Microeconomics Notes for Beginners

5/21/2018 Microeconomics Notes for Beginners

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Economics Notes for IBA Sindh Foundation ProgramPrepared by: Salman Ahmed Shaikh

Definition of EconomicsLionel Robbins provided one of the better definitions of mainstream economics. He wrote abook Nature and significance of Economic science in 1932 in which he defined economicsas:

Economics is a science which studies human behavior as a relationship betweenunlimited wants and limited resources which have many uses.

Following points are most important in this definition and explain why economics is said to bethe science of scarcity and choice:1. Our wants are unlimited in relation to our resources.2. Our resources are limited in relation to our wants.3. Wants are unlimited but each want is different in its intensity.4. Some wants are more intense (necessities) and some are less intense (comforts and

luxuries).5. Our resources cannot fulfill all of our wants, so we have to make choices.6. The choices we make are based on the assumption that our resources have alternative

uses.

Concept of ScarcityScarcity refers to the tension between our limited resources and our unlimited wants. For anindividual, resources include time, money and skill. For a country, limited resources includenatural resources, capital, labor force and technology.

Because our resources are limited in comparison to our wants, individuals and nations haveto make decisions regarding what goods and services they can buy and which ones theymust forgo.

Scarcity and unlimited wants force governments and individuals to decide how best tomanage resources and allocate them in the most efficient way possible.

Because of scarcity, people and economies must make decisions over how to allocate theirresources. Economics aims to study why we make these decisions and how we allocate ourresources most efficiently.

Branches of Economics: Macro and Microeconomics

MicroeconomicsMicroeconomics is the study of small segments of an economy. It can be defined as:

Microeconomics is the study of how individuals and businesses make decisions

about producing, exchanging, distributing and consuming particular goods andservices and the interaction of those decisions in the market.

It studies the behavior, choices and actions of individual and particular firms, industriesand households in the marketplace. Thus, we can say that it is the study of individual parts ofthe economy.

MacroeconomicsThe word Macro means large. It may be defined as:

Macroeconomics is the study of economics as a whole. It studies national income,total employment, aggregate income, total production and average prices.

It studies economy in a broad way. It takes into account the totality and aggregates ofdifferent performance variables like inflation (average price level), total employment, nationalincome and GDP (Gross Domestic Product).


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Concept of Opportunity CostOpportunity cost of any action is the cost of best alternative forgone.

The opportunity cost of going to college is the money you would have earned if you workedinstead. Undergraduate students lose four years of salary while getting their degrees. They doso because they expect to earn more during their professional career after their educationends.

If a gardener decides to grow wheat, his opportunity cost is the alternative crop that mighthave been grown instead (e.g. corn).

Put in another way, opportunity cost refers to the benefits we could have received by takingan alternative action.

Supply & DemandSupply and demand are one of the most fundamental concepts of economics. Demand refersto how much (quantity) of a product or service is desired by buyers. The quantity demanded isthe amount of a product people are willing to buy at a certain price; the relationship betweenprice and quantity demanded is known as the demand relationship.

Supply represents how much the market can offer. The quantity supplied refers to the amountof a certain good producers are willing to supply when receiving a certain price. Therelationship between price and how much of a good or service is supplied to the market isknown as the supply relationship. Price, therefore, is a reflection of supply and demand.

The Law of DemandThe law of demand states that, if all other factors remain equal, the higher the price of a good,the less people will demand that good. In other words, the higher the price, the lower thequantity demanded. The amount of a good that buyers purchase at a higher price is lessbecause as the price of a good goes up, so does the cost of buying that good. As aresult, people will naturally avoid buying a product that will force them to forgo theconsumption of something else they value more. The chart below shows that the curve has adownward slope.

A, B and C are points on the demand curve. Each point on the curve reflects a directcorrelation between quantity demanded (Q) and price (P). So, at point A, the quantitydemanded will be Q1 and the price will be P1, and so on. The demand relationship curveillustrates the negative relationship between price and quantity demanded. The higher theprice of a good, the lower the quantity demanded (A), and the lower the price, the more thegood will be in demand (C).

The Law of Supply

Like the law of demand, the law of supply demonstrates the quantities that will be sold at acertain price. But unlike the law of demand, the supply relationship shows an upward slope.This means that the higher the price, the higher the quantity supplied. Producers supply moreat a higher price because selling a higher quantity at a higher price increases revenue.


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A, B and C are points on the supply curve. Each point on the curve reflects a direct correlationbetween quantity supplied (Q) and price (P). At point B, the quantity supplied will be Q2 andthe price will be P2, and so on.

Equilibrium

When supply and demand are equal (i.e. when the supply curve and the demand curveintersect), then the economy is said to be at equilibrium. At this point, the allocation of goodsis at its most efficient level because the amount of goods being supplied is exactly the sameas the amount of goods being demanded.

At the equilibrium price, suppliers are selling all the goods that they have produced andconsumers are getting all the goods that they are demanding.

As you can see on the chart, equilibrium occurs at the intersection of the demand and supplycurve, which indicates no allocative inefficiency (there is no surplus or shortage). At this point,the price of the goods will be P* and the quantity will be Q*. These figures are referred to as

equilibrium price and quantity.

DisequilibriumDisequilibrium occurs whenever the price or quantity is not equal to P* or Q*.

1. Excess SupplyIf the price is set too high, excess supply will be created within the economy and there will beallocative inefficiency.


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At price P1, the quantity of goods that the producers wish to supply is indicated by Q2. At P1,however, the quantity that the consumers want to consume is at Q1, a quantity much lessthan Q2. Because Q2 is greater than Q1, too much is being produced and too little is beingconsumed. The suppliers are trying to produce more goods, which they hope to sell toincrease profits, but those consuming the goods will find the product less attractiveand purchase less because the price is too high.

2. Excess DemandExcess demand is created when price is set below the equilibrium price. Because the price isso low, too many consumers want the good while producers are not making enough of it.

In this situation, at price P1, the quantity of goods demanded by consumers at this price isQ2. Conversely, the quantity of goods that producers are willing to produce at this price is Q1.Thus, there are too few goods being produced to satisfy the wants (demand) of theconsumers. However, as consumers have to compete with each other to buy the good at this

price, the demand will push the price up, making suppliers want to supply more and bringingthe price closer to its equilibrium.

Shift in demand Versus Movement along Demand & Supply Curve

In Economics, the movements and shifts in relation to the supply and demand curvesrepresent very different market phenomena:

1. Movements along Demand CurveA movement refers to a change along a curve. On the demand curve, a movement denotes achange in both price and quantity demanded from one point to another onthe curve. The movement implies that the demand relationship remains consistent. Therefore,a movement along the demand curve will occur when the price of the good changes and thequantity demanded changes in accordance with the original demand relationship. In otherwords, a movement occurs when a change in the quantity demanded is caused only by achange in price.


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Like a movement along the demand curve, a movement along the supply curve means thatthe supply relationship remains consistent. Therefore, a movement along the supplycurve will occur when the price of the good changes and the quantity supplied changes inaccordance with the original supply relationship. In other words, a movementoccurs when a change in quantity supplied is caused only by a change in price, and viceversa.

2. Shift in DemandA shift in a demand or supply curve occurs when a good's quantity demanded or suppliedchanges even though price remains the same. For instance, if the price for a 250 ml bottleof Pepsi was Rs 15 and price for a 250 ml bottle of Coca Cola (substitute of Pepsi) increasedto Rs 20 from Rs 15, then quantity of Pepsi demanded would increase from Q1 to Q2. Therewould be a shift in the demand for Pepsi if there is change in other factors than price (likeincome of the consumer, price of substitute etc). Shifts in the demand curve imply that the

original demand relationship has changed, meaning that quantity demand is affected by afactor other than price.


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When the non-price factors or determinants of demand change, there is a change in thedemand curve or a shift in the demand curve. These factors are as follows:

PopulationIf the population of a country increases due to an increase in immigrants or an increase inbirth rate, the market demand of various kinds of goods will increase.

Changes in Tastes

Demand for a commodity may change due to change in tastes. For example, if people shiftfrom motorbikes to cars for travel due to change in tastes, the demand for cars will increaseand demand for motorbikes will decrease.

Changes in IncomeWhen the disposable income increases, the purchasing power of people also increases andthey demand more goods at the same price or even at a higher price. Conversely, decreasein income results in decrease in the purchasing power and hence demand also decreases.

Price of Related GoodsIn case of substitutes (the goods that can be used in place of other goods like tea and coffee),if the price of the coffee decreases, the demand of coffee will increase and demand of tea willdecrease. In case of compliments (the goods that are used in combination with other goods

like cars and fuel), if the price of fuel increases, the demand of cars will decrease.

3. Shift in SupplyIf the price for a 250 ml bottle of Pepsi was Rs 15 and if the price of sugar (raw material usedfor soft drink) increases, then the quantity supplied would decrease from Q1 to Q2. Therewould be a shift in the supply of Pepsi. Like a shift in the demand curve, a shift in the supplycurve implies that the original supply curve has changed, meaning that the quantitysupplied is caused by a factor other than price. A shift in the supply curve would occur if, forinstance, crop failure caused the sugar price to increase (which is a raw material for a softdrink) and hence it will increase the cost of the soft drink produced. If price remains constant,the supplier will be willing to supply less of the soft drink due to decreased profit margins withincrease in cost of production.

Equilibrium Algebra

Finding equilibrium price and quantity from inverse demand and supply function.

P = 100.2QdP = 2 + 0.2QsFrom inverse demand function, we have:0.2Qd = 10PQd = 505P

From inverse supply function, we have:-0.2Qs = 2PQs =10 + 5PEquate Qd=Qs for equilibrium


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50 - 5P = -10 + 5P10P = 60P = 6From demand function, we have:Q = 505PQ = 505(6)Q = 20

If you want to use reduced form formula, following is the derivation for it.

Algebra of Equilibrium

Linear FunctionsQD = a - bP

QS= c + d P

a - bP* = c+dP*

(a-c) = (b+d) P*

*a c b d a c

Q c d c d

b d b d b d b a

c db d b d

ElasticityThe degree to which a quantity demanded reacts to a change in price is the price elasticity ofdemand. Elasticity varies among products because some products may be more essential tothe consumer. Products that are necessities are more insensitive (less responsive) to pricechanges because consumers would continue buying these products despite price increases.

Conversely, a price increase of a good or service that is considered less of a necessity willhave responsive change in quantity demanded because the consumers could switch to cheapalternatives (substitutes).

A good or service is considered to be highly elastic if a slight change in price leads to a sharpchange in the quantity demanded. Usually these kinds of products are readily available in themarket and a person may not necessarily need them in his or her daily life.

On the other hand, an inelastic good or service is one in which changes in price bring aboutslight changes in the quantity demanded. These goods tend to be things that are more of anecessity to the consumer in his or her daily life. E.g. food items, clothing, shelter etc.

To determine the Price elasticity of the demand, we can use this simple equation:

Elasticity = (% change in quantity demanded / % change in price)

If elasticity is greater than or equal to one, the curve is considered to be elastic. If it is lessthan one, the curve is said to be inelastic.

The demand curve has a negative slope, and if there is a large decrease in the quantitydemanded with a small increase in price, the demand curve looks flatter, or more horizontal.This flatter curve means that the good or service in question is elastic.


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Meanwhile, inelastic demand is represented with a much more upright (vertical like) curve asquantity changes little with a large movement in price.

Degrees of Price Elasticity of Demand

We observe that for some commodities, the quantity demanded changes sharply with even aslight change in price. But, for some other commodities, a larger change in price does notbring much change in quantity demanded. There are different degrees of price elasticity ofdemand for different products.

Perfectly Elastic DemandWhen a small change in price results in quantity demanded dropping down to zero, theelasticity is said to be perfectly elastic.

Elasiticity of Dem and

0

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6

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0 3 6 9

Quantity Demanded

Price

Perfectly Inelastic DemandWhen a change in price doesnt affect quantity demanded at all and leaves it unchanged, theelasticity is said to be perfectly inelastic. The demand for too expensive or too economicalgoods is nearly perfectly inelastic.


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Elasiticity of Demand

0

5

10

15

20

0 3 6 9 12

Quantity Demanded

Price

Unitary Elastic Demand:When the quantity demanded changes by exactly the same percentage as price, the demandis said to be unitary elastic. For example, if a 10% decrease in price results in a 10% increasein quantity demanded, the elasticity of demand is unit elastic.


2.5, 2.5

0

1

2

3

4

5

0 1 2 3 4 5

Quantity Demanded

Price

Elastic Demand

When the quantity demanded increases by a higher percentage than price, the demand issaid to be elastic. In other words, if a 1% change in price brings a more than 1% change inquantity demanded, the demand is said to be elastic. The elasticity of luxurious goods isusually elastic. The demand for products having close substitutes is also elastic.


0

1

2

3

4

5

0 1 2 3 4 5 6 7 8 9 10

Quantity Demanded

Price

Inelastic DemandWhen the quantity demanded increases by a lower percentage than price, the demand is saidto be inelastic. In other words, if a 1% change in price brings a less than 1% change inquantity demanded, the demand is said to be inelastic. The elasticity of necessities is usuallyinelastic because we need necessities the most. The demand for products having no or fewersubstitutes is also inelastic.


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0

2

4

6

8

10

0 1 2 3 4 5 6 7 8 9 10

Quantity Demanded

Price

Two Methods of Measuring Elasticity of Demand

There are two most commonly used methods to measure price elasticity of demand. They areexplained below:

Point Elasticity Method

It may be defined as:

The measurement of elasticity at a point on the demand curve is called pointelasticity.

The point elasticity method is used when we want to measure a small change in quantitydemanded to a very small change in price. The formula for calculating point elasticity ofdemand is:

=

1001

12

1001

12

xP

PP

xQ

QQ

=

100

100

xP

P

xQ

Q

=P

Px

Q

Q

=Q

Px

P

Q

Arc Elasticity of Demand

It may be defined as:

The measurement of elasticity between any two points on the demand curve.

It gives elasticity measurement between any two points lying on the demand curveirrespective of the distance between them. Therefore, we can measure a large change inquantity demanded and price through this method. The formula for calculating Arc elasticity ofdemand is:


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=

100

2

21

12

100

2

21

12

xPP

PP

xQQ

QQ

=

P

P

Q

Q

Factors Affecting Demand Elasticity

There are three main factors that influence price elasticity of demand:

1. The availability of substitutes - In general, the more the substitutes, the more elastic thedemand will be. For example, if the price of a cup of coffee went up by Rs 5, consumers couldreplace their morning coffee with a cup of tea. This means that coffee is an elastic goodbecause a raise in price will cause a large decrease in demand as consumers start buyingmore tea instead of coffee.

But, if the price of a bread or public transport rises, then for a lower income class person, thechange in quantity demanded will not be that much. It is because necessities have inelasticdemand.

2. Amount of income available to spend on the good - If the price of a lemon sandwich biscuitgoes up from Rs 5 to Rs 6 and if the income of the consumer is sufficiently high, then the

consumer will not usually reduce his or her demand of lemon sandwich biscuits. But, for otherexpensive goods, the demand could be elastic. For example, car lease payments, airlinetravel etc.

3. Time - The third influential factor is time. If the price of cigarettes goes up Rs 5 per pack, asmoker with very few available substitutes will most likely continue buying his or her dailypack of cigarettes. This means that tobacco demand is inelastic because the change in pricewill not have a significant influence on the quantity demanded. However, if that smoker findsthat he or she cannot afford to spend the expensive cigarettes every day and begins tochange the habit over a period of time, the price elasticity of cigarettes for that consumer maybecome elastic in the long run.

Income Elasticity of Demand

The degree to which an increase in income will cause an increase or decrease in demand iscalled income elasticity of demand, which can be expressed in the following equation:

Income Elasticity = (% change in quantity demanded/ % change in income)

If Income elasticity is greater than one, demand for the item is considered to havehigh income elasticity. If income elasticity is less than one, demand is considered to beincome inelastic. Luxury items usually have higher income elasticity because when peoplehave a higher income, they become able to afford them and hence their demand for thoseitems increase.

With some goods and services, we may actually notice a decrease in demand as incomeincreases. These are considered goods and services of inferior quality that will be dropped bya consumer who receives a salary increase. An example may be the increase in the demand


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of branded clothing as opposed to low quality clothing. Products for which the demanddecreases as income increases have an income elasticity of less than zero.

Cross Price Elasticity of Demand

The demand for many goods is affected by the prices of other goods. It is a commonobservation that various goods have close substitutes like coffee is a substitute of tea and

mutton is a substitute of beef. If a price of one substitute changes, the demand for the othersubstitute is also affected. The cross elasticity of demand measures this effect. It may bedefined as:

Responsiveness of quantity demanded of one good (B) to a change in price ofanother good (A)

Mathematically, it can be expressed as:

EAB= (% change in quantity demanded of good B/ % change in price of good A)

Elasticities

MCQs

Q#1: A perfectly inelastic demand exists if a 10 percent change in the price of good results ina percentage change in quantity demanded that is:

a) Equal to 0.b) Equal to 10.c) Equal to infinity.

Q#2: A relatively elastic demand exists if a 10 percent change in the price of good results in apercentage change in quantity demanded that is:

a) Less than 10.b) Equal to 10.c) Greater than 10

Q#3: A perfectly inelastic supply curve:a) Has a relatively flat, positive slope.b) Has a relatively steep, positive slope.c) Is vertical.

Q#4: The elasticity of a demand curve with a constant slope:a) Is greater than the slope.b) Is less than the slope.c) Increases at higher prices.

Q#5: If the price of chocolate-covered peanuts decreases 10 percent and the quantitydemanded increases 5 percent, then the numerical elasticity of demand is:a) 0.5.b) 1.0.c) 2.0.

Q#6: Suppose your local public golf course increases the fees for using the golf course. If thedemand for golf is relatively inelastic, you would expect:

a) A decrease in total revenue received by the course.b) An increase in total revenue received by the course.c) No change in total revenue received by the course.

Q#7: There are several close substitutes for Bayer aspirin but fewer substitutes for a

complete medical examination. Therefore, you would expect the demand for:a) Medical exams to be more elastic.b) Medical exams to be more inelastic.c) Bayer aspirin to be more inelastic.


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Q#8: The income elasticity of demand of an inferior good is:a) Less than 0.b) Greater than 0.c) Between 0 and 1.

Q#9: The cross elasticity of demand of complements goods is:a) Less than 0.b) Greater than 0.

c) Greater than 1.

Q#10: The burden of a tax is shifted toward buyers if:a) Demand is perfectly elastic.b) Demand is relatively more elastic than supply.c) Demand is a relatively more inelastic than supply.

Worked Problems

Question 1:

Demand for a paperback Economics text is given by Q=200,000 - 300P.The book is initially priced at Rs 300.

a. Compute the point price elasticity of demand at P= Rs 300.b. If the objective is to increase total revenue, should the price be increased or decreased?Explain.c. Compute the arc price elasticity for a price decrease from Rs 300 to Rs 200.d. Compute the arc price elasticity for a price decrease from Rs 200 to Rs 150.

Answer:

a)At P = 300, Q = 200,000300 (300) = 110,000Elasticity = (Slope of Demand Function) x P/QElasticity = -300 x 300/110,000 = -0.81

b)Since demand is inelastic, price increase will increase total revenue. Hence, price must beincreased.

c)Elasticity = (Slope of Demand Function) x (Average P/Average Q)

At P = 200, Q = 200,000300 (200) = 140,000Elasticity = -300 x 250/125,000 = -0.6

d)Elasticity = (Slope of Demand Function) x (Average P/Average Q)

At P = 150, Q = 200,000300 (150) = 155,000Elasticity = -300 x 175/132,500 = -0.39

Question 2:

Suppose a firm sells 20,000 units when the price is $16, but sells 30,000 units when the pricefalls to $14.

a. Calculate the percentage change in the quantity sold over this price range using themidpoint formula.

b. Calculate the percentage change in the price using the midpoint formula.c. Find the price elasticity of demand over this range of prices. State whether demand is

elastic or inelastic over this range.

Suppose Firm's elasticity of demand is constant over a large range of prices. If the price wereto fall another 4%, what should Firm predict will happen to its sales?

Answer:


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a. The midpoint formula uses the average of the two quantities as the reference point forcomputing the percentage change. In this example, the percentage change is (30,000

20,000)/25,000 = 0.40, or 40%.

b. The percentage change is (1614)/15 = 0.133, or 13.3%.

c. The price elasticity of demand is the ratio of the percentage change in quantity to the

percentage change in price. In this example, Ed = 40/13.3 = 3. Since Ed is biggerthan one, demand is elastic.

d. Since Ed = 3, which equals the ratio of the percentage change in quantity to thepercentage change in price, this can be rearranged to determine that the percentagechange in quantity is equal to the elasticity of demand times the percentage changein price. In this example, sales will increase by 12%. 12% = 3 x 4%.

Question 3:

Suppose a firm sells 70 units when the price is $6, but sells 80 units when the price falls to$4.

a. Calculate Firm's revenue at each of the prices.b. Use the total-revenue test to determine whether demand is elastic or inelastic over

this range.

Verify your previous answer by calculating the elasticity of demand using the midpointformula.

Answer:

a. Revenue equals price times quantity sold. At P = $6, revenue equals $420. $420 = $6x 70. At P = $4, revenue = $4 x 80 = $320.

b. Revenue falls when the price falls, suggesting demand is inelastic over this range.

Ed= [(80 70)/75] / [(6 4)/5] = .133/.40 = .33, or 1/3. This is less than one, verifying thatdemand is inelastic.

Law of Diminishing Marginal Utility

Law of diminishing marginal utility explains a basic fact of life that whenever we consumesomething in sequence without break, we get less satisfaction from it with each successiveunit consumed. The law may be stated as:

The additional utility derived from consuming more quantities of a commoditydiminishes with each additional unit of consumption.

ExplanationThis law can be explained with a schedule and a graph. We take example of consumption ofmangoes. The total utility and marginal utility derived from each unit of consumption is listedin the following schedule. The table shows that with each additional unit of mango consumed,the marginal utility or additional utility decreases.

Units of Mangoes Total Utility Marginal Utility0 0 01 7 72 11 43 13 2

4 14 15 14 06 13 -1

The total utility and marginal utility curves are graphically expressed as:


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Law of Diminishing Marginal Utility

-2

0

2

4

6

8

10

12

14

16

0 5 10

Quantity of Mangoes

Total Utility

Marginal Utility

Note that the total utility is maximum when marginal utility is zero.

Difference between Short Run and Long Run

Short Run Long Run

It is the time period in which at least thequantities of one input are fixed while thequantities of other inputs can be varied.

It is the time period in which the quantities ofall the inputs (fixed or variable) can beincreased.

Law of Diminishing Marginal ReturnsIt may be stated as:

Increasing the quantities of one input while keeping all other inputs constant, the totaloutput increases at a decreasing rate with each unit of input added.

ExplanationWhen fixed resources are used to their capacity, adding variable inputs while fixed resourcesare kept constant, the productivity of each additional input or its marginal product decreases.Therefore, increasing the variable factor gives more output at a decreasing rate. This law canbe explained by a schedule and a graph.

Fixed Factor (Land) Labor Total Product Marginal Product5 1 20 205 2 45 255 3 65 205 4 80 15

5 5 90 10

Law of Diminishing Returns

03

6

9

12

15

18

21

24

27

30

0 1 2 3 4 5 6

Labor

MarginalProduct


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Returns to Scale

Suppose the inputs are capital or labor in a production process, and we double each of these(m= 2). We want to know if our output will more than double, less than double, or exactlydouble. This leads to the following definitions:

Increasing Returns to ScaleWhen the inputs are increased by mand the output increases by more than m.

Constant Returns to ScaleWhen the inputs are increased by m and the output increases by exactly m.

Decreasing Returns to ScaleWhen the inputs are increased by m and the output increases by less than m.

Factors of Production

In a market based economy, we can classify factors of production as follows:1. Land with natural resources.2. Labor.3. Capital.4. Entrepreneur.

Below, we try to present details of our proposed classification.

Land with natural resources It includes all things of value which are naturally occurringgoods such as soil, minerals, land etc and that are used in the creation of different products.The payment for the use of those resources in fixed supply is rent. When these are sold, theircompensation is profit.

LaborProviding physical or mental exertion by way of contract for consideration in the formof wage or salary. It does not include entrepreneurial labor as the compensation forentrepreneurial labor is the residual outcome of the productive activity and contains anelement of risk and uncertainty.

Capital Stock - It includes human-made goods or produced means of production. These aregoods which are used in the production of other goods. These include machinery, tools andbuildings. The payment for the use of those resources in fixed supply is interest as capitalalso includes financial capital.

EntrepreneurIt refers to an economic entity, natural person or corporation (juristic person),which undertakes the ultimate responsibility for the production process. It undertakes theresponsibility to bear losses (if any) and is entitled to the entire residual positive economic

outcome after interest on capital and rent on land and wages have been paid.

Fixed Costs and Variable Costs

Fixed CostFixed cost is the cost that is independent of the output level. It remains same at each level ofOutput. Changes in output level do not affect fixed cost. It is represented as a horizontal curveon the graph. Fixed cost curve is shown below:


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Fixed Cost and Total Cost

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20

25

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35

40

0 2 4 6

Output

Cost Fixed Cost

Total Cost

Average Fixed CostIt is total fixed cost per unit of output. It always decreases with the increase in the level ofoutput. With the increase in output, the fixed cost is distributed over many units. That is why;average fixed cost curve always decreases.

Variable CostIt is the cost of all the variable inputs. It increases as the output increases. At zero level ofoutput, there is no variable cost.

Variable Cost

0

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0 2 4 6

Output

Variable

Cost

Variable Cost

Average Variable CostIt is total variable cost per unit of output. It decreases initially and then it starts to increasewith the increase in output. It serves as a minimum compensation for Firm when it is incurringlosses. Firm will shut down operations if it is not able to cover its average variable cost.

Types of Variable Cost Functions

Let us say KESC gives us this electricity price slab as follows:

1200 Units Rs 18/unit

200500 Units Rs 20/unit5001,000 Units Rs 30/unit

Based on this data, if Firm uses these levels of electricity, then variable cost will be increasingat an increasing rate.

100 units Total bill = 18 x 100 = 1,800500 units Total bill = 20 x 500 = 10,0001000 units Total bill = 30 x 1,000 = 30,000


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Let us say PTCL gives us this internet price slab as follows:

1MB3 MB Rs 1,0004MB7 MB Rs 1,5007MB10 MB Rs 1,700

Based on this data, if Firm uses these levels of electricity, then variable cost will be increasing

at a decreasing rate.

1MB Total bill = 1,0004MB Total bill = 1,5007 MB Total bill = 1,700

Suppose a supplier supplies plastic to the dollar company for its pens at a rate of Rs 2 perunit. In this case, total variable cost will be an upward sloping curve, but a straight line with aconstant slope.

Production & Cost Analysis

Fill the other two columns, Average Cost & Marginal Cost

Labor Input Total Cost Average Cost Marginal Cost

0 100

1 120 =120/1 = 120 =(120-100)/(1-0) = 20

2 170 =170/2 = 85 =(170-120)/(2-1) = 50

3 250 =250/3 = 83.33 =(250-170)/(3-2) = 80

4 350 =350/4 = 87.5 =(350-250)/(4-3) = 100

5 500 =500/5 = 100 =(500-350)/(5-4) = 150

Fill the two other columns, Average Product and Marginal Product.

Labor Input Total Product Average Product Marginal Product0 01 12 =12/1 = 12 =(12-0)/(1-0) = 12


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2 28 =28/2 = 14 =(28-12)/(2-1) = 163 36 =36/3 = 12 =(36-28)/(3-2) = 84 42 =42/4 = 10.5 =(42-36)/(4-3) = 65 46 =46/5 = 9.2 =(46-42)/(5-4) = 4

Fill the other two columns, Average Variable Cost & Average Fixed Cost

Quantity Total Cost AVC AFC

0 4001 4802 8003 1,2004 1,8005 2,600

TC = TFC + TVCAt Zero quantity, TVC=0TC = TFC when TVC=0

AVC = TVC/QAFC = TFC/Q

ATC = TC/QATC = AVC + AFC

Quantity Total Cost TFC TVC AVC AFC0 400 400 01 480 400 =480 - 400 TVC/Q TFC/Q2 800 400 =800 - 400 TVC/Q TFC/Q3 1,200 400 =1,200 - 400 TVC/Q TFC/Q4 1,800 400 =1,800 - 400 TVC/Q TFC/Q5 2,600 400 =2,600 - 400 TVC/Q TFC/Q

Economies of Large Scale Production

The benefits obtained through large scale production are called economies of large scaleproduction. There are several advantages of large scale production. Broadly speaking, wedivide these benefits as internal economies and external economies of large scale production.

1. Internal EconomiesThe economies of large scale production benefiting an organizations internal structure arereferred to as internal economies of large scale production. Some of the internal economiesthat firms enjoy through large scale production are as follows:

a) Technical EconomiesAdvancement in technology is the most important tool to reduce cost of production andincrease productivity. But, new and improved technology is introduced after heavy investmentin research and development. A large scale producer can afford research and developmentspending and achieve increase in productivity which reduces cost of production.

b) Administrative EconomiesIn a large scale firm, each major task is performed by a specialized department. Therefore, abusinessperson has to worry only about the policy matters because he can pass on the workto his supervisors who are specialized in managing a particular task better.

c) Commercial EconomiesA firm needs raw materials to produce output. A large scale firm needs more inputs toproduce more outputs. It has to purchase raw materials in large quantities to produce moreoutput. A large scale firm can obtain raw materials at a cheaper price if it buys them in largequantity. Therefore, the cost of production decreases.


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d) Financial EconomiesTo operate any business activity, a firm needs finance. A large scale firm has a generallygreater reputation than a small scale firm. Because of its reputation, a large scale firm canobtain finance from banks and also purchase raw materials on credit.

e) Risk Bearing EconomiesNo business is without a risk. To operate any business, one needs to take risk. But, takingrisks also depends on risk bearing capability of a firm. A large scale producer or a firm has a

greater risk bearing capacity than a small scale firm. It can take greater risks and runsuccessfully through a financial crisis because of adequate capital.

2. External EconomiesThe economies of large scale production benefiting an organizations external environmentare referred to as external economies of large scale production. Some of the externaleconomies that firms enjoy through large scale production are as follows:

a) Reduced cost of productionSince a large scale firm can spend a huge amount on research and development, it has abetter chance of achieving advancements in technology and reducing cost of productionthrough increased productivity. Therefore, a large scale firm can reduce the price to increasethe demand of its products and still earn a higher profit on its products.

b) Establishment of supporting industriesA large scale firm can become its own supplier. It can produce equipments and raw materialsitself which it used to purchase from other firms. It can reduce the cost of production becausea firm producing its own supplies will not have to pay profit to other firms.

c) Establishment of subsidiary industriesA large scale producer can use wasted output to produce some useful by-products. This way,it will earn more profit and will be able to use its resources optimally.

d) Availability of trained manpowerA large scale firm can hire more trained workers for each department because it can pay thehigher salaries for getting specialized workers. But, the benefit obtained from specialization

and division of labor is much more than the extra cost of hiring trained manpower.

e) Better prospects of market leadershipSince a large scale producer can reduce its cost of production, it can transfer this benefit to itscustomers by charging them a lower price. This way, it will be able to maintain bettercustomer relationships and gaining the market share.

Diseconomies of Scale

The diseconomies are the disadvantages arising to a firm or a group of firms due to largescale production.

Internal Diseconomies of ScaleIf a firm continues to grow beyond the optimum capacity, the economies of scale disappearand diseconomies will start operating. For instance, if the size of a firm increases, after apoint, managing Firm becomes difficult which will increase the average cost of production ofthat firm. This is known as internal diseconomies of scale.

External Diseconomies of ScaleIf the size of Firm increases beyond a limit, it will create diseconomies in production which willbe common for all firms in a locality. For instance, the growth of an industry in a particulararea leads to high rents and high costs of utilities. These are the external diseconomies asthis affects all Firms in the industry located in that particular region.

Economic & Business Profit

Q1.After working as a head chef for years, Jared gave up his $60,000 salary to open his ownrestaurant last year. He withdrew $50,000 of his own savings that had been earning 4%


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interest and borrowed another $100,000 from the bank at a rate of 5%. As the restaurantspace he was leasing had no separate office, Jared converted his basement apartment intooffice space. He had previously rented the apartment to a student for $300/month. Thefollowing table summarizes his operations for the past year.

Total sales revenue $590,000

Employee wages $120,000

Materials $350,000Interest on loan $5,000Utilities $10,000Rent $25,000

Total explicit costs $510,000

a. What is Jared's accounting profit?b. Suppose Jared could have used his talents to run a similar kind of business instead.

If he values his entrepreneurial skill at $10,000 annually, find Jareds total implicitcosts

What was Jared's economic profit last year?

Solution

a. Jared's accounting profit is the difference between total sales revenue and his explicitcosts, or $80,000 in this example. $80,000 = $590,000$510,000.

b. Implicit costs include his foregone wages ($60,000), the value of his entrepreneurialskill ($10,000), foregone rent on the apartment ($3,600 = 12 x $300) plus theforegone interest on his savings ($2,000 = .04 x $50,000). These total $75,600.

Jared's total economic cost, explicit plus implicit, was $585,600 = $510,000 + $75,600. Hiseconomic profit is the difference between revenue and economic cost, or $4,400 (= $590,000

$585,600).

Q2.An IBA graduate turns down a job offer of 720,000 a year & starts his own business.

He will invest Rs. 1,200,000 of his own money which has been in a bank account earning 6%interest per year.

He also plans to use a building he owns in Karachi that has been rented for Rs. 20,000 permonth.

Revenue in the new business during the 1st year was Rs. 3,000,000 while other expenseswere:

Advertising Rs. 75,000Taxes Rs. 60,000Employees Salaries Rs. 500,000

Supplies Rs. 50,000

Required:Calculate Accounting Profit and Economic ProfitSolution:

Total Revenue = Rs 3,000,000Total Explicit Costs = Advertising Cost + Taxes + Salaries + SuppliesTotal Explicit Costs = Rs 685,000

Business Profit = Total Revenue - Total Explicit CostsBusiness Profit = 3,000,000685,000 = 2,315,000

Total Implicit (Opportunity) Costs = Job Income + Rent Income + Interest IncomeTotal Implicit (Opportunity) Costs = 720,000 + (20,000x12) + (0.06 x 1,200,000)Total Implicit (Opportunity) Costs = 720,000 + 240,000 + 72,000Total Implicit (Opportunity) Costs = 1,032,000


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Economic Profit = Total revenueTotal Explicit Coststotal Implicit CostsEconomic Profit = 3,000,000685,0001,032,000 = 1,283,000

Basic Characteristics of Market Structures

Perfect Competition There are large number of buyers and sellers. Buyers and sellers are price takers. Products are homogenous or identical with no differentiation. There are no barriers to entry and exit. Buyers and sellers are perfectly informed of the market conditions.

Monopoly There is only one seller. A single seller is a price setter. A single seller has a complete control over price. There are no close substitutes available. There are no competitors in the market.

Oligopoly There are few producers. Products may be identical or differentiated. Producers have some control over price. Firms advertise their products to create demand for them.

Monopolistic Competition There are a large number of sellers. Products are differentiated (either real or perceived differences). None of the sellers has a large share of the market. Sellers have some control over price. Firms advertise their products to create demand for them.

Equilibrium in Short Run under Perfect Competition

A firm under perfect competition faces a horizontal demand curve. It means that demand of itsproducts is perfectly elastic. If it increases the price of its product by even a smaller quantity,the demand for its products will immediately drop down to zero. Since the products arehomogenous and every firm is a price taker, the price remains constant and is equal tomarginal revenue at each level of quantity sold.

P = Average Revenue = Marginal revenue

The competitive firm will be in equilibrium at a point where its marginal cost is equal tomarginal revenue. Firms equilibrium at different points determine whether Firm is incurring

losses or earning profits and whether it should continue operations or shut down. Followingcases determine Firms performance.

Cases of Equilibrium If the marginal revenue intersects marginal cost at a point above average cost, the

competitive firm will enjoy supernormal profits.

If the marginal revenue intersects marginal cost where it also equals average cost, thecompetitive firm will enjoy normal or zero economic profits (including sellerscompensation for efforts).

If the marginal revenue intersects marginal cost at a point below average total cost butabove average variable cost, the competitive firm is incurring losses but it will not shut

down because it is able to cover the variable cost and a part of fixed cost. By shuttingdown at a point above average variable cost, it will incur a greater loss than fromcontinuing operations.


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If the marginal revenue intersects marginal cost at a point below average variable cost,Firm will minimize losses by shutting down.

Equilibrium in Long Run under Perfect Competition

A perfectly competitive firm in the long run is in equilibrium at a point where marginal revenueintersects marginal cost at a point where it also equals minimum average total cost. Thereforeat this point,

P = Marginal Revenue = Marginal Cost = Minimum Average Cost

If there are short run profits or losses in different industries operating under perfectcompetition, then short run profits will attract entry and short run losses will induce exit. Entryand exit will be constantly happening across industries until there is zero economic profit in allindustries. Unless that happens, entry or exit can benefit firms. With no barriers to entry andexit, any short run profits and losses will be wiped out in long run in competitive markets.

It also implies that in the long run, Firm can only survive if it can cover its minimum averagetotal cost (AVC as well as AFC). Therefore, zero economic profit point is the long runequilibrium point of a perfectly competitive firm.

In the long run, perfect competition has both productive efficiency and allocative efficiency.Productive efficiency implies producing the profit maximizing level of output most cheaply.

Allocative efficiency implies producing the kind of goods in such quantities for which the pricethe consumers are willing to pay equals the marginal cost of production. If people are willingto pay a price for a good for which P=MC, then, it will be produced by the competitive firms.


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Mathematical Proofs Related to Market Structures

Proof of P=MCTP = TR - TCTP = PQ - TCdTP/dQ =d/dQ(P.Q)d/dQ(TC)=0

Taking first derivative with respect to Q is same as calculating slope of a function.

Slope of TR is MR and slope of TC is MC.dTR/dQ reads as change in TR with respect to change in Q, which is MR.dTC/dQ reads as change in TC with respect to change in Q, which is MC.

dTP/dQ= P - MC=0Since P=MR in perfect competitionP = MC

Numerical Proof of MR


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A monopolist can restrict output and produce much lower output even if Average Total Cost(ATC) is declining further. By restricting output due to non-availability of substitutes, theMonopolist can set its own price and has the most control over prices than any othercompetition.

Green Rectangle is the economic profit region. Equilibrium takes place where MR=MC. Qm isthe equilibrium level of output and Pm is the equilibrium level of price.

Profit Maximization under Monopolistic Competition

In Monopolistic Competition,

There are a large number of sellers. Products are differentiated (either real or perceived differences). Sellers have some control over price. Firms advertise their products to create demand for them.

In monopolistic competition, there are limited barriers to entry. So, when a differentiatedproduct is offered exclusively by one innovating firm, it may get short run profits, but, imitationand adaptation will decrease the capability to earn short run profits and with more firmsoffering the good for sale, demand for Firm that has economic profit in the short run will godown and profits are beaten down to zero in the long run.

A monopolistically competitive firm confronts a downward-sloping demand curve for its output.Modest changes in the output or price of any single firm will have no perceptible influence onthe sales of any other firm. The relative independence of monopolist competitors means thatthey do not have to worry about retaliatory responses to every price or output change.

Another characteristic of monopolistic competition is the presence of low barriers to entry.

In the figure below, purple rectangle is the economic profit region. Equilibrium takes placewhere MR=MC. Qa is the equilibrium level of output and Pa is the equilibrium level of price.


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With low barriers to entry, new firms will enter the market if there is economic profit. Economicprofit is the difference between total revenues and total economic costs (including explicitcosts and implicit costs).

When firms enter a monopolistically competitive industry, the market supply curve shifts to theright. The demand curves facing individual firms shift to the left. In the long run, there are noeconomic profits in monopolistic competition as shown in figure below.

Price Discrimination

Price discrimination exists when sales of identical goods or services are transacted atdifferent prices. Price discrimination can only be a feature of monopolistic and oligopolisticmarkets, where market power can be exercised. In perfect competition, price discrimination isnot possible because perfectly competitive firm does not have a price setting ability.

Price discrimination can be used by educational institutions, charging higher prices from richstudents and lower prices from poor students. They offer programs like self-finance schemes,so that if rich students want, they can get admission in universities. The higher fees takenfrom these students are used to pay scholarships to the needy students. Price discriminationcan be used by medical institutions, charging higher prices from rich patients and lower pricesfrom poor patients. Other examples include airline fares, restaurant food packages, telecomcompanies call and SMS packages.

There are three forms of price discrimination. Charge each customer max willingness to pay Charge one price for first unit and a lower price for subsequent units Charge different customers different prices


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Game Theory

In Game Theory analysis, we try to find out the optimal choice for a player (Oligopolist) giventhe choices by other player (competitor or rival). Such interdependent decision making is thehallmark of Oligopoly markets. We follow these steps in solving the problem.

Player is an oligopolist in game theory. Payoff is an outcome of a certain action by a player.Payoff matrix is a table showing all possible actions that can be taken by each player withtheir payoffs. Dominant Strategy is the optimal strategy for player regardless of what the otherplayer does.

1) Find dominant strategy for each player separately. If each player has a dominantstrategy in the game, each would select the dominant strategy and game will havedominant strategy equilibrium.

2) If only one player has a dominant strategy, then the player with dominant strategy willplay the dominant strategy. That is rule of the game. If dominant strategy exists forplayer A, then player A would select the dominant strategy. The other player, player B

will select the optimal choice that exists for him, given the choice taken by player A.

Example 1: Payoff Matrix for an Advertising Game (in 000s PKR)

Firm BAdvertise DontAdvertise

Firm A Advertise (4,3) (5,1)Dont Advertise (2,5) (3,2)

To solve this game, we first have to check whether each or one of the player has a dominantstrategy. By advertising, Firm A would earn an increase in profit of Rs 4,000 when Firm B alsoadvertises and Rs 5,000 when Firm B does not advertise. By not advertising, Firm A wouldonly earn an increase in profit of Rs 2,000 when Firm B advertises and Rs 3,000 when Firm B

also does not advertise. So, regardless of what Firm B does, Firm A earns higher profits byadvertising. So, Firm A has dominant strategy, which is to advertise.

Next, we check whether Firm B also has a dominant strategy. By advertising, Firm B wouldearn an increase in profit of Rs 3,000 when Firm A also advertises and Rs 5,000 when Firm Adoes not advertise. By not advertising, Firm B would only earn an increase in profit of Rs1,000 when Firm A advertises and Rs 2,000 when Firm A does not advertise. So, regardlessof what Firm A does, Firm B earns higher profits by advertising. So, Firm B has dominantstrategy, which is to advertise.

Both Firms will play their dominant strategies, hence, there will be equilibrium at (4,3) whenboth advertise.

Example 2: Payoff Matrix for an Advertising Game (in 000s PKR)Firm BAdvertise Dont Advertise

Firm A Advertise (4,3) (5,1)Don Advertise (2,5) (6,2)

To solve this game, we first have to check whether each or one of the player has a dominantstrategy. By advertising, Firm A would earn an increase in profit of Rs 4,000 when Firm B alsoadvertises and Rs 5,000 when Firm B does not advertise. By not advertising, Firm A wouldearn an increase in profit of Rs 2,000 when Firm B also advertises and Rs 6,000 when Firm Balso does not advertise. Firm A does not have a dominant strategy.

Next, we check whether Firm B has a dominant strategy. By advertising, Firm B would earn

an increase in profit of Rs 3,000 when Firm A also advertises and Rs 5,000 when Firm A doesnot advertise. By not advertising, Firm B would only earn an increase in profit of Rs 1,000when Firm A advertises and Rs 2,000 when Firm A does not advertise. So, regardless of what


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Firm A does, Firm B earns higher profits by advertising. So, Firm B has dominant strategy,which is to advertise.

Rule of the game is to follow the dominant strategy, if it exists. Firm A knows that Firm B hasa dominant strategy, which is to advertise. If Firm B will play its dominant strategy, Firm A willearn increase in profits of Rs 2,000 by not advertising and Rs 4,000 while advertising. Hence,Firm A will also advertise. There will be equilibrium at (4,3) when both advertise. Thisequilibrium is Nash Equilibrium. Nash Equilibrium occurs where each player chooses optimal

strategy, given the choice by other player. Each dominant strategy equilibrium is a NashEquilibrium, but not every Nash Equilibrium is dominant strategy equilibrium.

Example 3: Payoff Matrix for Prisoners Dilemma (in Years)

Individual BConfess Dont Confess

Individual A Confess (5,5) (0,10)Don Confess (10,0) (1,1)

Essence of this kind of problem is that both players do not cooperate or cannot cooperate.Since they cannot cooperate, they choose their dominant strategies which make them worseoff than if they had cooperated. Its application is widespread. Two firms in a duopoly (a typeof oligopoly) could enter into price wars to beat the competition and reduce their prices to

such a level that eventually they charge the price which would have prevailed in a perfectcompetition.

Even though, there are two firms, but the competition could still from the point of view of price,give the same result as that of a perfect competition. That is very beneficial for society. That iswhy, Competition Commission of Pakistan is an authority which ensures that there is nohidden cooperation among oligopolists. In Pakistan, Cement sector has seen tacitcollusion/cooperation. Sugar mills have also behaved in similar way.

To solve this game, we first have to check whether each or one of the player has a dominantstrategy. By confessing, Individual A would get a sentence of 5 years when the Individual Balso confesses and goes free when the Individual B does not confess. By not confessing,Individual A would get a sentence of 10 years when the Individual B confesses and 1 yearwhen the Individual B also does not confess. So, regardless of what Individual B does,Individual A has a dominant strategy to confess.

Next, we check whether Individual B has a dominant strategy. By confessing, Individual Bwould get a sentence of 5 years when the Individual A also confesses and goes free when theIndividual A does not confess. By not confessing, Individual B would get a sentence of 10years when the Individual A confesses and 1 year when the Individual A also does notconfess. So, regardless of what Individual A does, Individual B has a dominant strategy toconfess.

Both individuals will play their dominant strategies, hence, both will confess and get asentence of (5,5) years. This is not the best outcome for them. If they have both notconfessed, they will have got only the sentence for 1 year. But, What if the other does line ofthinking forces them to choose an action which is worst for them, but good for society.Detectives convict criminals through this. Competition Commission of Pakistan by disallowingcollusion enables competition in the market and which results in price wars and this result infirms charging lower prices at such a level that they would be equal to prices charged if therewas perfect competition. Consumers benefit through this, else if oligopolists cooperate easily,they can earn monopoly like profits.

Example 4: Price Competition & Prisoners Dilemma (in 000s Rs.)

Firm BLow Price High Price

Firm A Low Price (2,2) (5,1)High Price (1,5) (3,3)

To solve this game, we first have to check whether each or one of the player has a dominantstrategy. By lowering price, Firm A would get an increase in profit of Rs 2,000 when Firm Balso charges low price and Rs 5,000 when Firm B charges high price. By keeping high price,Firm A would get an additional profit of Rs 1,000 when Firm B charges low price and Rs 3,000


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when Firm B also charges high price. So, regardless of what Firm B does, Firm A has adominant strategy to charge low price.

Next, we check whether Firm B has a dominant strategy. By lowering price, Firm B would geta increase in profit of Rs 2,000 when Firm A also charges low price and Rs 5,000 when Firm

A charges high price. By keeping high price, Firm B would get an additional profit of Rs 1,000when Firm A charges low price and Rs 3,000 when Firm A also charges high price. So,regardless of what Firm A does, Firm B has a dominant strategy to charge low price.

Both individuals will play their dominant strategies, hence, both will charge lower price andearn additional profit of Rs 2,000 each. This is not the best outcome for them. If they haveboth charged high price, they will have got additional profits of Rs 3,000 each. But, What ifthe other does line of thinking forces them to choose an action which is worst for them, butgood for society. Consumers benefit through this, else if oligopolists cooperate easily, theycan earn monopoly like profits.

Example 5: Pricing Game with a Threat



From the above example, it should be clear that equilibrium will occur at (3,4). Firm A has adominant strategy to charge high price. Firm B has a dominant strategy to charge lower price.Given the low price charged by Firm B, Firm A will charge higher price to earn more profits.

Example 6: Entry Deterrence (Uncredible Deterrent)

Firm BEnter Do Not Enter

Firm A Low Price (4,-2) (6,0)High Price (7,2) (10,0)

This is an example of barriers to entry. From the above example, it should be clear that

equilibrium will occur at (7,2) and Firm B will enter the market. Firm A will not be able to stopFirm B from coming into the market.

Firm A has a dominant strategy to charge high price. Firm B does not have a dominantstrategy. But, given the high price charged by Firm A, Firm B will enter the market since byentering; it earns positive profits if Firm A is going to play its dominant strategy, which is tocharge a high price.

Example 7: Entry Deterrence (Credible Deterrent)

Firm BEnter Do Not Enter

Firm A Low Price (4,-2) (6,0)High Price (3,2) (8,0)

This is an example of barriers to entry. Equilibrium will occur at (6,0) and Firm B will not enterthe market. Firm A will be able to stop Firm B from coming into the market.

Firm A does not have a dominant strategy. Firm B does not have a dominant strategy either.No firm has a dominant strategy. But, the objective of Firm A is to stop Firm B from enteringthe market.

By charging high price, Firm A will not be able to stop Firm B from entering the market and ifFirm B enters, the profit of Firm A will also shrink. By charging low price, Firm A will be able tostop Firm B from entering the market and if Firm B does not enter, the profit of Firm A will alsoincrease. Equilibrium will occur at (6,0).

Application:In industries, where initial infrastructure cost is very high, new entrants will notbe able to survive by charging low prices. Pakistan produces steel, but does not produce carsfrom scratch. It is because cars produced by Japan are less costly. Hence, Japanese car


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makers are able to charge lower prices and still be profitable, but, for Pakistani firms, it is notpossible to compete at low prices.

Example 8: International Competitiveness (First Mover Advantage)

Firm BEnter Not Enter

Firm A Enter (-10,-10) NNot Enter (0,100) (0,0)

Sometimes, in industries, where initial infrastructure cost is very high and market is so small,the costs could only be kept low at higher level of output. If market is small and if both firmsenter into a small market, then each will have to incur high fixed costs initially. As a result,they both could be in loss. It is because with both firms in the market, the costs are borne bythem separately, but their market share will be distributed from the same pie. Customer wonby one firm is customer lost by the other firm.

If both firms do not enter market, they earn nothing and lose nothing. If both simultaneouslyenter, both lose. In such cases, one firm could look for first mover advantage. Firm whichenters first, earns all the profits. But, since firms do not know about others and since theyhave to incur fixed costs which will be not be a reversible action, they tend to hesitate. In suchcases, they seek subsidies from the government and the confirmation that if they enter the

market, government will not allow the other firms to enter.

Application: Many multinationals come to Pakistan with this pact with government thatgovernment will not allow others to come and compete.

Q1. Pricing Game



Required Identify dominant strategies for both players (if any). Find Nash Equilibrium &

Cartel Equilibrium. Does this game have prisoners dilemma.

SolutionA has a dominant strategy in charging low price. B has a dominant strategy in charging lowprice as well. Dominant strategy equilibrium as well as Nash equilibrium is {(A,B)=(LP,LP)}.Equilibrium outcome is {(A,B)=(10,10)}. Cartel equilibrium is {(A,B)=(50,50)}. This game hasprisoners dilemma. Cartel solution is more welfare enhancing to both players.

Q2. Entry Deterrence

Potential EntrantEnter Not Enter

Large Oligopolist High Price (50,20) (150,0)

Low Price (70,-10) (130,0)

RequiredFind the outcome of game. Briefly explain your reasoning. Does this game havecredible deterrence?

SolutionBoth players do not have any dominant strategy. Hence, their actions cannot be pre-determined. If the large oligopolist wants to deter entry, then, he needs to create a crediblethreat of charging low price. By installing more capacity and announcing discount packages, itcan create a credible threat in the mind of the potential entrant. If potential entrant believes inthat threat, then it will not enter and the game will end with large oligopolist charging low priceand potential entrant not entering the industry.


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Market Concentration

Oil Exploration Daily Sales (in Rs.) Automobile Sector Daily Sales (in Rs.)

OGDC 25,000,000 PSMC 15,000,000

POL 12,000,000 IMC 60,000,000

PPL 3,500,000 Deewan Motors 5,000,000

Mari 5,500,000 Atlas 40,000,000

PARCO 8,000,000 Hino 50,000,000

Total 54,000,000 Total 170,000,000

Required

a) Calculate Four Firm Concentration Ratio for Oil exploration & Automobile sector.b) Calculate Herfindahl Index for Oil exploration & Automobile sector.c) Based on answer in part a) which industry is more competitive.d) Based on answer in part b) which industry is more competitive.

Solution

Industry Oil Exploration

Oligopolist Daily Sales Four Firm Contration Ratio Market Share % (Si) (Si2)

OGDC 25,000,000 46.3000 2144

POL 12,000,000 Market Share of 4 largest firms 50,500,000 22.2200 494

PPL 3,500,000 Total Market Share 54,000,000 6.4800 42

Mari 5,500,000 10.1900 104

PARCO 8,000,000 Ratio= 41,000,000/44,000,000 0.94 14.8100 219

Total 54,000,000

HI S12+S2

2+S3

2+S4

2+S5

2

HI 3003

Industry Automobiles

Oligopolist Daily Sales Four Firm Contration Ratio Market Share % (Si) (Si2)

PSMC 15,000,000 8.8200 78

IMC 60,000,000 Market Share of 4 largest firms 165,000,000 35.2900 1245

Deewan 5,000,000 Total Market Share 170,000,000 2.9400 9

Atlas 40,000,000 23.5300 554

Hino 50,000,000 Ratio= 41,000,000/44,000,000 0.97 29.4100 865

Total 170,000,000

HI S12+S2

2+S3

2+S4

2+S5

2

HI 2750

Which industry is more competitive as pe r HI Ans. Automobiles.

Which industry is more competitive as per 4-Firm Ratio Ans. Oil Exploration

Documents

Microeconomics Notes for Beginners