Economics for Engineers

By
Dr. Auro Kumar Sahoo

Department of Humanities
VSSUT Burla
 Market
What is market?
• Buyers and sellers meet, exchanges and the
transaction takes place
• A market is any one of a variety of different systems,
institutions, procedures, social relations, and
infrastructure whereby goods and services are
exchanged, forming part of the economy
• It is an arrangement that allows buyers and sellers to
exchange things.
• In mainstream economics, the concept of market is any
structure that allows buyers and sellers to exchange
any type of goods, services or information.
 Features of Market
• Sellers and buyers should be able to get in
close contact with each other
• Sellers and buyers should be well informed
about prices prevailing and other information
• A market is any organisation whereby buyers
and sellers of a good are kept in close touch
with each other
• Basic components: Buyers, Sellers, Commodity
and Price
 Criteria for Market classification
• Classification by Area: Local, National and Regional
• Classification by Nature of Transaction: Spot and Future
• Classification by Volume of Business: Wholesale and Retail
• Classification on the Basis of Time: Short Period and Long
Period
• Classification by Status of Seller: Primary and Secondary
• Classification by nature of Competitions: Substitutability
factor, Interdependence factor, and Ease of entry factors
 Various form of market structure
Form of Number of Nature of Price Elasticity Degree of
Market Firms Products of Demand for Control over
Structure an individual Price
Firm
Perfect Large number Homogeneous Infinite None
Competition of firms
Monopoly One Unique product Very Small Considerable
without close
substitute
Monopolistic Large number Product Large Some
of firms differentiation
by each firm
Pure Oligopoly Few firms Homogeneous Small Some
Product
Differentiated Few firms Differentiated Small Some
Oligopoly Product
 Equilibrium of the Firm
• Firm is said to be in equilibrium when it has no
tendency either to increase or to contract its
output
• Firm’s equilibrium level of output will lie
where its money profits are maximum
• Firms will attempt to maximise the difference
between Total Revenue and Total Cost
Contd…
• Equilibrium of firm by Total Revenue and Total
Cost
• Equilibrium of firm by Marginal Revenue and
Marginal Cost
Contd…
 Perfect Competition
• Perfectly Competitive market is the most basic form
of market structure
• It is theoretical and hypothetical, but the most ideal
form of market
• The term perfect competition refers to set of
conditions prevailing in the market
Contd…
• Perfect competition is a market structure
characterised by a complete absence of rivalry
among the individual firms
• In economic theory, it has a meaning diametrically
opposite to the everyday use of this term
• In practice, businessman use the word
competition as synonymous to rivalry
• In theory, perfect competition implies no rivalry
among firms
 Perfect Competition: Characteristics
✔ Large number of buyers and sellers in the
market
✔ Homogeneous product
✔ Perfect mobility of factors of production
✔ Free entry and exit of firms
✔ Perfect Knowledge
✔ Absence of collusion and artificial restraint
✔ No Government Intervention
 Demand and Revenue of a
Competitive Firm
• Total Revenue for a firm is the selling price
times the quantity sold
TR= (P×Q)
• Average Revenue tells us how much revenue a
firm receives for a typical unit sold
• Average revenue is total revenue divided by
the quantity sold
AR=(TR/Q)
Contd…
• In perfect competition, Average Revenue
equals the price of the good
AR=PQ/Q=P
• Marginal Revenue is the change in total
revenue from an additional unit sold
MR=∆TR/∆Q
• For competitive firms marginal revenue equals
the price of the good
TR, AR and MR for a Competitive Firm
Quantity (Q) Price(P) Total Revenue Average Marginal Revenue
(TR=P×Q) Revenue (MR=∆TR/∆Q)
(AR=TR/Q)
1 6 6 6
2 6 12 6 6
3 6 18 6 6
4 6 24 6 6
5 6 30 6 6
6 6 36 6 6
7 6 42 6 6
8 6 48 6 6
In order to determine just how much each firm
wants to sell or how much each firm willing to
offer at prevailing market price, we can analyse
by using the cost concept
Demand and Supply for a competitive
price taker
• The market demand curve for the whole
industry is a standard downward sloping curve
• The demand curve of individual firm is a
horizontal straight line showing that the firm
can sell infinite volume of output at the same
price
• Market supply curve is upward sloping. It is
the horizontal summation of all individual
supply curves.
Contd…
 Short run Profit Maximisation under
Perfect Competition
• The goal of a competitive firm is to maximise
profit. It means firm will want to produce a
quantity that maximises the difference
between Total Revenue and Total Cost.
• Alternatively, Profit maximisation occurs at
the quantity where Marginal Revenue equals
Marginal Cost
Contd…
Profit Maximising Conditions
1. Necessary Condition: Marginal Revenue
equals to Marginal Cost (MC=MR)
2. Sufficient Condition: Marginal Cost curve cuts
Marginal Revenue from below
Contd…
Contd…
Example
Contd…
Thumb Rule for Profit Maximisation
✔ When MR>MC : Increase Quantity Output
✔ When MR<MC : Decrease Quantity Output
✔ When MR=MC : Profit Maximised
Contd…
• In the short run, an individual firm may either
earn super normal profit, normal profit or
incur losses.
• It depends on the position of short run cost
curves. These three possibilities can be
analysed with the help of three short run
equilibrium positions
Case-1: Super Normal Profit Case-2: Normal Profit
Case-3: Loss
 Profit Maximisation in the Short run
In the Short run, managers must take two decisions:
1. Produce or Shut down?
✔ If shut down, produce no output and hires no
variable inputs
✔ If shut down, firm loses amount equal to TFC
2. If produce, what is the optimal output level ?
✔ If firm does produce, then how much ?
✔ Produce amount that maximises economic profit
 Contd…
Short run Output decision
✔ If price is less than average variable cost
(P<AVC), manager will shut down
❖ Produce zero output
❖ Loose only TFC
❖Shut down price is minimum AVC
Firm’s manager will produce output where
P=MC as long as :
✔ TR ≥ TVC
✔ or, equivalently, P ≥ AVC (Shut down
condition for firm in the short run)
Summary of short run Output Decision
• AVC tells whether to produce
✔ Shutdown if price falls below minimum AVC
• SMC tells how much to produce
✔ If P≥ minimum AVC, produce output at
which P=SMC
 Market Supply curve and Firm’s supply
curve in short run
A firm’s supply curve can be derived from the AVC and
shutdown conditions
✔ If price is less than minimum AVC, firm would not
supply, output = 0
For such price, supply curve will coincide with the
vertical axis
✔ Any Price above the minimum AVC, the firm would
choose an output level that would satisfy the
condition of profit maximisation
✔ Supply curve of the firm would be identical to the
SMC above the minimum point of AVC
✔ Industry supply curve can be obtained by horizontal
summation of the supply curve of all firms
 Long run Equilibrium
• In the long run perfect competitive firm only
earn normal profit
• This is due to unrestricted entry into and exit
of firms from the industry in the long run.
• Two extreme possibilities:
I. Firm’s earning supernormal profit
II. Firms earning losses in the short run
Contd…
• If some of the existing firms earns supernormal
profit, this attracts new firm into the industry to
gain profit
• With the entry of new firms, the supply of
commodity in the market increases, assuming no
change in the market demand, this lowers market
price
• This process of adjustment continues till the price
becomes equal to the long run average
cost(P=AR=AC=MR=MC)
Contd…
• Suppose firms are making losses in the short
run
• This would force some of them to leave the
industry in the long run, as they may not able
to sustain loss for a longer period of time.
• There exit from the industry causes a
reduction in supply of the product, demand
remaining constant. As a result equilibrium
price in the industry will rises
Contd…
• This process of adjustment continues to the point
where the marginal firm no longer earn losses( till
the price line is tangent to AC curve)
• Equilibrium occurs at a point where price line is
tangent to long run average cost curve and all
firms make normal profit in the long run
• Thus perfectly competitive firm earns only normal
profit in the long run
• Profit maximising condition in the long run:
P=MC=MR=LAC
Long run Equilibrium: Graphical
Presentation
 Monopoly Market
• Monopoly from the Greek word mono means
single and polo means seller
• It is a form of market where single seller sell a
product which has no close substitute
• Pure monopoly
 Features of Monopoly
• Single seller
• Single product
• No difference between firm and industry
• Independent decision making
• Restricted Entry
 Reason for Monopoly
• Monopolies often arise as a result of barriers
to entry
Barrier to Entry: Anything that impedes the
ability of the firms to begin a new business in an
industry in which existing firms are earning
positive economic profits.
 Sources-Barriers to entry
• Ownership of a key resource
• The Government gives a single firm the
exclusive right to produce some good
• Cost of production make a single producer
more efficient than a large number of
producer
 Demand and Revenue in Monopoly
Market
• Demand curve is downward sloping
• Demand curve of monopolist is highly price
inelastic
• When a monopolist increases the amount it
sells, it has two effects on total revenue (P×Q):
1.More output is sold, so Q is higher
2.Price falls, so P is lower
Contd…
• Average Revenue (AR) curve denotes the
demand curve for the firm and also
determines the slope of marginal revenue
curve
• Since the demand curve is highly inelastic, AR
curve would be downward sloping and MR
curve would lies below AR curve.
• A monopolist’s Marginal revenue is always
less than the price of its goods
Contd…
For a linear demand curve, the slope of MR is
twice that of AR and the MR curve would lie
halfway between the AR curve and price axis
 Profit maximisation conditions
• A monopolist maximises profit by producing a
quantity at which marginal revenue equals
marginal cost. MR = MC (Necessary Condition)
• Slope of MC greater than slope of MR
(Sufficient Condition)
• It then uses the demand curve to find the price
that will induce the consumer to buy that
quantity
Contd…
Steps for profit maximisation:
✔ Set MR=MC to find out the Quantity (Q) that
maximises profits
✔ Use the market demand curve to find the
price (P) that Q brings.
✔ Find ATC and AVC to determine profits,
losses, or shut down
 Firm’s Short-Run Equilibrium in
Monopoly
• There are three possibilities for a firm’s
Equilibrium in Monopoly.
• The firm earns normal profit – If the average
cost = the average revenue
• It earns super-normal profit – If the average cost
< the average revenue
• It incurs losses – If the average cost >
the average revenue
Contd…
Contd…
Contd…
 Firm’s Long-Run Equilibrium in
Monopoly
• In the long run monopoly firm would either
earn supernormal profit or normal profit but
it would not incur loss.
• It would instead try to reduce cost of
production by increasing control of raw
materials etc.
 Sales Revenue Maximisation Model
W. J. Baumol suggested sales revenue
maximisation as an alternative goal to profit
maximisation
• Firm ownership ≠ Firm Management
• It gives discretion to manager to pursue goals
which maximises their own utility and deviate
from profit maximisation
• Profit maximisation is the desirable goal of
owner
 Contd…
Baumol, being the consultant to large firms found
several justification for sales maximisation as alternative
goal for the manager:
✔Salaries and other earnings
✔Bank and other financial institutions
✔Personal problems can be handled satisfactorily
✔ Prestige of the managers relates to sales but profit go
into pocket of shareholders
✔ Manager prefers a steady performance with
satisfactory profit
✔ Large growing sales strengthen the power to adopt
competitive tactics
Baumol’s Static Model: Single product
without advertising
Assumptions:
• Time-horizon is Single period
• Firm attempts to maximise sales subject to
profit constraint
• Minimum profit constraint is exogenously
determined by shareholders, banks and other
financial institutions
• Conventional cost and revenue function:
U-shaped cost curve and downward sloping
demand curve
Model
 Conclusion
Provided that profit constraint is operative:
1. Sales maximiser will produce a higher level of
output as compared to a profit maximiser
2. Price of profit maximiser is higher than the
price of sales maximiser
3. The sales maximiser will earns lower profit
than profit maximiser
 Bain’s Limit Pricing Theory
J. Bain (1949) formulated limit price theory.
✔ Why firms over a long period of time were keeping their
price at a level of demand where elasticity is below unity ?
✔ Why not charging a price which would maximise their
revenue ?
• Traditional theory missing the concept Potential Entry. They
work with actual entry which result the long run equilibrium
at Price=LAC.
• Bain argued that price will not fall to the level of LAC in long
run because of the existence of Barriers to Entry. Similarly,
price will not set at the level of profit maximisation due to
threat of potential entry
Contd…
• Price will set up at the level above the LAC
(competitive equilibrium price) and below the
monopoly price (MC=MR)
• Existing firms will neither set competitive price
nor the monopoly price. But they will charge the
Limit Price assuming that there are barriers to
entry
• Limit Price is the highest price which the
established firms believe they can charge without
inducing entry
Contd…
Assumptions:
• Long run demand curve for industry is defined and
unaffected by price adjustments of sellers or by entry
• Effective collusion among established oligopolists
• The established firms can compute a limit price below
which entry will not occur. It depends on costs of
potential entrant, market elasticity of demand, shape
and level of LAC and number of firms in the industry
• Above the limit price entry is attracted and
considerable uncertainty about the sales of
established firms
• Established firms wish the maximisation of their long
run profit
Model: No collusion with the new
entrant
Contd…
Given that an entry preventing price is defined, the
alternatives open to the established firms are:
1. To charge a price same as limit price and prevent
entry
2. To charge a price below the limit price and
prevent entry (if monopoly price is less than limit
price)
3. To charge a price above the limit price and take
the risk associate with the ensuing entry.