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Inflation an its conse8%ences ................................................................................................ ....... +3!P"ices an incomes polic .............................................................................................................. +30

The Deman Fo" An S%ppl of Mone ............................................................................................ +3'The 8%antit theo" of mone ........................................................................................................ +3':e nesian #ie6s on the eman fo" mone ........................................................................... ....... +/3The moneta"ist #ie6point ............................................................................................................... +/!

A compa"ison of the t6o #ie6s ...................................................................................................... +/$Fiscal Polic ....................................................................................................................................... +!7

Fiscal polic ) national income an eman mana4ement .............................................................. +!7Ta2ation polic an its effects ........................................................................................................ +!/

Inte"national T"a e ...................................................................................................................... ....... +!'A&sol%te an compa"ati#e a #anta4e ................................................................................. ........ ... +!'F"ee t"a e an its a #anta4es ..................................................................................................... .... + +F"ee t"a e an p"otection ................................................................................................................ + ,

The 9alance Of Pa ments. E2chan4e Rates ..................................................................................... . + $The &alance of pa ments ................................................................................................................ + $Components of the &alance of pa ments ............................................................................... ........ + 'The Te"ms of T"a e ........................................................................................................................ +0,E2chan4e "ates .......................................................................................................................... ..... +03E2chan4e "ate policies of 4o#e"nments .............................................................................. ........ ... +0E%"opean moneta" coope"ation ............................................................................................. ....... +00


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The tools of economic analysis

In 4oin4 a&o%t thei" 6o"- economists ha#e to eal 6ith a n%m&e" of #a"ia&les. To the economist) a#a"ia&le is an thin4 that infl%ences the &asic ecisions) 6hich a"e the s%&?ect of his science1 6hat 6ill

&e p"o %ce ) 6hat 6ill &e cons%me an 6ho 6ill &enefit f"om the cons%mption Economic #a"ia&lesthe"efo"e incl% e) amon4st man othe"s1

;a< p"ices of commo ities an of se"#ices=

;&< 8%antities of p"o %ction "eso%"ces a#aila&le=

;c< n%m&e"s of s-ille an %ns-ille 6o"-e"s=

; < cons%me" attit% es ;since these can affect ecisions a&o%t spen in4 an sa#in4


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The c%"#e f"om @) "o%n to 9) sho6s the #a"io%s com&inations of 4%ns an &%tte" that a societ canma-e) if it %ses its limite "eso%"ces efficientl .

;a< The fi"m can choose to ma-e %p to1

;i< @+ %nits of 4%ns an no &%tte"=;ii< 9 + %nits of &%tte" an no 4%ns=;iii< @, %nits of 4%ns an 9, of &%tte" ;point p on the c%"#e4oo > on onea2is an >all othe" 4oo s> on the othe" a2is.

Choice in#ol#es sac"ifice. If the"e is a choice &et6een ha#in4 4%ns an ha#in4 &%tte") an a co%nt"chooses to ha#e 4%ns) it 6ill &e 4i#in4 %p &%tte" to ha#e the 4%ns. The cost of ha#in4 4%ns canthe"efo"e &e "e4a" e as the sac"ifice of not &ein4 a&le to ha#e &%tte".

The"e is a sac"ifice in#ol#e in the choices of cons%me"s an p"o %ce"s) as 6ell as the choices of4o#e"nments.

S%ppose a cons%me" has a limite amo%nt of mone ) an chooses to &% some e44s. One meas%"ementof the cost of the e44s is thei" mone p"ice. Anothe" 6a of loo-in4 at the cost is to consi e" thesac"ifice in#ol#e in choosin4 e44s "athe" than) sa ) mil-. If the cons%me" has some e44s) he o" she is4i#in4 %p the oppo"t%nit to ha#e some mil-) an the &enefits that the mil- 6o%l ha#e p"o#i e .The cost of an item meas%"e in te"ms of the alte"nati#es fo"4one is calle its oppo"t%nit cost. Th%sthe oppo"t%nit cost of &% in4 si2 e44s can &e meas%"e as the t6o pints of mil- o" the one &%s "i ethat co%l ha#e &een &o%4ht instea . Simila"l ) the oppo"t%nit cost of a co%nt" ha#in4 a n%clea"missile co%l &e meas%"e in te"ms of the n%m&e" of schools that co%l ha#e &een &%ilt an staffe6ith the same amo%nt of "eso%"ces

At the le#el of the fi"m) the p"o %ction possi&ilit c%"#e can &e seen as sho6in4 the ma2im%m o%tp%tof iffe"ent alte"nati#e 4oo s 6hich the fi"m can p"o %ce 6hen all of its "eso%"ces a"e f%ll %se 5fo"e2ample) a fi"m mi4ht ope"ate p"o %ction lines capa&le of p"o %cin4 6ashin4 machines o""ef"i4e"ato"s. P"o %cin4 mo"e 6ashin4 machines &ea"s the oppo"t%nit cost of a lo6e" le#el of

p"o %ction of "ef"i4e"ato"s.

Shi"ts in the p odu!tion possi#ility !u ve

hen the a#aila&ilit of "eso%"ces chan4es) o" the"e is a e#elopment in technolo4 ) the p"o %ction possi&ilit c%"#e ma shift. Chan4es a"e ma e possi&le & e#elopments s%ch as a &i44e" la&o%" fo"ce)mo"e efficient metho s of 6o"-in4) mo"e efficient machine" ) o" a ne6 isco#e" of nat%"al "eso%"ces)s%ch as oil) nat%"al 4as o" mine"als.


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;a< If the p"o %ction possi&ilit c%"#e mo#es o%t6a" s) to the "i4ht) it means that the econom iscapa&le of p"o %cin4 mo"e 4oo s an se"#ices in total than it co%l &efo"e) an the"e iseconomic 4"o6th.

;&< If it mo#es to the left ;in6a" s< it means that the econom cannot p"o %ce as m%ch as &efo"e;e.4. &eca%se of a si4nificant ecline in pop%lation o" the e2ha%stion of a nat%"al "eso%"ces p"o %ction possi&ilit c%"#e shifts o%t f"om 99 to AA) the"e is economic 4"o6th. The societ co%lno6 s6itch f"om ma-in4 @ + of 4%ns an 9 + of &%tte" ;point < to ma-in4 @ , of 4%ns an 9 , of &%tte";point (


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Si4nificant feat%"es of all >mo e"n> economies a"e specialisation an the i#ision of la&o%") &oth of6hich inc"ease the nee fo" e2chan4e.

;a< Specialisation of la&o%" occ%"s 6he"e a 6o"-e" ma-es ?%st one t pe of p"o %ct o" p"o#i es onet pe of se"#ice 5e.4. a fa"me") a octo") an acco%ntant) a &%tche") an ente"taine") an so on.In i#i %als a"e not self 5s%fficient an o not each ma-e themsel#es all the p"o %cts an

se"#ices the "e8%i"e fo" thei" pe"sonal 6ants. Instea ) in i#i %als specialise in ma-in4 a pa"tic%la" 4oo o" se"#ice.

;&< The i#ision of la&o%" "efe"s to specialisation 6ithin a sin4le in %st" . The man%fact%"e of one p"o %ct sometimes calls fo" the 6o"- to &e i#i e %p into >s%&5 specialities>= fo" e2ample) inthe ma-in4 of moto" ca"s) the"e a"e ca" &o &%il e"s) paint sp"a e"s an en4ine t%ne"s.

The e2istence of specialisation an i#ision of la&o%" necessitates e2chan4e in a mo e"n ma"-eteconom ) &eca%se specialists a"e not self 5s%fficient) an the m%st e2chan4e 6hat the p"o %ce in"et%"n fo" othe" 4oo s an se"#ices the nee . In p"actice) most 6o"-e"s sell thei" la&o%" to a fi"m ;o" tothe 4o#e"nment< in e2chan4e fo" mone 6a4es. Mone is the me i%m of e2chan4e) 6hich pe"mitsthem to &% othe" 4oo s an se"#ices.

Alternative economic systemsMeans o" allo!atin% esou !es

Sca"cit of "eso%"ces means that choices m%st &e ma e a&o%t ho6 the "eso%"ces 6ill &e allocate .The"e a"e th"ee &asic "eso%"ce allocation ecisions.

;a< hat 4oo s an se"#ices sho%l &e p"o %ce This 6ill epen on 6hat cons%me"s 6ant to &% ) an 6hat the 6ill pa fo" each p"o %ct o" se"#ice. The ecisions a&o%t 6hat 6ill &e p"o %ce "elate to eman an s%ppl 1

;i< eman means the eman f"om c%stome"s o" cons%me"s) an satisfie eman is

act%al cons%mption=

;ii< s%ppl of 4oo s an se"#ices is "efe""e to as p"o %ction.

;&< Ho6 6ill these 4oo s an se"#ices &e p"o %ce The p"o %ce"s o" s%pplie"s of 4oo s anse"#ices mi4ht &e small companies) la"4e companies) monopolies) state5o6ne ente"p"ises o"the 4o#e"nment itself.

The choice a&o%t 6ho 6ill p"o %ce the 4oo s an se"#ices) an 6hat mi2 of "eso%"ces the p"o %ce"s 6ill %se) 6ill epen on the costs of "eso%"ces an the efficiencies of "eso%"ce%tilisation.

;c< To 6hom 6ill the 4oo s an se"#ices &e ist"i&%te Some 4oo s an se"#ices a"e p"o#i e

f"ee & the state ;e.4. in the U:) some health ca"e an e %cation< &%t othe"s ha#e to &e paifo". The ist"i&%tion of 4oo s an se"#ices 6ill the"efo"e epen on the ist"i&%tion of incomean 6ealth in societ . This in t%"n 6ill epen on 6hat in i#i %als an o"4anisations ea"n) anthe theo" of ist"i&%tion in economics is conce"ne 6ith 6hat "e6a" s a"e ea"ne & theo6ne"s of sca"ce economic "eso%"ces1 lan ) la&o%") capital an ent"ep"ene%"ship.

The 6a in 6hich these "eso%"ce ecisions a"e "esol#e epen s on the t pe of econom 6e a"eealin4 6ith. In this conte2t) a n%m&e" of te"ms a"e e2plaine &"iefl &elo6 an 6ill &e e#elope

mo"e f%ll in late" chapte"s.

;a< In a f"ee ma"-et econom ) the ecisions an choices a&o%t "eso%"ce allocation a"e left toma"-et fo"ces of s%ppl an eman ) an the 6o"-in4s of the p"ice mechanism. In othe"6o" s) 6hat p"o %ce"s 6ill ma-e an 6hat cons%me"s 6ill &% a"e -ept in &alance & the

p"ice that p"o %ce"s 6ill 6ant fo" thei" o%tp%t an the p"ice that cons%me"s a"e 6illin4 to pa .


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;&< In a cent"all planne econom o" comman econom ) the ecisions an choices a&o%t"eso%"ce allocation a"e ma e & the 4o#e"nment. Mone #al%es a"e attache to "eso%"ces anto 4oo s an se"#ices) &%t it is the 4o#e"nment that eci es 6hat "eso%"ces sho%l &e %se )ho6 m%ch sho%l &e pai fo" them) 6hat 4oo s sho%l &e ma e an 6hat thei" p"ice sho%l

&e.

;c< In a mi2e econom the ecisions an choices a"e ma e pa"tl & f"ee ma"-et fo"ces of s%pplan eman ) an pa"tl & 4o#e"nment ecisions. All national economies a"e mi2eeconomies) altho%4h 6ith iffe"in4 p"opo"tions of f"ee ma"-et an cent"all planne ecision5ma-in4 f"om one co%nt" to the ne2t.

Consumer behaviour

In this section 6e loo- at ho6 cons%me"s ma-e economic choices) so that 6e can then 4o on toe2amine ho6 those choices inte"act to4ethe" in economic ma"-ets.

A -e concept in the st% of cons%me" &eha#io%" is %tilit . Utilit is the 6o" %se to esc"i&e the

pleas%"e o" satisfaction o" &enefit e"i#e & a pe"son f"om the cons%mption of 4oo s. Total %tilit isthen the total satisfaction that a pe"son e"i#es f"om spen in4 his income an cons%min4 4oo s.

Ma"4inal %tilit is the satisfaction 4aine f"om cons%min4 one a itional %nit of a 4oo o" thesatisfaction fo"4one & cons%min4 one %nit less. If someone eats si2 apples an then eats a se#enth)total %tilit "efe"s to the satisfaction he e"i#es f"om all se#en apples to4ethe") 6hile ma"4inal %tilit"efe"s to the a itional satisfaction f"om eatin4 the se#enth apple) ha#in4 al"ea eaten si2.

Assumptions a#out ationality

e nee to ma-e some a itional ass%mptions a&o%t the "ational &eha#io%" of the cons%me") 6hich6as isc%sse ea"lie"1

;a< 4ene"all the cons%me" p"efe"s mo"e 4oo s to less=

;&< 4ene"all the cons%me" is 6illin4 to s%&stit%te one 4oo fo" anothe" p"o#i e its p"ice is "i4ht=

;c< choices a"e t"ansiti#e. This means that if at a 4i#en time a commo it &%n le A is p"efe""e to &%n le 9 an &%n le 9 is p"efe""e to &%n le C then 6e can concl% e that commo it &%n leA is p"efe""e to commo it &%n le C.

Actin4 "ationall means that the cons%me" attempts to ma2imise the total %tilit attaina&le 6ith alimite income. hen the cons%me" consi e"s 6hethe" an %nit of a 4oo is 6o"th &% in4 he is

eci in4 6hethe" the ma"4inal %tilit of &% in4 anothe" %nit of the 4oo e2cee s the ma"4inal %tilitthat 6o%l &e iel e & an alte"nati#e %se of the same amo%nt of mone .

If a pe"son has ma2imise his total %tilit ) it follo6s that he has allocate his e2pen it%"e in s%ch a 6athat the %tilit 4aine f"om spen in4 the last penn on each of the commo ities he &% s 6ill &e e8%al)i.e. the cons%me" 6ill spen his income in s%ch a 6a that he 4ets the same ma"4inal %tilit f"om thelast penn spent on each commo it .

Diminishin% ma %inal utility

As a pe"son cons%mes mo"e of a commo it ) the total satisfaction he 4ains 6ill contin%e to inc"ease) &%t the ma"4inal %tilit e"i#e f"om inc"easin4 cons%mption 6ill fall 6ith each a itional %nitcons%me . The ea"lie" e2ample of a man on holi a p"o#i es as ill%st"ation of this. The totalsatisfaction he 4ains 6ill inc"ease as his holi a 4ets lon4e". He is %nli-el ) ho6e#e") to e"i#e as m%ch%tilit f"om the secon a as m%ch as the fi"st) o" the thi" as m%ch as the secon ) an so on.

The la6 of iminishin4 ma"4inal %tilit states that) all othe" thin4s &ein4 e8%al) the a itionalsatisfaction e"i#e f"om cons%min4 a itional %nits of a commo it 6ill iminish 6ith each


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s%ccessi#e %nit cons%me . Total %tilit 6ill contin%e to "ise as each s%ccessi#e %nit is cons%me ) &%t ata ec"easin4 pace.

The >la6> applies onl if the ass%mptions of fi2e ho%sehol income an fi2e tastes o" fashion a"e#ali . If eithe" chan4es) the >la6> 6ill &e tempo"a"il inapplica&le %ntil a sta&le sit%ation is "e5esta&lishe .

;a< Income1 if income chan4es) the %tilit a cons%me" o&tains f"om a commo it 6ill &e affecte & the chan4in4 cons%mption of othe" commo ities. Fo" instance) someone ma "in- instantcoffee an s6itch to &% in4 f"esh54"o%n coffee.

;&< Tastes1 a chan4e in tastes) fashion o" attit% es ma occ%" as mo"e of a commo it is cons%mean ma"4inal %tilit ma inc"ease 6he"e s%ch a chan4e is ta-in4 place. Fo" e2ample) a pe"sonma p"o4"ess f"om an occasional &% e" of pict%"es into an o&sessi#e a"t collecto".

Consume e&uili# ium' ma %inal utilities and elative p i!es

e state ea"lie" that a cons%me" 6ill ma2imise his total %tilit ) 6ith a 4i#en income an tastes) at ale#el of cons%mption 6he"e the ma"4inal %tilit f"om the last penn spent is the same fo" eachcommo it &o%4ht.

This p"oposition can &e e#elope into an al4e&"aic fo"m%la. S%ppose that a ho%sehol &% s t6ocommo ities) an (.

*et the ma"4inal %tilit of a %nit of &e MU 2 an the ma"4inal %tilit of a %nit of ( &e MU *et the p"ice pe" %nit of ;in pence< &e P 2 an the p"ice pe" %nit of ( &e P

The ho%sehol 6ill attain a %tilit 5ma2imisin4 e8%ili&"i%m 6he"e the ma"4inal %tilit f"om the last penn spent is the same fo" an () i.e. 6he"e

MU 2 MU ..;+"eal 6o"l >)

Pe "e!t !ompetition

In a pe"fect ma"-et fo" a p"o %ct1

;a< the"e is a la"4e n%m&e" of &% e"s an a la"4e n%m&e" of selle"s an no in i#i %al &% e" o"selle" can infl%ence the ma"-et p"ice. An in i#i %al fi"m m%st accept the p"e#ailin4 ma"-et

p"ice 5i.e. it m%st &e a >p"ice ta-e">=

;&< the"e is pe"fect comm%nication so that all &% e"s an selle"s ha#e the same info"mation a&o%t p"ices th"o%4h the ma"-et) an &% e"s an selle"s can o&tain this info"mation 6itho%t cost=

;c< the cons%me" 6ill act "ationall an 6ill the"efo"e t" to pa the lo6est p"ice at 6hich a p"o %ct is offe"e ..


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;&< P"o %ce"s can c"eate the imp"ession that thei" 4oo s a"e &ette" than those of thei" competito"s)altho%4h the a"e "eall 8%ite simila". S%ch p"o %ct iffe"entiation is achie#e not onl &

iffe"ences in p"o %ct esi4n &%t also & means of a #e"tisin4 an &"an in4.

;c< C%stome" lo alt o" ine"tia sometimes p"e#ents "ational ecisions & &% e"s. C%stome"s mi4htcontin%e to 4o to a s%pplie" 6ho has 4i#en 4oo se"#ice in the past "athe" than t" o%t a ne6

an cheape" competito".

; < Man ma"-ets a"e not pe"fectl competiti#e. Pe"fect an impe"fect competition 6ill &eisc%sse in a late" chapte". Ho6e#e") the essence of the istinction is that in an impe"fect

ma"-et the"e is an im&alance in economic po6e". A 4"o%p of s%pplie"s o" &% e"s ma &e a&leto infl%ence total ma"-et 8%antities s%pplie o" eman e an the p"ice of the p"o %ct.

Fo" o%" imme iate p%"pose) ho6e#e") a pe"fect ma"-et is ass%me to e2ist. Altho%4h this is an o#e"5simplification) it helps to p"o#i e %sef%l insi4hts into p"ice ete"mination. The ass%mption of pe"fectma"-ets 6ill &e "ela2e in late" chapte"s.

e shall no6 loo- at eman an s%ppl in t%"n) an then consi e" ho6 eman an s%ppl inte"actth"o%4h the p"ice mechanism.

DemandThe !on!ept o" demand

Deman "efe"s to the B%antit of a 4oo that potential p%"chase"s 6o%l &% ) o" attempt to &% ) if the p"ice of the 4oo 6e"e at a ce"tain le#el.

It is impo"tant that o% sho%l app"eciate the concept of eman p"ope"l . Deman oes not mean the8%antit that potential p%"chase"s 6ish the co%l &% . Fo" e2ample) potential p%"chase"s mi4ht esi"eto ha#e one million %nits of a 4oo ) &%t the"e mi4ht onl &e act%al attempts to &% one h%n "e %nits ata 4i#en p"ice.

Deman is 6hat 6o%l &e the act%al attempt to &% at a 4i#en p"ice. Deman mi4ht &e satisfie ) an soact%al B%antities &o%4ht 6o%l e8%al eman . On the othe" han ) some eman mi4ht &e %nsatisfie )6ith mo"e 6o%l 5&e p%"chase"s t" in4 to &% a 4oo that is in ins%fficient s%ppl ) an so the"e a"e noteno%4h %nits of the 4oo to 4o a"o%n .

Se#e"al facto"s infl%ence the total ma"-et eman fo" a 4oo . One of these facto"s is oio%sl its p"ice) &%t the"e a"e othe" facto"s too) an to help o% to app"eciate some of these othe" facto"s) o%nee to "eco4nise that ho%sehol s &% not ?%st one 4oo 6ith thei" mone &%t a 6hole "an4e of 4oo san se"#ices.

The facto"s on 6hich the 8%antit of eman fo" an in i#i %al 4oo is epen ent incl% e1

;a< the p"ice of the 4oo =

;&< the p"ice of othe" 4oo s ;p"o %cts an se"#ices


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The total 8%antit eman e is "efe""e to as the ma"-et eman . he"eas facto"s ;a< to ;e< can affect &% in4 ecisions & in i#i %al ho%sehol s) facto" ;f< impo"tant &eca%se it infl%ences the potentiala44"e4ate siGe of the ma"-et as a 6hole.

Demand and the p i!e o" a %ood

In the case of most 4oo s ;some e2ceptions) s%ch as @iffen 4oo s) 6ill &e isc%sse late"


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The a"ea of each "ectan4le "ep"esents cons%me"s> total mone o%tla at the p"ice in 8%estion. Fo"e2ample) at a p"ice of L ) eman 6o%l &e + -ilo4"am an total spen in4 6o%l &e L ) "ep"esente &"ectan4le A9CO. Simila"l ) at a p"ice of L,) eman 6o%l &e $ -ilo4"ams an the total spen in4 ofL+ is "ep"esente & "ectan4le DEFO.

If 6e ass%me that the"e is complete i#isi&ilit ) so that p"ice an 8%antit can &oth chan4e in infinitel

small steps) 6e can "a6 a eman c%"#e & ?oinin4 the points sho6n in Fi4%"e + & a contin%o%s line)DD. This is the cons%me">s eman c%"#e fo" soap po6 e" in the pa"tic%la" ma"-et 6e a"e loo-in4 at.

He"e the eman c%"#e happens to &e a st"ai4ht line. St"ai4ht line eman c%"#es a"e often %se as anill%st"ation in economics &eca%se it is con#enient to "a6 them this 6a . In "ealit ) a eman c%"#e ismo"e li-el to &e a c%"#e line con#e2 to the o"i4in. A con#e2 eman c%"#e 6ill mean that the"e a"e

p"o4"essi#el la"4e" inc"eases in B%antit eman e as p"ice falls.

Chan4es in eman ca%se & chan4es in p"ice a"e "ep"esente & mo#ements alon4 the eman c%"#e)f"om one point to anothe". The p"ice has chan4e ) an the 8%antit eman e chan4es) &%t the emanc%"#e itself "emains the same.

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In this simple e2ample) 6e a"e loo-in4 at the eman sche %le of a sin4le ho%sehol . A ma"-et emanc%"#e is a simila" c%"#e) "a6n f"om a eman sche %le) e2p"essin4 the e2pecte total B%antit of the4oo that 6o%l &e eman e & all cons%me"s to4ethe") at an 4i#en p"ice.

Ma"-et eman "efe"s to the total B%antities of a p"o %ct that all ho%sehol s 6o%l 6ant to &% at each p"ice le#el. A ma"-et eman sche %le an a ma"-et eman c%"#e a"e the"efo"e simpl the s%m of all

the in i#i %al eman sche %les an eman c%"#es p%t to4ethe". Ma"-et eman c%"#es 6o%l &esimila" to those in Fi4%"es , an 3) &%t 6ith B%antities eman e &ein4 hi4he" 5i.e. total ma"-et

eman .

The ma"-et eman c%"#e 4ene"all slopes o6n f"om left to "i4ht &eca%se1

;a< fo" the in i#i %al cons%me") a fall in the p"ice of the 4oo ma-es it "elati#el cheape"compa"e to othe" 4oo s an 6ith his limite &% 4et) e2pen it%"e 6ill &e shifte to the 4oo6hose p"ice has fallen. It is the "elati#e p"ice of the 4oo that is impo"tant. A fall in the"elati#e p"ice of a 4oo inc"eases eman fo" it. This is "efe""e to as the s%&stit%tion effect=

;&< a fall in the 4oo >s p"ice means that people 6ith lo6e" incomes 6ill also &e a&le to affo" it.The o#e"all siGe of the ma"-et fo" the 4oo inc"eases. The con#e"se a"4%ment applies to aninc"ease in p"ices= as a p"ice 4oes %p) cons%me"s 6ith lo6e" incomes 6ill no lon4e" &e a&le toaffo" the 4oo ) o" 6ill &% somethin4 else 6hose p"ice is "elati#el cheape") an the siGe ofthe ma"-et 6ill sh"in-. This is "efe""e to as the p"ice effect.

This anal sis in icates that the "elationship &et6een p"ice an 8%antit eman e is an in#e"se one1 as p"ice "ises) eman falls= as p"ice falls) eman inc"eases.

A eman c%"#e sho6s ho6 the 8%antit eman e 6ill chan4e in "esponse to a chan4e in p"ice p"o#i e that all othe" con itions affectin4 eman a"e %nchan4e 5i.e. p"o#i e that the"e is no chan4ein the p"ices of othe" 4oo s) tastes) e2pectations o" the siGe of ho%sehol income. ;This ass%mption)that all othe" #a"ia&les "emain %nchan4e as 6e e2amine chan4es in the #a"ia&le that inte"ests %s) isoften "efe""e to & %se of the *atin ph"ase cete"is pa"i&%s 5othe" thin4s &ein4 e8%al. 4oo is s%&stit%tion. E2amples of s%&stit%te 4oo s a"e1

;i< "i#al &"an s of the same commo it ) e.4. Coca5Cola an Pepsi5Cola=;ii< tea an coffee=;iii< &%s "i es an ca" "i es=;i#< iffe"ent fo"ms of ente"tainment.

S%&stit%tion ta-es place 6hen the p"ice of one 4oo "ises o" falls "elati#e to a s%&stit%te 4oo .

;&< Complements a"e 4oo s that ten to &e &o%4ht an %se to4ethe") so that an inc"ease in theeman fo" one is li-el to ca%se an inc"ease in the eman fo" the othe". E2amples of

complements a"e1

;i< c%ps an sa%ce"s=;ii< &"ea an &%tte"=;iii< moto" ca"s an moto" spa"es.


18/178


19/178

Ma ,et demand and the dist i#ution o" national in!omeMa"-et eman fo" a 4oo is infl%ence & the 6a in 6hich the national income is sha"e &et6eenho%sehol s. Consi e" the follo6in4 patte"ns of income ist"i&%tion1

In Fi4%"e !;a


20/178

Shi"ts o" the demand !u ve

Fi4%"e ;a< epicts a "ise in eman at each p"ice le#el) 6ith the eman c%"#e shiftin4 to the "i4ht)f"om D 7 to D +. Fo" e2ample) at p"ice P + ) eman fo" the 4oo 6o%l "ise f"om to (. This shift co%l

&e ca%se & an of the follo6in41

;a< a "ise in ho%sehol income=

;&< a "ise in the p"ice of s%&stit%tes=

;c< a fall in the p"ice of complements=

; < a chan4e in tastes to6a" s this p"o %ct=

;e< an e2pecte "ise in the p"ice of the p"o %ct. If the p"ice "ise late" fails to occ%") the shift ineman 6o%l &e tempo"a" . If the p"ice "ise oes occ%") the eman c%"#e 6o%l "e#e"t to its

p"e#io%s position) &%t fe6e" 4oo s 6o%l no6 &e eman e &eca%se the p"ice is no6 hi4he".

Fi4%"e ;&< epicts a fall in eman at each p"ice le#el 6hich is "ep"esente & a shiftin4 to the left ofthe eman c%"#e) f"om >ol > c%"#e D7 to >ne6> c%"#e D+.This shift ma &e ca%se & the opposite of thechan4es esc"i&e in the p"e#io%s pa"a4"aph

Fo" e2ample) at p"ice P, the eman 6ill fall f"om A to 9.

To s%mma"ise1

;a< a shift of the eman c%"#e to the "i4ht po"t"a s an inc"ease in the 8%antit eman e at an4i#en p"ice le#el=

;&< a shift of the c%"#e to the left po"t"a s a "e %ction in the B%antit eman e at an 4i#en p"icele#el.

7

P

(

D

D

7 9

P

A

D

D


21/178

Supply

The !on!ept o" supply

S%ppl "efe"s to the 8%antit of a 4oo that e2istin4 s%pplie"s o" 6o%l 5&e s%pplie"s 6o%l 6ant to p"o %ce fo" the ma"-et at a 4i#en p"ice. In this conte2t) an %s%all in economics) the te"m >4oo >incl% es se"#ices as 6ell as tan4i&le p"o %cts.

The 8%antit of a 4oo that can &e s%pplie to a ma"-et #a"ies %p o" o6n) eithe" &eca%se1

;a< e2istin4 s%pplie"s inc"ease o" "e %ce thei" o%tp%t 8%antities) o"

;&< fi"ms stop p"o %cin4 alto4ethe" an lea#e the ma"-et) o" ne6 fi"ms ente" the ma"-et an &e4in p"o %cin4 the 4oo .

If the B%antit that fi"ms 6ant to p"o %ce at a 4i#en p"ice e2cee s the B%antit that p%"chase"s 6o%leman ) the"e 6o%l &e an e2cess of s%ppl ) 6ith fi"ms competin4 to 6in 6hat sales eman the"e is.

O#e"5s%ppl an competition 6o%l then &e e2pecte to "es%lt in p"ice5competiti#eness an a fall in p"ices.

As 6ith eman ) s%ppl "elates to a pe"io of time 5e.4. an ann%al "ate of s%ppl 8%antities o" amonthl "ate.

As 6ith eman ) a istinction sho%l &e ma e &et6een1

;a< ma"-et s%ppl ) 6hich is the total B%antit of the 4oo that all fi"ms in the ma"-et 6o%l 6antto s%ppl at a 4i#en p"ice= an

;&< an in i#i %al fi"m>s s%ppl sche %le 6hich is the 8%antit of the 4oo that the in i#i %al fi"m6o%l 6ant to s%ppl to the ma"-et at an 4i#en p"ice.

Fa!to s (hi!h in"luen!e the supply &uantity

The 8%antit s%pplie of a 4oo epen s on1

;a< the p"ice o&taina&le fo" the 4oo =

;&< the p"ices of othe" 4oo s. An inc"ease in the p"ice of othe" 4oo s 6o%l ma-e the s%ppl of a4oo 6hose p"ice oes not "ise less att"acti#e to s%pplie"s=

;c< the cost of ma-in4 the 4oo ) 6hich in t%"n epen s on the p"ices of facto"s of p"o %ction 5ie6a4es) inte"est "ates) lan "ents an p"ofit e2pectations. A "ise in the p"ice of one facto" of

p"o %ction ;sa la&o%"


22/178

Supply and the p i!e o" a %ood

In 4ene"al) s%pplie"s 6ill 6ant to s%ppl a 4"eate" 8%antit of thei" o%tp%t at hi4he" p"ices.Fo" e2ample) if the p"ice of p"o %ct is L! pe" %nit) a s%pplie" mi4ht &e 6illin4 to s%ppl +)777 %nitsof the p"o %ct to cons%me"s in the ma"-et at that p"ice. If the p"ice of p"o %ct no6 4oes %p to L+7)the s%pplie" 6ill &e 6illin4 to s%ppl mo"e than +)777 %nits of the p"o %ct. Q%st ho6 man mo"e than

+)777 he 6o%l 6ant to s%ppl 6o%l epen on ci"c%mstances.

h 6o%l a s%pplie" &e 6illin4 to s%ppl mo"e o%tp%t at a hi4he" p"ice

It mi4ht seem lo4ical to s%ppose that hi4he" p"ices sho%l mean hi4he" p"ofits) an so the fi"m 6o%l &e att"acte & the p"ospect of &i44e" p"ofits into s%ppl in4 mo"e %nits of o%tp%t. This is not the f%llans6e") tho%4h. e m%st also as- 6h ) in o%" e2ample) the s%pplie" 6as onl 6illin4 to s%ppl +)777%nits of p"o %ct at a p"ice of L!.

The ans6e" m%st p"es%ma&l &e that it 6o%l not &e 6o"th6hile) an that the %nit cost of ma-in4 e2t"ao%tp%t 6o%l e2cee the sales p"ice of L! pe" %nit. This mi4ht &e) fo" e2ample) &eca%se the s%pplie">scapacit is al"ea f%ll e2ten e ) an the costs of inc"easin4 capacit ;an thin4 f"om o#e"time

p"emi%ms to the cost of a ne6 facto" < 6o%l not &e co#e"e & the L! pe" %nit sales p"ice. At a hi4he"sellin4 p"ice pe" %nit) the o%tp%t limit 6he"e %nit costs &e4in to e2cee %nit p"ices 6ill &e at a hi4he"le#el) an so the s%pplie" 6o%l no6 &e 6illin4 to p"o %ce mo"e at the ne6 hi4he" p"ice.

The supply !u ve

A s%ppl sche %le an s%ppl c%"#e can &e "a6n1

;a< fo" an in i#i %al s%pplie"= o"

;&< fo" all fi"ms 6hich p"o %ce the 4oo . ma"-et s%ppl c%"#e. This total s%ppl c%"#e of alls%pplie"s is the

E$ample

S%ppose that the s%ppl sche %le fo" p"o %ct is as follo6s.

Price per unit Quantity that supplierswould supply at this price

- Units+77 +7)777

+!7 ,7)777 377 37)777 !77 /7)777

A s%ppl c%"#e is const"%cte in a simila" manne" to a eman c%"#e ;f"om a sche %le of s%ppl8%antities at iffe"ent p"ices< &%t sho6s the 8%antit s%pplie"s a"e 6illin4 to p"o %ce at iffe"ent p"icele#els. It is an %p6a" 5slopin4 c%"#e f"om left to "i4ht) &eca%se 4"eate" 8%antities 6ill &e p"o %ce athi4he" p"ices.

Cont"ast the in#e"se "elationship &et6een p"ice an B%antit eman e 6hich 6e e2amine in o%"anal sis of eman . In the case of s%ppl ) the "elationship &et6een p"ice an B%antit s%pplie is

positi#e1 as p"ice "ises) so too oes the B%antit that p"o %ce"s a"e 6illin4 to s%ppl .The "elationship &et6een o%tp%t an p"ice) %sin4 the ata in o%" e2ample) is sho6n as a s%ppl c%"#e inFi4%"e 0.


23/178

A s%ppl c%"#e sho6s ho6 the 8%antit s%pplie 6ill chan4e in "esponse to a chan4e in p"ice) p"o#i ethat all othe" con itions affectin4 s%ppl "emain %nchan4e ;cete"is pa"i&%s


24/178

If the p"ice of the 4oo is P + ;Fi4%"e $


25/178

The price mechanism

If eman fo" a 4oo e2cee s s%ppl ) cons%me"s m%st eithe" stop eman in4 6hat the cannot ha#e) o"the m%st &e p"epa"e to pa mo"e fo" the 4oo . At a hi4he" p"ice) fi"ms 6ill &e p"epa"e to s%pplmo"e of the 4oo . On the othe" han ) if the p"ice of a 4oo is s%ch that fi"ms 6ant to s%ppl mo"e thancons%me"s a"e 6illin4 to &% ) p"o %ction m%st &e c%t &ac- in #ol%me o" the p"ice m%st &e "e %ce so asto stim%late eman .

The e&uili# ium p i!e

The p"ice mechanism &"in4s eman an s%ppl into e8%ili&"i%m an the e8%ili&"i%m p"ice fo" a 4oois the p"ice at 6hich the #ol%me eman e & cons%me"s an the #ol%me that fi"ms 6o%l &e 6illin4 tos%ppl a"e the same.

At p"ice P + the"e is an e2cess of the 8%antit that s%pplie"s 6ant to p"o %ce o#e" the 8%antit eman eat that p"ice) e8%al to the istance A9. The "eaction of s%pplie"s as %nsol stoc-s acc%m%late 6o%l &eto1

;a< c%t o6n the c%""ent le#el of p"o %ction in o" e" to isacc%m%late %n6ante stoc-s ;i.e. e5

stoc-


26/178

;a< If the"e is no chan4e in con itions of s%ppl o" eman ) the e8%ili&"i%m p"ice 6ill "%le thema"-et an 6ill "emain sta&le.

;&< If the e8%ili&"i%m p"ice oes not "%le) the ma"-et is in ise8%ili&"i%m) &%t s%ppl an eman6ill p%sh p"ices to6a" s the e8%ili&"i%m p"ice.

;c< Shifts in the s%ppl c%"#e o" eman c%"#e 6ill chan4e the e8%ili&"i%m p"ice an 8%antit .

The >la6> of s%ppl an eman is that in a f"ee ma"-et) the e8%ili&"i%m p"ice an o%tp%t le#el of a4oo is the p"ice an o%tp%t le#el at 6hich the ma"-et eman c%"#e an the ma"-et s%ppl c%"#einte"sect.

In a f"ee ma"-et) p"ice acts as a mechanism 6hich si4nals eman an s%ppl con itions to p"o %ce"san cons%me"s. It the"efo"e ete"mines the acti#ities of &oth p"o %ce"s an cons%me"s) infl%encin4 thele#els of eman fo" an the s%ppl of 4oo s.

>The p"ice s stem 6as not conscio%sl c"eate . It oes not "e8%i"e that an one conscio%sl fo"esee anco5o" inate the necessa" chan4es= a ?%stments occ%" a%tomaticall as a "es%lt of the sepa"ate ecisionsta-en & a la"4e n%m&e" of in i#i %als) all see-in4 thei" o6n &est inte"est.> ; R G Lipsey


27/178

Elasti!ity O" Demand And Supply

Your objectives

Afte" completin4 this chapte" o% sho%l 1

;a< %n e"stan the concept of elasticit in "elation to &oth s%ppl an eman =

;&< &e a6a"e of some of the facto"s that infl%ence elasticit of s%ppl an eman in the casesof pa"tic%la" p"o %cts.

Price elasticity of demand

The !on!ept o" elasti!ity

So fa" 6e ha#e isc%sse the i"ection of chan4es in eman an s%ppl 6hen p"ices chan4e. hen p"ice 4oes %p) the 8%antit eman e 6ill fall) an the 8%antit s%pplie"s 6ill &e 6illin4 to p"o %ce 6ill4o %p. 9%t 6e ha#e not et consi e"e the e2tent of these chan4es. Fo" e2ample) if p"ices 6ent %p &+7 ) 6o%l the 8%antit eman e fall & ! ) ,7 ) !7 o" 6hat An 6o%l the 8%antities thats%pplie"s 6o%l 6ant to p"o %ce 4o %p & ! ) +7 ) +! o" 6hat The e2tent of these chan4es ismeas%"e & the p"ice elasticit of eman an the elasticit of s%ppl .

e ha#e also isc%sse shifts in the eman c%"#e %e to chan4es in the p"ice of s%&stit%tes ancomplements an chan4es in ho%sehol income) &%t a4ain 6e ha#e not et consi e"e the e2tent of theshifts in eman a"isin4 f"om shifts in the eman c%"#e. The e2tent of these chan4es is meas%"e & 1

;a< the c"oss elasticit of eman ) in the case of s%&stit%tes an complements=;&< the income elasticit of eman . in the case of ho%sehol income.

The p i!e elasti!ity o" demand

P"ice elasticit of eman ;often enote & the @"ee- s m&ol ) p"ono%nce >eeta>< is a meas%"e of thee2tent of chan4e in ma"-et eman fo" a 4oo in "esponse to a chan4e in its p"ice. It is meas%"e as1

chan4e in B%antit eman e ) as a pe"centa4e of emanchan4e in p"ice) as a pe"centa4e of the p"ice

Since the eman 4oes %p 6hen the p"ice falls) an 4oes o6n 6hen the p"ice "ises) the elasticit has ane4ati#e #al%e) &%t it is %s%al to i4no"e the min%s si4n.

Elasti! and inelasti! demand

As mentione al"ea ) the elasticit of eman 6ill 4ene"all ha#e a ne4ati#e #al%e since emanc%"#es a"e no"mall o6n6a" slopin4. Ho6e#e") since the min%s si4n is often i4no"e ) an elasticit of5+ is %s%all "efe""e to as elasticit of l) o" %nit . The #al%e of eman elasticit ma &e an thin4 f"omGe"o to infinit .

Deman is1

;a< inelastic if the a&sol%te #al%e is less than I= an;&< elastic if the a&sol%te #al%e is 4"eate" than I.

he"e eman is inelastic) the B%antit eman e falls & a smalle" pe"centa4e than p"ice) an 6he"eeman is elastic) eman falls & a la"4e" pe"centa4e than the pe"centa4e "ise in p"ice.


28/178

P i!e elasti!ity and the slope o" the demand !u ve

@ene"all ) eman c%"#es slope o6n6a" s. Cons%me"s a"e 6illin4 to &% mo"e at lo6e" p"ices than athi4he" p"ices. E2cept in ce"tain cases ;6hich a"e "efe""e to late"hi4h> p"ices ;the top of the eman c%"#e p"ices ;the &ottom of the eman c%"#e


29/178

Spe!ial values o" p i!e elasti!ity

The"e a"e th"ee special #al%es of p"ice elasticit of eman = 7) + an infinit .

7. Deman is pe"fectl inelastic ;Fi4%"e ,;a


30/178

The "an4es of p"ice elasticit at iffe"ent points on a o6n6a" 5slopin4 st"ai4ht line eman c%"#e a"eill%st"ate in Fi4%"e 3.

9 st% in4 Fi4%"e 3 o% ma &e a&le to see the ?%stification fo" the follo6in4 impo"tant "%les.

;a< Fo" a commo it 6hose p"ice elasticit is 4"eate" than one o#e" the "an4e of the p"ice chan4e1

;i< a "e %ction in p"ice p"o %ces an inc"ease in total e2pen it%"e on the commo it =;ii< a "ise in p"ice p"o %ces a "e %ction in total e2pen it%"e on the commo it .

;&< Fo" a 4oo 6hose p"ice elasticit is less than

;i< a "e %ction in p"ice p"o %ces a "e %ction in total e2pen it%"e on the commo it =;ii< an inc"ease in p"ice p"o %ces an inc"ease in total e2pen it%"e on the commo it .

9%siness people can ma-e %se of info"mation on ho6 cons%me"s 6ill "eact to p"icin4 ecisions) notleast &eca%se of the effect of this on p"ofits. @o#e"nment polic ma-e"s can %se info"mation a&o%telasticit 6hen ma-in4 ecisions a&o%t in i"ect ta2ation. Items 6ith a lo6 p"ice elasticit of eman )s%ch as ci4a"ettes an alcohol) ten to &e ta"4ets fo" hi4h ta2ation since & inc"easin4 ta2es on these)total "e#en%e can &e inc"ease . If ci4a"ettes 6e"e p"ice elastic) inc"eases in ta2ation 6o%l &e co%nte"5

p"o %cti#e as the 6o%l "es%lt in lo6e" 4o#e"nment "e#en%e.

P"ice

B%antit

P7 D

P"ice

B%antit

P

7

+

V+

+

7

7.!P

7.!B


31/178

Fa!to s in"luen!in% p i!e elasti!ity o" demand "o a %ood

Facto"s that ete"mine p"ice elasticit of eman a"e simila" to the facto"s othe" than p"ice that affectthe #ol%me of eman . Elasticit is "eall a meas%"e of the st"en4th of these othe" facto"s on eman .The main facto"s affectin4 p"ice elasticit of eman a"e1

;a< the a#aila&ilit of s%&stit%tes=

;&< the time ho"iGon=

;c< the p"icin4 policies of competito"s.

The availability of close substitutes . The mo"e s%&stit%te 4oo s the"e a"e) especiall close s%&stit%tes)the mo"e elastic 6ill &e the p"ice elasticit of eman fo" a 4oo . Fo" e2ample) in a 4"een4"oce">s shop)a "ise in the p"ice of one #e4eta&le s%ch as ca""ots o" c%c%m&e"s is li-el to "es%lt in a s6itch ofc%stome" eman to othe" #e4eta&les) man #e4eta&les &ein4 fai"l close s%&stit%tes fo" each othe".A4ain the elasticit of eman fo" a pa"tic%la" &"an of &"ea-fast ce"eals is m%ch 4"eate" than theelasticit of eman fo" &"ea-fast ce"eals as a 6hole) &eca%se the fo"me" ha#e m%ch close" s%&stit%tes.This facto" is p"o&a&l the most impo"tant infl%ence on p"ice elasticit of eman .

The time period . O#e" time) cons%me"s> eman patte"ns a"e li-el to chan4e. If the p"ice of a 4oo isinc"ease ) the initial "esponse mi4ht &e #e" little chan4e in eman ;inelastic eman < &%t then ascons%me"s a ?%st thei" &% in4 ha&its in "esponse to the p"ice inc"ease) eman mi4ht fall s%&stantiall .The time ho"iGon infl%ences elasticit la"4el &eca%se the lon4e" the pe"io of time 6hich 6e consi e")the 4"eate" the -no6le 4e of s%&stit%tion possi&ilities & cons%me"s an the p"o#ision of s%&stit%tes &

p"o %ce"s.

Competitors' policies . If the "esponse of competito"s to a p"ice inc"ease & one fi"m is to -eep thei" p"ices %nchan4e ) the fi"m "aisin4 its p"ices is li-el to face elastic eman fo" its 4oo s at hi4he" p"ices. If the "esponse of competito"s to a "e %ction in p"ice & one fi"m is to match the p"ice "e %ctionthemsel#es) the fi"m is li-el to face inelastic eman at lo6e" p"ices. This is a sit%ation 6hich

p"o&a&l faces man la"4e fi"ms 6ith one o" t6o ma?o" competito"s ;i.e. oli4opolies


32/178

Other elasticities of demand

In!ome elasti!ity o" demand

The income elasticit of eman fo" a 4oo in icates the "esponsi#eness of eman to chan4es inho%sehol incomes. It is meas%"e as1

chan4e in 8%antit eman e ) as a pe"centa4e of eman chan4e in ho%sehol income) as a pe"centa4e of ho%sehol income

;a< A 4oo is income elastic if income elasticit is 4"eate" than I so that 8%antit eman e "ises & ala"4e" pe"centa4e than the "ise in income. Fo" e2ample) if the eman fo" compact iscs 6ill "ise &+7 if ho%sehol income "ises & 0 ) 6e 6o%l sa that compact iscs a"e income elastic.

;&< A 4oo is income inelastic if income elasticit is &et6een 7 an + an the 8%antit eman e "isesless than the p"opo"tionate inc"ease in income. Fo" e2ample) if the eman fo" &oo-s 6ill "ise & ifho%sehol income "ises & +7 ) 6e 6o%l sa that &oo-s a"e income inelastic.

9oth of these cate4o"ies a"e sai to &e no"mal 4oo s) 6hich means that eman fo" them 6ill "ise 6henho%sehol income "ises) an so the ha#e a positi#e income elasticit of eman .

If income elasticit is less than 7) income elasticit is ne4ati#e an the commo it is sai to &e aninfe"io" 4oo since eman fo" it falls as income "ises.

C oss elasti!ity o" demand

C"oss elasticit of eman "efe"s to the "esponsi#eness of eman fo" one 4oo to chan4es in the p"iceof anothe" 4oo .

C"oss elasticit chan4e in 8%antit of 4oo A eman e ) as a pe"centa4e of 8%antit eman e W

of eman chan4e in the p"ice of 4oo 9) as a pe"centa4e of p"ice

W;4i#en no chan4e in the p"ice of A fi2e e8%ipment to &e alte"e . The"e istime to &%il ne6 facto"ies an machines) an time fo" ol ones to &e close o6n. Ne6 fi"mscan ente" the in %st" in the lon4 "%n=

; < the sec%la" pe"io is so lon4 that %n e"l in4 economic facto"s s%ch as pop%lation 4"o6th)s%pplies of "a6 mate"ials ;s%ch as oil< an the 4ene"al con itions of capital s%ppl ma alte".;>Sec%la"> is e"i#e f"om the *atin 6o" >saec%la> meanin4 >cent%"ies>.< The sec%la" pe"io isi4no"e & economists e2cept in the theo" of economic 4"o6th.

These t pes of time pe"io 6e"e post%late & Alf"e Ma"shall in his P"inciples of economics ;+',7


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Ma ,et Failu e. E$te nalities And Inte vention

Your objectives

Afte" completin4 this chapte"1

;a< &e a6a"e of the "easons 6h f"ee ma"-ets ma not lea to an i eal allocation

;&< %n e"stan the concepts e2te"nalities) p%&lic 4oo s an me"it 4oo s

;c< %n e"stan 6h ) ho6 an fo" 6hat p%"pose a 4o#e"nment ma inte"#ene in a ma"-et ino" e" to imp"o#e the allocation of "eso%"ces

Market imperfections and market failure

Int odu!tion

In this chapte") 6e shall &e conce"ne 6ith 6h a f"ee ma"-et 6o%l "es%lt in an allocation of "eso%"cesthat is not optimal. If a f"ee ma"-et has ce"tain 6ea-nesses an "a6&ac-s) the 8%estion a"ises of6hethe" the"e o%4ht to &e some "e4%lation of the ma"-ets & the a%tho"ities ;ie a mi2e econom .


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Externalities and public oods

So!ial !osts and p ivate !osts

In a f"ee ma"-et) s%pplie"s an ho%sehol s ma-e thei" o%tp%t an &% in4 ecisions fo" thei" o6n p"i#ate &enefit) an these ecisions ete"mine ho6 the econom >s sca"ce "eso%"ces 6ill &e allocate to p"o %ction an cons%mption. P"i#ate costs an p"i#ate &enefits the"efo"e ete"mine 6hat 4oo s a"ema e an &o%4ht in a f"ee ma"-et.

It can &e a"4%e that a f"ee ma"-et mechanism 6o%l "es%lt in a satisfacto" allocation of "eso%"ces) p"o#i e that p"i#ate costs a"e the same as social costs) an p"i#ate &enefits a"e the same as social &enefits.

hen p"i#ate &enefit is not the same as social &enefit) o" 6hen p"i#ate cost is not the same as socialcost) an allocation of "eso%"ces) 6hich "eflects p"i#ate costs an &enefits onl ma not &e sociallaccepta&le.

P"i#ate cost meas%"es the cost to a fi"m of the "eso%"ces it %ses to p"o %ce a 4oo . ;This economic cost)as 6e shall see in a late" chapte") is the oppo"t%nit cost of the "eso%"ces %se costs> inc%""e & othe" mem&e"s of societ ) 6ho s%ffe" f"om the poll%tion.

P"i#ate &enefit meas%"es the &enefit o&taine i"ectl & a s%pplie" o" & a cons%me" .

Social &enefit meas%"es the total &enefit o&taine ) &oth i"ectl & a s%pplie" o" a cons%me") an

in i"ectl ) at no e2t"a cost) to othe" s%pplie"s o" cons%me"s.

An e2ample 6he"e p"i#ate &enefit an social &enefit iffe" is 6he"e c%stome"s at a cafe in a piaGGa inItal &enefit f"om the ente"tainment p"o#i e & p"ofessional m%sicians) 6ho a"e hi"e & the cafe. Thec%stome"s of the cafe a"e pa in4 fo" the se"#ice) in the p"ices the pa ) an the o&tain a p"i#ate &enefitf"om it. At the same time) othe" people in the piaGGa) 6ho a"e not c%stome"s of the cafe) mi4ht stop anlisten to the m%sic. The 6ill o&tain a &enefit) &%t at no e2t"a cost to themsel#es. The social &enefitf"om the m%sicians> se"#ice is 4"eate" than the p"i#ate &enefit to the cafe>s c%stome"s.

E$te nalitiesAn >e2te"nalit > ma &e efine as a iffe"ence &et6een the p"i#ate an the social costs) o" &enefits)a"isin4 f"om an acti#it . *ess fo"mall ) an >e2te"nalit > is a cost o" &enefit 6hich the ma"-et mechanismfails to ta-e into acco%nt &eca%se the ma"-et "espon s to p%"el p"i#ate si4nals.

The conse8%ence of e2te"nalities is ma"-et fail%"e to achie#e a sociall satisfacto" allocation of"eso%"ces) 6hich p"ope"l "eflects social costs an &enefits.

e can %se eman an s%ppl anal sis to ill%st"ate the conse8%ences of e2te"nalities. Ho6e#e") o%nee to accept that if an a #e"se e2te"nalit e2ists) so that the social cost of s%ppl in4 a 4oo is 4"eate"than the p"i#ate cost to the s%pplie" fi"m) then1

;a< a s%ppl c%"#e 6hich "eflects total social costs 6ill &e to the left of the ;p"i#ate cost< ma"-ets%ppl c%"#e= an

;&< the #e"tical istance &et6een the p"i#ate cost s%ppl c%"#e an the social cost s%ppl c%"#e"ep"esents the siGe of the e2te"nalities


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;a< if a f"ee ma"-et e2ists) the amo%nt of the 4oo p"o %ce 6ill &e ete"mine & the inte"actionof eman ;c%"#e D< an s%ppl c%"#e S. He"e) o%tp%t 6o%l &e () at p"ice P=

;&< if social costs 6e"e ta-en into acco%nt) an the ma"-et ope"ate s%ccessf%ll ) the amo%nt ofthe 4oo p"o %ce sho%l &e ?%st ) at p"ice P2.

@i#en a f"ee ma"-et) o%tp%t of the 4oo 6ill e2cee 6hat it i eall sho%l &e) an so "eso%"ces 6illha#e &een o#e"5allocate to p"o %ction of this pa"tic%la" 4oo .

Pu#li! %oods

Some 4oo s) & thei" #e" nat%"e) in#ol#e so m%ch >spillo#e"> of e2te"nalities that the a"e iffic%lt to p"o#i e e2cept as p%&lic 4oo s 6hose p"o %ction is o"4anise & the 4o#e"nment.

In the case of s%ch 4oo s) the cons%mption of the 4oo & one in i#i %al o" 4"o%p oes notsi4nificantl "e %ce the amo%nt a#aila&le fo" othe"s. An if one in i#i %al ma-es %se of the 4oo ) it

oes not "e %ce the a#aila&ilit of the 4oo an its &enefits to othe" in i#i %als. F%"the"mo"e) it is ofteniffic%lt o" impossi&le to e2cl% e an one f"om its &enefits) once the 4oo has &een p"o#i e .

E2amples of s%ch 4oo s a"e1

;a< efence an the a"me fo"ces=

;&< the police se"#ice=

;c< the fi"e se"#ice=

; < the Thames floo &a""ie" in En4lan ) an the As6an Dam in E4 pt.

Defence an policin4 a"e pe"haps the most oio%s e2amples of >nat%"all > p%&lic 4oo s. It is not p"actica&le fo" in i#i %als to &% thei" o6n efence s stems o" policin4 a""an4ements.

Me it %oods and deme it %oods

The"e a"e some t pes of 4oo s 6hich) in the a&sence of inte"#ention) the ma"-et 6o%l not s%ppl atall) o" 6o%l s%ppl in inapp"op"iate 8%antities. This is &eca%se in i#i %als o not al6a s "ealise 6he"ethei" &est inte"ests lie) an so mi4ht fail to p%"chase 4oo s 6hich 6o%l &enefit them o") alte"nati#el )mi4ht p%"chase 4oo s 6hich o not &enefit them.

R

R

R e2te"nalit

S s%pplc%"#e "eflectin4 the

p"i#ate cost fo" the

B s%pplc%"#e "eflectin4 the

O%tp%t

L

D

(

P

P2


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A 4o#e"nment ma inte"#ene to "i the ma"-et of this pe"cei#e inefficienc .

;a< The 4o#e"nment enco%"a4es) o" insists %pon) the p%"chase of 4oo s ;me"it 4oo s< 6hich it &elie#es cons%me"s sho%l &% . Fo" e2ample) if o% %se a moto"&i-e o% a"e compelle &la6 to p%"chase a helmet.

;&< The 4o#e"nment isco%"a4es) o" p"ohi&its) the p%"chase of 4oo s ; eme"it 4oo s< 6hich it &elie#es sho%l not &e &o%4ht & cons%me"s. Fo" e2ample) chil "en a"e not allo6e to p%"chase ci4a"ettes) an no&o ;othe" than me ical p"actitione"s etc< is allo6e to p%"chasea icti#e "%4s.

Price re ulation

Ma ,et "ailu e and the !ase "o e%ulation o" the ma ,et

Ma"-et fail%"e) "emem&e") "efe"s to the fail%"e of a f"ee ma"-et to "es%lt in an optimal allocation of"eso%"ces.

The e2istence of ma"-et fail%"e an of e2te"nalities s%44ests the nee fo" "e4%lation of the ma"-et &the 4o#e"nment) in o" e" to imp"o#e the allocation of "eso%"ces.

The main 6a s in 6hich a 4o#e"nment mi4ht choose to "e4%late o" cont"ol ma"-ets a"e as follo6s1

;a< cont"ol the means of p"o %ction ;i.e. ha#e state5o6ne in %st"ies


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;&< to set a minim%m p"ice fo" a 4oo . Fo" e2ample) OPEC ;the O"4anisation of Pet"ole%mE2po"tin4 Co%nt"ies< has t"ie in the past to impose minim%m p"ices fo" oil on the 6o"lma"-ets.

Ma$imum p i!e le%islation

The 4o#e"nment ma t" to p"e#ent p"ices of 4oo s "isin4 & esta&lishin4 a p"ice ceilin4. If the p"iceceilin4 is hi4he" than the e8%ili&"i%m p"ice) settin4 a p"ice ceilin4 6ill ha#e no effect at all on theope"ation of ma"-et fo"ces.

The p"ice ceilin4 is a&o#e the e8%ili&"i%m ma"-et p"ice an is the"efo"e ineffect%al &eca%se thee8%ili&"i%m p"ice an o%tp%t is "eache & the f"ee ma"-et inte"action of s%ppl an eman .

If the ma2im%m p"ice M is lo6e" than 6hat the e8%ili&"i%m p"ice 6o%l &e) the"e 6ill &e an e2cess ofeman o#e" s%ppl ;Fi4%"e , an >6ine la-es>)

E8%ili&"i%m P"ice

Ma2im%m P"ice

B%antitA B 9

M

P

P"ice

D

S


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If the minim%m p"ice M is set a&o#e the e8%ili&"i%m p"ice P the 8%antit eman e falls f"om B to A &%t the 8%antit s%pplie inc"eases to 9. The"e is e2cess s%ppl e8%al to the 8%antit A9.

hen the"e is an e2cess of s%ppl o#e" eman ) the"e is a an4e" that mo"e of the 4oo 6ill &e p"o %ce than can &e sol at the minim%m p"ice an so s%"pl%s 8%antities 6ill &%il %p) 6hichs%pplie"s mi4ht sell off at lo6 p"ices ?%st to 4et "i of them. To p"e#ent o#e"5s%ppl an %mpin4 ofe2cess s%ppl at lo6 p"ices) a s stem of 8%otas mi4ht &e int"o %ce 6he"e& each s%pplie" is allo6eto p"o %ce %p to a ma2im%m 8%antit an no mo"e.

Minim%m P"ice

B%antitA B 9

P"ice

D

S


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!ndirect taxes and subsidies

Indi e!t ta$ation

An alte"nati#e fo"m of p"ice an o%tp%t "e4%lation is in i"ect ta2ation. ;i.e. ta2ation on 4oo s o"se"#ices as appose to i"ect ta2ation on incomes sha"e of ta2 elasticit of s%ppl p"o %ce"s> sha"e of ta2 elasticit of eman

;A p"oof of this is &e on the scope of this &oo- 5tho%4h not &e on the po6e"s of a mathematicall

nim&le st% ent. (o% ma ca"e to t" it as an a itional e2e"cise.i eal> e8%ili&"i%m p"ice is at1

;a< a hi4he" o%tp%t= .an

;&< a lo6e" p"ice=

than the f"ee ma"-et e8%ili&"i%m p"ice an o%tp%t.

The effect of a s%&si is to shift the ma"-et e8%ili&"i%m to1

;a< a hi4he" o%tp%t= an

;&< a lo6e" p"ice.

If the amo%nt of the s%&si 6e"e ma e e8%al to the siGe of the &eneficial e2te"nalit ) the effect of thes%&si 6o%l &e to "e4%late the ma"-et in s%ch a 6a that an i eal allocation of "eso%"ces to the 4oois achie#e . hen the state oes this) it mi4ht &e sai to &e >inte"nalisin4 the e2te"nalit >.


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Theo y O" The Fi m. P odu!tion And Costs

Your objectives


;a< %n e"stan the concepts of total costs) a#e"a4e costs an ma"4inal costs an &e a6a"e ofthei" effects on sho"t5"%n ecision5ma-in4=

;&< %n e"stan the concept of economies of scale an ho6 it affects ecision5 ma-in4 in thelon4 "%n.

Costs of production and the firm

Int odu!tion

In this chapte" 6e shall loo- at the costs an o%tp%t ecisions of an in i#i %al fi"m. In othe" 6o" s) 6eshall loo- at 6hat the costs of p"o %ction a"e fo" a sin4le fi"m) an ho6 these a"e affecte & &othsho"t5"%n an lon45"%n facto"s.

e shall then 4o on to consi e" p"ofit an ho6 m%ch o%tp%t a fi"m 6ill p"o %ce at a 4i#en ma"-et p"ice. The a44"e4ate amo%nt of 4oo s s%pplie & e#e" in i#i %al fi"m a s %p to the ma"-et s%ppl = & st% in4 an in i#i %al fi"m 6e a"e loo-in4 at the >&%il in4 &loc-s> of ma"-et s%ppl .

The fi"m is a 6i e te"m fo" an o"4anisation 6hich ca""ies on &%siness. In spite of thei" st"%ct%"aliffe"ences) fi"ms 6ill &e t"eate as sin4le) consistent ecision5ta-in4 %nits) an 6e shall i4no"e aniffe"ences in ecision5ma-in4 p"oce %"es an economic st"%ct%"es &et6een them. In pa"tic%la") 6e

6ill ass%me that the -e o&?ecti#e of a fi"m is to ma2imise its p"ofits.

P"o %ction is ca""ie o%t %sin4 the facto"s of p"o %ction 6hich m%st &e pai o" "e6a" e fo" thei" %se.The cost of p"o %ction is the cost of the facto"s that a"e %se .

Factor of production Its cost

*an "ent*a&o%" 6a4esCapital inte"estEnt"ep"ene%"ship no"mal o" Yp%"e p"ofit

Fi2e an #a"ia&le inp%ts an costs

Fi"ms com&ine #a"io%s inp%t "eso%"ces to p"o %ce a 4i#en le#el of o%tp%t. 9 #a" in4 the amo%nts ofinp%t %se ) the le#el of o%tp%t can &e alte"e . Ho6e#e" not all inp%ts a"e e8%all fle2i&le. Ene"4 ) "a6mate"ials) the n%m&e" of la&o%" ho%"s an so on can &e com&ine 6ith each othe" 6ith a 4"eat eal offle2i&ilit ) &%t the siGe of the facto" o" n%m&e" of machines cannot &e #e"ifie so 8%ic-l .

Economist ta-e the #ie6 that in the sho"t "%n some facto"s of p"o %ction ;o" p"o %ction inp%ts< a"e#a"ia&le in s%ppl an so ha#e #a"ia&le costs. T picall la&o%" is "e4a" e as a #a"ia&le cost item. Onthe othe" han some facto"s of p"o %ction a"e fi2e in s%ppl an so ha#e fi2e cost item.

Mo"e p"ecisel ) fi2e costs a"e those costs 6hich o not #a" i"ectl 6ith o%tp%t) &%t 6hich "emainconstant 6hethe" an thin4 is p"o %ce o" not. a"ia&le costs a"e those 6hich o #a" i"ectl 6ith thele#el of o%tp%t.


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In the lon4 "%n ho6e#e" the s%ppl of sho"t te"m fi2e cost items can &e ma e to #a" an so all facto"sof p"o %ction a"e #a"ia&le. Mo"e lan an &%il in4s can &e o&taine ) mo"e capital o&taine an mo"eent"ep"ene%"ship stim%late .

In the sho"t "%n) p"ofit ma2imisin4 ecisions m%st &e ta-en 6ithin the "est"iction of ha#in4 some"eso%"ces in fi2e s%ppl . In the lon4e" "%n ho6e#e" most cases a"e #a"ia&le &eca%se the s%ppl of

s-ille la&o%") machine" ) &%il in4s an so on can &e inc"ease o" ec"ease . P"ofit5ma2imisin4ecisions in the lon4 te"m a"e the fo"e s%&?ect to fe6e" "est"ictions a&o%t "eso%"ce a#aila&ilit .

Sho t) un !osts. total !osts' ave a%e !osts and ma %inal !osts

*et %s no6 t%"n o%" attention to sho"t5"%n costs 5i.e. costs of o%tp%t %"in4 a time pe"io in 6hich onlsome "eso%"ces of p"o %ction a"e #a"ia&le in a#aila&ilit an some "eso%"ces of p"o %ction a"e fi2e in8%antit .

The"e a"e th"ee aspects of cost to &e consi e"e .

;a< Total cost 5TC.

;&< A#e"a4e cost 5AC. A#e"a4e cost is simpl the total cost i#i e & the total 8%antit p"o %ce

;i< A#e"a4e cost is ma e %p of an a#e"a4e fi2e cost pe" %nit pl%s an a#e"a4e #a"ia&lecost pe" %nit.

AC TC TFC T C n n n

;he"e n is the n%m&e" of %nits p"o %ce stan a" > #al%e fo" e#e" %nit p"o %ce .The follo6in4 points a"e 6o"th st"essin4.

;a< To the economist) cost incl% es an element fo" >no"mal> p"ofit.

;&< To the economist) cost means oppo"t%nit cost. No"mal p"ofit) 6hich is the cost ofent"ep"ene%"ship) is an oppo"t%nit cost) &eca%se it is the amo%nt of p"ofit that an ent"ep"ene%"co%l ea"n else6he"e) an so it is the p"ofit that he m%st ea"n to pe"s%a e him to -eep on 6ithhis in#estment in his c%""ent ente"p"ise.

;c< The sho"t5"%n ma"4inal cost pe" %nit can chan4e as mo"e o%tp%t is p"o %ce .

Avera e costs" mar inal costs and diminishin returns

The elationship #et(een AC and MC

The "elationships &et6een a#e"a4e an ma"4inal costs a"e impo"tant.

;a< hen the a#e"a4e cost sche %le is "isin4) the ma"4inal cost 6ill al6a s &e hi4he" than thea#e"a4e cost.

This ma-es sense. If the ma"4inal cost of ma-in4 one e2t"a %nit of o%tp%t e2cee s the a#e"a4ecost of ma-in4 all the p"e#io%s %nits) then ma-in4 the e2t"a %nit 6ill clea"l ca%se an inc"easein the a#e"a4e %nit cost.

;&< hen the a#e"a4e cost c%"#e is fallin4) the ma"4inal cost lies &elo6 it.

;c< hen the a#e"a4e cost c%"#e is ho"iGontal) ma"4inal cost is e8%al to it.

The ma"4inal cost c%"#e al6a s c%ts th"o%4h the a#e"a4e cost c%"#e at the lo6est point of the a#e"a4ecost c%"#e ;Fi4%"e +


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a"ia&le costs a"e ma e %p f"om the cost of the facto"s of p"o %ction 6hose %se can &e #a"ie in thesho"t5"%n ;fo" e2ample 6a4es) f%el &ills an "a6 mate"ial p%"chases


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In the sho"t5"%n) to p"o %ce mo"e o%tp%t) a fi"m m%st ac8%i"e e2t"a 8%antities of #a"ia&le facto"s of p"o %ction) &%t fi2e facto"s of p"o %ction cannot &e inc"ease . a"ia&le facto"s 6ill &e com&ine 6ithfi2e facto"s to p"o %ce the fi"m>s o%tp%t.

;a< The e2t"a ph sical o%tp%t p"o %ce & an e2t"a %nit of #a"ia&le facto" is calle the ma"4inal ph sical p"o %ct ;MPP


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Total evenue0 ave a%e evenue and ma %inal evenue

9efo"e loo-in4 at ho6 a fi"m eci es its p"ofit5ma2imisin4 o%tp%t) 6e m%st loo- at its "e#en%es. The"ea"e th"ee aspects of "e#en%e to consi e" .

;a< Total "e#en%e ;TR< 6hich is the total income o&taine f"om sellin4 a 4i#en B%antit of o%tp%t.

e can thin- of this as B%antit sol m%ltiplie & the p"ice pe" %nit1 TR P 2 B. ;&< A#e"a4e "e#en%e ;AR< 6hich 6e can thin- of as the p"ice pe" %nit sol 1 AR TR

n

;c< Ma"4inal "e#en%e ;MR< 6hich is the a ition to total "e#en%e ea"ne f"om the sale of onee2t"a %nit of o%tp%t1 MR p AR.

hen a fi"m can sell all its e2t"a o%tp%t at the same p"ice) the AR >c%"#e> 6ill &e a st"ai4ht line on a4"aph) ho"iGontal to the 2 a2is. The ma"4inal "e#en%e pe" %nit f"om sellin4 e2t"a %nits at a fi2e p"icem%st &e the same as the a#e"a4e p"ice. ;See Fi4%"e /


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Ma %inal evenue and p i!e elasti!ity o" demand

Ma"4inal "e#en%e an p"ice elasticit of eman can &e "elate mathematicall th"o%4h the follo6in4fo"m%la.

MR P \+ 5 + ]

^6he"e MR is ma"4inal "e#en%e

P is p"ice ^ is the a&sol%te #al%e of p"ice elasticit of eman ;ie i4no"in4 the min%s si4ns sales the ma"4inal "e#en%e can &ecome ne4ati#e. This happens in Fi4%"e ! at p"ice PN 6hen a "e %ction in p"ice oes not inc"easeo%tp%t s%fficientl to ea"n the same total "e#en%e as &efo"e. In this sit%ation) the p"ice elasticit of

eman 6o%l &e inelastic.

Ma %inal analysis

Ma"4inal ecision5ma-in4 is &ase on the p"inciple of meas%"in4 the chan4e in &enefits an o" coststhat 6o%l a"ise as a conse8%ence of a ecision. The chan4e 6o%l &e 6o"th ha#in4 if the e2t"a &enefitse2cee e the e2t"a isa #anta4es.

Ma"4inal anal sis is &ase on some fai"l simple "%les an a"ithmetical "elationships.

R%le +. hen the"e a"e no "eso%"ce limitations) the scale of an acti#it sho%l &e inc"ease if thema"4inal &enefits f"om the chan4e o" inc"ease e2cee the ma"4inal costs. Essentiall ) anacti#it is 6o"th %n e"ta-in4 if it a s mo"e &enefits than it oes cost.

In the case of a fi"m) fo" e2ample) it 6o%l &e 6o"th spen in4 e2t"a mone on a #e"tisin4)4i#en no "est"ictions on the cash a#aila&le to spen on a #e"tisin4) p"o#i e that the e2t"a

p"ofits f"om the "es%ltin4 e2t"a salesW 6e"e hi4he" than the e2t"a cost of the a #e"tisin4.

;W i.e. e2t"a p"ofits &efo"e e %ctin4 a #e"tisin4 costs


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P o"it ma$imisation. MC 4 MR

As a fi"m p"o %ces an sells mo"e %nits) its total costs 6ill inc"ease an its total "e#en%es 6ill alsoinc"ease ;%nless the p"ice elasticit of eman is inelastic an the fi"m faces a o6n6a" slopin4 ARc%"#es p"ofits 6o%l &e "e %ce & ma-in4 an sellin4 the e2t"a %nit.

;c< If the e2t"a cost of ma-in4 an e2t"a %nit of o%tp%t is e2actl e8%al to the e2t"a "e#en%eo&taina&le f"om sellin4 it) &ea"in4 in min that economic cost incl% es an amo%nt fo" no"mal

p"ofit) it 6ill &e 6o"th the fi"m>s 6hile to ma-e an sell the e2t"a %nit. An since the e2t"a costof et anothe" %nit 6o%l &e hi4he" ;the la6 of iminishin4 "et%"ns applies< 6he"eas e2t"a"e#en%e pe" %nit f"om sellin4 e2t"a %nits is ne#e" hi4he") the p"ofit5ma2imisin4 o%tp%t is"eache at this point 6he"e MC MR.

In othe" 6o" s) 4i#en the o&?ecti#e of p"ofit5ma2imisation1

;a< If MC is less than MR p"ofits 6ill &e inc"ease & ma-in4 an sellin4 mo"e.

;&< If MC is 4"eate" than MR p"ofits 6ill fall if mo"e %nits a"e ma e an sol ) an a p"ofit5ma2imisin4 fi"m 6o%l not ma-e the e2t"a o%tp%t.

;c< If MC MR) the p"ofit5ma2imisin4 o%tp%t has &een "eache ) an this is the o%tp%t B%antitthat a p"ofit5ma2imisin4 fi"m 6ill eci e to s%ppl .

Economies of scale and lon #run costs

Int odu!tion

e ha#e not et consi e"e a fi"m>s lon45"%n costs of o%tp%t. In the lon45"%n) all inp%ts a"e #a"ia&le) sothe p"o&lems associate 6ith the iminishin4 "et%"ns to #a"ia&le facto"s o not a"ise= in othe" 6o" s) thela6 of iminishin4 "et%"ns applies onl to sho"t5"%n costs an not to lon45"%n costs. he"eas sho"t5"%no%tp%t ecisions a"e conce"ne 6ith iminishin4 "et%"ns to scale 4i#en fi2e facto"s of p"o %ction)lon45"%n o%tp%t ecisions a"e conce"ne 6ith economies of scale 6hen all facto" inp%ts a"e #a"ia&le.

O%tp%t 6ill #a" 6ith #a"iations in inp%ts) s%ch as la&o%" an capital.

;a< If o%tp%t inc"eases in the same p"opo"tion as inp%ts ;e.4. o%&lin4 all inp%ts o%&les o%tp%t ineconomics.mone in the &an->.

Capital "efe"s to man5ma e items s%ch as plant) machine" an tools 6hich a"e ma e an %senot fo" thei" o6n sa-e) &%t to ai the p"o %ction of othe" 4oo s an se"#ices. The cost of %sin4machine" an plant an so on is >inte"est>)

; < Ent"ep"ene%"ship o" ente"p"ise is the fo%"th facto" of p"o %ction. An ent"ep"ene%" is someone6ho %n e"ta-es the tas- of o"4anisin4 the othe" th"ee facto"s of p"o %ction in a &%sinessente"p"ise) an in oin4 so) &ea"s the "is- of the #ent%"e. He c"eates ne6 &%siness #ent%"es anthe "e6a" fo" the "is- he ta-es is p"ofit.

The cost of p"o %ction ;"ent) 6a4es) inte"est an p"ofit< is the s%m total of the "e6a" s fo" all thefacto"s of p"o %ction that 4o into ma-in4 a 4oo .

Dist i#ution theo y

Dist"i&%tion theo" is conce"ne 6ith ho6 m%ch "e6a" each facto" of p"o %ction 4ets. hatete"mines the amo%nt that is pai fo" lan ) la&o%") capital an ent"ep"ene%"ship Ho6 is the total

income >ca-e> i#i e &et6een them

The total income ea"ne & all facto"s of p"o %ction 6ithin a national econom e8%als the nationalincome. National income is the s%&?ect of a late" chapte".


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Fa!to p i!es

The p"ices pai to each facto" of p"o %ction a"e sometimes "efe""e to as >facto" p"ices>. The p"ices fo"lan ) la&o%" an capital a"e ete"mine & s%ppl an eman . Ent"ep"ene%"ship an p"ofit a"e

iffe"ent) an these 6ill &e isc%sse late".

Fa!to demand as a de ived demand

The eman fo" facto"s of p"o %ction is a e"i#e eman .

9 this 6e mean that the facto"s of p"o %ction a"e not eman e fo" thei" o6n sa-e. The a"eeman e &eca%se a fi"m nee s them to ma-e 4oo s) 6hich a"e then sol to ho%sehol s. It is theeman & ho%sehol s fo" 4oo s f"om 6hich the eman & fi"ms fo" the facto"s of p"o %ction ise"i#e .

Capital and interest

Inte"est is the "e6a" fo" capital. Capital as a facto" of p"o %ction consists of1

;a< stoc-s of finishe 4oo s=

;&< p"o %ce" 4oo s ;i.e. machines) tools) &%il in4s) office e8%ipment etc


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The MEC c%"#e fo" all the fi"ms in an in %st" is the in %st" >s eman c%"#e fo" capital) an it is thes%m of the eman c%"#es ;MEC c%"#es< of all the in i#i %al fi"ms in the in %st" . An in %st" >s MECc%"#e an an in i#i %al fi"m>s MEC c%"#e ha#e the same &asic shape) as sho6n in Fi4%"e I.

The supply o" !apital

The "ate of inte"est also epen s on the s%ppl of capital f"om in#esto"s) an the inte"action of s%pplan eman esta&lishes inte"est "ates.

The s%ppl of capital comes f"om sa#e"s. Sa#in4s a"e the "eso%"ces that a"e nee e to p"o %ce capital;i.e. to pa fo" the mate"ials an la&o%" that p"o %ce the capital< an 6hich co%l ha#e &een %se fo"c%""ent cons%mption instea . Sa#in4s lea to in#estment an the c"eation of capital) &%t sa#in4s a"eonl ma e & >sac"ificin4> some c%""ent cons%mption.

Sa#e"s choose to sa#e in o" e" to ma-e possi&le the p"o %ction of e#en mo"e o%tp%ts in the f%t%"e) anso the amo%nt of sa#in4s is ete"mine & compa"in41

;a< 6hat the a#aila&le 6ealth co%l &e %se to o&tain no6 f"om the c%""ent cons%mption= an

;&< ho6 m%ch e2t"a 6ealth 6ill &e o&taine in the f%t%"e f"om sa#in4.

This e2t"a 6ealth in the f%t%"e) 6hich ma-es sa#e"s p"efe" to sa#e "athe" than cons%me thei" 6ealthno6) is "ep"esente & inte"est.

Hi4he" inte"est 6ill ma-e sa#in4 mo"e att"acti#e) an the s%ppl of sa#in4s 6ill the"efo"e inc"ease.The p"ice of capital ;the inte"est "ate< sho%l the"efo"e &e ete"mine & the inte"action of s%ppl;sa#in4s< an eman ;ma"4inal efficienc of capital


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;&< *a&o%" is emplo e to help to ma-e the 4oo s an se"#ices of the fi"m) an the mo"e la&o%"

that is emplo e ) the 4"eate" sho%l &e the total #ol%me of 4oo s o" se"#ices p"o %ce .;c< Ho6e#e") 6ith la&o%" the la6 o iminishin4 "et%"ns applies) &eca%se as mo"e an mo"e la&o%"

is hi"e ) the p"o %cti#it of the e2t"a 6o"-fo"ce 6ill 4"a %all ecline. A fi"m cannot -eep onhi"in4 e2t"a la&o%") in the sho"t te"m at least) an e2pect e#e" a itional "ec"%it to cont"i&%te

the same e2t"a o%tp%t to the fi"m as othe"s in the 6o"-fo"ce.

In o%" &asic anal sis of ma"4inal p"o %cti#it theo" ) 6e shall ass%me that the amo%nt of othe" facto"sof p"o %ction is in fi2e s%ppl ) so that an a itions to a fi"m>s o%tp%t an "e#en%e can onl comef"om a itions to the la&o%" fo"ce. In othe" 6o" s) la&o%" is a #a"ia&le facto" of p"o %ction.

The ma"4inal ph sical p"o %ct ;MPP< of la&o%" is the a itional %nits of o%tp%t f"om one e2t"a %nit ofla&o%". In acco" ance 6ith the la6 of iminishin4 "et%"ns) the MPP of la&o%" 6ill ecline as mo"e anmo"e o%tp%t is p"o %ce .

The ma"4inal "e#en%e p"o %ct ; MRP < of la&o%" is the ma"4inal "e#en%e #al%e of the ma"4inal ph sical p"o %ct of la&o%". This is the e2t"a "e#en%e that fi"ms in the in %st" 6o%l o&tain f"om the e2t"ao%tp%t p"o#i e & each e2t"a "ec"%it to the 6o"-fo"ce. *i-e the MPP) the MRP 6ill &e 4"a %all

eclinin4. Ta&le + &elo6 ill%st"ates this "elationship &et6een MPP an MRP .

Ta&le +Num#e o" units

o" la#ouTotal output

unitsRevenue value o"

this output-

Ma %inalphysi!al p odu!t

Ma %inalevenue p odu!t

-+ 7 077 5, ++7 +),77 !7 !773 +!7 +)!77 /7 377/ +$7 +)077 37 ,77

The MRP of la&o%" is simila" in concept to the ma"4inal efficienc c%"#e of capital. It also "ep"esentsthe eman c%"#e fo" la&o%" & a fi"m ;o" & fi"ms in the in %st" as a 6hole


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;a< to pa a hi4he" 6a4e fo" the same 8%antit of emplo ees as ?o& t pe A= o"

;&< to emplo mo"e emplo ees into ?o& t pe 9 than ?o& t pe A if the 6a4e "ate fo" &oth 6e"e .

This anal sis of the MRP of la&o%" onl consi e"s the eman & fi"ms fo" la&o%" of iffe"ent t pes

an s-ills. It oes not consi e" the s%ppl of la&o%".

Acco" in4 to ma"4inal p"o %cti#it theo" ) 6a4e le#els a"e ete"mine & the inte"action of theeman fo" an the s%ppl of la&o%". The s%ppl of la&o%" is infl%ence & 6a4e "ates. Hi4he" 6a4es

6ill att"act mo"e people 6illin4 to o the 6o"-.

The s%ppl c%"#e fo" la&o%" can the"efo"e &e sho6n as the ma"4inal cost of the la&o%") i.e. the e2t"atotal 6a4e pa ments nee e to inc"ease total la&o%" s%ppl & each ma"4inal e2t"a amo%nt.

Fo" e2ample) s%ppose that at a 6a4e le#el of L+ 7 pe" 6ee-) the s%ppl of la&o%" into a ?o& 6o%l &e $men. At a 6a4e le#el of L+07 pe" 6ee-) the 6illin4 s%ppl 6o%l &e ' men) an at L+$7 pe" 6ee-) +7men 6o%l &e 6illin4 to o the ?o&. The ma"4inal cost of the 'th an l7th men 6o%l &e as in Ta&le ,.

Ta&le ,

5a%e 4 Ave a%e!ost o" la#ou 2 AC +3

Supply2num#e o" men3

Total (a%es Ma %inal !ost o"la#ou 2MC +3

L L L

+ 7 $ +,$7 5+07 ' +!37 ,!7 ;+!375+,$7 of la&o%" in thein %st" . S%ch a fi"m is sai to &e a >monopsonist> &% e" of la&o%".MRP*

In this sit%ation) the fi"m 6ill pa lo6e" 6a4es if it nee s fe6e" emplo ees) an hi4he" 6a4es if itnee s to att"act mo"e la&o%". The AC* c%"#e "ises 6ith o%tp%t n%m&e"s emplo e ) an mo"esi4nificantl ) the MC* c%"#e ;the s%ppl c%"#e fo" la&o%"< is also "isin4.

Deman an s%ppl anal sis sho6s that the n%m&e" emplo e 6ill &e *) 6hich is the le#el 6he"e MC* MRP*.

+imitations o" ma %inal p odu!tivity theo y

The ma"4inal p"o %cti#it theo" of 6a4es cannot acco%nt 6holl fo" the ete"mination of 6a4e "atesan 6a4e iffe"entials &eca%se the ass%mptions on 6hich it is &ase o not appl in "ealit .

;a< It is often impossi&le to calc%late the ma"4inal p"o %cti#it of la&o%") especiall ina minist"ati#e 6o"- o" se"#ice in %st"ies e.4.) &an- cle"-s an shop assistants o not p"o %ce ameas%"a&le ph sical o%tp%t.

;&< Ma"4inal p"o %cti#it theo" fo" la&o%" ass%mes that all othe" facto"s of p"o %ction a"e hel inconstant s%ppl . This is %nli-el to &e so) especiall in the case of capital. As the amo%nt ofla&o%" emplo e chan4es) so too 6o%l the amo%nt of capital.

;c< A f%"the" ass%mption of the ma"4inal p"o %cti#it theo" of 6a4es is that la&o%" is f"ee toente" the ma"-et o" lea#e it fo" alte"nati#e emplo ment else6he"e. In p"actice) this mi4ht not

&e the case) an the"e mi4ht &e impe"fections in the la&o%" ma"-et.

*

MC

MRP

AC


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/Impe "e!tions/ in the la#ou ma ,et

>Impe"fections> in the la&o%" ma"-et p"e#ent a f"ee ma"-et in la&o%" f"om ope"atin4) &eca%se of"est"ictions on the f"ee s%ppl of la&o%".

These la&o%" s%ppl "est"ictions incl% e the follo6in4.

;a< Societ ) la6s an c%stoms. ;Fo" e2ample) the social c%stom mi4ht &e fo" 6omen to 6o"-) o"not to 6o"-= o" fo" chil "en to 6o"- f"om a ce"tain a4e. Some ?o&s mi4ht &e mo"e >sociallaccepta&le> than othe"s.s ma"4inal "e#en%e p"o %ct than%ns-ille 6o"-e"s. In Fi4%"e ) 6e ass%me that emplo e"s effecti#el fo"m a &% e"s> ca"tel o">monopson >. The MRP of a s-ille la&o%" fo"ce is sho6n & MRP s) an the MRP of an %ns-illela&o%" fo"ce is sho6n & MRP% .

Bs

MCs

MRP s

ACs

B%

MC%

AC%

MRP

%


65/178

S-ille 6o"-e"s e2pect to &e pai mo"e fo" thei" s-ills. In o" e" to att"act a &i44e" s%ppl of s-ille6o"-e"s) i.e. mo"e people 6illin4 to ac8%i"e the necessa" t"ainin4) s-ills an 8%alifications) hi4he"6a4es m%st &e pai ) an the s%ppl c%"#e of s-ille la&o%" ;MCs< 6ill the"efo"e lie to the left of thes%ppl c%"#e of %ns-ille la&o%" ;MC%&a"4ainin4 theo" > of 6a4es 6hich states that 6a4e le#els a"e set & ne4otiation &et6een %nions an mana4ement.

Collecti#e &a"4ainin4 is a te"m 6hich "efe"s to the p"ocess & 6hich %nions ne4otiate an "eacha4"eements 6ith emplo e"s. It is common fo" collecti#e &a"4ainin4 to in#ol#e a sin4le monopolistselle" of la&o%" ;the t"a e %nion< an one &% e" o" monopsonist ;a sin4le fi"m o" an emplo e"s>fe e"ation4iants>.

The "ole of t"a e %nions) in economic te"ms) has t6o aspects1

;a< to e"ect an maintain &a""ie"s to ent" into ?o&s in the in %st" ) th%s ens%"in4 hi4h ea"nin4s fo"the e2istin4 mem&e"s=

;&< to monopolise the s%ppl of la&o%" in the in %st" . If the eman fo" la&o%" is in the han s ofa sin4le emplo e" o" emplo e"s> fe e"ation) this can infl%ence the p"ice at 6hich la&o%" is

&o%4ht. If the s%ppl of la&o%" is in the han s of a collecti#e &o as oppose to in i#i %als)this can infl%ence the p"ice at 6hich it can &e sol .

9 "est"ictin4 ent" to the la&o%" fo"ce) t"a e %nions can fo"ce 6a4es to mo#e f"om 7 to +) ;seeFi4%"e 0< & effecti#el chan4in4 the s%ppl c%"#e f"om S7 to S +.This 6ill ho6e#e" "es%lt in fe6e" ?o&s.The n%m&e" emplo e 6ill fall f"om * 7 to * +.


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Ho6e#e") once 6a4e "ates ha#e &een 4i#en an initial inc"ease & the %nionisation of the 6o"- fo"ce)an f%"the" pa "ises) 4i#en no chan4e in the ma"4inal "e#en%e p"o %ct ;MRP< of la&o%") 6ill p"o&a&l"e %ce the total eman fo" la&o%" & emplo e"s.

hen 6a4es "ise f"om ) to ,) the eman fo" la&o%" 6ill fall f"om * + to * , ;Fi4%"e $


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a4e "ises an inflation

A 6a4e inc"ease can ha#e one of t6o effects

;a< As ill%st"ate in Fi4%"e ' if the emplo e" cannot "aise the p"ices of his final p"o %ct thema"4inal "e#en%e p"o %ct of la&o%" cannot &e inc"ease an so the amo%nt of la&o%"

eman e & the emplo e" 6ill fall f"om * + to * , .

;&< If the emplo e" can pass the e2t"a la&o%" costs on the en c%stome" & "aisin4 the p"ice of theen p"o %ct the MRP of the la&o%" 6ill &e inc"ease an so the same 8%antit of la&o%" *+can &e -ept in emplo ment at the ne6 6a4e le#el as sho6n in fi4%"e '

,

+

MRP+

MRP,

*+

*,


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Minimum (a%es

In some in %st"ies of some co%nt"ies) the"e is a minim%m 6a4e a4"eement 6hich means that all6o"-e"s in the in %st" m%st ea"n at least the minim%m 6a4e. Some t"a e %nionists ha#e a"4%e fo" anational minim%m 6a4e. The p%"pose of a minim%m 6a4e is to ens%"e that lo65 pai 6o"-e"s ea"n atleast eno%4h in 6a4es to ha#e a ce"tain stan a" of li#in4.

If a minim%m 6a4e is enfo"ce & le4islation o" ne4otiate nationall fo" an in %st" & a t"a e %nionthe minim%m 6a4e 6ill p"o&a&l &e a&o#e the c%""ent 6a4e le#el fo" the ?o&s conce"ne . Theconse8%ences of a minim%m 6a4e 6o%l then &e1

;a< to "aise 6a4e le#els fo" 6o"-e"s emplo e to a le#el a&o#e the >e8%ili&"i%m> 6a4e "ate= &%t ;&< to "e %ce the eman fo" la&o%" an so ca%se ?o& losses.

itho%t a minim%m 6a4e) OB 6 6o"-e"s 6o%l &e emplo e at 6a4e "ate ;Fi4%"e +7 the emplo e" 6ith la&o%"ha#in4 lo6 ma"4inal "e#en%e p"o %cti#it ) %nions 6ill fin it iffic%lt to &a"4ain fo" hi4he" 6a4es o" to

p"ese"#e ?o&s in the in %st" .

Fa!to s in"luen!in% demand "o la#ou

As 6e ha#e seen) eman fo" la&o%" is infl%ence & the ma"4inal p"o %cti#it of la&o%". e no6 loo-at specific facto"s infl%encin4 eman an ma"4inal p"o %cti#it . These a"e1

;a< the efficienc o" p"o %cti#it of la&o%"=;&< the s-ills of la&o%"=;c< the s%&stit%ta&ilit of capital fo" la&o%".

The e""i!ien!y o" la#ou

Imp"o#ements in p"o %cti#it 6ill inc"ease the eman fo" la&o%") an p"o %cti#it in t%"n epen s on1

;a< the attit% es of the in i#i %al=

M

B6

Bm

S MC* in f"ee la&o%" ma"-et

D MRP*

Minim%m 6a4e


69/178


70/178

&and and rent

Rent

The p"ice of lan ) 6hich is "ent) is also ete"mine & s%ppl an eman . In isc%ssin4 lan ) it isimpo"tant to 4et o%" &asic efinitions clea". In e#e" a lan4%a4e) if a pe"son &% s some lan ) 6e

p"o&a&l mean that he &% s some &%il in4s 6ith a s%ppl of 6ate") elect"icit an so on. To theeconomist) &%il in4s an 6ate" s%ppl a"e capital= lan is the ea"th an its nat%"al "eso%"ces.It is also common to spea- of "entin4 a ho%se) a ca" o" a tele#ision. This is >comme"cial "ent> pai to thelan lo" 6ho is an o6ne" of capital. Comme"cial "ent is not the same as the mo"e specific concept ofeconomic "ent) 6hich "efe"s to a pa ment ma e in e2cess of the pa ment nee e to -eep a facto" of

p"o %ction) s%ch as lan ) la&o%" o" capital) in c%""ent %se. e shall "et%"n to this a little late".

The p i!e o" landThe special efinitions of lan an "ent 6hich a"e %se & economists e"i#e f"om those fi"st %se &Da#i Rica" o in the +'th cent%" . Rica" o 6as conce"ne ) not 6ith ho6 m%ch "ent is pai fo" lan%se fo" a pa"tic%la" p%"pose) &%t ho6 m%ch "ent is pai fo" lan as a 6hole. He a"4%e that1

;a< the total amo%nt of lan a#aila&le is fi2e ) the"efo"e the s%ppl of lan is inelastic) "e4a" lessof ho6 m%ch "ent is pai fo" it=

;&< since the s%ppl of lan is inelastic) the amo%nt of "ent 6ill &e ete"mine & the p"ice of the4oo s p"o %ce f"om the lan fo" sale to ma"-ets.

E$ample. land and ent

As a simplifie e2ample) let %s s%ppose that a piece of lan ;fi2e in siGe< has onl one %se) 6hich is to4"o6 ca""ots. S%ppose also that this fi2e amo%nt of lan ) 6hich can onl &e %se fo" 4"o6in4 ca""ots)has a pe"fectl elastic la&o%" fo"ce to 6o"- on it an that no capital is emplo e .Fi4%"e ++ sho6s1

;a< the 6a4e "ate of la&o%") ) 6hich is constant "e4a" less of the n%m&e" of 6o"-e"s emplo e ) &eca%se la&o%" s%ppl is pe"fectl elastic=

;&< the ma"4inal "e#en%e p"o %ct of la&o%" c%"#es fo" t6o iffe"ent p"ice le#els) Po an p + of a p"o %ct) sa ca""ots.

hen the p"ice of ca""ots is P 7) O* 6o"-e"s &e emplo e at the 4i#en 6a4e "ate1

;i< the total cost of la&o%" 6ill &e "ep"esente & the a"ea O S*=;ii< the total "e#en%e f"om the sale of ca""ots 6ill &e OBS*=

MRP7

;P"ice le#el P

MRP+

P"ice le#el P

* M

TS

B

R


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;iii< the iffe"ence) BS) is "ent=;c< if the p"ice of ca""ots "ises to P) ) the MRP of la&o%" 6ill imp"o#e. OM 6o"-e"s 6ill &e

emplo e ) an =

;i< the total cost of la&o%" is no6 O TM==;ii< the total "e#en%e is ORTM

;iii< the"efo"e "ent has "isen to RT=

e concl% e that 6hen lan is in fi2e s%ppl ) the siGe of the "ent epen s on the p"ice of the 4oo s p"o %ce on the lan .

The p i!e o" land "o spe!i"i! uses

e can e2ten this p"inciple to co#e" the sit%ation 6he"e the s%ppl of lan is not pe"fectl elastic. Thissit%ation a"ises 6he"e 6e a"e consi e"in4 the s%ppl of lan fo" a pa"tic%la" p%"pose) fo" e2ample)office e#elopment o" a4"ic%lt%"al %se. Since it is %s%all possi&le to chan4e the %se of a piece of lan )the s%ppl of lan fo" a pa"tic%la" p%"pose sho%l not no"mall &e consi e"e fi2e .

If the p"ice of a4"ic%lt%"al lan in the U: 6ent %p 6e 6o%l e2pect a t"ansfe" of lan f"om ;sa < theomestic ho%sin4 secto" to the a4"ic%lt%"al secto". In fact) the s%ppl c%"#e of a4"ic%lt%"al lan slopes

%p6a" f"om left to "i4ht. The e8%ili&"i%m p"ice an 8%antit of a4"ic%lt%"al lan a"e ete"mine & theinte"section of the eman c%"#e ; e"i#e f"om the p"ice of 4oo s p"o %ce on the lan < an the s%pplc%"#e ; e"i#e f"om the p"ice p 6hich p"e#ents a 8%antit of lan 8 &ein4 t"ansfe""e to an othe" %ses p"ofits. 9%siness ente"p"ise in#ol#es "is- an %nce"taint ) an act%al p"ofits mi4ht &e hi4he" o"lo6e" than e2pecte = an it is the ent"ep"ene%">s "ole to &ea" the &%" en of this %nce"taint . His "e6a" )

p"ofit) is 6hat is left o#e" afte" the othe" th"ee facto"s of p"o %ction ha#e &een "e6a" e ) an if the"e isnothin4 left o#e" the ent"ep"ene%" 6ill ma-e no p"ofits o" e#en a loss.

e can i entif t6o aspects to the "ole of the ent"ep"ene%"=

;a< he o"4anises p"o %ction an ma-es ecisions a&o%t ne6 &%siness #ent%"es=;&< he ea"ns the "e6a" of p"ofit.

These %al aspects of ent"ep"ene%"ship a"e possi&l most appa"ent in pa"tne"ships an small p"i#ate

limite companies) 6he"e the o6ne"s of the &%siness ;pa"tne"s o" sha"ehol e"s< a"e often also the senio"mana4e"s. The o"4anise p"o %ction) ma-e the ecisions) an ea"n the p"ofits fo" themsel#es.

The natu e o" p o"it

Unli-e lan ) la&o%" an capital) 6hich a"e "e6a" e & "ents) 6a4es an inte"est "especti#el ) theent"ep"ene%" cannot &e s%"e of 4ainin4 a "e6a" ;ma-in4 a p"ofit< &eca%se his &%siness mi4ht ma-e%nanticipate losses.

P"ofit is the "e6a" of the ent"ep"ene%" fo" the "is-s he ta-es. The ent"ep"ene%" &ea"s the &%" en of &%siness "is- an %nce"taint .

No mal p o"it

The"e o%4ht to &e an amo%nt of >p%"e> p"ofit 6hich an ent"ep"ene%" sho%l e2pect as a "e6a" fo" the"is-s that he o" she ta-es. This e2pecte o" app"op"iate p"ofit is -no6n as >no"mal> p"ofit) an it is aneconomic cost of p"o %ction.

No"mal p"ofit is ea"ne 6hen total "e#en%es e8%al the total oppo"t%nit costs of all inp%t "eso%"ces.If "e#en%es a"e ?%st eno%4h to e8%al oppo"t%nit costs) this means that the inp%t "eso%"ces a"e &ein4%se as 6ell as the co%l &e %se an 6he"e else.

If act%al economic p"ofit is &elo6 no"mal p"ofit ;i.e. a >loss> in economic te"ms< the fi"m 6o%l o &ette" to lea#e the &%siness it is in an p%t the "eso%"ces at its isposal to &ette") mo"e p"ofita&le %se.

Supe no mal p o"its

hen total "e#en%es e2cee the total oppo"t%nit costs of inp%t "eso%"ces) the fi"m 6ill &e ea"nin4 p"ofit in e2cess of no"mal p"ofits) an so "eso%"ces a"e ea"nin4 mo"e than the co%l in an alte"nati#eocc%pation.

These e2cess p"ofits a"e calle s%pe"no"mal p"ofits) o" monopol p"ofits ;&eca%se monopol fi"ms a"e &est a&le to e2ploit oppo"t%nities fo" ea"nin4 s%pe"no"mal p"ofits


73/178

;a< Ent"ep"ene%"s of &ette" a&ilit sho%l al6a s &e a&le to ea"n s%pe"no"mal p"ofits 6hen othe"sa"e ma-in4 onl no"mal p"ofits.

;&< Monopolists can ma-e s%pe"no"mal p"ofits & const"%ctin4 ent" &a""ie"s 6hich p"e#ent o"ete" "i#al fi"ms f"om ente"in4 the ma"-et as competito"s.

;c< S%pe"no"mal p"ofits can in icate to ent"ep"ene%"s the &est ma"-ets fo" ne6 in#estments o" fo"

a s6itch of thei" e2istin4 in#estments.

No mal p o"it and is, and un!e tainty

Fi"ms in hi4h5"isin %st"ies sho%l e2pect to ea"n a hi4he" "et%"n than fi"ms in lo65"isin %st"ies. Thehi4he" the "is-) the hi4he" the >"is- p"emi%m> "e8%i"e . ;Ris- p"emi%m can &e efine as the a itional"et%"n in e2cess of a "is-5f"ee "et%"n nee e to compensate an in#esto" fo" ma-in4 the "is-in#estment


74/178

Ma ,et St u!tu es. F om Pe "e!t Competition To Monopoly

Your objectives


;a< %n e"stan the "an4e of ma"-et st"%ct%"es that ma e2ist=

;&< %n e"stan the main feat%"es of t6o e2t"eme ma"-et st"%ct%"es1 pe"fect competition anmonopol .

Pe "e!t and impe "e!t !ompetition

In Chapte" , 6e set o%t the cha"acte"istics of a h pothetical pe"fect ma"-et. Consi e"ation of s%ch ama"-et is %sef%l espite the fact that it ne#e" e2ists in p"actice. The

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