Economics Overall Summary

7/31/2019 Economics Overall Summary

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CHAPTER 1:DEMAND AND SUPPLY

LEARNING OBJECTIVES

the purpose of this lesson is to reach an understanding of

how markets operate, how prices are set and transactions occur.The two market forces of demand and supply are defined and

explained. The equilibrium point is studied. Conclusions and

applications are offered.

MARKET

Markets exist for the purpose of facilitating exchanges of

products, services or resources. Buyers and sellers are brought

together and convey their desire to buy or sell by stating their

offered and asked prices for different quantities. Even if a

transaction does not take place, information if translated in

the pricing of the product.

An example of a market is that of the New York Stock Exchange. Its purpose is to facilitatethe purchase and sale of securities. The transactions are not performed by the buyers andsellers themselves, but by brokers and dealers on their behalf. Daily transaction prices arereported in many newspapers nationwide because markets also perform the importantfunction of pricing of goods, or in these case securities.

DEMAND

Demand is the expression of willingness and ability of a

potential buyer to acquire certain quantities of an item for

various possible prices the buyer can reasonably offer. Demand

can be thought of as a schedule of prices and quantities in the

mind of the buyer.

Dealers of the New York Stock Exchange keep books in which orders from various clientsare entered: how many shares and at what price. Such a listing is an illustration of whatinvestors are willing and able to buy.

LAW OF DEMAND

The law of demand postulates that the relationship between price

and quantity in the mind of buyers is inverse. The law of demand

is represented graphically by a down sloping demand curve. The

law of demand is explained by the diminishing marginal utility,

the income effect, the substitution effect and with the help of

indifference curves analysis.

A retail store would certainly be most interested to know what its customers will be willing


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to pay for what they want to buy. Such knowledge would allow the store to price its productsmost efficiently. This is the reason why market research is conducted to determine whatcustomers want to buy and at what price.

LAW OF DEMAND REASONS

the law of demand can be explained by

- price being an obstacle to consumption,

- diminishing marginal utility,

- price change income effect and substitution effect.

It can also be derived from the diminishing marginal rate of

substitution of indifference curves.

All department stores have periodic sale days during which the prices are reducedsubstantially. The purpose of this price reduction is to get rid of old merchandise andstimulate the buying by customers (who may purchase many other items as well). Thus,stores take advantage of the law of demand: merchandise which would otherwise be hard to

sell, is sold because customers are willing to pay a lower price.

INCOME EFFECT

The law of demand can be explained by observing that an

unexpected price change affects the purchasing power of

consumers. If the price is lower than expected, income is

liberated which allows the consumer to buy more. An unexpected

price increase would cause the consumer to buy less.

When a housewife goes to the supermarket to buy groceries and finds one of the products

she intended to buy being reduced in price because of a special sale, it makes her feelwealthier. Indeed, she can buy more with the money she started with. This is the incomeeffect.

SUBSTITUTION EFFECT

The law of demand can be explained by the substitution effect.

If the price of a good is lower than expected then that good

appears to the consumer as a bargain opportunity in comparison

to the goods which remain at full price. The consumer will

temporarily switch his/her pattern of consumption by

substituting bargain items for full price items.

Suppose a customer is undecided between pork chops and steak before entering thesupermarket. If pork chops have been put out on special at a reduced price, while steak hasnot, that is likely to induce the customer to buy the pork chops with no remaining hesitation.This is an illustration of the substitution effect.

DEMAND GRAPH

The law of demand is represented graphically by a down sloping


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curve showing that when price decreases, quantity increases and

vice versa.

Graph G-MIC1.1

MARKET DEMAND

The market demand is the sum total of individual demands.

DEMAND DETERMINANTS

Price is the major determinant of the quantity demanded.

The nonprime determinants of demand are:

- number of buyers,

- tastes,

- income,

- price of other goods (either complementary or substitute), and

- expectations about future prices.

Advertising by companies shows that customers can be prompted to buy products for a greatvariety of reasons. The foremost inducement is still price.

INFERIOR GOOD.

An increase in income will generally cause the consumption of most goods to increase: these goods are said to be

normal or superior goods. There are a few goods for which the pattern is reversed: an increase in income causes a

decrease in consumption. These goods are known as inferior or Geffen goods. Most often, these inferior goods are

tied in the mind of individuals to hard times.


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PRICE OF RELATED GOODS

The price of related goods affects the demand of an item in two opposite patterns depending if the goods are viewed

by the buyer as complementary or substitute.

COMPLEMENTARY GOODS

Goods are complementary when their consumption is tied to each other. For instance, automobiles and tires: tires are

sold because automobiles are sold and vice versa. The increase of the price of automobiles will cause fewer

automobiles to be purchased, and thus, fewer tires as well. The relationship between the price of automobiles and the

quantity of tires is inverse.

Tires and cars, bullets and guns, lamps and lamp shades, cream and coffee, nails andhammer, nuts and bolts, are all items that go together. They are complementary goods.

SUBSTITUTE GOODS

Substitute goods are goods which can be replaced by each other in the mind of the consumer. For instance, tea and

coffee are for many (but not all) consumers interchangeable goods. If the price of tea goes up, the purchases of teawill decrease and the purchases of coffee will increase. Thus, the relationship between the price of tea and the

quantity of coffee is direct.

Butter and margarine, tea and coffee, taxi and bus, pen and pencil, hotel and motel, radio andrecord player, are all items which, for most people, can be replaced byeach other. They are substitute goods.

QUANTITY DEMANDED

a change in any of the nonprime determinants will cause the entire demand of consumers to change. Graphically this

can be shown as a shift of the demand curve to the right or to the left. These shifts in demand must be distinguished

from movements along the demand curve caused by changes in price: these changes in price only cause the quantity

demanded to change, but the entire demand schedule remains the same.

The availability of new products can change the tastes of consumers. Not long ago, complexcalculation used to be done with slide rules. With the arrival of hand calculators, slide rulesno longer satisfied customers.

SUPPLY

Supply is the willingness and ability of sellers or suppliers to make available different possible quantities of a good

at all relevant prices.

Supply is what we have to offer. All of us have our time and skills to offer to our employers.For some of us, the number of hours of work may change from day to day or from week toweek. Then, most often, if additional hours are required to be worked, we can expect ahigher price, i.e., overtime pay.


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LAW OF SUPPLY

The law of supply postulates that the relationship between price and quantity in the mind of sellers or producers is a

direct one. When price increases so does quantity.

The payment of overtime shows that the more one is expected to supply, the more one can

be expected to be paid. In some professions, extra hours over regular overtime are paid ateven higher wage rates.

LAW OF SUPPLY REASONS

The law of supply is explained by

- price being an inducement for sellers or producers to sell

more, and

- cost of production increasing (because of the law of

diminishing returns).

SUPPLY GRAPH

the law of supply can be shown graphically by an up sloping

supply curve. When price increases, quantity increases; thus,

the direct relationship is verified.

Graph G-MIC1.2

SUPPLY DETERMINANTS

Price is the major determinant of supply. Nonprime determinants are:


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- number of sellers or producers,

- costs of production (including taxes),

- technology (since it affects costs),

- prices of other goods (as sources of possible profits),

- expectations (but the effect is ambiguous).

Returning to the employee supplying his/her hours of work, thewillingness of the employee to accept changing work scheduleis likely to depend on the time devoted to other needs (such asleisure, family, hobbies). Nevertheless, the major determinantwill be the price or wage expected.

QUANTITY SUPPLIED

a change in any one of the supply non price determinants will

change the entire supply schedule and shift the supply curve.

This shift of the supply curve is to be distinguished from the

movement along the supply curve itself when price is changed:

this only changes the quantity supplied (not supply).

EQUILIBRIUM

The price and quantity equilibrium is where demand and supply

intersect. At any price above that equilibrium, the quantity

supplied exceeds the quantity demanded, which results in a

surplus (and no transaction between buyer and seller). At any

price below, the quantity demanded exceeds the quantity

supplied, which results in a shortage. Only at the intersection

of demand and supply are the quantities demanded and supplied

equal. The price and quantity equilibrium is stable.

Graph G-MIC1.3


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SHORTAGE

a shortage means that the quantity demanded exceeds the quantity

supplied. A shortage exists if the price is below the

equilibrium. If the market is free, the shortage will disappear

as the price increases. The shortage will continue anytime the

market is not free; for instance, if the government has

instituted a price ceiling. If the price ceiling is above the

equilibrium, it is not relevant and has no bearing on the

market.

Graph G-MIC1.4


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Many cities have rent control laws to make sure that poor peoplecan find apartments they can afford. But landlords do not find itprofitable to rent at these prices and sometimes convert theirbuildings to condominium or cooperative ownership. This reducesthe number of apartments available: it creates a shortage.

SURPLUS

a surplus means that the quantity supplied exceeds the

quantity demanded. The surplus exists only above the

equilibrium. If the market is free, the surplus will tend todisappear as the price is lowered. The surplus will continue

only if the market is not free; that is, a minimum price has been

instituted by the government. If the minimum price is below

equilibrium, it is irrelevant and has no bearing on the market.

Graph G-MIC1.5


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The prices of many agricultural commodities, such as milk forinstance, are subject to government price support. This higherprice encourages farmers to produce too much: this createssurpluses. For instance, in the 1980's, the government has beenforced to make cheese from milk surplus and to distribute thatcheese free to poor people.

INDIFFERENCE CURVES

Indifference curves shows the combinations of two goods that

an individual would be willing to buy, and which would make

him/her equally satisfied (or indifferent). Indifference curves

assume that more is preferred to less. They are convex as seen

from the origin. The indifference curves form an entire map of

various level of satisfaction.

Graph G-MIC1.6


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The shopping list of any consumer would reveal that, beyond someminimum basic necessities, purchases are a matter of choosingbetween various items that can provide equivalent satisfaction.This pattern of equivalent satisfaction from the consumption oftwo selected goods is what the indifference curves portray.

MARGINAL RATE OF SUBSTITUTION

The quantity of one good an individual must forego in order to

increase the quantity of another good and leave the individual

indifferent, is called the marginal rate of substitution. Thismarginal rate of substitution is shown graphically as the

tangent to the indifference curve. The marginal rate of

substitution is decreasing. This verifies that the

indifference curves are convex as seen from the origin.

BUDGET LINE

The budget line is the locus of combinations of two goods an

individual can afford to buy with his/her income. The slope of

the line is the price ratio of the two goods: Pa/Pub or relative

price of each good.

Graph G-MIC1.7


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A housewife going to the supermarket with a specificamount of money knows exactly what is the maximum she canspend. The proportions of the different items can change.

POINT OF TANGENCY

The equilibrium point which will give most satisfaction to the

consumer, and which the consumer can afford, is where the budget

line is tangent to the highest indifference curve.

Graph G-MIC1.8


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DERIVATION OF DEMAND

Demand can be derived from the indifference curves by lowering (increasing) the price of one good and observing

that the budget line will shift as a result, causing the equilibrium point to reflect a larger (smaller) quantity

purchased of that good.

CHAPTER 2:ELASTICITY

LEARNING OBJECTIVE

The purpose of studying elasticity is to determine how a small

change in price may result in either a large or small change in

quantity. The concept is first defined and explained. Its

measurement is discussed. The relationship between total revenue

and elasticity is outlined. Supply elasticity and its

determinants are analyzed. The concepts are applied to analyzeprice ceilings, price supports and tax incidence.

ELASTICITY

The concept of elasticity is intended to measure the degree of

responsiveness of a buyer or seller to a change in a key

determinant, in particular price. The degree of responsiveness

of the quantity demanded to a price change is called the price

elasticity of demand. If the price change is that of another

good then the study deals with cross elasticitys of demand.

Suppose a store manager wants to run a sale. Should he lowerthe price of a given item? And, if yes, by how much?The answer will depend on whether the increase in purchases bycustomers will be larger than the price decrease, (bothcalculated on a relative basis). This change in purchases bycustomers is what elasticity is intended to measure.

ELASTICITY MEASUREMENT

if elasticity were measured by absolute quantities, then it

would be affected by the units of measure used for both price and

quantity. To avoid this difficulty, elasticity is a ratio of

relative changes in quantity and price:

Ed = (dQ/Q) / (dP/P)

Or


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Ed = % change in quantity / % change in price.

If a grocery store can increase its sale of milk by 12 quarts(from 24 to 36) when the price is dropped by 10 cents (from $1.00

to $.90), the elasticity measured in absolute terms is 1.2 (thatis 12/10). But, when the quantity of milk is expressed ingallons, the elasticity in absolute terms is now 0.4 (4/10). Ifdollars instead of cents are used, it becomes 40 (4/0.1). Thisdifficulty disappears when the elasticity is a relative measure.

MIDPOINT ELASTICITY

The calculation of elasticity using the formula of change in

relative quantity over change in relative price results in

different values depending on whether the starting point of the

calculation is the highest or lowest price. To avoid this

difficulty, both price and quantity are averaged: this is theequivalent of taking the elasticity at the midpoint of the

price-quantity range.

Ed = ((Q2-Q1)/ ((Q1+Q2)/2)) / ((P2-P1)/ ((P1+P2)/2))

It should be noted that price elasticity of demand is always negative

and absolute values are often quoted without indicating the negative sign.

If price is decreased by -10 percent (from $1.00 to $.90) toincrease sales of milk by 50% (from 24 to 36), the elasticity is

-5 (that is 50% divided by -10%). Looking at the same number theother way: there is a decrease in quantity of -33.3% (from 36 to24) when the price is increased 11.1% (from $.90 to $1.00): anelasticity of -3. The presence of 2 values does not make sense.The midpoint (and correct) elasticity is -3.8 (that is (12/30)/ (-0.10/0.95)).

ELASTIC DEMAND

if the demand is elastic, it means that a small price change

results in a large quantity change. This would generally take

place on the upper portion of the demand curve. If the demand is

perfectly elastic (which means that the smallest possible price

change results in a virtually infinite quantity change), the

demand curve is then horizontal.

A mother wants to surprise her children by bringing homesome fancy pastry for desert. But, after discovering that thepastry shop has raised its prices to unreasonable levels, shedecides to skip the pastry. Her reaction shows very high,virtually infinite, elasticity.


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INELASTIC DEMAND

if the demand is inelastic, it means that even a substantial

change in price leads to hardly any change at all in quantity

demanded. This generally occurs in the lower portion of the

demand curve. If the demand is perfectly inelastic, quantity

does not change at all. A perfectly inelastic demand is vertical.

For most people, items that are considered as necessities areitems for which the demand is inelastic. No matter how much theprice may change, if we think we really need an item, we willbuy it. Medicine or basic food items are probably in thiscategory. Milk for a family with children is such a basic food:you will always find it somewhere in the refrigerator, no matter its price.

TOTAL REVENUE AND ELASTICITY

if demand is elastic, then price and total revenue are inversely

related; that is, if price is increased, total revenue decreases.

If demand is inelastic, price and total revenue are directly

related; that is, if price is increased, then total revenue

increases as well.

In the previous milk example, the demand was elastic: 3.8. Therevenues increase from $24 (when the price is $1.00 for 24gallons) to $32.40 (when the price is lowered to $.90 for 36gallons). Thus, total revenue is indeed inversely related toprice change when demand is elastic.

DEMAND ELASTICITY DETERMINANTS

The determinants of demand elasticity are

- the time framework (market period, short run or long run),

- the availability of substitutes,

- the proportion the item represents in total income,

- the perception of the item as necessity or luxury.

The ability to switch to another brand, another product oranother form of consumption, is the overall criterion of allthe determinants of demand elasticity. It is clearly a verysubjective factor, quite different from person to person.

SUPPLY ELASTICITY

Supply elasticity is the degree of responsiveness of the quantity

supplied to a change in price. It is calculated as

Es = % change in quantity / % change in price.


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The government is interested to know how much more electricityelectric companies would be willing to supply if they wereallowed an increase in the rates they charge. Whatmeasures this responsiveness of the electric companies is thesupply elasticity. Naturally, building a power plant takes a longtime. Thus, the supply price elasticity of electricity can be expected

to be higher in the long run than in the short run.

SUPPLY ELASTICITY DETERMINANTS

the major determinants of supply elasticity are

- the time framework (market period, short run or long run),

- the ability to shift resources.

INCREASING COST INDUSTRY

when a resource is scarce and the cost of that resource

increases over time, the long run equilibrium price of products made from it

increases and the industry is referred to as an increasing costindustry. Most industries have increasing costs over time. Some

industries do not have scarce resources; they are constant cost

industries. New emerging industries may experience decreasing

costs for a while.

Production of electricity is very likely to be of increasingcost industry type. The various energy sources (gas, coal, fuel,hydropower) are all extensively used. Alternative sources(nuclear, sun, wind) have their own additional danger or costs.That is why our electric bill usually goes up, and is likely todo the same in the future.

PRICE CEILING

A price ceiling creates a shortage in the short run. Since both

demand and supply curves are more elastic as the time framework

lengthens, this causes the shortage to increase over time. This

can be verified by observing that a price below equilibrium is

an incentive for buyers to buy more and a disincentive for suppliers to supply

more.

In most major cities, rent control laws have been enacted toprovide affordable housing to low and middle income families.But, landlords have been discouraged to keep increasing thenumber of apartments available at those moderate rents, and haveoften preferred to convert ownership to cooperative orcondominium form. This has taken apartments off the rental marketand increased shortages of affordable housing in many cities.


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PRICE SUPPORT

In the short run a price support creates a surplus. In the long run, both demand and supply become more elastic. This

causes the surplus to increase over time. The price support, being higher than equilibrium, acts as an incentive for

producers to produce more and as a disincentive for buyer to buy.

Milk production has been subject to price support for many years in many countries.Consequently, governments have been forced to buy up excess milk produced by farmers.These government stock piles are regularly converted into cheese distributed free to poorpeople. The surplus of milk continues because farmers have a price incentive to producemore. Now, the government is trying to cut the number of cows farmers are allowed to have.

TAX INCIDENCE AND ELASTICITY

technically a sales tax is paid by the consumer; the seller only collects the tax on behalf of the taxing authority. A

further analysis of the incidence of a sales tax (i.e. the analysis of

who really bears the burden of the tax) reveals that the burden of the tax is shared. The price increase resulting from

the sales tax reduces the quantity traded and forces the seller to lower the selling price.

TAX INCIDENCE AND ELASTIC DEMAND.

If the demand is highly elastic (that is, customers are able to switch), the supplier will be forced to lower selling

prices considerably to continue on selling some of his/her products. Thus, if demand is elastic while supply is

inelastic the burden of the tax is shifted almost in its entirety to the supplier.

Suppose a county increases its sales tax while its adjoining county does not. The residentswill prefer to buy their products in the county which does not have a sales tax. To retain theircustomers, merchants of the county which has enacted the sales tax will have to lower theirprices. Thus the incidence of the tax has been shifted onto sellers.

TAX INCIDENCE AND INELASTIC DEMAND.

If the demand is inelastic, the quantity demanded will not change much after the sales tax is imposed, the supplier

will not have to lower the price and the burden of the tax is borne almost in its entirety by the buyer.

In the example of the adjoining counties, the shift in the incidence takes place because theresidents are assumed to be able to shop equally in one or the other county. (That is, theyhave a highly elastic demand). But, if some barrier existed, such as a toll bridge between thetwo counties or customs duties, the incidence of the tax would then remain entirely on theconsumers.

TAX REVENUE AND ELASTICITYIf the purpose of a sales tax is to raise revenue for the government, such tax will be effective only if demand and

supply are inelastic. Indeed, if both or either are elastic - which they usually are in the long run - the decrease in

quantity purchased will cause the additional revenue from the tax to be minimal or even negative.

Many countries have import duties on luxury items. When those import duties are very high(30% or more), smugglers are willing to take the chance on breaking the law. Then, revenuesfrom those duties decline.


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SUMPTUARY TAX AND ELASTICITY

The purpose of a sumptuary tax is to change the pattern of consumption in a society. Such a sales tax will be

effective only if the demand and supply are elastic. Indeed, if both or either are highly inelastic, no matter how large

the tax is, the quantity will not change.

Sumptuary taxes exist in virtually every country, including the United States. They are mostoften assessed on items such as cigarettes, wines and liquor.

TAX INCIDENCE AND SUPPLY ELASTICITY

When supply is elastic; an increase in sales taxes will result in a large increment in the price paid by consumers and

the tax burden being largely paid by consumers. When supply is inelastic, an increase in sales taxes will result in a

price reduction by sellers, and the tax burden is largely paid by sellers.

CHAPTER 3:PRODUCTION COSTS

LEARNING OBJECTIVE

The purpose of this chapter is to analyze how costs of

production change as output is changed. First the concept of

economic costs is investigated. Short run patterns of total,

average and marginal costs are derived on the basis of the law

of diminishing returns. Long run cost patterns are briefly

outlined.

OPPORTUNITY COST

All costs in economics are said to be opportunity costs because

anytime a resource is used for any purpose, it implies that some

other good cannot be produced with that quantity of the

resource, that some other resource is not used for the given

production instead, and that revenues from other production are

foregone. Thus, costs are either explicit cost for the resource

used or implicit costs from alternative use of the resource.

When a student takes a course in economics, the cost of taking the course is more than just

the money spent on tuition, textbooks and study aids. For instance, the time devoted tostudying could have been used to work in a supermarket and earn a nice salary. That salaryis not an out-of-pocket cost, but an opportunity cost, which is a real cost nevertheless.

NORMAL PROFIT

Among the implicit costs of a firm, normal profit is the most important cost which must be met. Normal profit is that

income the business owner, or entrepreneur, would receive if he/she were engaged in some other activity or


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employment. Thus, if the business owner does not derive what he/she feels he/she deserves, then he/she may well

close the business.

The owner of a small retail specialty store uptown should expect the store to generate at leastas much income as what he/she could earn working as a manager for the department store

downtown. Otherwise, the reasonable decision would be to close the store.

PURE PROFIT

Pure profit, also known as economic profit, is the excess of revenues over all costs of the firm, explicit as well as

implicit (i.e. opportunity) costs (one of which is normal profit). Pure or economic profit, thus, differs from

accounting profit since in accounting profit only out-of-pocket explicit costs are taken into consideration.

As opposed to normal profit, pure profit is a reward for taking the risk in running a business,and sometimes it can be negative. Thus, the owner of a store will see ups and downs in totalprofit due to changes in pure profit, which occasionally eats up some of the normal profit.

SHORT RUN

The short run time framework for a firm is that time period during which some of its resources, and thus costs, are

fixed. A typical example of a fixed cost for most firms is rent or the salary of key personnel (such as the president of

the company). The number of days, months or years which constitutes the short run differs greatly from firm to firm.

Most commercial rentals require a lease (a contract to rent forseveral months or years). Setting up a business also oftenrequires installation of fixtures, furniture or equipment.Over the duration of the lease, the business would lose a lotof money if it had to change location. Thus, space is prettymuch fixed over that period of time.

LONG RUN

The time framework is considered to be long run when all the

costs of a firm can be changed to some extent. For instance,

the factory size can be modified. In the long run, there are no

truly fixed costs: all costs are variable.

At the expiration of the rental lease, a business can move toa more desirable location, which can be larger or smaller. Thus,in the long run, not even the working space of the business hasto remain the same: everything can change.

DIMINISHING RETURNS

The law of diminishing returns shows the observable occurrence

that if variable inputs are increased beyond a certain point the

incremental (or marginal) quantity produced (or returns) starts

to decrease. Starting from a very low level of production, firms

usually will benefit from increasing efficiency at first, but


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the gains dissipate and production becomes less efficient when

the size capacity of the firms is overutilized.

In a restaurant, the first employees that need to be hired areprobably the manager, the cook and the waiter or waitress.

Without them the restaurant would be very inefficient. Otherhelp can be hired later: maitre d', somellier, cashier, kitchenattendants, etc. If there are too many waiters in the restaurantor too many cooks in the kitchen, they may spill or spoil thebroth.

LAW OF DIMINISHING RETURNS

The law of diminishing return takes place only in the short run.

It is entirely due to the presence of some fixed resource, and

the need to overutilize that fixed resource.

FIXED COSTS

Fixed costs are those costs over which a firm has no control.

They are usually tied to fixed inputs or resources. The fixed

costs must be paid, otherwise the firm may have to close down.

Graph G-MIC3.1

Rent is a typical fixed cost. It does not change from month tomonth (or from year to year) over the period of the lease, nomatter what the volume of output may be.


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VARIABLE COST

Variable costs are those costs which a firm can change at will.

They pertain to inputs or resources which are not fixed.

Graph G-MIC3.2

Salaries, especially those of extra help and part-time employeesare typical variable costs. Many other expenses are alsovariable: freight and postage, telephone in excess of the basicrate, maintenance and cleaning, and energy consumption. All thesechange with the volume of production.

TOTAL COST

Total cost is the sum of all costs: fixed and variable. The total

cost curve is represented graphically as an upsloping curve:

costs increase as output volume increases. The curve is

generally S shaped, reflecting the increasing efficiency

starting from a low level of production, and then a decreasing

efficiency as the volume of production goes beyond the point of

diminishing returns.

Graph G-MIC3.3


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The total cost of the restaurant increases as the number of mealsincreases (which is the volume of output here). When therestaurant becomes overcrowded and the law of diminishing returnssets in, the total cost increases very fast because employeesbecome less efficient.

AVERAGE FIXED COST

Average fixed cost is calculated by dividing total fixed cost by

the quantity produced. AFC=TFC/Q. The average fixed cost curve

is represented graphically as an ever decreasing curveasymptotic to the horizontal axis.

Graph G-MIC3.4


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The rent paid by the restaurant is divided (or allocated),among more and more meals as the volume of production increases.The average cost per meals attributable to the fixed rentdecreases as the number of meals increases.

AVERAGE VARIABLE COST

Average variable cost is calculated by dividing total variable

cost by quantity produced. AVC=TVC/Q. The average variable cost

curve is graphically represented by a U shaped curve reflecting

the increasing then decreasing efficiency in production asvolume changes.

Graph G-MIC3.5


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Starting from a few meals and customers, a restaurant can improveits efficiency and decrease its average variable cost per mealas it increases it volume. After having expanded too much, theaverage variable cost starts to rise as employees start to getin each others way when the restaurant is too crowded.

AVERAGE TOTAL COST

Average total cost is calculated by dividing total cost by the

quantity produced. ATC=TC/Q. It can also be obtained by adding

up average fixed cost and average variable cost at each level ofproduction. The average total cost curve is represented

graphically as a U shaped curve with a steep decreasing portion

and a mildly increasing portion. These are attributable to the

fixed and variable cost patterns.

Graph G-MIC3.6


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The pattern of the average total cost of the restaurant is acombination of the pattern of average fixed costs and averagevariable costs. As output increases, average total cost decreasesthen increases with diminishing returns.

MARGINAL COST

Marginal cost is calculated by dividing the change in total cost

by the change in quantity. MC=(change in TC)/(change in Q). The

marginal cost curve is represented graphically by a U shaped

curve reflecting the increasing then decreasing efficiency asvolume increases.

The marginal, or additional, cost per meal changes more thanthe average total cost for each meal. The cost of one additionalmeal start to increase before average total cost does.

MARGINAL COST GRAPH

The shape of the marginal cost curve can be explained by the

pattern of total cost: it is due to the law of diminishing

returns. The trough (or minimum) of the marginal cost curve

corresponds to the point of diminishing returns. Marginal cost

itself is also the slope of the tangent to the total cost curve.

Graph G-MIC3.7


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MINIMUM AVERAGE TOTAL COST

Marginal cost curve intersects the average total cost curve

at its minimum (or trough). One may verify that this must

necessarily be true by observing that

- if marginal cost is below average cost, average cost decreases,

- if marginal cost is above average cost, average cost increases,

Average cost remains the same only if marginal cost is neither

above nor below.

Graph G-MIC3.8


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ECONOMIES OF SCALE

Economies of scale, or economies of large scale, result from

gains in efficiency as the size of production is increased along

with appropriate changes in fixed resources to utilize the

available resources more fully. Economies of scale can only

occur in the long run.

Economies of scale are observable in most manufacturing.Automobile production is especially sensitive to volume. A singlecar (for instance, those constructed for car racing) can costmillions of dollars. But, when the same features are incorporatedin millions of parts, the cost becomes affordable. Recent studiesindicate the minimum production of a line of cars is 100,000units.

ECONOMIES OF SCALE CAUSES

The major causes for the presence of economies of scale are- division of tasks and labor specialization minimizing labor

cost,

- more intensive use of highly skilled personnel,

- more intensive use of capital (for instance, with shifts),

- ability to utilize by-products rather than discard them.

ECONOMIES OF SCALE GRAPH

Economies of scale are observed graphically by a pattern of

lowering of the marginal and average total cost curves. The

envelope of the short run average total cost curves can be

looked upon as a long run cost curve.

DISECONOMIES OF SCALE

Diseconomies of scale take place when the size of a firm is

excessive. A firm may indeed increase its size to take advantage

of economies of scale, but the gains disappear when the firm

reaches a certain size. Diseconomies of scale belong to the long

run and must be clearly distinguished from diminishing returns

which occur in the short run. It is often argued that

diseconomies of scale are rarely - if ever - observed in

industry because firms would cut back on their size.

General Motors is still made of several divisions which have never beenintegrated into a single production. There may be many reasonsfor this. An apparent one is that keeping the divisions separatestimulates some amount of competition among them, and thusavoids diseconomies of large scale.


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DISECONOMIES OF SCALE CAUSES

Some of the possible causes of diseconomies of scale are

- difficulties in control and supervision,

- slow decision making due to excessive size of administration,

- lack of employee motivation.

CHAPTER 4:PERFECT COMPETITION

LEARNING OBJECTIVE

In this topic the principles which guide firms in their price

and quantity decisions will be set out in the short and long

run. Perfect competition is defined. The demand and marginal

revenue are derived. The equivalence between profit

maximization and equality of marginal revenue and marginal costis established. The long run equilibrium is studied. The

economic effect of this market form is shown to be optimum for

society.

PERFECT COMPETITION

Perfect competition is a type of market characterized by

- a very large number of small producers or sellers,

- a standardized, homogeneous product,

- the inability of individual sellers to influence price,

- the free entry and exit of sellers in the market, and- unnecessary nonprice actions.

Examples of markets in perfect competition are extremely rare.Numerous markets in the retail, service and agricultural sectorsapproach perfect competition best. But, in the agriculturalsector, government support price programs distort the marketmechanism. Notwithstanding the lack of good examples, this formof market is important because of a general conviction amongeconomists that it is the best form of market.

PERFECT COMPETITION NUMBER OF FIRMS

The very large number of firms in perfect competition implies

that each individual firm is very small in comparison to the

total market. Indeed, if one firm were to become significantly

large, it would dominate the market and competition would be

eliminated or at least diminished.

In the milk production segment of agriculture, farms are usually


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small. They are especially small compared to the size of theentire market for milk. Note that the milk distributors areoccasionally large, but not the productive farms.

PERFECT COMPETITION STANDARDIZED PRODUCT

The product in perfect competition is said to be standardized

(or homogeneous). This means that it does not make any

difference to customers which specific firm sells the product:

it is absolutely identical. This is the main distinction

between perfect competition and monopolistic competition: once

some differences can be recognized by customers, firms acquire

power over these customers.

Milk is a uniform and homogeneous product. It is not possible tomake a distinction between the milk of one farm and another. Thegovernment has indeed set standards of quality, fat content and

cleanliness.

PRICE TAKER

The firms in perfect competition have no power over price: they

have to sell at the going market price. The firms in perfect

competition are said to be price takers. Should a firm attempt

to raise the price by the smallest possible amount, customers

would not buy from it because they could buy the same product

from other firms. Lowering the price is also not necessary

because the firm can already sell all its output at the going

price.

A milk producer who would try to raise his/her revenues byincreasing the price for milk, would find the company collectingthe milk in that region unwilling to buy his/her milkany longer. One individual farmer is thus unable to affect theprice of milk in the entire market.

PERFECT COMPETITION ENTRY AND EXIT

There are no barriers to entry to or exit from a market in

perfect competition. This condition assures that no firm will

dominate the market and evict other firms. It also assures that the

number of firms (although changing) will remain large.

Agricultural production can start for most crops by simplyplanting on a parcel of land. For instance, that is true forfruit trees and vegetables. (It is true. however, that for someproducts such as milk or tobacco, the government limitsproduction because of the existing overproduction).


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PERFECT COMPETITION NONPRICE ACTION

Nonprice actions such as advertising, service after sale or

warranty, are not necessary in perfect competition because

the firm can already sell all its output at the going price, and

incurring additional expense would only make it unprofitable.

(Nonprice action for the entire industry may however be useful).

A single milk producer cannot possibly influence the consumptionof milk at large, and needs not advertise. An association of milkproducers or a large milk distributor may, however, be in aposition to use advertisement effectively.

PERFECT COMPETITION DEMAND

The demand of firms in perfect competition is perfectly elastic

(i.e., the smallest possible price change results in a

virtually infinite quantity change). Such demand is represented

graphically by a horizontal demand curve: no matter what

quantity is sold, the price is the same, and it is the going

price in the market.

Graph G-MIC4.1

Nationwide, the demand for milk is likely to be downsloping, thatis inversely related to price. But for a single milk producer, itis given by the price the farmer can receive: the going marketprice. It does not change, no matter what quantity the farmerproduces. Thus demand is horizontal.


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PERFECT COMPETITION MARGINAL REVENUE

The horizontal demand curve is also the marginal revenue of a

firm in perfect competition. The marginal revenue, or

additional revenue from one more unit sold, is just equal to

the going price (which is shown graphically by the demand curve

itself). Note that the average revenue is also the demand curve

and total revenue is an upsloping straight line.

PROFIT MAXIMIZATION

A firm must seek to sell a volume of output where its total

revenue exceeds its total cost by the largest amount possible;

that is, its profit is the maximum.

LOSS MINIMIZATION

If a firm fails to derive a profit, it may nevertheless seek,

in the short run, to produce at that level of sales where the

difference between its cost and its revenue, i.e., its loss,

is minimum.

CLOSE DOWN DECISION

If a firm has revenues that are insufficient to cover even its

fixed costs in the short run, the firm must close down.

BREAK-EVEN POINT

The volume of output where total revenue is equal to total cost

is known as the break-even point. A firm must be beyond its

break-even point in order to be maximizing its profit.

MARGINAL REVENUE MARGINAL COST RULEProducing at the level of output where marginal revenue equals

marginal cost is equivalent to profit maximization. Indeed, if

one less unit were to be produced, profit would be smaller by the

excess of marginal revenue over marginal cost for that last

unit. If one more unit were to be produced, profit would also be


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smaller, this time by the excess of marginal cost over marginal

revenue.

MARGINAL REVENUE MARGINAL COSTThe marginal revenue = marginal cost rule is applicable to

loss minimization as well as profit maximization. However, if

marginal revenue intersects marginal cost below average

variable cost, it means that revenues are not sufficient to

cover fixed costs and the firm should close down.

MAXIMUM PROFIT

The maximum profit is obtained by first determining the level

of output for which marginal revenue equals marginal cost (thusprofits cannot possibly be increased). Then determining

1- total revenue given by price multiplied by quantity,

2- total cost given by average total cost multiplied by

quantity,

3- the difference between 1 and 2 above is the profit (or loss).

MAXIMUM PROFIT GRAPH

Since maximum profit is the excess of total revenue over

total cost, it is shown graphically as the area by which the

total revenue rectangle exceeds the total cost rectangle. The

height of total revenue rectangle is the price received by the

firm, and the width is the optimum quantity (where MR=MC). The

height of total cost rectangle is average total cost (on ATC

curve), and the width is the optimum quantity.

Graph G-MIC4.2


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SHORT RUN SUPPLY CURVE

The short run supply curve of firms in perfect competition is

the upsloping portion of the marginal cost curve (above the

average variable cost intersection). Indeed, a firm determines

its optimum volume of sales by taking the intersection of

marginal revenue and marginal cost. The marginal revenue is also

the price it receives. Thus supplier's price-quantity

combinations are given by the marginal cost upsloping portion.

LONG RUN PERFECT COMPETITION EQUILIBRIUM

The long run equilibrium for firms in perfect competition

is where demand (and marginal revenue which is identical to it)

is tangent to the minimum of average total cost (where marginal

cost also intersects average total cost). At that point, there

is no profit or loss for the firm. (Note that there is no pure

or economic profit, but normal profit must still be covered).

ENTRY OF FIRMS IN PERFECT COMPETITION

Should demand be above the minimum of average total cost, pure

profit would exist for firms in perfect competition. This profit

would attract new firms to the industry. Such entry of new

firms is not impeded by any entry barriers in industries in

perfect competition. The new firms would increase the total

market supply and drive the price down. The lower price pushes


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the demand for each firm down toward or even below the

equilibrium minimum average total cost point.

EXIT OF FIRMS IN PERFECT COMPETITIONShould the demand be below the minimum of average total cost,

losses of firms would force some firms to leave the industry.

As firms leave, a decreasing total supply pushes price back up.

The increasing price lifts the demand curves for individual

firms upward toward or even above the equilibrium point. Firms

departure or entry will continue until the price settles to be

just equal to minimum average cost.

LONG RUN SUPPLY CURVEThe long run supply curve for an industry in perfect competition

is perfectly elastic (that is horizontal) in constant-cost

industries and upsloping in increasing-cost industries. Whether

an industry is constant-cost or increasing-cost is determined by

the presence of adequate or insufficient resources.

PERFECT COMPETITION ECONOMIC EFFECT

Perfect competition is seen as an ideal or optimum form of

market because of its very beneficial economic effect for

society, which comes from- allocative efficiency, and

- productive efficiency.

But there are a few shortcomings nevertheless.

PRODUCTIVE EFFICIENCY

The productive efficiency of perfect competition can be observed

in the long run equilibrium point of all firms in the industry,

which is at the minimum of average total cost. This means that

all firms are forced to cut their costs and utilize the best

available technology in order to have their minimum average

total cost no higher than that of all the other firms in the

industry. There is also no under or over utilized capacity.

ALLOCATIVE EFFICIENCY

The allocative efficiency in perfect competition comes from the


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fact that the quantity produced by each firm is just that for

which the price paid by society is equal to the cost of

additional resources (marginal cost). More could not possibly

be obtained for a lower price. The resources are also the most

efficiently allocated among industries since firms will bid for

these resources up to the price consumers want to pay for them.

PERFECT COMPETITION SHORTCOMINGS

In spite of its beneficial economic effect, perfect competition

fails to

- provide any correction for income distribution inequity,

- generate any public goods since there is not profit,

- stimulate technological progress because of lack of profits,

- offer diversity in products since these are standardized.

CHAPTER 5:PURE MONOPOLY

LEARNING OBJECTIVE

The goal of this topic is to show how a monopoly determines

price and quantity for its maximum profit. The monopoly form of

market is defined. Demand and marginal revenue are presented.

The rule of equating marginal revenue to marginal cost is

shown to secure the optimum quantity and price. The economic

effects of monopoly and price discrimination are outlined. Thechapter closes with an analysis of regulated monopolies.

PURE MONOPOLY

Pure monopoly is a type of market characterized by

- a single seller or producer,

- a unique product, with no close substitute,

- the ability of the seller to ask any price it wishes,

- entry to the industry completely blocked by legal,

technological or economic barriers, and

- no need for nonprice actions, except public relations

or goodwill advertising.

Examples of pure monopolies are not common because monopolies areeither usually regulated or prohibited altogether. Cases wherea company has substantial amount of monopoly power, but cannotbe considered a pure monopoly, can easily be found.


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MONOPOLY UNIQUE PRODUCT

A monopoly exists when a firm is the only producer of a given

product. That product is therefore unique to that firm. Such

situation is rarely observed because products providing a

similar service can usually be found in other industries or

regions of the world. The product is unique in the sense that

no close substitutes are presently easily available to

consumers.

For close to half a century, ALCOA was a virtual monopoly becauseit had control over mining of the aluminum ore (bauxite).

MONOPOLY POWER OVER PRICE

A monopoly has extensive power over the price it may want to

charge its customers. The monopolist is sometimes referred to as

a price maker. It must be noted, however, that a monopolist doesnot charge the highest possible price. Instead it charges the price

for which its profits are the largest. Moreover, a monopolist does

not set a price independently of the volume produced: quite the

contrary, price setting is implemented by restricting output.

MONOPOLY ENTRY BARRIERS

Monopoly exists when entry barriers are present; these may be

- legal, from the ownership of a patent or a copyright,

- legal, from its appointment as public utility for natural

monopolies,- technological, from a secret method of production,

- due to large size, age, or good reputation,

- stemming from access to a key resource (such as ore), or

- resulting from unfair tactics or unfair competition.

UNFAIR COMPETITION

Various strategies used by firms to eliminate competitors by

forcing them into bankruptcy or preventing new firms from

entering the industry, are referred to as unfair competition.

They may include

- drastic underpricing of products, or

- cornering of a resource market.

Most of these tactics have been declared illegal in antitrust

legislation.

The history of railroad expansion in the United States duringthe latter half of the 19th century is full of examples of


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actions by railroad companies seeking to eliminate competitors

MONOPOLY NONPRICE ACTION

Since a monopolist is the only firm in the industry, it appears

that there is no need for nonprice action, such as advertising.

However, advertising and other nonprice action are used

as a form of public relations and for the purpose of avoiding

customer antagonism.

Electric companies are natural monopolies and do not need toadvertise because customers have no choice but to receive theirelectricity from them. But, they do advertise. The purpose isoften to convince consumers that the company is on their side bygiving them tips on energy conservation, for instance.

MONOPOLY DEMANDThe demand of a monopoly is downsloping because the monopoly is

the only firm in the market, and demand for most products is price

sensitive.

Graph G-MIC5.1

The demand of natural monopolies, such as an electric company, isdownsloping. Indeed, if the electric company were successful inobtaining a large rate increase, many customers may switch toalternative sources of energy, such as gas for heating andcooking.


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MONOPOLY MARGINAL REVENUE

Marginal revenue is the additional revenue received for the last

unit sold. Since the monopolist can sell one more unit only by

lowering the price on all the units sold, the marginal or

additional revenue is not constant but decreasing. The marginal

revenue is less than price at any quantity. If the demand curve

is a straight line, the slope of marginal revenue is twice the

slope of the demand curve.

Simple algebra can show that the slope of marginal revenue istwice that of the corresponding demand curve. If demand can bewritten as P=-aQ+b, total revenue is PQ, or PQ=(-aQ+b)Q. Then,marginal revenue is the first derivative of total revenue, andthat is P=-2aQ+b. Thus, the coefficient of the slope of marginalrevenue is -2a, twice that of demand -a.

MONOPOLY DEMAND ELASTICITY

The upper portion of the demand curve of a monopoly is elastic,

and marginal revenue is positive for this region of output.

The lower portion of demand is inelastic, and marginal revenue

is negative in that region. It follows that a monopolist would

never want to be in the inelastic portion of its demand since it

can increase revenues by raising price.

MONOPOLY PROFIT

A monopoly finds its maximum profit by producing at a level of

output where marginal revenue equals marginal cost (i.e. the

intersection of marginal revenue and marginal cost curves). If

it produces one less unit a profit is foregone (on the last

unit it failed to sell), and if it produces one more unit a

decrease in profit is incurred (as the marginal cost exceeds

the marginal revenue for that last unit).

Many of the largest fortunes in the United States are theresult of monopoly profits accumulating over time. For instance,

Standard Oil (before it was split up) produced the wealth of theRockefeller family.

MONOPOLY OPTIMUM QUANTITY

The profit of a monopoly is determined by first finding the

optimum quantity with the marginal revenue equal to marginal

cost rule. After that, the unit price on the demand curve and


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the unit cost on the average total cost curve are found based

on the optimum quantity established first.

MONOPOLY PROFIT GRAPH

The monopoly profit is the difference between total revenue and

total cost. Total revenue is represented as a rectangle with

price (on the demand curve) as its height, and quantity

(determined by MR=MC) as it width. Total cost is a rectangle

with average unit cost (on average total cost) as its height,

and quantity as its width. The area by which total revenue

exceeds total cost is the profit area.

Graph G-MIC5.2

MONOPOLY LOSS

A monopoly seeks to maximize profits, and is capable of

achieving such a goal by controlling price and quantity.

However, should customer demand decrease significantly, the

monopolist will be content with minimizing loss (in the short

run) and may even be forced to close down.

Graph G-MIC5.3


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MONOPOLY SUBOPTIMAL PROFIT

The strategy of a monopoly should be to maximize total profit.

Such outcome would not be obtained by maximizing either unit

profit, unit price or total revenue.

However, in some cases a monopoly may want to use a suboptimal

pricing strategy, for instance, to create additional entry

barriers or to avoid customer confrontation.

MONOPOLY ECONOMIC EFFECT

A monopoly form of market is highly undesirable for our society

because of the sizable loss of productive and allocative

efficiency: the price paid is higher than in perfect competition

and the quantity is smaller. The monopoly underutilizes the

resources for the production of a good wanted by society. The

price charged is much higher than the cost of additional

resources used. However, economies of scale and technological

progress are possible.

OPEC is not a pure monopoly. But, in 1973 and 1979, it acted as

a monopoly in successfully increasing prices of oil and fuelby limiting their supply. Many people throughout the world,including the United States, were harmed by these actions. Somecould no longer afford the cost of heating their home and thecost of needed transportation. Others lost their jobs asbusinesses were forced to cut production as costs increased.


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MONOPOLY ECONOMIES OF SCALE

In spite of the undesirable economic effect of a monopoly in

general, a monopoly may in certain circumstances generate

substantial economies of scale, which can be passed on

to society in a lower price. The small firms of perfect

competition are not large enough to bring about the economies

of scale. Such economies of scale are to be found primarily in

natural monopolies. Some economists have questioned the existence

of this beneficial economic effect.

MONOPOLY TECHNOLOGICAL PROGRESS

Another potential benefit to society from monopoly type firms is

that profits are often the motivation for technological progress

and investment in new technology is made possible by the

presence of these profits. However, monopolies well protected by

entry barriers will not need to seek new technology, and if they

do, their goal may be to lower costs for additional profits and

new entry barriers.

PRICE DISCRIMINATION

Price discrimination exists whenever different prices are

charged for the same product and the difference in price cannot

be explained by costs.

The telephone company charging different rates for night and daycalls is a good example of price discrimination. The reason whythe telephone company is able to charge the higher day rates isbecause the demand is inelastic: certain calls have to be madeduring business hours. The regulatory commission tolerates theprice discrimination because it provides a saving for those whocan wait until the evening to make their calls.

PRICE DISCRIMINATION CONDITIONS

In order for the price discrimination to be possible, a firm

must

- be a monopoly or have some power over price,

- be able to segment its market, and

- be able to prevent cross selling from one market segment to

another.

Generally, the market segments will have different elasticities.


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PRICE DISCRIMINATION EFFECTS

The purpose of price discrimination is to increase the profit

of the monopolist. This is achieved by charging a higher price

to those customers who are more inelastic. Price discrimination

is generally considered harmful to society and an unfair

practice. It is declared illegal in the Sherman Act. However,

price discrimination is, nevertheless, tolerated in many

instances, in part, because it may result in larger overall

output, and is occasionally a form of income redistribution.

NATURAL MONOPOLY

Natural monopolies are said to exist in industries where

competition is unworkable and would result in costly

duplication of fixed capital. Most natural monopolies are public

utilities. These are regulated by commissions.

A water supply company is a typical natural monopoly. It isusually the only supplier of water for a given section of atown because it would be wasteful (in fixed assets) to havemore than one company offering water to the same house.

REGULATED MONOPOLY

The major task of the commission regulating a natural monopoly

is to set the price (or rate) that the utility is allowed to

charge. One method is the fair-return pricing method. The price

is set at the point where it is equal to average total cost. The

average total cost is allowed to include a market rate of return

to make sure that new funds can be attracted for expansion. This

practice often results in cost padding by utilities.

Gas, water, electric and telephone companies are all regulatedcompanies. Many companies in the transportation sector are alsoregulated (such as urban bus transportation and trucking).Deregulation of some of the industries has shown that theregulatory process was (for instance in the case of airlines) tothe detriment - not benefit - of consumers.

REGULATED MONOPOLY SUBSIDY

In a few cases of natural monopolies, a price below average cost

is imposed on a utility to require a large output from the firm.

The loss incurred by the firm is then offset with a subsidy.

This is most often present in transportation companies.

CHAPTER 6:


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MONOPOLISTIC COMPETITION

LEARNING OBJECTIVE

The purpose of this topic is to look at a very common form of

market where firms are numerous but have some monopoly power.

The characteristics of the market are first stated. The shortand long run equilibrium is shown. The economic effect of this

market is derived. Because of the importance of nonprice action

in this market, advertising is given special attention.

MONOPOLISTIC COMPETITION

Monopolistic competition is a type of market characterized by

- a large number of firms,

- products which are differentiated and not seen as perfect

substitutes by consumers,

- some ability of sellers to set prices as they wish,- free entry to and exit from the market,

- heavy reliance on nonprice actions to differentiate one's

product.

The monopolistic competition form of market is extremely common.Almost all retail operations are in this form of market. Smallbusinesses in all sectors fall in this category. Starting abusiness is relatively easily, but staying in business is not:that requires an ability to convince customers that the productis different and better than that of competitors.

MONOPOLISTIC COMPETITION NUMBER OF FIRMS

The large number of firms in monopolistic competition implies

that the firms are small in comparison to the entire market.

Although they have some power over price (to the extent that

their products are differentiated), they do not have sufficient

power to retaliate if another firm changes its price. This is

the major distinction between this market form and oligopoly.

MONOPOLISTIC COMPETITION DIFFERENTIATED PRODUCTThe differentiated product sold by a firm in monopolistic

competition has some features that makes a customer prefer it

over the available similar products of other firms. The features

may be physical or created by advertising. The power of any firm

over price stems from this very fact that products are not perfect

substitutes. Nonprice actions are necessary to make the products

differentiated.


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MONOPOLISTIC COMPETITION ENTRY TO MARKET

No barriers to entry or exit exist in monopolistic competition.

However, the need to make one's product differentiated may

require nonprice action, which, if unsuccessful, would drivethe firm out of the market.

MONOPOLISTIC COMPETITION DEMAND

The demand of a firm in monopolistic competition is downsloping

because of the preference of customers for the features of

the differentiated product. However, because there are many

close (if not perfect) substitutes readily available, the demand

is highly elastic. Graphically, this means that the demand in

monopolistic competition is flatter than in monopoly.

The demand of a restaurant is likely to be very elastic becausethere are many other food outlets available to customers. Butthe demand is not perfectly elastic (i.e. horizontal) as in thecase of perfect competition because, each restaurant hassomething to offer other restaurants do not: for instance,convenience, location, elaborate menu, or just atmosphere.

MONOPOLISTIC COMPETITION PROFIT

The profit of a firm in monopolistic competition is determined

in the same fashion as in any other type of market by finding theoptimum quantity where marginal revenue intersects marginal

cost. This optimum level of output, in turn, determines the

price charged (on the demand curve) and average unit cost (on

the average total cost curve). The profit is the excess of

total revenue area over total cost area.

A restaurant should accept customers as long as the additionalor marginal revenue exceeds the additional or marginal cost ofthe last meal served. This seems to be apparent in thereservation process which limits the number of patrons. Without

reservations, the restaurant would either have to serve customersin overcrowded conditions or make them wait on line.

MONOPOLISTIC COMPETITION LONG RUN EQUILIBRIUM

The long run equilibrium of a firm in monopolistic competition

is where demand is tangent to the average total cost curve.

There is no profit. Should there be a profit (if demand is

above the average total cost curve), firms would enter the


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market and drive the demand down. And should there be a loss

(when demand is below average total cost), firms would leave

the market and push demand up. Firms may, however, retain some

profits by using more nonprice action.

All successful restaurants have scores of imitators. Severalchains have attempted to duplicate McDonald, and siphoned someof its customers and profits. But, McDonald has fought back withextensive advertising.

MONOPOLISTIC COMPETITION ECONOMIC EFFECT

The economic effect of monopolistic competition is an overall

undesirable loss of allocative and productive efficiency: the

customer pays more and is able to buy less than in perfect

competition. However, the effect is not as serious as in

monopoly and the differentiated products provide a much sought

diversity. Nevertheless, some waste is present in excess

capacity and in use of nonprice competition.

Generic product markets approach perfect competition becausethey are standardized. Brand name products of the same type(for instance, cookies) are in monopolistic competition becausethey are not the same uniform item, but somewhat different.Customers have to pay a higher price for brand name products(such as Nabisco or Keebler), but they do not seem to mind toomuch.

MONOPOLISTIC COMPETITION NONPRICE ACTION

Nonprice action of firms in monopolistic competition consists

primarily in either

- product development, or

- advertising.

Product development is sometimes only cosmetic to give the

illusion of novelty. Another danger stems from excessive

diversity which may confuse consumers.

Brand name producers have a variety of means to make their

products special to customers. Most important is advertisementwhich generic item producers would obviously not use.

ADVERTISING - ARGUMENTS IN FAVOR

Some of the arguments in favor of advertising are

- advertising is informative,

- advertising increases sales and permits economies of scale,

- advertising increases sales and contributes to economic


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growth,

- advertising supports the media,

- advertising increases competition and lowers prices.

New product advertisement is essential: think of a major artistic

event that interested viewers would fail to see because it hasnot been announced widely enough. But, most of the advertisement(on television for instance) is for existing, well-establishedproducts such as soft drinks or other consumer products; thatadvertisement seeks only to sway customers away from competitors.

ADVERTISING - ARGUMENTS AGAINST

Some of the arguments against advertising are

- advertising is not informative but competitive,

- the economies of scale are illusory,

- advertising raises the cost curve,

- advertisers may use their influence to bias the media,

- advertising is used as an entry barrier, and

- advertising is not a productive activity.

CHAPTER 7:OLIGOPOLY

INTRODUCTION

In this topic the oligopoly form of market is studied. You will

learn that fewness of firms in a market results in mutual

interdependence. The fear of price wars is verified with the

help of the kinked demand curve. Collusive forms and

non-collusive forms of market are analyzed. The economic effect

of the oligopoly form of market is presented.

OLIGOPOLY CHARACTERISTICS

The oligopoly form of market is characterized by

- a few large dominant firms, with many small ones,

- a product either standardized or differentiated,

- power of dominant firms over price, but fear of retaliation,

- technological or economic barriers to become a dominant firm,

- extensive use of nonprice competition because of the fear of

price wars.

All "big" business is in the oligopoly form of market. Being amajor corporation almost automatically implies that the companyhas means of controlling its market.


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OLIGOPOLY CONCENTRATION

An oligopoly form of market is characterized by the presence of

a few dominant firms. There may be a large number of small

firms, but only the major firm have the power to retaliate. This

results in a high concentration of the industry in only 2 to 10

firms with large market shares.

The gasoline industry is an oligopoly in the United States: it isdominated by a few giant firms such as Exxon, Mobil, Chevron andTexaco. Note, however, that many small firms exist in themarket: small independent gas stations which sell in just onecity or just a limited region.

OLIGOPOLY CONCENTRATION CAUSES

The most notable causes for the high concentration in oligopoly

type of markets are

- economies of scale present in production of certain goods,

- business cycles eliminating weak competitors,

- benefits from firms merging, and

- other barriers such as technological development and

advertising.

The history of the U.S. automobile manufacturing shows acontinuous process of increasing concentration of the market inthe hands of the big 3: G.M., Ford and Chrysler. Not long ago,Chrysler acquired the failing American Motors. In the beginning of this century, a newround of concentration is now taking place on a global scale as Daimler acquired Chrysler,

Renault acquired Honda and GM seeks to acquire Daewoo. The needed volumeof production to be profitable (100,000 vehicles) is a majorbarrier for any new firm wishing to start producing cars.

OLIGOPOLY KINKED DEMAND

The demand of a firm in oligopoly is made of two segments of two

separate demand curves. The upper part is highly elastic

because if the firm raises its price, the other firms will not

follow, and the firm will lose its market share. The lower part

is inelastic because if the firm lowers its price, the other

firms follow, and no firm can expand its market share.

Graph G-MIC7.1


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Several gas stations are often found next to each other at majorhighway intersections. They also often have same or similarprices. If one gas station tries to increase its price from theprevailing 125.9 to 127.9, customers will go across the streetand the gas station will lose revenues. If the same gas stationlowers is price to 123.9, it will attract new customers onlyuntil the other also drop their prices; then all will loserevenues.

OLIGOPOLY PRICE STABILITY

The lesson from the kinked demand is that a strategy of

increasing its price will cause a firm to lose revenue, but so

will decreasing price. Thus, firms will tend not to change

prices. Furthermore, as a result of the kinked demand curve,

marginal revenue has a gap or break, and any marginal cost

curve would lead to the same optimum quantity. Thus the same

price is optimum for many different cost structures.

COLLUSION

All firms benefit from avoiding price wars and seeking to

agree on higher prices and protected sale volumes. These

agreements are generally illegal. Thus, secret agreementsare sought: these constitute collusion.

All businesses tend to watch each other, as in the case of thegas stations. Their actions are however independent. Collusionwould occur if all gas stations decided simultaneously to raisetheir prices in order to increase their revenues. Such aconcerted and deliberate action is the form of collusion which is


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prohibited.

OLIGOPOLY PROFIT

The profit of firms in oligopoly is determined exactly in the

same fashion as in other forms of markets: from optimum

quantity where marginal revenue equals marginal cost, price is

determined on the demand curve and unit cost on the average

total cost curve. However, this determination may be affected

by the kinked demand curve. Furthermore, in a collusive

oligopoly, all the firms act as if they constituted one

monopoly and the output is divided up among firms.

OPEC acts as a monopoly by restricting output of its memberswith quotas. Each member shares in the profits of the would-bemonopoly, but does not set price and output independently.

CARTEL

A cartel is an official agreement between several firms in an

oligopoly. The agreement sets the price all firms will charge

and often specifies quotas or market shares of the various

firms. Cartels are illegal in most countries of the world.

OPEC is a major example of a cartel. It exists because it is

beyond the control of an individual country.

OPEC is naturally the prototype of a successful cartel. Output

quotas of its members produced staggering price increases (from$1.10 to $11.50 per barrel in the early 1970's, and up to $34.00in the late 1970's: an increase of 3400% in ten years). RecentOPEC difficulties are also characteristic of cartels: newproducers, difficulty to enforce quotas and maintaining prices.

CARTEL BREAKDOWN

Cartels and other forms of collusion tend to break down because

- an incentive exists for each firm to undersell,

- firms may have different cost structures causing hardship for

some,

- recessions put additional strains on firms,- new firms entering the market do not abide by the agreement,

- when many firms join in, discipline is difficult.

Many producers of basic commodities tried to duplicate thesuccess of OPEC during the 1970's. Agreements on quotas werereached for coffee, cocoa, tin and copper, for instance. Withina few years the quotas were not obeyed and the cartels broke


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down.

OLIGOPOLY MUTUAL INTERDEPENDENCE

The mutual interdependence of firms in oligopoly is demonstrated in the necessity to maintain price stability ahown

in the kinked demand. It may lead firms

to follow strategies which do not constitute outright collusion

but produce a similar outcome. These strategies include

- price leadership where one firm - usually, the dominant or most

dynamic firm - is the first to change its price and all firms

follow, and

- cost plus pricing where prices are aligned because all firms

have the same profit or markup margin on similar costs.

The prime rate (i.e. the interest rate charged by commercialbanks to their best customers) is usually very similar among

major banks. Changes in the prime also take place within a veryshort period of time (less than one day), at the initiative ofone of the banks. It has been established that no outrightcollusion exists in this simultaneous changes, but a high degreeof interdependence.

OLIGOPOLY NONPRICE ACTION

Both product development and advertising are extensively used in

the oligopoly form of market because of the fear of price wars.

Furthermore, these strategies are essential to maintain the

dominant positions of the firms.

Car manufacturers use extensive product development andadvertisement.Oil companies (Exxon, Mobil, Chevron) are also in an oligopolyform of market and advertise extensively. They advertise theirnames more than their product because their product is identicalto that of competitors.

OLIGOPOLY ECONOMIC EFFECT

The oligopoly form of market is harmful to society in comparison

to perfect competition because of the loss of productive and

allocative efficiency. In addition, the undesirable effect mayeven be worse than in monopoly because supervision is not

possible, less economies of scale are present and more wasteful

nonprice actions are used. However, some beneficial effects are

argued to exist from technology progress and scale of production.

The extreme case of a successful cartel such as OPEC shows the


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harm brought on by an oligopoly form of market in reducedavailability of a needed product and a much increased price.But even in non cartel situations, some high prices can beobserved in many manufactured products.

OLIGOPOLY TECHNOLOGICAL PROGRESSThe oligopoly form of market is seen as a necessary framework

in which profit and competition are present to stimulate

technological progress and make it rewarding. However, studies

show that most technological breakthroughs are generated by

small rather than dominant firms.

The computer industry is dominated by a few companies, IBM mostnotably. While all companies depend heavily on new technology,it is often small companies which come up with the most farreaching breakthroughs. Supercomputers are produced by Cray.

A new generation of microcomputers was recently introducedby Next.

The extreme case of a successful cartel such as OPEC shows theharm brought on by an oligopoly form of market in reducedavailability of a needed product and a much increased price.But even in non cartel situations, some high prices can beobserved in many manufactured products.

CHAPTER 8:ECONOMIC RESOURCES

DEMAND FOR RESOURCES

The purpose of this topic is to outline how much and at what

price will firms use resources: labor, land, capital and

entrepreneurial ability. The demand for resources is shown to be

derived from the demand for the goods produced with them. Causes

for demand changes and demand elasticity are listed. The optimum

combination of resources is set out to be based on the equality

of marginal revenue product and marginal resource cost.

DERIVED DEMANDThe demand for any resource is said to be derived from the

demand for the product for which the resource is used.

A restaurant will hire employees if it needs to serve more meals.No demand for meals, no demand for employees. The two gotogether.


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MARGINAL REVENUE PRODUCT

The marginal revenue product is the increase in revenue

generated by one more unit of a resource used in production.

The marginal revenue product can be calculated by multiplying

the marginal physical product by the price of the product sold

by the firm.

If a restaurant hires one more cook or any other type ofemployee, that restaurant could not possibly pay the cook oremployee more than what he/she generates in additional revenues.Otherwise, the restaurant would obviously go out of business.

MARGINAL PHYSICAL PRODUCT

The marginal physical product is the additional quantity of

output which can be produced by using one more unit of a

resource used in production.

Suppose a restaurant serves 1000 meals a day with the existingstaff of waiters. If the number of meals the restaurant canserve increases to 1050 by adding one more waiter, the marginalphysical product of the employee is 50 meals.

OPTIMUM RESOURCE USE

The optimum quantity of any resource a firm should use is

determined by the intersection of the marginal resource cost

and the marginal revenue product. Should one less unit of the

resource be used, the firm would forego an opportunity for

more profit. Should one more unit of resource be used, the

additional cost would exceed the additional revenue and

profits would be smaller.

Suppose a restaurant needs to hire a few more waiters. It willkeep on adding one more waiter to its staff as long as theadditional (or marginal) revenue generated by that new waiterexceeds the additional (or marginal) cost of having that newemployee. If the additional cost exceed the additional revenue,the restaurant should not keep that last employee.

MARGINAL RESOURCE COST

The marginal resource cost is the additional cost resulting

from one more unit of a resource used in production. If the

resource market is in perfect competition, the marginal

resource cost is equal to supply and price of the resource.

If a monopsony (i.e. a firm that has the power to pay less than the going price for a resource by limiting how much it


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uses of that resource) is present, the marginal resource cost of the

monopsonist is higher that the supply curve.

If a firm is able to pay a lower wage for fewer employees, but has toincrease the wage it offers to attract more employees, it is

in a monopsonistic position. The monopsonist face a supply of labor thatis upsloping (seeGraph G-MIC9.2in Chapter 9).

If the supply line can be written as W=aH+b (where W is wage,H is hours worked, a and b are coefficients), its total laborcost is WxH, or (aH+b)H, and its marginal cost of labor isMRC=2aH+b. Marginal resource cost is twice as steep as supply.

RESOURCE DEMAND

The demand for a resource is the marginal revenue product for

that resource. This can be verified by noting that the optimum

quantity of resource is given by the intersection of marginal

resource cost and marginal revenue product.

The fact that the demand for a resource is the marginal revenueproduct can be seen in professional sport organizations. A teamcan hire many good players for a moderate salary, but it canhire only one or very few superstars at an extremely highsalary. The reason why the superstar receives the millions ofdollars in salary is because he/she attracts fans and generatesadditional revenues.

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