The price system and the

micro economy (A2 Level)

Prepared by:
Didier N. Hardy
 Sub Topics
What is Util?
What is Utility?
Total Utility
Marginal Utility
Law of diminishing Marginal Utility
 What is Util?
Util – It is a hypothetical unit used to
measure how much utility a person
obtains from consuming a good
What is Utility?

Utility – level of satisfaction / happiness from

consuming goods and service.
 Definition
Total utility – would be the number of units of
utility that a consumer gains from consuming a
given quantity of a good or service.

Marginal utility – the amount by which total

utility rises with consumption of an additional
unit of a good or service.
When is trully enough?
 Definition
Law of diminishing marginal utility –
tendency of marginal utility to decline beyond
some level of consumption during a period of
time.
The chocolate cake example
Quantity (Q) Total Utility Marginal Utility
1 100 100
2 170 70
3 190 20
4 180 -10
5 140 -40
Total and marginal utility
Demand curve and Marginal
Utility
Our demand curve is derived from our
marginal utility.

If a good gives us more satisfaction, e.g. it

becomes more fashionable, our MU and
demand curve will shift to the right.
Cont’d
 Optimum level of
consumption
For one good, the optimum level of
consumption would be to consume a
quantity of the good unto the point where
MU = Price.
A B
 Equi-Marginal Principle
Equi-marginal principle states that
consumers will choose a combination of
goods to maximize their total utility. This will
occur where:

(Marginal Utility of A) = (Marginal utility of B)

———————— ———————–
(Price of A) (Price of B)
 Cont’d
Consumer will consider both the marginal
utility MU of goods and the price.

In effect the consumer is evaluating the

MU/price.

This is known as the marginal utility of

expenditure on each item of good.
 Example
Assume there are only three commodities
available in the market, A, B and C. Also assume
that Tom has a daily income of only $15 to spend
and that he can exactly order his utility preference
for each of the three products.

Product A costs $1 per unit, Product B costs $3

per unit and Product C costs $5. Note that
diminishing marginal utility sets in immediately for
each of the three products.
Example
 Cont’d (1)
Marginal utility per dollar shows that one
dollar spend on Product A provides the
highest satisfaction of 20 utils as opposed
to only 12 and 8 utils from products B and
C, respectively.
 Cont’d (2)
Second dollar spends again buys the
highest utility of 15 utils. However, when
Tom spends the third dollar, a switch to
Product B promises 12 utils of added
satisfaction as opposed to 11 utils from
Product A.
 Cont’d (3)
Following the principle, the best
combination Tom can purchase with $15
would be 4 units of A, 2 units of B and 1
unit of C. The total utility generated would
be 154 utils.

No other combination will result in as high

utility as this with an expenditure of $15.
The results from the table above can be generalized to n
commodities and the following condition should hold in equilibrium:
 Assumptions of marginal
utility theory
Consumers are rational
Utility can be described in cardinal terms
(e.g. monetary units)
Constant prices and incomes.
Goods can be split up into small units
Marginal utility and diminishing marginal
returns
 Cont’d
For most goods, we expect to see
diminishing marginal returns. This means
the marginal utility of the fifth good tends
to be lower than the marginal utility of the
first good. The more we buy, the less total
utility increases.
 Limitations of marginal
utility theory
Difficulty of evaluating utility.
Consumers don’t have time to work out
Marginal utility / price.
Consumers are not always rational.
Numerous goods.
Many goods are related (complement).
Often goods can’t be split up into small
portions.
 Behavioural economics
Behavioural economic models explore
why consumers make irrational decisions,
against what might have been predicted
by conventional economic theory.
 Sub Topics
Indifference curves
budget lines
Income, substitution and price effects for
various types of goods
 Indifference curves and
budget lines
An indifference curve is a line showing all
the combinations of two goods which give
a consumer equal utility.

In other words, the consumer would be

indifferent to these different combinations.
Example
 Explanation
The indifference curve is convex because
of diminishing marginal utility.
When you have a certain number of
bananas – that is all you want to eat in a
week. Extra bananas give very little utility,
so you would give up a lot of bananas to
get something else.
 Explanation
All choices on I2 give the same utility. But,
it will be a higher net utility than
indifference curve I1.
I4 gives the highest net utility. Basically, I4
would require higher income than I1.
 Budget line
A budget line shows the combination of
goods that can be afforded with your
current income.
 Example
If an apple costs £1 and a banana £2, the
above budget line shows all the
combinations of the goods which can be
bought with £40.
20 apples @ £1 and 10 bananas @£2
10 apples @£1 and 15 bananas @£2
 Explanation
Given a budget line of B1, the consumer will
maximize utility where the highest
indifference curve is lateral to the budget line
(20 apples, 10 bananas)
Given current income – IC2 is unobtainable.
IC3 is obtainable but gives less utility than
the higher IC1
The optimal choice of goods, can also be
shown with the equimarginal principle
As income rises, you can afford to consume on higher indifference curves.
This optimal choice will shift to the right. This we can plot consumption as
income rises.
Impact of lower price
With a lower price of bananas (from £2 to £1.50), we can now afford more
bananas with the same income. The budget line shifts to the right.
 Income and substitution
effect of a rise in price
When the price of a good rises. People buy less
for two reasons
Income effect – This looks at the effect of a price
increase on disposable income. If the price of a good
increases, then consumers will have relatively lower
disposable income.
Substitution effect – This looks at the effect of a
price increase compared to alternatives. If the price of
petrol rises, then it is relatively cheaper to go by bus.
Income and substitution for a normal good
A rise in price changes the budget line. You can now buy less of good
Bananas. The budget curve shifts to B2
Consumption falls from point A to point C (fall in Quantity of bananas from Q3
to Q1
 Review
Price and income elasticity for:
Normal goods
Inferior goods
Giffen goods

* Students presentation
 Elasticity Normal Inferior Giffen
Price a good which a good which A good for
demand falls demand falls which demand
with an increase with an increase increases as the
in price. in price. Price increases,
(negative PEd) (negative PEd) and falls when
the price
decreases.
(positive PEd)

Income a good which a good for which A good for

demand rises demand falls which demand
with an increase with an increase increases as the
in income. in income. income
(positive YEd) (negative YEd) increases, and
falls when the
Income
decreases.
(positive YEd)
 Explanation
The substitution effect (using parallel budget line
of B-3) causes big fall from a to b.
However, the income effect leads to an increase in
demand (Q1 to Q2)
Overall demand falls, but the substitution effect is
partly offset by the income effect.
This is because when income falls, the decline in
income causes us to buy more inferior goods
because we can’t afford normal / luxury goods any
more.
 Giffen goods
A giffen good occurs when the income
effect outweighs the substitution effect.
This is quite rare, but it is theoretically
possible for poor peasants who have a
choice between expensive meat and
cheap rice.
 Sub Topics
Short-run function
Long-run function
Revenue
Profit
Short-run production
function
 Law of diminishing returns
Only happen in the short-run

When where the output from an additional

unit of input leads to a fall in the marginal
product.

the change in output arising from the use of

one more unit of a factor of production.
 Definition
Total Product: Maximum output attainable from a
given amount of a fixed input (capital) as the amount
of the variable input (labor) is changed
Average Product: Total Product divided by the total
amount of the variable input used to produce it.
Marginal Product: the increase in total output from a
one unit increase in the amount of the variable input
Fig. 1 Total Product
Fig. 2 Average Product
Fig. 3 Marginal Product
Fig. 4 Total, Average and Marginal
 Definition
Fixed costs: those costs that are
independent of output in the short run.

Variable costs: those that vary directly

with output; all costs are variable in the
long run.
 Fig. 5 Total fixed cost
Costs

Total fixed cost

0 Output
 Fig. 6 Average fixed cost
Costs

Average fixed cost

0 Output
 Fig. 7 Total variable cost
Costs

Total variable cost

0 Output
Fig. 8 The Composition of total cost
Costs
Total costs

Variable costs

Fixed costs

0 Output
Fig. 9 Average variable cost
Average Cost or Average Total Cost

In the short run, average costs consist of

average fixed cost and average variable
cost.

The shape for short run average cost is U-

shaped.

The long run curve is also U-shaped.

Fig. 10 AC Short and Long-Run
Fig. 11 Product and Cost
Fig. 12 Marginal Cost
 Summary
Total cost rises with output
In the short run, firms incur both fixed and
variable costs
Fixed costs do not change with output in
the short run
Average fixed costs falls as output rises
Variable costs increases as output rises
 Cont’d (1)
Average variable costs tends to fall and then
rise, as output increases
In the short run, total cost consist of fixed and
variable costs
In the long run, all costs are variable
The shape of the long run average variable
costs is influenced by economies and
diseconomies of scale
Long-run production
function
 Isoquant
In analyzing of production in a long run we
now assume that volume of production
then changes with varying amount of labor
and capital its graphical representation will
be an isoquant map.
 Cont’d
Isoquant is consisted of all combinations
of the inputs (i.e. labor and capital) that
lead to the production of the same output.
isoquant which are located further from
the origin, are associated with a higher
level of output.
 Isocost
The capacity of the producer is shown by
his monetary resources, i.e., his cost
outlay (or how much money he is capable
of spending) on capital and labour, the
prices of which are taken as constant. This
is picturized by his budget line called
isocost line.
 Cont’d
An isocost line is a locus of points showing
the alternative combinations of factors that
can be purchased with a fixed amount of
money. These lines are straight lines
because factor prices are constant and they
have a negative slope equal to the factor-
price ratio, i.e., the ratio of labour price to
capital price
Fig. 13 Isoquant and Isocost
 Returns to Scale
 Long run production assumes there are no
fixed factors
 In the long run, all factors of production are
variable
 How the output of a business responds to a
change in factor inputs is called returns to
scale
Units of Units of Total % Change % Change Returns to
Capital Labour Output in Inputs in Output Scale
20 150 3000
40 300 7500
60 450 12000
80 600 16000
100 750 18000
Units of Units of Total % Change % Change Returns to
Capital Labour Output in Inputs in Output Scale
20 150 3000
40 300 7500 100 150 Increasing
60 450 12000 50 60 Increasing
80 600 16000 33 33 Constant
100 750 18000 25 13 Decreasing
 Cont’d
 Increasing returns to scale occur when the
% change in output > % change in inputs

 Decreasing returns to scale occur when the

% change in output < % change in inputs

 Constant returns to scale occur when the

% change in output = % change in inputs
 Break even
 Break even level of output
 Total revenue – total cost = 0 (break
even)

 How to calculate break even level of

output Total Fixed cost
Price per unit – variable cost per unit
 Economies of scale
 Economies of scales – are the advantages, gain by
an individual firm by increasing its size, so it will be
able to reduce the cost of production
 There are two types of economies of scale, in which
are:
 Internal economies of scale – lower long run
average cost resulting from a firm growing in size
 External economies of scale – lower long run
average cost resulting from an industry growing
in size
 Diseconomies of scale
 Diseconomies of scale – is the
disadvantages of being to large, so it will
increase the cost of production

 A firm increase its scale of operation to a

point where it encounters rising long run
average costs.
 Cont’d
 There are two types of diseconomies of
scale, in which are:
 Internal diseconomies of scale –
higher long run average cost arising from
a firm growing too large
 External diseconomies of scale -
higher long run average cost arising from
an industry growing too large
Fig. 14 Effect of external economies of
scale
LRAC

LRAC1
Fig. 15 Effect of external
diseconomies of scale
LRAC1
LRAC
 Internal economies of scale
 Buying economies
 Marketing economies
 Managerial economies
 Financial economies
 Technical economies
 Technological economies
 Risk bearing economies
 Internal diseconomies of scale
 Difficulties controlling the firm
 Communication problem
 Poor morale
 External economies of scale
 A skilled labour force
 A good reputation
 Specialist suppliers of raw materials and
capital goods
 Specialist services
 Specialist markets
 Improved infrastructure
 External diseconomies of scale

 traffic congestion which increases

distribution costs
 land shortages and therefore rising fixed
costs
 shortages of skilled labour and therefore
rising variable costs.
 The firm’s revenue
There are only two possible revenue
relationships:
In a competitive market - each firm has to
accept the ruling market price. Its demand curve
is horizontal, meaning that all it sells is at this one
price. (MR=AR=D=P or MR DARP)
in any other type of market – each firm will face
a downwardsloping demand curve for its product.
If they chooses to increase its output, the extra
sales will pressure the price to fall. (MR<AR)
 Cont’d
The following definitions are
used by economists when looking at a
firm’s revenue:
Total revenue (TR) = price × quantity
Average revenue (AR) = TR / output.
Marginal revenue (MR) = additional revenue
comes from selling one extra unit
Fig. 16 TR, AR and MR
 Profit
Profit – is what is left over when total
costs are deducted from total revenue.
Accounting profit = TR – TC
economic profit = TR – TC – OC

*TR (total revenue)

TC (total cost)
OC (opportunity cost)
 Market Structures
Degree of competition in the industry
High levels of competition – Perfect
competition
Limited competition – Monopoly
Degrees of competition in between –
Oligopoly and Monopolistic
 Determinants of market
structure
Freedom of entry and exit
Nature of the product – homogenous
(identical), differentiated?
Control over supply/output
Control over price
Barriers to entry
Spectrum of competition
 Perfect Competition
Free entry and exit to industry
Homogenous product – identical so no consumer
preference
Large number of buyers and sellers – no
individual seller can influence price
Sellers are price takers – have to accept the
market price
Perfect information available to buyers and sellers
 Advantages of Perfect
Competition
High degree of competition helps allocate
resources to most efficient use
Price = marginal costs
Normal profit made in the long run
Firms operate at maximum efficiency
Consumers benefit
 What happens in a
competitive environment?
New idea? – firm makes short term abnormal
profit
Other firms enter the industry to take advantage of
abnormal profit
Supply increases – price falls
Long run – normal profit made
Choice for consumer
Price sufficient for normal profit to be made but no
more!
 Imperfect or Monopolistic
Competition
Many buyers and sellers
Products differentiated
Relatively free entry and exit
Each firm may have a tiny ‘monopoly’ because of
the differentiation of their product
Firm has some control over price
Examples – restaurants, professions – solicitors,
etc., building firms – plasterers, plumbers, etc.
 Oligopoly
Industry dominated by small number of firms
High barriers to entry
Products could be highly differentiated – branding or
homogenous
Non–price competition
Price Rigidity (kinked demand curve?)
Potential for collusion or cartel
Abnormal profits (long and short-run)
High degree of interdependence between firms
 Cont’d
Examples of oligopolistic structures:
Supermarkets
Banking industry
Chemicals
Oil
Medicinal drugs
Broadcasting
 Price discrimination
Price discrimination – is the practice of
charging a different price for the same good or
service.
There are three types of price discrimination
first-degree - uses
second-degree - frequency
third-degree – elasticity
 Cont’d
Price discrimination can only occur if
certain conditions are met.
Different segments must have different price
elasticities (PEDs).
Markets must be kept separate, either by time,
physical distance and nature of use
There must be no seepage between the two markets
The firm must have some degree of monopoly power.
 Monopoly
Pure monopoly – industry is the firm!
Actual monopoly – where firm has >25%
market share
Natural Monopoly – high fixed costs – gas,
electricity, water, telecommunications, rail
 Cont’d
Characteristic of monopoly structures:
High barriers to entry
Firm controls price OR output/supply
Abnormal profits in long run
Possibility of price discrimination
Consumer choice limited
Prices in excess of MC
 Advantages and
disadvantages of monopoly
Advantages:
May be appropriate if natural monopoly
Encourages R&D
Encourages innovation
Development of some products not likely without
some guarantee of monopoly in production
Economies of scale can be gained – consumer may
benefit
 Cont’d
Disadvantages:
Exploitation of consumer – higher prices
Potential for supply to be limited - less choice
Potential for inefficiency – X-inefficiency –
complacency over controls on costs
 Natural Monopoly
Natural monopoly – occurs when the most
efficient number of firms in the industry is
one.
A natural monopoly will typically have very
high fixed costs meaning that it is
impractical to have more than one firm
producing the good.
 Cont’d
Examples of Natural Monopolies
Gas network
Electricity grid
Railway infrastructure
National fibre-optic broadband network.
 Example
Tap water company
It makes sense to have just one company
providing a network of water pipes and sewers
because there are very high capital costs
involved in setting up a national network of pipes
and sewage systems. To have two different
companies offering water wouldn’t make sense
as the average cost would be very high
compared to just one firm and one network.
 Regulation of Natural
Monopolies
Natural monopolies are uncontestable
and firms have no real competition.
Therefore, without government
intervention, they could abuse their market
power and set higher prices. Therefore,
natural monopolies often need
government regulation or control.
 Contestable market
Contestable market – any market structure
where there is a threat that potential entrants
are free and able to enter this market.

A contestable market can be particularly

seen as a means by which governments
have sought to deregulate markets. This
requires the removal of barriers to entry so
opening up the market to competition.
 Cont’d
The important features of a contestable
market are as follows:
Free entry
Only normal profits can be earned in the long run
All firms are subject to the same regulations
Mechanisms are in place to prevent the use of unfair
pricing and market control
Natural price control (no incentive for lowering price)
 Concentration ratio
The concentration ratio – is a ratio that
indicates the size of firms in relation to their
industry as a whole.
Low concentration ratio in an industry would
indicate greater competition among the firms
in that industry
High concentration ratio (closer to 100%)
would indicate the industry as true monopoly.
 Growth of firms
The long run for a single firm is entered when it
uses more fixed and variable factors to
increase its scale of production.

• Internal (organic growth)

• External (merger or take over)
 Internal growth

To grow organically, a firm will need to retain

sufficient profits to enable it to purchase new
assets, including new technology. Over time,
the total value of a firm’s assets will rise, which
provides collateral to enable it to borrow to fund
further expansion.

• Branding
 External growth

• Vertical integration
– Backward
– Forward
• Horizontal integration
• Horizontal integration
• Conglomerate integration
 Cartels

Cartel is a formal agreement between

member firms in an industry to limit
competition. The agreement may involve
fixing the quantity to be produced by each
member or fixing the price for which the
product is sold. e.g. OPEC
 Survival
The reasons why so many small firms exist in a world where the
economic power lies with large MNCs are as follows:

• There are economic activities where the size of the market is

too small to support large firms.
• The business may involve specialist skills possessed by very
few people.
• Where the product is a service – e.g., solicitors, accountants,
hairdressers, dentists and small shops the firm will be small in
order to offer the customers personal attention for which they
will pay a higher price.
Differing objectives of a firm
• Profit maximization (MC=MR)
• Sales revenue maximization (MR=0)
• Sales maximization (AC=AR)
• Productive efficiency (AC=MC)
• Allocative efficiency (MC=AR)
• Satisficing
• Ethical objectives
Thank you