N-Project Economics 2009

Foreword
Hello dear student, You have purchased a set of supplementary notes that hopefully would help you in your first common test. This set of notes is not meant to be a substitute for your school notes. Just studying this set of notes is not enough. However, this set of notes contains valuable experience donated by many outstanding students on how to deal with difficult questions that RI (JC) examiners love to set. This set of notes will contain three parts. First, a short summary of a particular topic with a number of key words that ought to be memorized and understood. For in many essays or questions these are the key words that must be procured in order to score high marks. So this is one set of definitions that all of you must remember by heart. Second, a set of exam strategies to use will be included. These are personal outtakes by many of your seniors on how to answer questions. These are especially relevant for economics, where the questions are seldom direct and easy. However, for us, after practicing question after question for one and a half years, weve kind of got the hang of it. You guys, however, have just started on that journey. We hope that this set of strategies would give you a bit of head start on what we took so long to understand. Its not easy, but just keep on going and youll get it. Lastly, there will be worked examples for you to see how the strategies and points are to be used in these questions. For economics, every example that you see would not be limited to just one chapter alone. For these examples, the analysis would be, for the sake of simplicity, limited to that chapter where it is located alone. At the end of all chapters, there will be more examples to summarize the entire CT1 topics. Hopefully, these would be a conglomeration of everything inside and allow you to see the full picture. A few essays would also be included, to see how a potential distinction essay would look like. We realize that for you guys, it is your first Common Test, which is very different from what you did in Secondary 4, be it RP or O level. This set of notes will help you along your way to achieve your goals, but much of it is dependent upon your own practicing and efforts, as well as banking upon your own knowledge of the notes. It is not a magical thing that would suddenly propel you to As!! Good luck, and if you liked this, well see you at Promos once again. Sincerely,

(for the pdf format) Red: is used when there is an important point to be made. Purple: is used for all the keywords that you must understand Blue: is used for an extremely important lesson that you must know at the end of a particular point. Gold: is used for examples to illustrate the point. These are usually important as well.

TOPIC 1: DEMAND AND SUPPLY

Key words: Opportunity cost: The cost when the next best alternative is forgone. Production Possibility Curve (Frontier): A diagram showing the maximum output possible of one good for various outputs of another (or several others), given technology and factor endowments. Demand: Demand for a good refers to the amount that consumers are willing and able to purchase at that a given price. Supply: Supply of a good refers to the amount that firms are willing to and able to supply at a given price. Price of a good: Determined by the interactions (not intersection) of demand and supply forces

Px Supply

Demand Quantity
Diagram 1 Basic diagram of demand and supply

Factors that cause a shift in demand Population (Long run issue) Determination of the size of the market As total population changes, demand of all goods change, as increased population = increased demand As the population makeup changes, i.e. more elderly, demands for specific goods and services will change A demand for one good will change should prices of a substitute or complement change Changes in demand due to fashion or fads Changes in demand due to new inventions or new items on the market. i.e. Less demand for CD-players due to ipod invention. Closely related to substitutes / complements. As seasons change, demand of goods change as well, i.e. more demand for winter clothing. Changes as a result of expectations of future price changes (if people believe prices would increase in the future, they would spend more now at the relatively lower price, and vice versa) An increase in income leads to an increase in spending on luxury goods, and vice versa.

Interrelated goods Taste & Preferences

Season Expectations Income (Y)

Factors that cause a shift in supply Costs (Price of )Related products, Innovations Natural factors Government Changes in costs of production Competitive supply with other products / Joint supply (e.g. fuels + petroleum,) R&D may lower production costs and shift the supply curve rightward, hence supply changes. Favourable climate may increase crop yield, increasing supply, and vice versa. Discovery of new sources of natural resources shifts supply outwards as well. Taxation and subsidy policies affect the cost of production Subsidies decrease the minimum price at which producers will supply Taxes, on the other hand, increase the minimum price, as cost of production increases, hence increasing the minimum price producers are willing to supply at Changes as a result of expectations of future price changes

Expectations

Two acronyms to remember: PITSEY and CRINGE. Note: As long as a change in the demand or supply is not price initiated, i.e. no change in price of the good, then it is a shift. i.e. quantity demanded for a good increases because of a decrease in price. This would be a movement along the demand curve hence implies change in supply. However, if demand for a good increased due to a change in a non price factor, i.e. income increased, it would be a shift of the demand curve. 1. MUST BE CLEAR ABOUT DIFFERENCE BETWEEN SHIFTS AND MOVEMENTS MOVEMENT IS ALWAYS RELATED TO CHANGES IN PRICE OF THE GOOD. SHIFT IS EVERYTHING ELSE.

Illustration of shift:

Px Supply 1 P2 P1 2
Shortage

DD2 DD1
Q1 Q3 Q2

Example This is an example of how you should explain your answer if asked about. What would be the effect of an increased income on the market for toys?

The passage below suggests a suitable answer for a shift in demand, which is about half of the answer. This level of detail is usually necessary for a complete analysis, especially for 10-12 mark questions. The passage below usually constitutes anywhere from 4-6 marks of the question. The remaining 4-6 marks would come from a detailed analysis of the YED and other factors, explained in the next chapter. The diagram above would be used as the diagram supposedly drawn. Initial equilibrium occurs at price P1 and Quantity Q1. Due to an increased income, people have more money to spend on goods they want to buy, hence there is an increase in demand for toys, illustrated by a shift in the demand curve (1) from DD1 to DD2. Hence there is now a greater demand for the good. This excess demand of toys results in a shortage at price P1 and quantity Q1, as quantity demanded exceeds quantity supplied, i.e. Q1 > Q2. Hence market forces would create upward pressure on the price, i.e. price increases from P1to P2 and producers are encouraged to supply more of the toys. Hence quantity supplied would increase via an upward movement along (2) the supply curve. At the same time, consumers are discouraged from purchasing toys due to the higher price and hence quantity demanded decreases from Q 2 to Q3. As a result, the shortage is eliminated and the equilibrium for the toy market established again. An increased price and quantity demanded for toys is observed. Comments: Always start off your answer with a description of the situation and identify the change as a shift or a movement. For example, due to increased income, hence... there is a shift of demand curve and a movement along the supply curve Then go on to mention each logical step of the process whereby equilibrium is once again established. For example, Demand increased. Hence there is a shortage at previous price. Hence Hence and hence equilibrium established once again. (of course, dont overuse the word hence in your essay because it annoys your examiner!) The logical links in between each point are extremely important. Without them the marks awarded would not be much. Also, always refer to the diagram when you state changes, i.e. quantity supplied increased Always add on the Q1 to Q3, P1 to P2 statement. This is especially important as without it the examiner would think that you would be unable to apply the diagram into your analysis. Hence fewer marks would be awarded. Usually, it is not important to regurgitate all thats in the notes. For example, there is seldom a need to list in detail what causes a shift in demand. What the question wants you to do is to apply what you know to answer a specific situation that the question demands. Hence this is lesson 1: IF YOU START REGURGITATING EVERYTHING YOU KNOW FROM YOUR NOTES TO ANSWER THE QUESTION, CHANCES ARE THAT YOURE NOT ANSWERING THE QUESTION. YOU MUST HAVE BOTH DEPTH AND SCOPE; SCOPE ALONE WITHOUT DEPTH IS LIKE WRITING A LOT BUT GETTING NO MARKS. At this point, the first chapter would be concluded, that of demand and supply. Please review your notes accordingly to fill in any missing pieces of information that you might have.

Topic 2: Elasticities and the Labour Market

Key words: Price Elasticity of Demand (PED): PED measures the degree of responsiveness of the Q DD of a good to a change in its price - P Q P
Q

Q00

Price Elasticity of Supply (PES): PES measures the degree of responsiveness of the QSS of a good to a change in its price -

Q00
Q Y

Income Elasticity of Demand (YED): YED measures the degree of responsiveness of the DD of a good to a change in consumers income -

Q00

Cross Elasticity of Demand (CED): CED measures the degree of responsiveness of the DD of good A to a change in price of good B - PB
Q A

QBA

Price Elasticity of Demand

Determinants of PED Availability of Substitutes

Greater Elasticity Few Substitutes, e.g. Microsoft Windows

Greater Inelasticity Many substitutes, e.g. a particular brand of pens having many other substitutes Necessity Small Proportion

Nature of Good Proportion of Income spent on the good Time Period

Luxury Large Proportion

Long run

Short run

If demand changes by more than the price has changed, the good is demand price-elastic. If demand changes by less than the price, it is price-inelastic. Hence for good whose PED is >1, it is price elastic, and vice versa. Uses of PED Government taxation policies When a government taxes, it would have one of these two aims: 1) Raise Revenue 2) Decrease Consumption of the good For each of the aim, it would be beneficial for the government to understand the PED of the good, or more specifically, how much would the quantity change for an increase in price due to the tax.

SS0 + Tax SS0 Tax P1 P0

= consumers incidence = producers incidence = tax revenue

DD0 PED > 1

Q1

Q0

In this case, on the above diagram, if the aim of the tax is to decrease the quantity demanded of a good, instead of collecting tax revenue, a demand curve with PED>1 would have more effect. As one can see, the price increase is minimal, while there is a greater decrease in quantity demanded of the good. When the price elasticity of the good is 1, a tax levied would be shared equally amongst the consumers and producers, i.e. a shift of the supply curve upwards would increase the price of the good by exactly half of the shift upwards. In the case of price elastic goods there will be less of a burden (incidence) on the consumer in the situation of a tax, as the increase in price is less than half the tax levied. From an intuitive sense, when a price increase is less than half of a tax levied, it means that the consumer would be paying less than half of the tax levied, which means the other half is paid by the producer. Hence in a sense, they are better off than the producer. The reverse is true for a price inelastic good, where the consumer bears more of the tax burden.
Px SS0 + tax = Tax revenue = Producer Incidence Tax SS0 P1 = Consumer Incidence

P0

DD0 (PED<1) Quantity

Q1 Q0

Hence firms can also use this as a reference for pricing decisions, in addition to many other factors. For example, should a good be price inelastic, firms can price it higher, as total revenue would exceed total cost for any quantity above the equilibrium quantity.

Example: Evaluate the effectiveness and feasibility of a tax on Cigarettes by the Singaporean Government. The passage below explains how you would argue from a PED point of view. It would contain about the required amount of marks, the other coming from a market failure point of view, which is not included in the JC1 CT1. The first diagram on the inelastic demand curve should be drawn. The purpose of a tax by the government on the sale of cigarettes is two-fold. It is to be a form of government revenue via the tax revenue collected, and also to decrease the amount of quantity demanded of cigarettes, as it is detrimental to society welfare. Hence diagram 1 is drawn to illustrate such a situation. (Factors of Price inelastic good) Due to a lack of substitutes, such as marijuana in Singapore, as well as the addictive nature of the good, coupled with the relatively cheap price of cigarettes, cigarettes are a price inelastic good. This implies that for a given increase in price, there will be a less than proportionate decrease in quantity demanded of cigarettes, following the law of demand. Hence diagram 1 illustrates the price inelastic nature of cigarettes by DD0. Hence as a tax is levied, the cost of production per unit of good rises, hence the supply curve would shift up from SS0 to SS1 as producers produce less of the good. (Aims of the government evaluation) If the governments aim was to raise tax revenue, the tax would be effective, as there would be a large amount of revenue collected, due to the price inelasticity of the good. However, if the governments aim was to decrease the quantity demanded of the good, the tax would be less effective, as the good is price inelastic. Hence for a given increase in price due to the tax, there would be a less than proportionate decrease in the quantity demanded of the good, hence the tax may have less effect. (Further elaboration) Furthermore, a large portion of the tax incidence is on the consumer instead of the producer, as the producer is able to pass on much of the increase in cost of production to the consumer. Hence in addition to the lesser decrease in quantity demanded, there would be less disincentive for the producer to produce more as well, since the tax burden does not lie upon the producer. Hence the aim of reducing quantity demanded of the good via a tax is less effective.

Comments: There are a few logical links to follow here. Firstly, always start off with the purpose of the tax, i.e. what exactly the tax is for? Try not to put up a generic description, but rather shape your answer specific to what the context or prelude contains, i.e. Mention that because cigarettes are detrimental to societys health, they should be taxed and quantity demanded reduced. Secondly, go on to mention the price elasticity of the good in question. This is especially important as it would define the effectiveness of the tax. Give a few reasons for why the good is price elastic or price inelastic, according to the factors used to evaluate. Again, they should be specific to the context of the question. For example, cigarettes are price inelastic because there is a lack of substitutes, especially in Singapore etc Thirdly, go on to mention the implementation of the tax and what effects it would have i.e. shifts the supply curve quantity demanded falls Fourthly, evaluate the effectiveness of the tax for each purpose specifically. For the purpose of tax revenue, tax on price inelastic goods are more effective, for the purpose of decreasing quantity demanded of the good, tax on price elastic goods would be more effective. Explain why as well, i.e. because the decrease in quantity demanded is less than price increase, hence Lastly, mention any additional evaluations that you think may be relevant to the question. Here, sometimes logic or common sense would play a large part. For example, when there is a greater consumer incidence than producers incidence, one can say that producers are not really much affected by the tax.

Income Elasticity of Demand

Q Y

YED measures the degree of responsiveness of the DD of a good to a change in consumers income -

Q00

Usefulness: Production plans Knowledge of YED can allow firms to ascertain the nature of their product (inferior, necessity or luxury) and plan their future output. o When the economy is favourable, firms should expand their production of normal goods with high YED (luxuries) o Similarly, if the economy is experiencing a potential recession, firms should cut down their production of luxuries and (if possible) increase production of inferior goods. Not very responsive to income change NORMAL GOOD INFERIOR GOOD NECESSITY LUXURY

Cross Elasticity of Demand

CED measures the degree of responsiveness of the quantity demanded of a good to a change in the price of another good Q P

Q00

Usefulness: Provides firms the effects on their products demand when faced with a change in the price of a rivals product or complementary products. If two goods have a high negative CED, the two firms selling them can come together to sell the goods jointly. Unrelated goods COMPLEMENTS STRONG -1 WEAK 0 SUBSTITUTUES WEAK 1 STRONG

Price Elasticity of Supply

Q PES measure the degree of responsiveness of the quantity supplied of a good to a change in its price - P

Q00

Determinants Inelastic Elastic

Time period Short run Long run

Factor mobility Low High

Number of firms Few Many

Spare capacity/ stocks Unavailable Available

Production period Long Short

Px

= consumers incidence = producers incidence SS0 + Tax

P1 P0

Tax SS0

DD0

Q1

Q0

Quantity Demanded

Note: During analysis of effectiveness of tax, you may wish to use PES as an analysis as well, if there is little mention of PED in the context of the question. The more elastic the PES, the more the incidence will fall upon the consumer, irregardless of the PED of the demand curve.

Note: For both taxes and subsidies, one can use PED and PES to evaluate the effectiveness of the tax/subsidy. For most cases, unless the context specifies it, all indirect taxes/subsidies are specific instead of ad valorem (or percentage tax).

The Control of Prices Minimum and Maximum Pricing Minimum price set above market equilibrium Protection of the welfare of certain producers or workers May want to create a surplus which can be stored in preparation for future shortages Maximum price set below market equilibrium Set to achieve some form of equity to protect consumers (i.e. ensures that those of lower incomes can still afford the good) o Price control for basic goods in wartime o Rent control

Leads to a persistent surplus: continuous accumulation of stocks Misallocation of resources: allocatively inefficient Misinterpretation of price signals: creates illusion of a lucrative market o Producers become complacent o May bring in new producers, creating greater surpluses Stock storage = waste of money

Resultant shortages create problems Misallocation of resources: allocatively inefficient Prices no long serve as signals to distribute scarce resources o Alternative allocative mechanisms: balloting, rationing Emergence of the black market

Px Pbm
= deadweight loss

SS

Pe Pmax
Shortage DD Maximum Price

Q1

Qe

Quantity Demanded

Example: The government has set a price ceiling for producers of rice in wartime. Evaluate and discuss the effectiveness of such a policy. The passage below would be an example on how to answer such a question (1) In a free market economy, prices are determined by the interactions of demand and supply, where equilibrium is obtained at a certain price and quantity. Should price fall below that of the equilibrium price, there will exist a shortage of the good, hence consumers would bid up the price, while as the price increases, producers have incentive to supply more of the good. Hence market forces pressure any disequilibrium prices or quantity demanded back to the equilibrium. (2) A maximum price is imposed if the government feels that the equilibrium price is not the ideal price for society. In wartime, the government feels that rice should be available to all consumers, instead of only to those who are able to pay for it. Hence as they feel that the equilibrium price, Pe, is too high, they would implement a maximum price at Pmax, which is below the equilibrium price. (3) At this price, although quantity supplied would drop from Qe to Q1, it would allow more people to enjoy the consumption of the good or service. Hence there is increased equity in the economy. However, a maximum price on rice would create a shortage at price P 0, as there is excess demand but limited supply, as producers are unable to supply a large amount of goods at such a low price. As market forces are disrupted, the price would be unable to increase, hence there would exist a perpetual shortage of the good or service. (4) This has detrimental effects on the economy. At this point, should there be a black market or resale market, the price of the good would increase to P bm, a price where there are people who are willing and able to pay for the good. Hence effectively, the price ceiling would not be feasible, since some consumers would simply purchase the good at Pmax and sell it at a higher price at Pbm. Especially, taking into account the extreme price inelasticity of demand of rice during wartime, there will be a huge difference between the maximum price set and the price that it can be sold for on the black market. Hence there will be even more incentive for some people to resell their goods purchased at Pmax on the black market. Also, the shortages represent a misallocation of scarce resources. Resources are not efficiently allocated to produce the goods that maximize society welfare. Hence there exists allocative inefficiency, as seen by the deadweight loss shown in the diagram. Furthermore, prices are no longer effective signals for resource allocation, hence alternate, more ineffective ways of distribution have to be used, such as first come, first serve or rationing.

10

(5) In this case, to lower price, to promote equity, other policies should be implemented, such as subsidies for rice, which would lower the production costs for rice. Hence producers have greater incentive to produce more of the good and the decrease in production costs can be passed on to the consumer via a decrease in price. Given the price inelasticity of demand of rice, this is likely to work, as an outward shift of the supply curve would bring about a larger decrease in price, albeit a smaller increase in quantity demanded of rice. Hence equity could be encouraged via such a policy. (6) In conclusion, although in a theoretical situation, a maximum price policy may work, in the real world it is unlikely that it would succeed, due to the presence of many resale channels, such as Ebay for usual goods, and black markets in the context of the question. Hence the government should access other policies, such as subsidizing the cost of production of rice, as these may work better, as well as maintain the market forces in the economy. Comments: In this case, one should first start off with an introduction of the situation, of how price and quantity are determined in a normal laissez faire market. Hence a description of how market forces work would be a good start. If you think you have the time, also define demand and supply using the keywords specified in the previous chapter. Then go on to mention the situation of the context, and why a maximum price would be effective. Remember, logical links between each sentence and points are extremely important, especially for economic questions. Start with the rationale of the maximum price, then go on to mention each step of the process, i.e. maximum price imposed shortage disruption of market forces. Next, evaluate the effectiveness of the maximum pricing, giving both sides of the argument. Remember, for a discuss question, you must have a thesis and antithesis. You cannot just write one side of the argument! Finally, mention any additional evaluations that you think might be helpful, such as additional policies that may work. This part is only done if you have the time, else you should go straight on to the conclusion and evaluate your stand there. The numbered points 1-6 should be followed as thoroughly as possible, as these represent a thought process that is useful for answering such questions. 1) 2) 3) 4) 5) 6) Introduction, define demand and supply, how things usually work Purpose of situation, why should it be implemented Explanation, why it works x1-2 Counter point, why it does not work x1-2 Additional policies, what else can we consider Conclusion, what should be the way to go (for this, usually just say a mix of policies should be implemented, or something like, although this is not perfect, the government has to do something and it is the best policy out of all the rest)

Note: When asked about What will happen in an economy, always refer to three things 1) Consumers 2) Producers 3) Government

11

Topic 3: Firms and how they operate: Introduction Keywords: Production function: relationship between output and factor inputs Industry: A group of firms that produce a single good or service, or a group of related goods and services Short Run: Where factors of production are varied. o The following assumptions are made: Total production is only a function of labour and capital. Labour is variable and is considered homogeneous Capital is considered a fixed factor of production Law of Diminishing Marginal Returns (LDMR): As more units of variable factors are applied to a given quantity of a fixed factor, there comes a point beyond which each additional unit variable factor adds less to the total output than the previous variable factor. Fixed cost (overhead costs): Sum of all costs of production that do not vary with level of output Variable cost: Sum of all costs of production that vary with level of output Marginal cost: Additional cost incurred in producing an extra unit of output in the short run Marginal Revenue: Change in firms total revenue resulting from sale of an additional unit of output Long run average curve: A representation of how the average cost varies with output in the long run Economies of scale (internal): Savings in cost to a firms production as the firm expands, created by the firms own policies and actions Economies of scale (external): Savings in costs that occur to all firms in an industry as a result of the expansion of the industry.

Profit Maximization Accounting Profit = Implicit Cost Zero economic profit Normal Profits Positive economic profit Supernormal Profits Accounting Profit > Implicit Costs Accounting Profit < Implicit Costs Negative economic profit Subnormal Profits For this chapter, one point is the most important, that you HAVE TO REMEMBER. PROFIT MAXIMISATION AT MR = MC Of course, thats not all. Whenever you write this statement, you must write this subsequent explanation for the statement as well. This is especially important, as most students would just write firms maximize profit at MR = MC, and leave it there. That usually would net them very little marks, as examiners look out for more detailed explanations of why producers produce until MR = MC, and why they stop there and do not go further.

The main objective for firms is to maximize profit. Hence they would always produce more if the additional revenue from the next unit of good produced would be greater than the additional cost of that unit of good. Hence at the point where Marginal Revenue = Marginal Cost, the firm would have maximized total available profit, as there is no additional profit to be gained.

12

Px

Pe MC AC

AR Qe MR Quantity

Note: The MR extends towards the negative region, as following the law of diminishing marginal returns; there exist a portion where any additional factors of production added would yield negative marginal benefits. Drawing that and explaining it well would show the examiner that you understand the concept of LDMR. Note: Always draw the MC intersecting the lowest or minimum point on the AC. This is especially important.

Supernormal profits exist if the point where at the equilibrium quantity, Q e, the AR curve is above the AC curve. Similarly, normal profits exist where at Qe the AR and AC curve intersect, while subnormal profits exist where at the equilibrium quantity AC is above AR. Try to extrapolate this to the AVC (average variable cost) curve. Remember that AVC + AFC (average fixed cost) equals AC (or average total cost). Firms would always produce if they earn supernormal profits and normal profits. If they do earn subnormal profits, one must look at the AVC curve. Should the revenue gained be higher than the AVC curve, the firm would continue production as long as it can cover its variable costs. However, should the firm be unable to cover the variable costs, i.e. AR < AVC, it would stop production. Economies of Scale Questions on economies of scale themselves are usually simple, because one simply has to regurgitate them from the notes. However, it is unlikely that this is usually the case. It is usually used in cases where one has to evaluate the choice between a monopoly and a perfect competition market structure, which you would see later. In this section, what would be inside would be very similar to that of your notes, hence please refer to your economics notes instead. A list of iEOS: 1) Technical a. Factor indivisibility b. Increased dimensions c. Multi stage production d. Specialization 2) Managerial / Administrative 3) Marketing 4) Financial 5) Risk bearing 6) R&D

The bolded ones are the ones that we (the JC2s) prefer to use in our essays, because they are usually easier to remember and are more general. However, should the context specify a single type of EoS, please use that instead of others. For example, Due to a

13

merger of two companies, the two companies can now advertise less and do more R&D together. Discuss the implications on the economy. In this case, since it is specified, you should be able to identify the correct EoS to mention. A list of external EoS 4) Economies of concentration a. Availability of skilled labour b. Well developed infrastructure c. Reputation From our experience, only mention external EoS when the question specifically asks you for it. In most other cases, only if you have the extra time, then do you mention external EoS, for generally it is the iEoS that are more important. Also, one must know where the Minimum efficient scale is, and what it represents. It is the quantity of production where no more internal EoS can be reaped, shown by the minimum point on the LRAC. Survival of Small Firms

The last subsection in this topic would be that of survival of smaller firms, which is an analysis of why some markets are small, or why some small firms are still able to survive in markets which are dominated by major players. A summary of the factors is produced below: Demand-side Factors Supply-side Factors Nature of product DOS setting in early Bulky and perishable products: bricks, fresh MES is low: tailor shops fish Vertical disintegration Specialized products: machines, religious Small firms perform small parts of a larger items production process when disintegration occurs Prestige markets Markets limited by prices: luxury vehicles, Low entry barriers jewelery Lack of capital Product-life cycles Direct, personalized services Banding allows small firms to band together to gain G&S where direct, individual attention Is advantages of bulk buying required: lawyers, doctors, dentists, Non-traditional motives hairdressers etc. etc. Geographical limitations Local markets due to larger bulk as compared to value and transport costs Hence these factors would be used for any analysis for possibility of survival of small firms, when asked about. Usually these appear in case studies instead of essays, from our experience.

14

Topic 4: Firms and how they operate Market structure & Price discrimination Keywords Equilibrium (of the firm): This is a case where there is no tendency for the firm to change its price/output decision. This usually takes place at the level of output where MR = MC. Theory of Contestable Markets (TCM): The case where monopolies or near monopolies practice competitive pricing (i.e. non-monopoly pricing) due to low barriers to entry n-Concentration Ratio: A measure of how much percentage of the total output n firms in an industry possess. For example, a 3 firm concentration ratio at 60% would mean the top 3 firms in the industry produce 60% of the output of the industry. Market saturation: A case where the market is saturated, meaning a decrease in price can no longer bring about an increase in quantity demanded of the good. A graphical illustration would be that of a perfectly inelastic demand curve, where further shifts of the supply curve would only bring about a decrease in price, but no increase in quantity demanded. Price discrimination: A case where a producer sells a good to different buyers at different prices based on ability and willingness to pay.

Summary of market structures Number of buyers and sellers and concentration ratio Perfect Competition Large number of buyers and sellers, low concentration ratio Large number of buyers and sellers, low concentration ratio Small number of sellers, high concentration ratio One seller, high concentration ratio Nature of product Knowledge of product and production process Perfect Knowledge Barriers to entry P.E (S) A.E Type of profit (excluding subnormal) Normal

Homogeneous

Low barriers to entry

Monopolistic Competition

Minimally differentiated

Imperfect knowledge

Low barriers to entry

Normal

Oligopoly

Monopoly

Homogeneous or Differentiated Unique

Imperfect knowledge Imperfect knowledge

High barriers to entry High barriers to entry (low in TCM)

Normal / Supernormal Normal/ Supernormal

For perfect competition, the first thing you must internalize is that there are always 2 graphs to draw.
Px Supply Px MC

AC Pe DD = MR = AR

Demand Qindustry Fig. 1- Market Demand Quantity Qfirm Fig. 2 - Firms Demand Quantity

15

Profits In a perfect competition, due to the homogeneous nature of the good as well as the low barriers of entry, each firm is a price taker instead of a price setter. This means that they have no say or power in deciding a price to set their goods at, and that it has been set already, following the market supply and demand. Hence the perfect competition firm would have a perfectly elastic demand curve, as any decrease in production (or shift leftwards of supply) would yield no increase in price, hence it would be a decrease in total revenue and hence a decrease in profit. In the long run, it is only possible to make normal profits in the perfect competition. If there are supernormal profits to be made in the short run, more firms would enter the market and dilute the supernormal profits due to the ease of entry. If there are subnormal profits, some firms would leave the market due to the ease of leaving, hence profits would once again improve as each firms market share is now greater, as well as commanding a higher price. Efficiency For efficiency there are always at least 3 to consider, listed in order of importance 1) 2) 3) 4) 5) 6) Allocative efficiency Productive efficiency (society point of view) Dynamic efficiency Consumer sovereignty Distributive efficiency (or equity) Productive efficiency (firms point of view)

In your essay, try your best to at least talk about the first three efficiencies, because they are usually important. Below are some points to note when writing about these points 1) Allocative efficiency YOU MUST ALWAYS EXPLAIN WHY P = MC MEANS ALLOCATIVE EFFICIENCY This is one huge mistake that most of us made in our year. We simply stated P=MC, hence it is allocatively efficient without further elaboration. The passage below is the minimum amount of detail you should include in your analysis of why P=MC means allocative efficiency.

When the firm produces at a point where price equals to marginal cost, allocative efficiency is achieved. This is due to the fact that the price represents the benefit that society views of the good. When the price of the last good produced equals to the additional cost of producing that good, this means that the value society places on that last good equals to the added cost of producing that good, hence societys welfare is maximized at the point where P = MC.

a) For a perfect competition, price is always equals to MC, as a PC firm makes normal profit, it would always produce quantity Qe which is equals to the marginal cost. b) For a monopoly, price is always higher than MC, as the monopoly always maximizes profit at the quantity where MR = MC, the point where the additional revenue from the last good equals to additional cost. As the Demand slope for a monopoly is negative, P is always greater than MR. Hence P>MC, hence a monopoly is allocatively inefficient, as the value society places on that good is always higher than the marginal cost of that good. Such an explanation should be sufficient for the examiner to know that you are not simply regurgitating what is in your notes.

16

2) Productive efficiency (societys point of view) For productive efficiency in a monopoly, simply state (and refer to the graph) that the firm never intentionally produces at the MES, or the minimum efficient scale (shown by the minimum point on the AC). If it does it would just be coincidental. Hence as the firm is not produced at the lowest cost possible, society would be faced with a higher price than the minimum price, hence productive efficiency is not achieved. For P.E. in a PC market, the firm would always produce at the minimum point of the AC, as only normal profits are made. Hence it has to produce at that point; else it can only make subnormal profits, and would be unable to survive in the market. 3) Dynamic efficiency Just a few things to remember: a) PC firms are unable and unwilling to engage in R&D a. No incentive to, due to perfect knowledge. Any R&D would simply be adopted by rival firms b. No means to, due to lack of supernormal profits to finance the R&D process b) Monopoly firms willing and able to engage in R&D a. Possible incentive due to maintenance of barriers to entry to prevent other firms to enter the market (Creative destruction) b. Possess means to do so due to supernormal profits. c. However, they may be unwilling to spend extra cost on R&D if they believe that the barriers of entry are high enough such that rival firms are unable to enter the lucrative market. These are some ideas that should be used in your evaluation, an example which would be shown later. 4) Equity or distributive efficiency These are usually not as important, but if you do have time try your best to explain it. A short example is provided below: A monopoly exacerbates inequity due to: 1) High monopoly power and price inelastic demand curve, hence small amount of consumer surplus 2) Transfer of capital from many consumers to one producer, instead of being spread out across the economy. Price Discrimination Price discrimination is the situation where: a) Producers sell a good to different buyers at two or more different prices b) When the same consumer is charged different prices for the same product for reasons not associated with cost differences. CONDITIONS NECESSARY FOR PRICE DISCRIMINATION 1) 2) 3) Control over market supply Ability to segment the market without arbitrage (or resale of the good) Market Segments must have different PEDs.

TYPES OF PRICE DISCRIMINATION First degree Each customer is charged the maximum price he is willing to pay Auctions, Ebay, etc Second degree (block pricing) Different prices are charged for different blocks or sections of the same good. Utilities, taxi fare (arguable) Third degree Same product sold at different prices to different customers. Admission tickets to parks, etc.

COSTS AND BENEFITS O F PRICE DISCRIMINATION Costs 1. Consumer surplus lost Benefits 1. Higher output

17

2. 3. 4.

Higher profits for the firm Selective pricing of the good, i.e. cheaper to elderly Provision of goods that would otherwise not be produced a. With PD, a firm may be able to cover costs (shown in the diagram below)
st

Remember: With 1 degree PD, the MR curve becomes the AR curve.

Px

AC MC

MR

AR = MR (pd)

Q1

Q2

Quantity

With no Price discrimination, the firm would not produce at Q1, as it would be making subnormal profit, i.e. AC>AR. However, if the firm is able to price discriminate, it would be able to produce at Q 2, with additional revenue of the shaded region. Hence the cost (the purple region) is now less than the additional revenue (the blue region). Hence the firm would continue to provide the good, instead of previously being unable to do so.

Example: Discuss and evaluate the statement that all firms which make normal profits are beneficial to society. [17 or 25m] An example of an answer is provided. In an economy, there are many different markets, each with its different types of firms. For the sake of the comparison in the essay, the evaluation would be limited to two different types of firms, that of the Perfect Competition firm and the Monopoly, as the monopolistic competition and oligopoly firms are to a large extent less extreme forms of these two examples. A perfect competition firm would always make normal profit in the long run.
Px Supply Px MC

AC Pe DD = MR = AR

Demand Qindustry Quantity Q1 Qfirm Q2 Quantity

Fig. 1- Market Demand

Fig. 2 - Firms Demand

18

From the diagram drawn, one can see that the demand curve for the PC firm is extremely elastic. This implies that the firm is not a price setter, but rather a price taker, meaning it has no market power in deciding the price for a good. This is due to the homogeneity of the product, where there is no differentiation and hence at any higher prices than the market price, consumers would simply switch to another firms product. The firm has no incentive to lower prices, as at that price the market would purchase all that it has to sell. Hence the market has only one price that all firms must follow. In this case, the firms in a PC would only make normal profit. In the short run, if the firm is able to make supernormal profit, other firms would enter the market. They are able to do so easily because of the lack of barriers of entry. Hence the supernormal profits are diluted and gradually all firms make normal profit in the long run. Similarly, should the firms only make subnormal profit, some firms would leave the market due to the ease of leaving, hence in the long run, all firms would only make normal profit. Having established that PC firms make normal profit, one would examine the effect to society. Firstly, PC firms are allocatively efficient, as they produce at a quantity where P = MC. This is due to the fact that the price represents the benefit that society views of the good. When the price of the last good produced equals to the additional cost of producing that good, this means that the value society places on that last good equals to the added cost of producing that good, hence societys welfare is maximized at the point where P = MC. Hence as scarce resources are allocated for maximum society welfare, allocative efficiency is achieved. Also, productive efficiency is achieved as well. As firms in the PC market can only make normal profit in the long run, they must produce at the lowest point on the AC curve in order to survive. At any higher points long the AC curve, they would make subnormal profit, such as at point Q1 or Q2. Hence as the firms produce at the lowest cost that is possible, productive efficiency is achieved. Productive efficiency from the firms point of view is achieved as well, as the firm cannot afford to produce at any point above the AC, as they would then face subnormal profits. Hence evaluating these two points, a PC firm being both allocatively and productively efficient, from both society and the firms point of view, a PC firm is very beneficial to society. A monopoly, on the other hand, is more detrimental to society. A monopoly firm would make supernormal profits in the long run.
Px

MC P1

AC

C1

MR

AR

Q1

Quantity

From the diagram, we can see that the firms Total Revenue, at 0P1Q1, is higher than that of the total cost, 0P1C1. Hence it makes supernormal profit. This could be due to the high barriers of entry as well as the high market power that a monopoly holds; hence rival firms are unable to enter the market. As the monopoly is the only firm in the market, it possesses a price inelastic demand curve as well; hence it holds a greater amount of market power by being able to control a greater price change via a smaller change in quantity supplied. Hence it is able to make supernormal profits in the long run.

19

Having established that, a monopoly is neither allocative nor productively efficient. A monopoly produces at a point where price is always higher than MC. As the monopoly always maximizes profit at the quantity where MR = MC, i.e. the point where the additional revenue from the last good equals to additional cost, coupled with the fact that the Demand slope for a monopoly is negative, P is always greater than MR at the point of production, i.e. Q 1. Hence P>MC, and a monopoly is allocatively inefficient, as the value society places on that good is always higher than the marginal cost of that good. Also, productive efficiency is not achieved, as the monopoly does not go out of its way to produce at the lowest point on the AC curve. This is due to the fact that the profit maximizing quantity is always at MR = MC, and the monopoly is only productively efficient (from societys point of view) by coincidence. Also, productive efficiency from the firms point of view may not be achieved. Because the monopoly makes supernormal profit, there may be unnecessary wastage of revenue, as the incentive to minimize costs is not as much as that of a PC firm, which cannot survive if costs are not minimized. Hence a monopoly may not be productively efficient from a firms point of view as well. Hence a monopoly is detrimental to society based on the yardstick of allocative and productive efficiency. However, there are situations where a monopoly is more beneficial to society. In the case where there are large economies of scale to be reaped, a monopoly is more beneficial than a perfect competition. As the monopoly is able to reap large amounts of Economies of Scale, it is able to produce at a lower MC than that of the PC firm. From the diagram below, one can see that if that is possible, the monopoly is able to produce at a greater quantity and lower price, i.e. Pm < Ppc, Qm > Qpc This implies that society benefits more from a monopoly than a PC firm, as more goods and services can be enjoyed at a lower price.
Px SS (pc)

Ppc Pm

MC (m)

MR

AR

Qpc Qm

Quantity

Furthermore, a monopoly is able to have dynamic efficiency, due to the incentive and capability to engage in R&D. A PC market has no incentive to innovate, as due to perfect knowledge rival firms would simply adopt the new technology, as well as no means, due to a lack of supernormal profits. A monopoly, on the other hand, to maintain barriers of entry, would have to innovate in order to do so, such as Microsoft frequently coming up with new software. A monopoly has supernormal profits to fund the R&D process as well. In conclusion, even though under most circumstances a monopoly is allocatively inefficient as well as productively inefficient, in terms of absolute benefit to society, especially in the real world where economies of scale is very relevant, a monopoly may be more beneficial to society than a PC firm. An oligopoly may be beneficial to society, but there is always a chance of price collusion

20

where prices are raised up collectively to exploit the consumers. Hence all in all, by relative comparison, a PC firm may be more allocatively and productively efficient than a monopoly, but based in absolute terms the comparison may not hold true. Final Words For your CT1, this is probably all that you may need. Please be sure to read the examples thoroughly. Instead of memorizing points, try your best to internalize the logic links instead, because these are the stuff that the examiners look out for. Try your best to put in keywords as well, especially in the introduction where you have to define them. Finally, good luck. We hope that this set of notes has helped you. Team N-Project Daniel Chew Darren Foong Tony Liew Elson Ng Sharon Tan Tan Sikai Readon Teh Paul Tern Zhou Penghui Thanks to: 29 Council for helping us to publicize and collect orders Teachers for allowing and trusting us to do this project Everyone who bought a softcopy so as to save the Earth Fiveless.wordpress.com for ideas And a lot of many others whom helped us along the way Else confirm cannot make it. Thanks guys. Hopefully this would help you along for the Common Tests.
th

See you at Promos.

21