, perfectly competitive firms can only sell their output at the market price that is
determined by the market forces of demand and supply. In other words, perfectly competitive firms
face a perfectly price elastic demand curve at the market price. At the market price, perfectly
competitive firms can sell an infinite amount of output and hence they do not have the incentive to
charge a lower price. Furthermore, perfectly competitive firms do not have the incentive to charge a
price higher than the market price as the quantity demanded is zero.
No Barriers to Entry
In perfect competition, there are no barriers to entry which means that firms can make only normal
profit in the long run. This will be explained in greater detail in Section 2.3.
Perfect competition does not exist in reality due to the unrealistic assumption of perfect knowledge.
Market Representative firm
In the above left-hand diagram, the market price (P0) is determined by the market demand (D) and the
market supply (S). In the above right-hand diagram, the perfectly competitive firm faces a perfectly
price elastic demand curve (D0) at P0. At P0, the quantity demanded of the good produced by the firm
is infinite. Total revenue is the amount of money received from selling a quantity of a good which is
the product of the price and the quantity. Average revenue is revenue per unit of a good. It is calculated
by dividing total revenue by the quantity. Therefore, average revenue is the price of the good and
hence the average revenue curve (AR0) is the demand curve. Marginal revenue is the additional
revenue resulting from selling one more unit of a good. It is calculated by dividing the change in total
revenue by the change in the quantity. If the perfectly competitive firm wants to sell one more unit of
the good, it does not need to decrease the price. Therefore, marginal revenue is equal to the price of
the good and hence the marginal revenue curve (MR0) is the demand curve.
Note: The word ‘perfect’ in ‘perfect competition’ does not mean ‘the best’ or ‘the most desirable’.
Rather, when it is used with the word ‘competition’, perfect means ‘of the highest degree’.
Although perfect competition does not exist in reality, there are some markets which approximate
perfect competition, such as the agriculture market.
Perfect competition will be discussed in economics tuition by the Principal Economics Tutor in greater
detail.
2.2 The Profit-maximising Condition

A firm will maximise profit when it produces the output level where marginal cost is equal to marginal
revenue.
In the above diagram, profit is maximised at Q0 where marginal cost (MC) is equal to marginal revenue
(MR). If the firm increases output from Q0, both total revenue and total cost will rise. However, at an
output level higher than Q0, such as Q1, MC is higher than MR. Therefore, the increase in total cost
will be greater than the increase in total revenue and hence the increase in output will lead to a
decrease in profit. If the firm decreases output from Q0, both total revenue and total cost will fall.
However, at an output level lower than Q0, such as Q2, MR is higher than MC. Therefore, the decrease
in total revenue will be greater than the decrease in total cost and hence the decrease in output will
lead to a decrease in profit. Since profit cannot be increased by changing output from Q0, it must be
maximised at Q0. The profit is represented by the shaded area, assuming the firm is making
supernormal profit.
Furthermore, MC is equal to MR at two output levels, Q0’ and Q0. At Q0’, where MC is falling, profit is
NOT maximised. Between Q0’ and Q0, MR is higher than MC. If output increases from Q0’ to Q0, a
profit will be made on each unit of output and this means that the profit at Q0 is higher than the profit
at Q0’. Therefore, the profit of a perfectly competitive firm is maximised at the output level where MC
is equal to MR, assuming MC is rising.
Note: Although the profit-maximising condition states that marginal cost must be equal to marginal
revenue for profit to be maximised, the condition is generally not applied in practice. This is mainly due
to the difficulty in measuring marginal cost in reality. For firms that engage in mass production on
assembly line, marginal cost is virtually impossible to measure. This is also true for firms that provide
services. In practice, most firms set their prices by adding a certain percentage mark-up to their
average costs and this is known as cost-plus pricing.
2.3 Equilibrium of a Perfectly Competitive Market
A perfectly competitive market is in short-run equilibrium when all the firms in the market are producing
the profit-maximising output level. However, this does not necessarily mean that they are making
positive economic profit. In the short run, a perfectly competitive firm can make three types of profit:
supernormal profit (positive economic profit), normal profit (zero economic profit) and subnormal profit
(negative economic profit or economic loss).
Supernormal Profit
In the above diagram, at the profit-maximising output level (Q0) where marginal cost (MC) is equal to
marginal revenue (MR), average revenue (AR) is higher than average cost (AC). Therefore, the firm
is making supernormal profit represented by the shaded area.
Normal Profit
marginal revenue (MR), average revenue (AR) is equal to average cost (AC). Therefore, the firm is
making normal profit.
Subnormal Profit
marginal revenue (MR), average revenue (AR) is lower than average cost (AC). Therefore, the firm is
making subnormal profit represented by the shaded area.
A perfectly competitive market is in long-run equilibrium when firms that wish to leave the market and
potential firms that wish to enter the market have done so. In other words, a perfectly competitive
market is in long-run equilibrium when the number of firms in the market is constant. In a perfectly
competitive market, this occurs when firms make normal profit.
If the firms in a perfectly competitive market are making supernormal profit, potential firms will enter
the market in the long run due to the absence of barriers to entry. As the number of firms in the market
increases, the market supply will increase which will lead to a fall in the market price resulting in a fall
in the profits of the firms. This process will continue until the firms in the market make only normal
profit.
In the above diagram, the supernormal profit represented by the shaded area induces potential firms
to enter the market in the long run, which leads to a rightward shift in the market supply curve (S) from
S0 to S1. When this happens, the market price (P) falls from P0 to P1. At P1, as the firms in the market
make only normal profit, the incentive for potential firms to enter the market disappears.
If the firms in a perfectly competitive market are making subnormal profit, they will leave the market
when their fixed factor inputs need replacing. Those that cannot cover their total variable costs will
leave the market immediately. As the number of firms in the market decreases, the market supply will
decrease which will lead to a rise in the market price resulting in a fall in the losses of the firms. This
process will continue until the firms in the market start making normal profit.
In the above diagram, the subnormal profit represented by the shaded area induces firms to leave the
market, which leads to a leftward shift in the market supply curve (S) from S0 to S1. When this happens,
the market price (P) rises from P0 to P1. At P1, as the firms in the market start making normal profit,
the incentive for them to leave the market disappears.
2.4 The Shut-down Condition
If a firm is making supernormal profit (i.e. positive economic profit) which means that the total revenue
is greater than the total cost, it is obvious that it should continue production. However, if a firm is
making subnormal profit (i.e. negative economic profit or economic loss) which means that the total
revenue is less than the total cost, it does not mean that it should shut down production. In the short
run, a firm should continue production so long as the total revenue is greater than or equal to the total
variable cost. In other words, in the short run, a firm should only take into consideration variable costs
and ignore fixed costs when it is deciding whether to continue or shut down production as fixed costs
will be incurred in any case.
Assume that a firm is making subnormal profit as the total revenue is less than the total cost. If the
firm shuts down production, it will not incur variable costs as it will not need to employ labour or buy
materials which means that the total variable cost will be zero. In this case, no sale will be made as
there will be no production and hence the total revenue will also be zero. However, the firm will incur
fixed costs as it will incur rent and possibly other costs that do not vary with the output level such as
interest payments on loans which means that the total fixed cost will be positive. Therefore, it will make
a loss equal to the total fixed cost. If the firm continues production, it will incur variable costs as it will
need to employ labour and buy materials which means that the total variable cost will be positive. In
this case, sale will be made as there will be production and hence the total revenue will also be positive.
In addition, the firm will incur fixed costs as it will incur rent and possibly other costs that do not vary
with the output level such as interest payments on loans which means that the total fixed cost will also
be positive. Therefore, it will make a loss equal to the total revenue minus the total fixed cost and the
total variable cost.
In this case, whether the firm will make a loss greater or less than the total fixed cost which is the loss
that it will make if it shuts down production, will depend on whether the total revenue is greater or less
than the total variable cost. If the total revenue is less than the total variable cost, the shortfall will add
to the loss. In this case, the firm will make a loss greater than the total fixed cost. Assume that the
variable costs are the cost of labour and the cost of materials and the only fixed cost is the rent. If the
total revenue is less than sufficient to pay for the costs of labour and materials, the shortfall will add to
the loss and hence the firm will make a loss greater than the rent which is the loss that it will make if
it shuts down production. Therefore, the firm should shut down production. However, if the total
revenue is greater than the total variable cost, the excess will partially offset the total fixed cost. In this
case, the firm will make a loss less than the total fixed cost. Using the above example, if the total
revenue is more than sufficient to pay for the costs of labour and materials, the excess will partially
offset the rent and hence the firm will make a loss less than the rent which is the loss that it will make
if it shuts down production. Therefore, the firm should continue production. If the total revenue is equal
to the total variable cost, the firm will make the same amount of loss whether it continues or shuts
down production. In this case, the firm should continue production as doing so may enable it to make
supernormal profit in the future as the market conditions may improve. In the event that the market
conditions worsen, the firm can shut down production without being worse off than if it had shut down
production now. Therefore, the firm should continue production. It follows that a firm should continue
production if the total revenue is greater than or equal to the total variable cost, and shut down
production if the total revenue is less than the total variable cost.
In the long run, as all costs are variable, there is no distinction between fixed costs and variable costs.
Therefore, in the long run, if a firm makes subnormal profit which means that the total revenue is less
than the total cost, it should shut down production and leave the market. It follows that in the long run,
a firm should continue production if the total revenue is greater than or equal to the total cost.
Note: The short-run and long-run shut-down conditions discussed above apply to firms in all market
structures.
In the short run, unlike the long run, if a firm shuts down production, it does not leave the market.
Shut-down condition will be discussed in economics tuition by the Principal Economics Tutor in greater
detail.
2.5 Supply Curve in Perfect Competition

Recall that the supply of a good is the quantity of the good that firms are able and willing to sell at each
price over a period of time, ceteris paribus, and the supply curve shows the quantity supplied at each
price. The portion of the marginal cost curve above the average variable cost curve of a perfectly
competitive firm is the supply curve. As the supply curve shows the quantity supplied at each price,
this means that given the price of a good, the quantity supplied is determined entirely by the supply
curve.
In the above diagram, given the market price of the good (P0) that is determined by the market forces
of demand and supply, the quantity supplied (Q0) is determined entirely by the marginal cost (MC).
Intuitively, given the price of a good, the quantity supplied is determined by the marginal revenue and
the marginal cost. However, in the case of a perfectly competitive firm, price is equal to marginal
revenue. Therefore, given the price of the good produced by a perfectly competitive firm, the quantity
supplied is determined entirely by the MC curve. Furthermore, at a price below the average variable
cost (AVC), the firm will shut down production to avoid making a loss greater than the total fixed cost.
Therefore, the supply curve of a perfectly competitive firm is the portion of the marginal cost curve
above the average cost curve. The industry supply curve of a perfectly competitive industry is the
horizontal summation of the supply curves of all the firms in the industry.
2.6 Advantages and Disadvantages of Perfect Competition
Advantages of Perfect Competition
A firm is productively efficient when it produces on its long-run average cost curve, from firm’s
perspective. This occurs when it is x-efficient and technically efficient. A firm is x-efficient when it is
not lax in cost control. In other words, it uses the most efficient production technology, it is not
overstaffed, it does not occupy premises that are larger than necessary for its output level, etc. A firm
is technically efficient when it uses the least-cost combination of factor inputs to produce its output
level which means that the last dollar of each factor input that it employs produces the same additional
output. From society’s perspective, a firm is productively efficient when it produces at the minimum
efficient scale. Due to competition in the market, perfectly competitive firms are not lax in cost control.
Therefore, perfectly competitive firms are x-efficient and hence productively efficient.
Allocative Efficiency
A firm is allocatively efficient when it cannot change the allocation of resources in the economy in a
way that will increase the welfare of society. This occurs when it charges a price equal to its marginal
cost, assuming no externalities. When the price of a good is equal to the marginal cost, the marginal
benefit that consumers place on the last unit of the good is equal to the forgone marginal benefit that
they place on the amount of other goods that could have been produced using the same resources.
Therefore, the firm cannot change its output level to increase the total benefit for consumers and hence
is allocatively efficient. In perfect competition, price equals marginal revenue and firms maximise profit
by producing the output level where marginal revenue equals marginal cost. Therefore, perfectly
competitive firms charge a price equal to their marginal cost and are hence allocatively efficient.
marginal revenue (MR), the price (P0) is equal to the marginal cost (MC0).
Lower Price
Firms with greater market power are able to charge a higher price relative to their marginal cost
compared to firms with less market power. Unlike a monopoly that has substantial market power,
perfectly competitive firms have no market power and hence the price charged by perfectly competitive
firms is lower than the price that would be charged by a monopoly operating in the same market,
assuming the cost structure of a monopoly is the same as that of a perfectly competitive industry.
In the above diagram, the perfectly competitive price (PPC) is lower than the monopoly price (PM).
Income Equity
As perfectly competitive firms can make only normal profit and monopolists and oligopolists can make
supernormal profit in the long run, the distribution of income in an economy that abounds with perfectly
competitive markets will be more equitable than one that abounds with monopolistic markets and
oligopolistic markets.
No Price Discrimination
Perfectly competitive firms are price-takers and hence they are unable to exploit consumers through
price discrimination. Price discrimination is commonly considered a form of consumer exploitation as
it will convert some of the consumer surplus to the producer surplus. Price discrimination will be
explained in greater detail in Section 6.
Disadvantages of Perfect Competition
Higher Price
Firms which reap more economies of scale are able to pass on their lower average costs of production
to consumers in the form of a lower price. As a perfectly competitive firm is smaller than a monopoly,
a perfectly competitive industry reaps less economies of scale than a monopoly and hence the price
charged by perfectly competitive firms may be higher than the price that would be charged by a
monopoly operating in the same market.
In the above diagram, the perfectly competitive price (PPC) is higher than the monopoly price (PM).
Dynamic Inefficiency
Perfectly competitive firms do not engage in research and development due to lack of ability and
incentive and hence are dynamically inefficient. Research and development will lead to product
innovations and process innovations. Product innovations will lead to higher product quality and better
product features and process innovations will lead to a better production technology and hence a lower
cost of production which may be passed on to consumers in the form of a lower price. However,
research and development requires high expenditure which perfectly competitive firms are unable to
finance as they can make only normal profit in the long run. Furthermore, due to perfect knowledge,
any innovation can easily and quickly be copied by other firms.
No Variety of Choices
Perfectly competitive firms sell homogeneous products and hence offer consumers no variety of
choices. In contrast, monopolistically competitive firms sell differentiated products which offer
consumers a great variety of choices.
Note: From society’s perspective, a firm is productively efficient when it produces on the lowest point
of its long-run average cost curve. This output level is known as the minimum efficient scale. However,
a discussion of society’s perspective of productive efficiency at the level of the firm is usually not
required in the examination due to the time constraint, unless the main focus of the question is on
efficiency.
Students are not required to explain technical efficiency as a condition for productive efficiency in the
examination as it has been removed from the Singapore-Cambridge GCE ‘A’ Level Economics
syllabus. Nevertheless, it is good for them to state the condition.
As discussed in Chapter 1, although productive efficiency is a necessary condition for allocative

efficiency at the level of the economy, this is not true at the level of the firm. Therefore, a firm is
economically efficient when it is productively efficient and allocatively efficient.
The advantages and disadvantages of perfect competition will be discussed in economics tuition by
the Principal Economics Tutor in greater detail.
3 MONOPOLY
3.1 Characteristics of Monopoly
Single Large Firm
In monopoly, there is a single large firm which dominates the whole market.
Unique Product
A monopoly sells a unique product that has no close substitutes.
Price-setter
A monopoly is a price-setter in the sense that it is able to set its price by setting its output level. In
other words, a monopoly faces a downward sloping demand curve.
High Barriers to Entry
In monopoly, there are high barriers to entry which means that the firm can make supernormal profit
in the long run.
An example of monopoly is the television broadcast market in Singapore.
In the above diagram, the demand curve (D) of the monopoly, which is the average revenue curve
(AR), is downward sloping. If the firm wants to sell one more unit of the good, it must decrease the
price. However, as the lower price will also apply to all the previous units of the good, the marginal
revenue is lower than the price and hence the marginal revenue curve (MR) is lower than the demand
curve. With the use of differential calculus, we can show that the slope of the marginal revenue curve
is twice that of the demand curve.
Note: In reality, a monopoly is defined as a firm that has more than a certain percentage of the market
share and the percentage varies from country to country.
The demand curve of a monopoly is also the market demand curve as it is the single firm in the market.
3.2 Barriers to Entry
A barrier to entry is an obstacle which restricts potential firms from entering a market to compete with
the incumbent firm or firms.
Economies of Scale
A monopoly may emerge naturally if it can reap very substantial economies of scale due to very high
capital costs such that the market can accommodate only one firm. In such a market where the market
demand is low which results in a high minimum efficient scale relative to the market demand and
hence the long-run average cost curve falling over the entire range of market demand, a single firm
can meet the market demand at an average cost which allows it to make supernormal profit. However,
with two or more firms, all firms will make subnormal profit as there is simply no price that will allow
any firm to cover its average cost. A monopoly that emerges in this way is known as a natural
monopoly. An example of a firm with the characteristics of a natural monopoly is an electricity utility
firm.
In the above diagram, the monopoly which faces the demand curve (D1) can make at least normal
profit by producing anywhere within the output range from QMIN to QMAX. With two firms in the market,
each firm faces the demand curve (D2), which lies entirely below the long-run average cost (LRAC)
curve and hence neither firm can make at least normal profit regardless of the output level. Even if a
market can accommodate more than one firm, if the monopoly is experiencing substantial economies
of scale, potential firms may decide not to enter the market as it will be difficult for them to achieve the
same level of cost competitiveness and hence the same level of price competitiveness.
Financial Barriers
Some industries have high start-up costs which are difficult to finance. These high start-up costs which
make it difficult for potential firms to enter the industries may be due to expensive capital goods. They
may also be due to heavy advertising which is costly especially when there are established brand
names in the market.
Legal Barriers
A firm may have obtained its monopoly position through the acquisition of a patent or copyright. A
patent is granted to an inventor to allow him the exclusive right to produce the good or use the
production process that is patented. In the latter, potential firms cannot enter the market as they do
not have access to the technology. The aim of awarding patents is to promote research and
development. A copyright, which is similar to a patent, is granted on plays, textbooks, novels, songs,
computer software, and the like. Patents and copyrights are known as intellectual properties.
Control of Key Factor Inputs or Wholesale and Retail Outlets
If a firm controls the supply of some key factor inputs, it can deny access to these factor inputs to
potential firms which will make it difficult for them to enter the market. Similarly, if a firm controls the
outlets through which the good is sold, it can prevent potential firms from gaining access to consumers
which will make it difficult for them to enter the market.
3.3 Equilibrium of a Monopolistic Market
A monopolistic market is in short-run equilibrium when the monopoly is producing the profit-maximising
output level. However, this does not necessarily mean that it is making positive economic profit. In the
short run, a monopoly can make three types of profit: supernormal profit (positive economic profit),
normal profit (zero economic profit) and subnormal profit (negative economic profit or economic loss).
Supernormal Profit
Normal Profit
Subnormal Profit
Unlike perfectly competitive firms, a monopoly can make supernormal profit in the long run. If a
monopoly is making supernormal profit, potential firms would like to enter the market. However, due
to high barriers to entry, they are unable to do so. Therefore, apart from normal profit, a monopoly can
make supernormal profit in the long run.
3.4 Advantages and Disadvantages of Monopoly

Advantages of Monopoly
Lower Price
to consumers in the form of a lower price. As a monopoly is larger than a perfectly competitive firm, a
monopoly reaps more economies of scale than a perfectly competitive industry and hence the price
charged by a monopoly may be lower than the price that would be charged by perfectly competitive
firms operating in the same market.
In the above diagram, the monopoly price (PM) is lower than the perfectly competitive price (PPC).
Dynamic Efficiency
As a monopoly can make supernormal profit in the long run, it has the ability to engage in research
and development. Therefore, a monopoly may engage in research and development and hence be
dynamically efficient. Research and development will lead to product innovations and process
innovations. Product innovations will lead to higher product quality and better product features and
process innovations will lead to a better production technology and hence a lower cost of production
which may be passed on to consumers in the form of a lower price.
Price Discrimination
A monopoly is a price-setter and hence it may be able to practise price discrimination which may be
beneficial to consumers. Price discrimination may allow a firm to reach a market that otherwise would
not be reached or to produce a good that otherwise would not be produced. Price discrimination will
be explained in greater detail in Section 6. Furthermore, if the increase in profit from price
discrimination is ploughed back into research and development, more benefits to consumers will be
created.
Disadvantages of Monopoly
Productive Inefficiency
Recall that a firm is productively efficient when it produces on its long-run average cost curve, from
firm’s perspective. This occurs when it is x-efficient and technically efficient. A firm is x-efficient when
it is not lax in cost control. In other words, it uses the most efficient production technology, it is not
efficient scale. Due to the absence of competition in the market, a monopoly may be lax in cost control.
Therefore, a monopoly may be x-inefficient and hence productively inefficient. However, if a monopoly
faces potential competition, it may be x-efficient and hence productively efficient to prevent potential
firms from entering the market. A monopoly may also be x-efficient and hence productively efficient
due to the pursuit of greater profit.
Allocative Inefficiency
Recall that a firm is allocatively efficient when it cannot change the allocation of resources in the
economy in a way that will increase the welfare of society. This occurs when it charges a price equal
to its marginal cost, assuming no externalities. When the price of a good is equal to the marginal cost,
the marginal benefit that consumers place on the last unit of the good is equal to the forgone marginal
benefit that they place on the amount of other goods that could have been produced using the same
resources. Therefore, the firm cannot change its output level to increase the total benefit for consumers
and hence is allocatively efficient. In monopoly, price is higher than marginal revenue and the firm
maximises profit by producing the output level where marginal revenue equals marginal cost.
Therefore, a monopoly charges a price higher than its marginal cost and is hence allocatively
inefficient.
marginal revenue (MR), the price (P0) is higher than the marginal cost (MC0).
Higher Price
compared to firms with less market power. Unlike perfectly competitive firms that have no market
power, a monopoly has substantial market power and hence the price charged by a monopoly is higher
than the price that would be charged by perfectly competitive firms operating in the same market,
assuming the cost structure of a monopoly is the same as that of a perfectly competitive industry.
In the above diagram, the monopoly price (PM) is higher than the perfectly competitive price (PPC).
Although a monopoly has the ability to engage in research and development as it can make
supernormal profit in the long run, it may not have the incentive to engage in research and
development due to the absence of competition in the market. Therefore, a monopoly may not engage
in research and development and hence be dynamically inefficient.
Income Inequity
As a monopoly can make supernormal profit and perfectly competitive firms and monopolistically
competitive firms can make only normal profit in the long run, the distribution of income in an economy
that abounds with monopolistic markets will be less equitable than one that abounds with perfectly
competitive markets and monopolistically competitive markets.
A monopoly is a price-setter and hence it may be able to exploit consumers through price
discrimination. Price discrimination is commonly considered a form of consumer exploitation as it will
convert some of the consumer surplus to the producer surplus.
Note: The advantages and disadvantages of monopoly will be discussed in economics tuition by the
Principal Economics Tutor in greater detail.
3.5 Natural Monopoly
A natural monopoly is a monopoly that emerges when it can reap very substantial economies of scale
due to very high capital costs such that the market can accommodate only one firm. In such a market
where the market demand is low which results in a high minimum efficient scale relative to the market
demand and hence the long-run average cost curve falling over the entire range of market demand, a
single firm can meet the market demand at an average cost which allows it to make supernormal profit.
However, with two or more firms, all firms will make subnormal profit as there is simply no price that
will allow any firm to cover its average cost. The very high capital costs also result in an average cost
curve falling over the entire range of the market demand. An example of a firm with the characteristics
of a natural monopoly is an electricity utility firm.
In the above diagram, the monopoly which faces the demand curve (D1) can make at least normal
profit by producing anywhere within the output range from QMIN to QMAX. With two firms in the market,
each firm faces the demand curve (D2), which lies entirely below the long-run average cost (LRAC)
curve. Neither firm can make at least normal profit regardless of the output level.
In the above diagram, at the profit-maximising output level (QM) where marginal cost (MC) is equal to
marginal revenue (MR), the price (PM) is higher than the marginal cost (MCM) and this leads to
allocative inefficiency. The profit-maximising output level (QM) is lower than the allocatively efficient
output level (QAE) where price is equal to marginal cost. As a natural monopoly is a very large firm, the
government may see a need to intervene in the market. In the event that the government wishes to
intervene in the market, it can do so through marginal cost pricing, average cost pricing, subsidy or
nationalisation.
Marginal Cost Pricing
The government can pass a pricing regulation that requires the monopoly to charge a price equal to
its marginal cost to achieve allocative efficiency, assuming no externalities, and this is known as
marginal cost pricing.
In the above diagram, marginal cost pricing leads to a fall in the price (P) from PM to PMC and an
increase in the output level (Q) from QM to QMC. As the price (PMC) is equal to the marginal cost (MCMC),
allocative efficiency is achieved. The output level (QMC) is equal to the allocatively efficient output level
(QAE). However, to make more profit, the monopoly may provide false information about its cost
structure to the government by overstating its marginal cost. If this happens, the use of marginal cost
pricing in a monopolistic market will not achieve allocative efficiency. Furthermore, assuming the
monopoly is unable to use a two-part tariff, marginal cost pricing will cause the monopoly to make a
loss represented by the shaded area as the price (PMC) is lower than the average cost (AC) at QMC.
Therefore, the government needs to give the monopoly a lump-sum subsidy to allow it to cover its
loss. However, if the government is unwilling or unable to do so, marginal cost pricing will not be
feasible.
Average Cost Pricing

In the event that marginal cost pricing is infeasible, the government can pass a pricing regulation that
requires the monopoly to charge a price equal to its average cost to reduce allocative inefficiency and
this is known as average cost pricing.
In the above diagram, average cost pricing leads to a fall in the price (P) from PM to PAC and an
increase in the output level (Q) from QM to QAC. As the difference between the price (P) and the
marginal cost (MC) decreases from (PM – MCM) to (PAC – MCAC), allocative inefficiency is reduced.
The output level (QAC) is closer to the allocatively efficient output level (QAE). However, although the
use of average cost pricing in a monopolistic market will reduce allocative inefficiency, it will not
achieve allocative efficiency.
Subsidy
The government can give a subsidy to the monopoly to achieve allocative efficiency. A subsidy will
lead to a fall in the cost of production. When this happens, the monopoly will increase output which
will reduce allocative inefficiency.
In the above diagram, a subsidy leads to a fall in the average cost (AC) curve and the marginal cost
(MC) curve. If the new AC curve and the new MC curve are AC’ and MC’, the price (PM’) will be equal
to the marginal cost before subsidy (MCM’) and hence allocative efficiency will be achieved. The profit-
maximising output level (QM’) will be equal to the allocatively efficient output level (QAE). However, to
make more profit, the monopoly may provide false information about its cost structure to the
government by overstating its marginal cost. If this happens, the use of subsidy in a monopolistic
market will not achieve allocative efficiency. Furthermore, the subsidy will increase the profit of the
monopoly which is already making supernormal profit. As it will be financed by taxpayers’ money, the
government may be reluctant to use it to avoid hurting its popularity rating.
Nationalisation
Nationalisation refers to the conversion of a private firm to a state-owned firm. The government can
nationalise the firm to produce the good itself. In order to achieve allocative efficiency, it can charge a
price equal to its marginal cost. However, opponents of nationalisation argue that as state-owned firms
do not need to consider factors such as profitability and survival, they are likely to be x-inefficient and
hence productively inefficient. Therefore, although nationalisation can solve the problem of allocative
inefficiency, it is likely to create the problem of productive inefficiency.
4 MONOPOLISTIC COMPETITION
4.1 Characteristics of Monopolistic Competition
Large Number of Small Firms
In monopolistic competition, there are a large number of small firms each with a small market share.
Differentiated Products
In monopolistic competition, firms sell differentiated products that are close substitutes. Differentiated
products are products that are sufficiently similar to be distinguished as a group from other products.
An example is restaurant foods.
Price-setters
Monopolistically competitive firms are price-setters in the sense that they are able to set their prices
by setting their output levels. In other words, monopolistically competitive firms face a downward
sloping demand curve.
Low Barriers to Entry
In monopolistic, there are low barriers to entry which means that firms can make only normal profit in
the long run.
An example of monopolistic competition is the restaurant market.
In the above diagram, the demand curve (D) of the monopolistically competitive firm, which is the
average revenue curve (AR), is downward sloping. If the firm wants to sell one more unit of the good,
it must decrease the price. As the lower price will also apply to all the previous units of the good, the
marginal revenue is lower than the price and hence the marginal revenue curve (MR) is lower than the
demand curve. With the use of differential calculus, we can show that the slope of the marginal revenue
curve is twice that of the demand curve.
Note: As monopolistically competitive firms sell differentiated products, there are no market demand
and market supply curves in monopolistic competition. Therefore, the theory of monopolistic
competition is only analysed at the level of the firm.
4.2 Equilibrium of a Monopolistically Competitive Market
A monopolistically competitive market is in short-run equilibrium when the firms in the market are
producing the profit-maximising output level. However, this does not necessarily mean that they are
making positive economic profit. In the short run, a monopolistically competitive firm can make three
types of profit: supernormal profit (positive economic profit), normal profit (zero economic profit) and
subnormal profit (negative economic profit or economic loss).
Supernormal Profit
Normal Profit
Subnormal Profit
A monopolistically competitive market is in long-run equilibrium when firms that wish to leave the
market and potential firms that wish to enter the market have done so. In other words, a
monopolistically competitive market is in long-run equilibrium when the number of firms in the market
is constant. In a monopolistically competitive market, this occurs when firms make normal profit.
If the firms in a monopolistically competitive market are making supernormal profit, potential firms will
enter the market in the long run due to low barriers to entry. As the number of firms in the market
increases, the demand for the good produced by each firm will decrease which will lead to a fall in the
price resulting in a fall in the profits of the firms. This process will continue until the firms in the market
make only normal profit.
In the above diagram, the supernormal profit represented by the shaded area induces potential firms
to enter the market in the long run, which leads to a leftward shift in the demand curve of each firm (D)
from D0 to D1. When this happens, the price (P) falls from P0 to P1. At P1, as the firms in the market
make only normal profit, the incentive for potential firms to enter the market disappears.
If the firms in a monopolistically competitive market are making subnormal profit, they will leave the
market when their fixed factor inputs need replacing. Those that cannot cover their total variable costs
will leave the market immediately. As the number of firms in the market decreases, the demand for
the good produced by each firm will increase which will lead to a rise in the price resulting in a fall in
the losses of the firms. This process will continue until the firms in the market start making normal
profit.
In the above diagram, the subnormal profit represented by the shaded area induces firms to leave the
market, which leads to a rightward shift in the demand curve of each firm (D) from D0 to D1. When this
happens, the price (P) rises from P0 to P1. At P1, as firms in the market start making normal profit, the
incentive for them to leave the market disappears.
Note: The extent of barriers to entry in a market does not only determine the type of profit made by
firms in the long run, it also determines the number of firms in the market. For example, low barriers
to entry in monopolistic competition lead to a large number of firms in the market and high barriers to
entry in monopoly result in a single firm in the market.
4.3 Advantages and Disadvantages of Monopolistic Competition
Advantages of Monopolistic Competition

efficient scale. Due to competition in the market, monopolistically competitive firms are not lax in cost
control. Therefore, monopolistically competitive firms are x-efficient and hence productively efficient.
Lower Price
compared to firms with less market power. Monopolistically competitive firms have less market power
than a monopoly and hence the price charged by monopolistically competitive firms may be lower than
the price that would be charged by a monopoly operating in the same market. The price charged by
monopolistically competitive firms may also be lower than the price that would be charged by a
monopoly operating in the same market due to low barriers to entry which does not allow them to
charge a price higher than their average cost in the long run.
Income Equity
As monopolistically competitive firms can make only normal profit and monopolists and oligopolists
can make supernormal profit in the long run, the distribution of income in an economy that abounds
with monopolistically competitive markets will be more equitable than one that abounds with
monopolistic markets and oligopolistic markets.
Variety of Choices
Monopolistically competitive firms sell differentiated products which offer consumers a great variety of
choices. In contrast, perfectly competitive firms sell homogeneous products and hence offer
consumers no variety of choices.
Disadvantages of Monopolistic Competition
and hence is allocatively efficient. In monopolistic competition, price is higher than marginal revenue
and firms maximise profit by producing the output level where marginal revenue equals marginal cost.
Therefore, monopolistically competitive firms charge a price higher than their marginal cost and are
hence allocatively inefficient.
marginal revenue (MR), the price (P0) is higher than the marginal cost (MC0). However, the difference
between the price and the marginal cost and hence the extent of allocative inefficiency in a
monopolistically competitive market is smaller than that in a monopolistic market. This is due to the
larger number of substitutes in a monopolistically competitive market which leads to the higher price
elasticity of demand for the good produced by each firm.
Higher Price
to consumers in the form of a lower price. As a monopolistically competitive firm is smaller than a
monopoly, monopolistically competitive firms reap less economies of scale than a monopoly and
hence the price charged by monopolistically competitive firms may be higher than the price that would
be charged by a monopoly operating in the same market. Furthermore, firms with greater market
power are able to charge a higher price relative to their marginal cost compared to firms with less
market power. Unlike perfectly competitive firms, monopolistically competitive firms have market
power and hence the price charged by monopolistically competitive firms may be higher than the price
that would be charged by perfectly competitive firms operating in the same market.
Monopolistically competitive firms do not engage in research and development due to lack of ability
and hence are dynamically inefficient. Research and development will lead to product innovations and
process innovations. Product innovations will lead to higher product quality and better product features
and process innovations will lead to a better production technology and hence a lower cost of
production which may be passed on to consumers in the form of a lower price. However, research and
development requires high expenditure which monopolistically competitive firms are unable to finance
as they can make only normal profit in the long run.
Note: The advantages and disadvantages of monopolistic competition will be discussed in economics
tuition by the Principal Economics Tutor in greater detail.
5 OLIGOPOLY
5.1 Characteristics of Oligopoly
Small Number of Large Firms
In oligopoly, there are a small number of large firms each with a large market share.
Differentiated Products
Oligopolists generally sell differentiated products such as cars and electrical appliances. Some
oligopolists, however, sell homogeneous products such as cement and steel.
Price-setters
Oligopolists are price-setters in the sense that they are able to set their prices by setting their output
levels. In other words, oligopolists face a downward sloping demand curve.
High Barriers to Entry
In oligopoly, there are high barriers to entry which means that firms can make supernormal profit in
the long run.
Strategic Interdependence (also known as Mutual Interdependence)
In oligopoly, due to the small number of large firms and hence the large market share of each firm, the
actions of one firm affect and are affected by the actions of the other firms in the market, and this is
known as strategic interdependence. When an oligopolist changes its price, it will have a significant
effect on the other firms in the market. The rival firms will hence react by changing their prices which
will affect the first firm. Therefore, when an oligopolist makes pricing and output decisions, it must take
into consideration the reactions of the other firms in the market. In this sense, the pricing and output
decisions of an oligopolist depend on the behavior of competitors.
An example of oligopoly is the pharmaceutical market.
5.2 Collusive versus Competitive (non-collusive) Behaviour
Due to strategic interdependence, oligopolists may collude or compete.
Collusive Behaviour
Formal Collusion
Oligopolists can collude overtly by having a formal collusive agreement and this is known as formal
collusion. Formal collusion typically takes the form of cartelisation. In cartelisation, the firms agree on
a common target price which is higher than the prices that they currently charge. To achieve the
common target price, the firms will agree on a set of output quotas to decrease production. A likely
method to decide on the set of output quotas is to divide the market according to the market shares of
the firms. There are certain factors that favour cartelisation. Cartelisation is more likely in a market
where there are no government measures to prevent collusion, there are a small number of firms, the
firms produce homogeneous products, the firms have the same cost structure, the demand is stable
and the barriers to entry are high which will prevent disruptions to the agreement by new firms.
Cartelisation is illegal in many countries. For example, the competition policy in Singapore and the
anti-trust laws in the United States prohibit attempts to distort competition.
Tacit Collusion
In countries where cartelisation is illegal, such as Singapore and the United States, oligopolists can
collude covertly without having a formal agreement and this is known as tacit collusion. Tacit collusion
typically takes the form of price leadership. In price leadership, the price leader will set the price and
the price followers will take the price set by the price leader. The price followers will also follow any
price increase or decrease by the price leader. The price leader may be the firm with the largest market
share which is called the dominant firm price leadership. The price leader may also be the firm with
the most information about the market conditions which is called the barometric firm price leadership.
Apart from price leadership, tacit collusion may also take the form of a rule of thumb. An example is
mark-up pricing. In mark-up pricing, which is also known as cost-plus pricing, a firm sets its price by
adding a certain mark-up for profit to its average cost. Firms may engage in tacit collusion by following
the same mark-up pricing.
Competitive Behaviour
If oligopolists collude, there will be price stability. At first thought, if they do not collude, price war will
be inevitable. However, price stability has been found to be an empirical regularity in most oligopolistic
markets, even in those where the firms do not collude. This phenomenon can be explained by the
theory of the kinked demand curve.
The theory of the kinked demand curve is based on two asymmetrical assumptions. First, if a firm in
an oligopolistic market increases its price, its rivals will not follow suit because by keeping their prices
the same, they can attract consumers from the firm. Accordingly, if a firm in an oligopolistic market
increases its price, its quantity demanded will decrease by a larger percentage as consumers will
switch from the firm to the rivals which will lead to a fall in revenue for the firm. Second, if a firm in an
oligopolistic market reduces its price, its rivals will follow suit to avoid losing consumers to the firm.
Accordingly, if a firm in an oligopolistic market reduces its price, its quantity demanded will increase
by a smaller percentage as consumers will not switch from the rivals to the firm, which will lead to a
fall in revenue for the firm. Therefore, oligopolists do not have the incentive to change their prices,
assuming no substantial changes in the cost of production.
The theory of the kinked demand curve can be illustrated with a diagram. A firm in an oligopolistic
market faces a demand curve that is kinked at the equilibrium and the kink on the demand curve leads
to a discontinuity on the marginal revenue curve.
In the above diagram, as the price (P) and the output level (Q) are P0 and Q0, the marginal cost (MC)
curve must be cutting the marginal revenue (MR) curve at the discontinuity. A change in the cost of
production will lead to a shift in the MC curve. However, as long as the MC curve lies between MC’
and MC”, the price will remain constant and this explains price stability in oligopolistic markets where
there is no collusion. In the event of a substantial change in the cost of production, the MC curve will
shift out of the range between MC’ and MC” which will lead to a change in the price and the output
level. If this happens, firms may plunge into a price war before they reach a new equilibrium and the
new demand curve will be kinked at the new equilibrium.
Although the theory of the kinked demand curve can explain price stability in the absence of collusion,
it does not explain how the price is set in the first place. Furthermore, price stability may be due to
other factors. For example, oligopolists may not want to change price too frequently to prevent
upsetting consumers.
Note: Although the diagram of the kinked demand curve has been removed from the Singapore-
Cambridge GCE ‘A’ Level Economics syllabus, it is good for students to include it in their responses
as it demonstrates a better understanding of the theory.
5.3 Non-price Competition
Firms engage in non-price competition through product development and product promotion. Product
development will improve the quality and the features of the good and product promotion will increase
the awareness and the appeal. Product development and product promotion will lead to an increase
in the demand for the good. Furthermore, they will make the demand for the good less price elastic as
the good will become more different from its substitutes and this is known as product differentiation.
There are two types of product differentiation: real product differentiation and imaginary product
differentiation. Product development will lead to real product differentiation as it will result in physical
changes of the good. Product promotion will lead to imaginary product differentiation as it will only
affect the perception of consumers.
5.4 Advantages and Disadvantages of Oligopoly
Advantages of Oligopoly
efficient scale. As oligopolists face competition in the market, they are not lax in cost control and this
is true even in the presence of collusion as oligopolists which collude still face non-price competition.
Therefore, oligopolists are x-efficient and hence productively efficient.
Lower Price
to consumers in the form of a lower price. As an oligopolist is larger than a perfectly competitive firm
and a monopolistically competitive firm, oligopolists reap more economies of scale than perfectly
competitive firms and monopolistically competitive firms and hence the price charged by oligopolists
may be lower than the price that would be charged by perfectly competitive firms and monopolistically
competitive firms operating in the same market.
Dynamic Efficiency
As oligopolists can make supernormal profit in the long run, they have the ability to engage in research
and development. Furthermore, competition gives them the incentive to engage in research and
development and this is true even in the presence of collusion as oligopolists which collude still face
non-price competition. Therefore, oligopolists engage in research and development and hence are
dynamically efficient. Research and development will lead to product innovations and process
innovations. Product innovations will lead to higher product quality and better product features and
process innovations will lead to a better production technology and hence a lower cost of production
which may be passed on to consumers in the form of a lower price.
Variety of Choices
Oligopolists generally sell differentiated products which offer consumers a variety of choices. In
contrast, perfectly competitive firms sell homogeneous products and hence offer consumers no variety
of choices.
Oligopolists are price-setters and hence they may be able to practise price discrimination which may
be beneficial to consumers. Price discrimination may allow a firm to reach a market that otherwise
would not be reached or to produce a good that otherwise would not be produced. Price discrimination
will be explained in greater detail in Section 6. Furthermore, if the increase in profit from price
discrimination is ploughed back into research and development, more benefits to consumers will be
created.
Disadvantages of Oligopoly
and hence is allocatively efficient. In oligopoly, price is higher than marginal revenue and firms
maximise profit by producing the output level where marginal revenue equals marginal cost. Therefore,
oligopolists charge a price higher than their marginal cost and are hence allocatively inefficient.
marginal revenue (MR), the price (P0) is higher than the marginal cost (MC0).
Higher Price
compared to firms with less market power. Unlike perfectly competitive firms that have no market
power and monopolistically competitive firms that have little market power, oligopolists have
substantial market power and hence the price charged by oligopolists may be higher than the price
that would be charged by perfectly competitive firms and monopolistically competitive firms operating
in the same market. Furthermore, an oligopolist is likely to be smaller than a monopoly. Therefore,
oligopolists are likely to reap less economies of scale and hence charge a higher price than a
monopoly.
Income Inequity
As oligopolists can make supernormal profit and perfectly competitive firms and monopolistically
competitive firms can make only normal profit in the long run, the distribution of income in an economy
that abounds with oligopolistic markets will be less equitable than one that abounds with perfectly
competitive markets and monopolistically competitive markets.
Oligopolists are price-setters and hence they may be able to exploit consumers through price
discrimination. Price discrimination is commonly considered a form of consumer exploitation as it will
convert some of the consumer surplus to the producer surplus.
Note: The advantages and disadvantages of oligopoly will be discussed in economics tuition by the
Principal Economics Tutor in greater detail.
5.5 Market Concentration Ratio
The market concentration ratio, or simply known as the concentration ratio, is a measure of the
combined market share of a specified number of the largest firms in the market. It is calculated by
summing the market shares of a specified number of the largest firms in the market. The market share
of a firm is the domestic sales of the firm expressed as a percentage of the domestic sales of all the
domestic firms in the market. The concentration ratio can range from close to 0% to 100%.
It is commonly believed that the degree of competition in a market is directly related to the number of
firms. Although this is true to some extent, the number of firms in a market is not a perfect indicator of
the degree of competition. In a market where there are a large number of firms, the degree of
competition may be low if the bulk of the market share is concentrated in the hands of a few large
firms. To overcome this problem, economists use the concentration ratio to show the extent of market
control of a specified number of the largest firms in the market and hence the degree to which the
market is oligopolistic. A commonly used concentration ratio is the four-firm concentration ratio (CR4).
The four-firm concentration ratio (CR4) measures the combined market share of the four largest firms
in the market. A four-firm concentration ratio (CR4) of between 0% and 50% indicates low market
concentration and a market with low concentration may be monopolistic competition or an oligopoly.
In this range, the higher the concentration ratio, the more likely the market is oligopolistic and vice
versa. A four-firm concentration ratio (CR4) of between 50% and 80% indicates medium market
concentration and a market with medium concentration is likely to be an oligopoly. A four-firm
concentration ratio (CR4) of between 80% and 100% indicates high market concentration and a market
with high concentration may be an oligopoly or a monopoly. In this range, the lower the concentration
ratio, the more likely the market is oligopolistic and vice versa.
Apart from the four-firm concentration ratio (CR4), the one-firm concentration ratio (CR1) is also
commonly used. The one-firm concentration ratio (CR1) measures the market share of the largest firm
in the market. It is used to indicate the degree to which the largest firm in the market is monopolistic.
In the United Kingdom, the largest firm is considered a monopoly if the one-firm concentration ratio
(CR1) is 25% and above. Such a monopoly is commonly known as an actual monopoly as opposed to
a pure monopoly which is a single large firm in a market. In Singapore, the largest firm is considered
a dominant firm, which can be interpreted as a monopoly, if the one-firm concentration ratio (CR1) is
60% and above.
The concentration ratio is subject to several limitations. First, the concentration ratio does not provide
information about the distribution of the market shares among the specified number of the largest firms
in the market. For example, assuming the four-firm concentration ratio (CR4) in a market is 80%, the
degree of competition will be lower if one firm has 70% of the market share and the other three firms
have the remaining 10%, compared to the case where each of the four firms has 20% of the market
share. Second, the concentration ratio does not provide a comprehensive picture of the market shares
of all the firms in the market as only the market shares of the specified number of the largest firms are
included. In contrast, the Herfindahl-Hirschman index (HHI), which is another measure of market
concentration, takes into account the market shares of all the firms in the market. Third, the
concentration ratio does not capture all aspects of competition in the market. For example, it does not
capture any collusive behaviour among the firms in the market or potential competition. Fourth, the
concentration ratio does not take into account the domestic sales of foreign firms as it only includes
the domestic sales of domestic firms rather than the total domestic sales. The omission of imports
from the concentration ratio causes it to understate the degree of competition in the market. Fifth, the
concentration ratio is a national total but the relevant market may be regional or local due to the
characteristics of the good or high transport costs. If this happens, the concentration ratio will overstate
the degree of competition in the relevant market.
Note: The Herfindahl-Hirschman index (HHI) is another measure of market concentration. It is

calculated by squaring the market share of each firm in the market and then summing the results. The
HHI can range from close to zero to 10,000. The U.S. Department of Justice and the Federal Trade
Commission consider a market with an HHI of less than 1500 to be an unconcentrated market, a
market with an HHI of between 1500 and 2500 to be a moderately concentrated market and a market
with an HHI of greater than 2500 to be a highly concentrated market. Students are not required to
explain the HHI in the examination as it is not in the Singapore-Cambridge GCE ‘A’ Level Economics
syllabus.
Market concentration ratio will be discussed in economics tuition by the Principal Economics Tutor in
greater detail.
6 PRICE DISCRIMINATION
6.1 Types of Price Discrimination
Price discrimination is the practice of using a pricing scheme more sophisticated than charging the
same price for each unit of a good to increase profit. According to Arthur Cecil Pigou, although
discriminatory pricing can take many forms, it can usefully be classified into three degrees: first-
degree, second-degree and third degree.
First-degree Price Discrimination
First-degree price discrimination is the practice of charging each consumer the highest price that they
are able and willing to pay for each unit of the good. Therefore, under first-degree price discrimination,
the consumer surplus is zero.
In the above diagram, if the firm wants to sell one more unit of the good, it must decrease the price.
However, under first-degree price discrimination, as the lower price will not apply to all the previous
units of the good, the marginal revenue is equal to the price and hence the marginal revenue curve
(MR) is the demand curve (D). The profit-maximising output level where marginal cost (MC) is equal
to marginal revenue (MR) is Q0. In reality, first-degree price discrimination is uncommon because it is
likely to make consumers feel exploited.
Second-degree Price Discrimination
Second-degree price discrimination is the practice of using a pricing scheme to approximate first-
degree price discrimination; that is to appropriate to the firm all the consumer surplus. There are three
types of second-degree price discrimination: quantity discount, block pricing and two-part tariff. Block
pricing is a pricing scheme where a certain price is charged for the first so many units of a good for
which there are no substitutes, a lower price for the next so many units, and so on. Many public utility
firms use block pricing.
In the above diagram, the profit-maximising output level where marginal cost (MC) is equal to marginal
revenue (MR) is Q2. For the first block of Q0 units of the good, the price of P0 is charged for each unit,
for the second block of (Q1 – Q0) units of the good, the price of P1 is charged for each unit, and for the
third block of (Q2 – Q1) units of the good, the price of P2 is charged for each unit. The marginal revenue
curve is a series of steps comprising P0 for the first block of Q0 units of the good, P1 for the second
block of (Q1 – Q0) units of the good and P2 for the third block of (Q2 – Q1) units of the good. A two-part
tariff is a pricing scheme where a lump-sum charge is imposed in addition to a per-unit charge. The
lump-sum charge may take the form of admission fee, registration fee, connection fee, etc. For
example, when the Disneyland in the United States first started operations, it imposed an admission
fee in addition to a charge for each ride. Under a two-part tariff, the lump-sum charge will convert the
consumer surplus to the producer surplus. Therefore, the firm will produce the output level where price
is equal to marginal cost to maximise the total surplus and hence the producer surplus in order to
maximise profit, assuming consumers have the same demand for the good.
In the above diagram, the profit-maximising output level under a two-part tariff where price is equal to
marginal cost (MC) is Q0 and the profit-maximising price is P0. The lump-sum charge is represented
by the shaded area.
Third-degree Price Discrimination
Third-degree price discrimination is the practice of charging different prices for the same good in
different markets. For example, cinema operators charge different prices for the same movies to
different groups of consumers. To practise third-degree price discrimination, a firm must be able to
identify at least two distinct markets which differ in terms of their price elasticities of demand. In
addition, it must be able to prevent consumers in the lower-priced market from reselling the good to
consumers in the higher-priced market which is known as arbitrage prevention. Suppose that a good
is sold in two different markets, market A and market B, at two different prices. Under third-degree
price discrimination, profit will be maximised when the marginal revenue in market A (MRA), the
marginal revenue in market B (MRB) and the marginal cost (MC) are equal. If MRA is not equal to MRB,
profit can be increased by selling less of the good in the market with the lower MR and more of the
good in the market with the higher MR. If MC is not equal to MRA and MRB, profit can be increased by
changing the output level. The firm will charge a higher price in the market with the lower price elasticity
of demand and a lower price in the market with the higher price elasticity of demand.
In the above diagram, the sum of the output level in market A (QA) and the output level in market B
(QB) is equal to the market output level (QT). MRA is equal to MRB which is equal to MC. The price in
market A (PA) with the lower price elasticity of demand is higher than the price in market B (PB) with
the higher price elasticity of demand.
Note: For a firm to be able to practise price discrimination, it must have price-setting ability and this
is true for all types of price discrimination. Therefore, only a firm that operates in an imperfect market
may be able to practise price discrimination.
Although the cost of business-class air travel is higher than that of economy-class air travel, the cost
difference does not fully account for the price difference due to the lower price elasticity of demand for
business-class air travel than for economy-class air travel. Therefore, airlines do engage in third-
degree price discrimination.
When explaining third-degree price discrimination, students should explain why the price elasticities
of demand in the markets differ.
Price discrimination will be discussed in economics tuition by the Principal Economics Tutor in greater
detail.
6.2 Desirability of Price Discrimination
Firms
From the firm’s perspective, price discrimination is desirable. Price discrimination will convert some of
the consumer surplus to the producer surplus. Therefore, price discrimination will lead to an increase
in the producer surplus which is desirable for the firm.
In the above diagram, without price discrimination, the profit-maximising output level where marginal
cost (MC) is equal to marginal revenue (MR) is Q0’ and the profit-maximising price is P0’. The producer
surplus is represented by area B. With first-degree price discrimination, the profit-maximising output
level where marginal cost (MC) is equal to marginal revenue (MRFDPD) is Q0. As the firm charges each
consumer the highest price that they are able and willing to pay for each unit of the good, the producer
surplus is higher which is represented by the sum of area A, area B and area C.
Consumers
From consumers’ perspective, price discrimination is generally undesirable. Price discrimination is

commonly considered a form of consumer exploitation as it will convert some of the consumer surplus
to the producer surplus. Therefore, price discrimination will lead to a decrease in the consumer surplus
which is undesirable for consumers.
In the above diagram, without price discrimination, the profit-maximising output level where marginal
cost (MC) is equal to marginal revenue (MR) is Q0’ and the profit-maximising price is P0’. The consumer
surplus is represented by area A. With first-degree price discrimination, the profit-maximising output
level where marginal cost (MC) is equal to marginal revenue (MRFDPD) is Q0. As the firm charges each
consumer the highest price that they are able and willing to pay for each unit of the good, the consumer
surplus is zero.
Price discrimination may be desirable for consumers because it may allow a firm to produce a good
that otherwise would not be produced. An example is first-degree price discrimination. If the cost of
production for a good is high, it may be unprofitable to produce. If this happens, first-degree price
discrimination which will increase the producer surplus may allow a firm to make a profit and hence
produce the good.
In the above diagram, without price discrimination, the output level where marginal cost (MC) is equal
to marginal revenue (MR) is Q0’. However, as the average cost (AC) is higher than the average
revenue (AR) at this output level, a loss will be incurred and hence the good will not be produced. With
first-degree price discrimination, the output level where marginal cost (MC) is equal to marginal
revenue (MRFDPD) is Q0. Since the total revenue is area A plus area C and the total cost is area B plus
area C, a profit can be made if area A is greater than area B and hence the good will be produced.
Furthermore, if the increase in profit from price discrimination is ploughed back into research and
development, more benefits to consumers will be created.
Price discrimination may also be desirable for consumers because it may allow a firm to reach a market
that otherwise would not be reached. An example is third-degree price discrimination. If the firm cannot
practise third-degree price discrimination, the uniform price that it will charge may be too high for
consumers in the market with the lower ability and willingness to pay. However, if the firm can practise
third-degree price discrimination by charging a higher price in the market with the higher ability and
willingness to pay and a lower price in the market with the lower ability and willingness to pay, both
markets will be reached. If this happens, consumers will be better off.
Government
From the government’s perspective, price discrimination may be desirable because it may lead to a
decrease in allocative inefficiency. In imperfect competition, allocative inefficiency occurs as the firm
or firms charge a price higher than their marginal cost which leads to under-production. Under first-
degree price discrimination, the price that the firm charges for the last unit of the good is equal to the
marginal cost. Therefore, allocative efficiency is achieved under first-degree price discrimination.
From the government’s perspective, price discrimination may be undesirable as it will worsen income
inequity. Price discrimination will lead to an increase in the profits of firms. As firms are generally
owned by high income individuals, this will lead to a less equitable distribution of income.
7 ALTERNATIVE OBJECTIVES OF FIRMS

Firms generally seek to maximise profit. However, some firms seek to maximise market share, sales
revenue and long-run profit.
Profit Maximisation
Firms generally seek to maximise profit for several reasons.
A firm generally seeks to maximise profit as it can be used to finance expansion of its scale of
production. A firm can expand its scale of production by ploughing back its profit into increasing its
production capacity. It can also expand its scale of production by using its profit to take over other
firms that produce the same good which is known as horizontal acquisition. An increase in the scale
of production will enable a firm to lower its average cost which is known as economies of scale,
assuming the firm is not producing on the upward sloping portion of its long-run average cost curve.
Due to globalisation, among other factors, the business environment is becoming increasingly more
competitive. Therefore, to ensure its survival, it is imperative that a firm increases its cost-
competitiveness to increase its price-competitiveness.
A firm generally seeks to maximise profit as it can be used to engage in non-price competition such
as product development and product promotion. Engaging in non-price competition is important
particularly if the firm operates in an oligopolistic market where there exists strategic interdependence.
Product development will improve the quality and the features of the good and product promotion will
increase the awareness and the appeal. Product development and product promotion will lead to an
increase in the demand for the good. Furthermore, they will make the demand for the good less price
elastic as the good will become more different from its substitutes and this is known as product
differentiation. There are two types of product differentiation: real product differentiation and imaginary
product differentiation. Product development will lead to real product differentiation as it will result in
physical changes of the good. Product promotion will lead to imaginary product differentiation as it will
only affect the perception of consumers.
A firm generally seeks to maximise profit as it can be used to build up cash reserves for recession
years.
A firm generally seeks to maximise profit as it can be used to make dividend payments to its
shareholders.
Market Share Maximisation
A firm may seek to maximise market share. For example, if a firm is a new entrant, it may want to
maximise market share to compete with the incumbent firms. In this case, although profit will not be
maximised, the larger market share may ensure the survival of the new entrant. For example, when
StarHub entered the telecommunications market in Singapore in 2000, it charged prices lower than
those charged by the incumbent firms, namely SingTel and M1. The objective of StarHub was to
induce mobile phone users to switch service providers so that it could capture sufficient market share
to compete with SingTel and M1. To maximise market share, a firm will produce the output level where
price is equal to average cost, assuming it wants to make at least normal profit.
In the above diagram, market share is maximised at QMS where price (P) is equal to average cost
(AC), assuming the firm wants to make at least normal profit. Beyond this output level, price is lower
than average cost and hence a loss will be incurred.
Sales Revenue Maximisation
A firm may seek to maximise sales revenue. For example, in many large firms today, there is a
separation between ownership and management. Although it may be in the interest of the
shareholders to have the management maximise profit and hence dividend, it may be in the interest
of the management to maximise sales revenue if it is the key performance indicator. To maximise
sales revenue, a firm will produce the output level where marginal revenue is equal to zero.
In the above diagram, sales revenue is maximised at QSR where marginal revenue (MR) is equal to
zero. If output increases from QSR, total revenue will fall as MR is negative. If output decreases from
QSR, some revenue will be forgone as MR is positive.
Long-run Profit Maximisation
A firm may seek to maximise long-run profit. For example, one of the potential problems of a monopoly
maximising profit is that the profit-maximising price may attract potential firms to enter the market. If
this happens, the profit of the firm will fall in subsequent periods. Therefore, to maximise long-run
profit, the firm may need to practise limit pricing which is a pricing strategy where a monopoly charges
a price below the profit-maximising price with the objective of preventing potential firms from entering
the market. In this case, although profit will not be maximised, long-run profit may be maximised.
Note: Student should not confuse limit pricing with predatory pricing. Limit pricing is a pricing strategy
where a monopoly charges a price below the profit-maximising price with the objective of preventing
potential firms from entering the market. Predatory pricing is a pricing strategy where an oligopolist
charges a price below the profit-maximising price with the objective of driving competitors out of the
market.
The alternative objectives of firms will be discussed in economics tuition by the Principal Economics
Tutor in greater detail.
8 GROWTH OF FIRMS
8.1 Types of Growth of Firms
Firms can grow internally or externally.
Internal Growth
A firm can expand by ploughing back its profit into increasing its production capacity. It can also expand
by increasing its production capacity through issuing shares, issuing bonds or getting bank loans.
External Growth
A firm can expand by joining with other firms which is known as a merger. A firm can also expand by
acquiring or taking over other firms which is known as an acquisition or takeover. Merger and
acquisition are the two types of integration. In practice, however, the term ‘merger’ is loosely used to
refer to both merger and acquisition. There are three types of mergers: horizontal merger, vertical
merger and conglomerate merger.
Horizontal Merger
A horizontal merger is a merger between two firms that produce the same good. An example of a
horizontal merger is the merger between Exxon and Mobil in 1999. The merger is a horizontal one as
Exxon and Mobil were both oil companies.
Firms that produce the same good may merge to expand the scale of production in order to reap more
economies of scale and to reduce the number of firms in the market in order to reduce competition.
Vertical Merger
A vertical merger is a merger between two firms where one firm is a supplier or a customer of the other
firm. When a firm merges with a supplier, the act is known as a backward merger. When a firm merges
with a customer, the act is known as a forward merger. An example of a vertical merger is the merger
between America Online and Time Warner in 2000. The merger is a vertical one as Time Warner,
which was a media conglomerate, supplied content to consumers through properties like CNN and
Time Magazine, while America Online, which was an internet provider, distributed such information
via its internet service.
A vertical merger is usually initiated by the customer. A firm may initiate a backward merger to achieve
greater control and stability in the supply of factor inputs, eliminate transaction costs which include the
costs of negotiating, monitoring and enforcing a contract, restrict the supply of factor inputs to
competitors and prevent leakage of vital information pertaining to the firm’s product.
Conglomerate Merger
A conglomerate merger is a merger between two firms that produce different and unrelated goods. In
the case where the two firms produce different but related goods, the act is known as a lateral merger.
For example, many of the chaebols in South Korea such as Samsung Group and LG Group were
formed through conglomerate mergers.
Firms that produce different goods may merge to reap more economies of scope, spread risk and
create an internal capital market.
8.2 Reasons for Growth of Firms
Large firms have advantages over small firms.
Cost Advantage of Large Firms
Large firms have a cost advantage over small firms due to economies of scale. Large firms have a
lower average cost than small firms because of their larger scales of production. When a firm expands
the scale of production, average cost will usually fall and this phenomenon is called economies of
scale. Economies of scale occur due to several reasons. For example, division of labour is the process
whereby each job is broken up into its component tasks and each worker is assigned one or a few
component tasks of the job. An expansion of the scale of production may enable the firm to engage in
greater division of labour and hence greater specialisation which will lead to higher labour productivity
resulting in a fall in average cost. Furthermore, larger machines are often more efficient than smaller
machines as they generally make more efficient use of materials and labour. Therefore, an expansion
of the scale of production may enable the firm to use larger machines that are often more efficient than
smaller machines which will also lead to higher labour productivity resulting in a fall in average cost.
Larger firms may be able to afford to create more specialised departments where specialists perform
specific administrative functions. These specific administrative functions include human resource,
purchasing, finance and marketing. Greater specialisation in these areas of expertise will lead to
greater efficiency resulting in a fall in average cost.
Large firms may also have a cost advantage over small firms due to economies of scope. Large firms
may have a lower average cost than small firms because of their greater financial resources which
allow them to produce more types of goods. When the types of goods produced increase, average
cost will usually fall. The decrease in average cost due to an increase in the size of the firm associated
with an increase in the types of goods produced rather than an increase in the scale of producing any
one good is called economies of scope. Economies of scope occur due to several reasons. For
example, an increase in the types of goods produced will lead to a fall in the research and development
cost per unit of output if the technologies that are used to produce the goods are related. An increase
in the types of goods produced will also lead to a fall in the marketing cost per unit of output if the
goods use the same branding.
Revenue Advantage of Large Firms
Large firms have a revenue advantage over small firms due to their greater appeal to consumers. For
example, large supermarkets carry a wider range of goods than small retail stores which makes them
more appealing to consumers who place a premium on convenience resulting in a higher total revenue.
Large firms may also have a revenue advantage over small firms due to their greater ability to practise
price discrimination, particularly third-degree price discrimination. Recall that third-degree price
discrimination is the practice of charging different prices for the same good in different markets. For
example, cinema operators charge different prices for the same movies to different groups of
consumers. To practise third-degree price discrimination, a firm must be able to identify at least two
distinct markets which differ in terms of their price elasticities of demand. In addition, it must be able
to prevent consumers in the lower-priced market from reselling the good to consumers in the higher-
priced market which is known as arbitrage prevention. Most large firms sell their goods in more than
one country which may allow them to prevent arbitrage and hence give them the ability to practise
third-degree price discrimination. Conversely, most small firms sell their goods in only one country
which makes arbitrage harder to prevent and hence precludes them from practising third-degree price
discrimination.
Other Advantages of Large Firms
In addition to cost advantage and revenue advantage, large firms have other advantages over small
firms. First, large firms are more likely to survive a recession than small firms. Due to their great
financial resources, large firms are able to sustain losses for a long period of time. Furthermore, apart
from bank borrowings, large firms also have other sources of funds such as share issue and bond
issue and hence if banks reduce lending in a recession, such as what happened in the 2008-2009
Subprime Mortgage Crisis, large firms can raise funds through other means to tide them over the
difficult period. In contrast, small firms are more vulnerable in a recession due to their limited financial
resources and this is particularly true if banks reduce lending. Second, as large firms have greater
financial resources and more sources of funds than small firms, they are likely to be able to undercut
small firms to drive them out of the market. Small firms, however, are much less likely to be able to do
so due to their limited financial resources and their limited sources of funds.
8.3 Survival of Small Firms

Although the advantages of large firms over small firms have driven many small firms out of the market,
there are small firms which are able to survive.
Personalised Services
Small firms that provide personalised services are able to survive. For example, small medical clinics
and small law firms exist today. In these markets, there is limited room for economies of scale due to
the nature of the services provided and this limits the cost advantage of large firms over small firms
which enables small firms to survive.
Niche Market
Small firms that cater for niche markets are able to survive. For example, small firms that sell plus size
clothing to obese women and small firms that sell organic foods to health-conscious consumers exist
today. In these markets, there is limited benefit of economies of scale due to the small sizes of the
markets which enables small firms to survive.
Supporting Role
Small firms that play a supporting role to large firms are able to survive. Many large firms outsource
certain functions and activities to small firms for several reasons such as reducing costs, increasing
flexibility and focusing on core competences. Small firms that play a supporting role through
performing these functions and activities for large firms do not face competition from large firms which
enables them to survive.
Convenience
Small firms that cater for consumers in a particular area are able to survive. For example, small retail
stores located in the neighbourhoods that cater for the residents exist today. Due to their proximity to
the residents in the neighbourhoods, these small retail stores have more appeal than large
supermarkets located further away which enables them to survive.
Note: The survival of small firms will be discussed in economics tuition by the Principal Economics
Tutor in greater detail.
9 THE THEORY OF CONTESTABLE

MARKETS
The theory of contestable markets was put forward in 1982 by William Baumol who was a renowned
American economist. The theory of contestable markets is commonly considered an alternative theory
to the theory of market structure. Proponents of the theory of contestable markets argue that the
behaviour of firms in a market depends on whether there is threat of competition rather than on the
structure of the market.
A perfectly contestable market is a market where there are no barriers to entry, zero exit costs and all
firms have equal access to production technology. In the words of William Baumol, “A contestable
market is one into which entry is absolutely free, and exit is absolutely costless.” By “freedom of entry”,
William Baumol was referring to absence of barriers to entry and equal access to production
technology for all firms. In reality, barriers to entry and exit costs do exist and hence what is discussed
is the degree of contestability of a market. The lower the barriers to entry and exit costs in a market,
the more contestable the market, and vice versa. As stated in the definition, the absence of barriers
to entry, the absence of exit costs and equal access to production technology for all firms are the three
key characteristics of a perfectly contestable market. The absence of barriers to entry provides
potential firms the ability to enter the market. Recall that a barrier to entry is an obstacle which restricts
potential firms from entering a market to compete with the incumbent firm or firms. In the absence of
such obstacles, potential firms are able to enter the market when a profit opportunity arises. In contrast,
high barriers to entry prevent potential firms from entering the market even if the incumbent firm or
firms are making substantial supernormal profit. The absence of exit costs provides potential firms the
incentive to enter the market. If potential firms enter the market, there is always a possibility that they
will make subnormal profit (i.e. economic loss) which will induce them to exit the market. If they are
unable to sell or transfer their capital to other uses without incurring a loss substantially greater than
the normal depreciation, their exit costs which are also known as sunk costs, will be high which will
discourage them from entering the market in the first place. In contrast, the absence of exit costs will
encourage them to enter the market. Equal access to production technology for all firms provides
potential firms both the ability and the incentive to enter the market. If potential firms do not have equal
access to production technology as the incumbent firm or firms, the former will have a cost
disadvantage over the latter which will reduce their chances of making supernormal profit. In contrast,
if potential firms have equal access to production technology as the incumbent firm or firms, the former
will be able to compete with the latter on an equal footing which will enable and incentivise them to
enter the market.
The crucial feature of a contestable market is its vulnerability to hit-and-run competition. If the
incumbent firm or firms in a perfectly contestable market are making supernormal profit, potential
transient entrants will enter the market to exploit the profit opportunity by charging prices slightly lower
than those charged by the incumbent firm or firms. When this happens, the incumbent firm or firms
will respond by reducing their prices to levels lower than those charged by the transient entrants. This
will induce the transient entrants to reduce their prices to levels lower than those charged by the
incumbent firm or firms which will prompt the latter to further reduce their prices. This process will
continue until the prices fall to the levels which correspond to normal profit, at which point the transient
entrants will exit the market. According to the proponents of the theory of contestable markets, the
prospect of such hit-and-run competition from potential transient entrants will induce the incumbent
firm or firms in the market to behave in a way which firms in a highly competitive market do, even if
there are only one or a few firms in the market. In other words, in a perfectly contestable market, firms
will be x-efficient and hence productively efficient and they will charge a price lower than the price that
would be charged if the market was less or non-contestable. The lower price will be equal to the
average cost resulting in normal profit in the long run and hence an equitable distribution of income.
The implication of the theory of contestable markets for government policy is that the government may
increase the degree of contestability of a market to achieve results closer to those of a perfectly
competitive market. There are several measures which the government can take to increase the
degree of contestability of a market. If a firm controls the supply of some key factor inputs, it can deny
access to these factor inputs to potential firms which will make it difficult for them to enter the market.
Therefore, the government can lower the barriers to entry by preventing these key factor inputs from
being controlled by the incumbent firm or firms in the market. For example, it can block proposed
vertical mergers which may result in such a situation. The government can also lower the barriers to
entry by granting more licenses to operate in the market. For example, it can grant more licenses to
operate the same routes in the airline industry. Apart from lowering the barriers to entry, the
government can also increase the degree of contestability of a market by increasing access to the
same production technology of the incumbent firm or firms in the market. For example, it can compel
the incumbent firm or firms in the market to open up their infrastructure to other firms.
Edited & Assembled by:

Md. Touhidul Islam
Assistant Professor,
Department of Business Administration
Mail: mtouhiddu@gmail.com

Fundamental of Economics-GEN-201-Touhid Sir

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Fundamental of Economics-GEN-201-Touhid Sir

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NPI University of Bangladesh

Sub: Fundamental of Economics

THE CENTRAL PROBLEM OF ECONOMICS will be

Consider the following statement:

‘A decrease in personal income tax will lead to a rise in unemployment.’

Consider the following statement:

Enterprise refers to the ability and the willingness to take risk.

Factors of production will be discussed in greater detail in economics tuition by the

3 SCARCITY, CHOICE AND OPPORTUNITY

4 THE PRODUCTION POSSIBILITY CURVE

Possible Combinations of Good Y and Good X

Combination Good X Good Y

Production Possibility Curve

4.2 Movements along versus Shifts in the Production Possibility Curve

4.3 Shape of the Production Possibility Curve

4.4 Economic Efficiency

5.1 The Market System

What and How Much to Produce?

For Whom to Produce?

5.2 The Command System

5.3 The Mixed System

5.4 Advantages and Disadvantages of Economic Systems

Advantages of the Market System and Disadvantages of the Command System

Advantages of the Command System and Disadvantages of the Market System

Economics Lecture Notes – Chapter 2

DEMAND AND SUPPLY will be taught in economics

2.2 Movements along versus Shifts in the Demand Curve

2.3 Non-price Determinants of Demand

Tastes and Preferences

Prices of Substitutes and Complements

Number of Substitutes and Complements

Expectations of Price Changes

Size of the Population

Structure of the Population

3.2 Movements along versus Shifts in the Supply Curve.

3.3 Non-price Determinants of Supply

Expectations of Price Changes

Profitability of Goods in Joint Supply

Profitability of Substitutes in Supply

Disasters (Natural and Man-made)

An equilibrium is a state where there is no tendency to change. The equilibrium of a market is

4.2 Effects of a Change in Demand on Price and Quantity

An increase in demand will lead to a rise in price and quantity.

A decrease in demand will lead to a fall in price and quantity.

4.3 Effects of a Change in Supply on Price and Quantity

An increase in supply will lead to a fall in price and a rise in quantity.

A decrease in supply will lead to a rise in price and a fall in quantity.

Same Directional Changes in Demand and Supply

Different Directional Changes in Demand and Supply

5.1 Consumer Surplus

5.2 Producer Surplus

Economics Lecture Notes – Chapter 3

ELASTICITY OF DEMAND AND SUPPLY will be

2 PRICE ELASTICITY OF DEMAND

2.2 Applications of Price Elasticity of Demand

2.3 Determinants of Price Elasticity of Demand

Proportion of Income Spent on the Good

3 INCOME ELASTICITY OF DEMAND

3.2 Applications of Income Elasticity of Demand

3.3 Determinants of Income Elasticity of Demand

4 CROSS ELASTICITY OF DEMAND

% Δ Demand for Good A

4.2 Applications of Cross Elasticity of Demand