economics study notes

7/31/2019 Economics Study Notes

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WEEK 1(Chapter 1)

DEFINITION OF ECONOMICSAll economic questions arise because we want more than we can get.

SCARCITYInability to satisfy all our wants.

Because we face scarcity, we must make choices .The choices we make depend on the incentives we face . An incentive is a reward that

encourages an action or a penalty that discourages an action.

ECONOMICS is the social science that studies the choices that individuals, businesses, governments, and

entire societies make as they cope with scarcity and the incentives that influence and reconcilethose choices

ECONOMICS IS DIVIDED INTO MICRO AND MACROECONOMICSMicroeconomics Macroeconomics

The study of choices that individuals andbusinesses make, the way those choices

interact in markets, and the influence of governments.

The study of the performance of the nationaland global economies.

E.g. Why are people buy mobile phones? E.g. Why China economy grows so fast?

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TWO big questions summarize the scope of economicsHow do choices end up determining what ,how , and for whom goods and services get

produced?

When do choices made in the pursuit of self-interest also promote the social interest ?

What?Goods & Services are objects that people

value & produce to satisfy wants.What determines how much coal, cars or milk

to produce?

Self-interestsMaking choice in your self interests

Using time & resources in the way that benefityou & not concerning about others. E.g. Youorder pizza, you not concern that delivery guy

have too ride on rain to bring you pizza. How?

Gods & Services are produced by usingproductive resources called

FACTORS OF PRODUCTION theycategories into 4 categories:

Land gifts of nature (natural resources usedto produce Goods & Services)

Labour Human Capital knowledge & skillthat people obtain from education & work

experience. And time & effort used in producing Goods & Services.

Capital Tools, machines, buildings & ect.Use to produce Goods & Services (Not a

Financial Capital like Money, Shares)Entrepreneurship Human resource that

organises land, labour & capital to produceGoods & Services

Social InterestsSelf-interests promote Social Interest if they

lead to an outcome that uses resourcesefficiently & distributes Goods & Services

equally among individuals

For whom?Who gets Goods & Services that are produceddepends on the incomes people earn. Peoplecan earn income by selling services of the

factors of the production:Land earns Rent

Labour earns WagesCapital earns Interests

Entrepreneurship earns Profits

TRADE-OFF

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is choice we make in our decisions giving up one thing to get something elseGuns vs. Butter (if u wants more of one thing we have to exchange something else for it)

TRADE-OFF (WHAT? HOW? & FOR WHOM?)WHAT?

How individuals spend their money? How government spends tax? When business choose what

to produce E.g. Spend money or defence and cut from education, Gov. trade-off education for defence.HOW?

How goods & services get produced depends on the choice made by businessFOR WHOM?

For whom goods & services are proceed depends on distribution of buying power (payment,theft & tax).

Government redistribution of income from the rich to the poor creates big trade off betweenequity & efficiency. (E.g. Taxing Rich & give tax breaks to poor)

OPPORTUNITY COSTThe highestvalued alternative that we give up to get something is opportunity cost of the

activity chosen. No such idea as free stuff each and every choice has cost.E.g. If you enrolled in uni, the highest value alternative you chose if you were not at uni iswork therefore you lose money by not working, but getting greater job opportunities later.

Choosing at the MarginMARGIN

People make choices at the margin , which means that they evaluate the consequences of making incremental changes in the use of their resources.

MARGINAL BENEFITThe benefit from pursuing an incremental increase in an activity. E.g. Student average mark is

60%, to get higher mark student have too study extra night. Mark rises by 10% to 70% themarginal benefit from studding extra night is 10% NOT 70% because you already had 60%from studding 4 nights.MARGINAL COST

The cost in increase in activity E.g. By choosing to study extra one night it will cost extra onenight lost to spend doing other activities. To make a choice you compare marginal benefits oneextra night study with marginal cost. If marginal benefits exceeds the marginal costs you will

chose to study extra night. If not you dont. By choosing only actions that bring greater benefitsthan cost, we use resources in pest possible way.

RESPONDING TO INCENTIVESWhen we make choice we response to incentives, for any activity if marginal benefit exceeds

marginal cost, people have an incentive to do more of that activity. E.g. If you are told that thenext week home work will be on exam you have grater incentives to do work, rather than if youtold none of the next week work will be on exam.

If marginal cost exceeds marginal benefit, people have less incentive to do that activity.HUMAN NATURE

From economical point of view all people acting in self-interests as it bring most value for you based on your view of the value.

Positive Statement Normative Statement (cannot be tested)

Is about what is What ought to beWhat are the facts: can be true or false. E.g.

unemployment is 20%What is opinion: E.g. Australia is the best

country in world

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UNSCRAMBLING CAUSE & EFFECTEconomist particularly interested in positive statements about cause & effect. E.g. is computersgetting cheaper because people buying more of them or do they buy more computers because

they are getting cheaper? Or there is another factor that affects that.To answer questions like this economists create and test economic models

ECONOMIC MODELDescription of some aspects of the economic world that includes only those features that are

needed for the purpose at hand.E.g. economic model of the mobile phone network might include: price of calls, number of

users, volume of calls, model will ignore insignificant data like the ringtone types. The modeltested by comparing its predictions with the facts.

BUT TESTING AN ECONOMICAL MODEL IS DIFFICULT, SO ECONOMIST ALSOUSE:

Natural Experiment Statistical Investigations Economic ExperimentE.g. Tax study (Australian &

NZ economies are similar butthe tax is different, so

economist compare this twocountries to see the tax effect)

Looks at correlation of twovariables moving together

(same or opposite directions)E.g. cigarettes & cancer are

correlated but smoking causecancer hard to determine

E.g. In computer labanswering test questions

ECONOMIC AS POLICY TOOLTHE WAY TO APPROACH PROBLEMS IN ALL ASPECTS OF HUMAN LIVES.

THREE AREAS

Personal Economic Policy Business Economic Policy Government EconomicShould I buy this product or other one

Should Sony make only flatTV & Stop making mobile

phones

Should government lower tax?

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Chapter 2PRODUCTION POSSIBILITIES & OPPORTUNITY COST

PRODUCTION POSSIBILITIES FRONTIER (PPF)

Boundary between those combinations of goods & services that can be produced & those thatcannot. ( If want to produce more of something we have too decrease or stop productions of

something else ).PPF will focus on two goods at time & hold the quantities of all other goods & servicesconstant. Model economy in which everything remains the same except the two goods wereconsidering. Production efficiency producing goods & services at lowest production cost. Ondiagram it is point Z. 3 mill pizza & 9 mill cola.

TRADE-OFF ALONG THE PPFEvery choice along the PPF involves a tradeoff we trade off cola for pizza. E.g. If you want to

study more you tradeoff you sleep time. Every Tradeoff involve a cost: an opportunity costOPPORTUNITY COST

An action is the highest valued alternative sacrificed. We can produce more pizzas only if we produce less cola. The opportunity cost of producing additional cola is quantity of pizzas we

must sacrificed.

THE PPF & MARGINAL COSTCost of goods & services is the opportunity cost of producing ONE more unit of it.

This illustrates the marginal cost of pizza. As we move along the PPF in part (a), theopportunity cost of a pizza increases. The opportunity cost of producing one more pizza is themarginal cost (MC) of a pizza.

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In part (b) the bars illustrate the increasing opportunity cost of pizza. The black dots and theline MC show the marginal cost of pizza. The MC curve passes through the centre of each bar.

Preferences & Marginal Benefit

PREFERENCESPersons likes & dislikes, economists describe preferences by using: Marginal Benefits

MARGINAL BENEFITSOf a Goods & Services is benefit received from consuming ONE more unit of it. We measuringmarginal benefits by the amount person is willing to pay for an additional unit of a goods or service .

TO ILLUSTRATE THAT WE USE MARGINAL BENEFIT CURVE.MARGINAL BENEFIT CURVE

Shows the relationship between the marginal benefit of a good and the quantity of that goodconsumed. It is a general principle that the more we have of any goods, the smaller is itsmarginal benefit and the less we are willing to pay for an additional unit of it. We call thisgeneral principle the principle of decreasing marginal benefit . The reason why marginal

benefit from good or service decreases because consumer likes variety, consumer get tire of it& switches to something else. E.G. if Pizza was rare item and you can only obtain few pieces ayear you will be willing to pay high price for an addition slice. But if you eat pizza on daily

bases addition slice has almost no value to you.The MB curve slopes downward to reflect the principle of decreasing marginal benefit. At

point A, with pizza production at 0.5 million, people are willing to pay 5 cans of cola for a pizza. At point E , with pizza production at 4.5 million, people are willing to pay 1 can of colafor a pizza

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Allocative efficiencyWhen we cannot produce more of any one good without giving up some other good, we have

achieved production efficiency. We are producing at a point on the PPF . When we cannot produce more of any one good without giving up some other good that we value more highly ,we have achieved Allocative Efficiency .

This Illustrates allocative efficiency. The point of allocative efficiency is the point on the PPF at which marginal benefit equals marginal cost. This point is determined by the quantity at

which the marginal benefit curve intersects the marginal cost curve

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If we produce fewer than 2.5 million pizzas, marginal benefitexceeds marginal cost.We get more value from our resources by producing more pizzas.On the PPF at point A, we are producing too much cola, and weare better off moving along the PPF to produce more pizzas


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ECONOMIC GROWTHThe expansion of production possibilitiesan increase in the standard of living

Two key factors influence economic growth:Technological change Capital accumulation

is the development of new goods and of better ways of producing goods andservices

is the growth of capital resources, whichincludes human capital

THE COST OF ECONOMIC GROWTH To use resources in research and development and to produce new capital, we must decrease

our production of consumption goods and services. So, economic growth is not free. Theopportunity cost of economic growth is less current consumption.

WE produce pizzas or pizza ovens along PPF 0.By using some resources to produce pizza ovens today, the PPF shifts outward in the future.

ECONOMIC COORDINATIONFIRM MARKET PROPERTY RIGHTS MONEY

Is an economic unitthat hires factors of

production andorganizes those

factors to produce

and sell goods andservices.

arrangementthat enables buyers andsellers anddo business

with eachother

Are the socialarrangements that govern

ownership, use, anddisposal of resources,

goods or services. Money

is any commodity or token that is generallyacceptable as a means

of payment

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If we produce more than 2.5 million pizzas, marginal cost exceedsmarginal benefit.We get more value from our resources by producing fewer pizzas.On the PPF at point C , we are producing too many pizzas, and weare better off moving along the PPF to produce fewer pizzas


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CIRCULAR FLOWS THROUGH MARKETS

WEEK 2 Chapter 3

MARKET & PRICES

MarketIs any arrangement that enables buyers and sellers to get information and do business with each

other

Competitive marketIs a market that has many buyers and many sellers, so no single buyer or seller can influence

the price E.g. Item get produced if price is high enough to cover their opportunity costs

Money Price

The price of the good or service is number of dollars that is must be give up in exchange for it

Opportunity Cost & Relative Price

Opportunity cost of an action is highest value alternative forgone. E.g. if buy coffee, the highestvalued thing you forgone is chocolate you were planning to buy, the opportunity cost of coffee

is quantity of chocolate forgone. We can calculate quantity of chocolate forgone from themoney price of coffee & chocolate. If coffee = $2 & chocolate $1 than Opportunity Cost of

coffee is 2 chocolate. ($2 coff / $1 Choc) that = ratio of one price to another . Ratio of one priceto other called Relative Price

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Relative Price

Of a goodthe ratio of its money price to the money price of the next best alternative goodisits opportunity cost .

DEMAND

If you demand something, then you:1. Want it

2. Can afford it3. And have defendant plan to buy it

Wants are the unlimited desires or wishes people have for goods and services. Scarcityensure that most of our will never be satisfied. Demand reflects a decision about which

wants to satisfy.

Quantity demanded of a good or service is the amount that consumers plan to buy during a particular time period,

and at a particular price.Quantaty demand is measured as amount per unit of time. E.g. you buy a cup of coffee a day, 7

cups a week & 365 a year. The question is does quantity demand would change if pricechanges? This were law of demand come in place.

Law of Demand States:

Other things remaining the same, the higher the price of a good, the smaller is the quantitydemanded; and the lower the price of a good, the larger is the quantity demanded.

Why does higher price reduces quantity?Two reasons:

Substitution Effect & Income EffectSubstitution Effect Income Effect

When the relative price (opportunity cost)of a good or service rises, people seek

substitutes for it, so the quantity demandedof the good or service decreases.

When the price of a good or service risesrelative to income, people cannot afford all thethings they previously bought, so the quantitydemanded of the good or service decreases.

E.g. Energy bars price drops from $3 to$1.50 people substitute energy bar with an

energy drink, but with lowering of pricequantity demand increases. If roles

changed & energy bars cost increase from$3 to $6 than people will buy more energy

drinks & fewer energy bars

Demands Curves & Demand Schedule

The term demand refers to the entire relationship between the price of the good and quantitydemanded of the good

Demand curve

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The supply is more than just having the resources & the technologies to produce something.Resources & Technologies are the constraints that limit what is possible.

Resources and technology determine what it is possible to produce. Supply reflects a decisionabout which technologically feasible items to produce.

E.g. many things can be produced, but they are not produced unless it profitable to do so.

The quantity supplied of a good or service is the amount that producers plan to sell during agiven time period at a particular price. It is measured by as amount of units per time. E.g.

Toyota produces 1000 cars per day. The quantity supplied can be calculated as 1K a day, 7K aweek, 365K a year. To find out how does quantity supplied of goods change as it price change

and all other variables remain the same we look at law of supply.

The Law of Supply states:

Other things remaining the same, the higher the price of a good, the greater is the quantitysupplied; and the lower the price of a good, the smaller is the quantity supplied.

The reason why higher price increases quantity supplied because marginal cost of producing agood or service to increase as the quantity produced increases and firm only produces if can at

least cover marginal cost of production.WE CAN ILLUSTRATE THE LAW OF SUPPLY WITH SUPPLY CURVE & SUPPLY

SCHEDULE .

The term supply refers to the entire relationship between the quantity supplied and the price of a good

The supply curve shows the relationship between the quantity supplied of a good and itsprice when all other influences on producers planned sales remain the same.

CHANGE IN SUPPLYWhen some influence on selling plans changes (other than the price of the good), there is a

change in supply of that good.

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The quantity of the good that producers plan to sell changes at each and every price, so there isa new supply curve.

When supply increases , the supply curve shifts rightward .When supply decreases , the supply curve shifts leftward.

The five main factors that change supply of a good are prices of factors of

production

prices of related goods

produced

Expectedfuture prices

Number of suppliers

Technology state of nature

E.g. Price of jet fuel

increase, air travel

decrease

E.g. if priceexpected torise, thenreturn is

higher thantoday, so

supplydicreasestoday &

increases infuture

Larger amount of

firms greater is supply

New tech thatlower cost of production

goods &increasesupply

Bad weather smaller

supply of vegetables

Equilibriumis a situation in which opposing forces balance each other. Equilibrium in a market occurswhen the price balances the plans of buyers and sellers

equilibrium price equilibrium quantity price at which the quantity demanded equals

the quantity suppliedQuantity bought and sold at the equilibrium

price.

Price regulates buying and selling plans Price adjusts when plans dont matchPrice of goods regulate the quantity demanded

& suppledPrice changes when there is shortage or

surplusPrice high = quantity supplied exceed quantity

demanded and opposite.Shortage forces price up

Surplus forces price down

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PRICE ADJUSTMENTSShortage forces price up Surplus forces price down

At the equilibrium price, the price doesnt change until either demand or supply changes.

Predicting Changes in Price and Quantity

AN INCREASE IN DEMAND AN INCREASE IN SUPPLY

When demand increases the demand curveshifts rightward.The price rises, and the quantity suppliedincreases along the supply curve.

when supply increases the supply curveshifts rightwardThe price falls, and the quantity demandedincreases along the demand curve.

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Chapter 4

Price Elasticity of Demand

increase in supply brings increase in supply bringsA large fall in price

A small increase in the quantity demandedA small fall in price

A large increase in the quantity demanded

The contrast between the two outcomes in Figure 4.1 highlights the need for,A measure of the responsiveness of the quantity demanded to a price change

Elasticity is such a measurePRICE ELASTICITY OF DEMAND

Units-free measure of the responsiveness of the quantity demanded of a good to a change in its price when all other influences on buyers plans remain the same.

CALCULATING PRICE ELASTICITY OF DEMAND

This is a measure of the responsiveness of demand to changes in price. Price elasticity of demand may be calculated using the point method as follows:

For example, assume the price of particular newcar model rose from $20,000 to $25,000, resulting in demand falling from 10,000 to 5,000 newcar sales.

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If elasticity is greater than 1 (as in the above example), there is an ELASTIC demand; if elasticity equals 1 (or less) then demand is INELASTIC.

ELASTIC DEMAND INELASTIC DEMANDthe price elasticity of demand is less than 1

and the good has inelastic demandthe price elasticity of demand is less than 1and the good has inelastic demand

The degree of elasticity depends on theavailability of substitutes. Elastic demandtends to be for products often regarded asluxuries, including DVD equipment, cameras,and cars etc.

. Inelastic demand tends to be for essential products, which cannot be done without, suchas bread, milk, beer and cigarettes etc.

If the quantity demanded doesnt change when the price changes, the price elasticity of demandis zero and the good has a perfectly inelastic demand

Demand becomes less elastic as the price falls along a linear demand curve. At prices above themid-point of the demand curve, demand is elastic. At prices below the mid-point of the demand

curve, demand is inelastic.

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If the price falls from $15 to $10, the quantity demanded increases from 20 to 30 pizzas anhour.

The average price is $12.50 and the average quantity is 25 pizzas.The price elasticity is (10/25)/(5/12.5), which equals 1.

TOTAL REVENUE AND ELASTICITYThe total revenue from the sale of a good or service equals the price of the good multiplied by

the quantity sold.

When the price changes, total revenue also changes.But a rise in price doesnt always increase total revenue

The change in total revenue due to a change in price depends on the elasticity of demand

If demand is elastic, a 1% price cut increases the

quantity sold by more than1%, and total revenue

increases.

If demand is inelastic, a 1% price cut increases the

quantity sold by less than 1%,and total revenues decreases

If demand is unit elastic, a 1% price cut increases the

quantity sold by 1% , andtotal revenue remains

unchanged

TOTAL REVENUE TEST

method of estimating the price elasticity of demand by observing the change in total revenuethat results from a price change (when all other influences on the quantity sold remain the

same).If a price cut increases total

revenue, demand is elastic

If a price cut decreases total

revenue, demand is inelastic

If a price cut leaves total

revenue unchanged, demandis unit elastic.

DEMAND TOTAL REVENUE

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As the price falls from $25 to $12.50, thequantity demanded increases from 0 to 25

pizzas. Demand is elastic, and total revenueincreases.

At $12.50, demand is unit elastic and totalrevenue stops increasing.

As the price falls from $12.50 to zero, thequantity demanded increases from 25 to 50

pizzas. Demand is inelastic, and total revenuedecreases.

As the quantity increases from 0 to 25 pizzas,demand is elastic, and total revenue increases.

At 25, demand is unit elastic, and totalrevenue is at its maximum.

As the quantity increases from 25 to 50 pizzas,demand is inelastic, and total revenue

decreases

THE FACTORS THAT INFLUENCE THE ELASTICITY OF DEMAND

The closeness of substitutes The proportion of incomespent on the good

The time elapsed since a pricechange

The closer the substitutes for a good or service, the more

elastic are the demand for it.E.g. Necessities, such as food

Larger proportion of incomespends on good greater

elasticity of demand. E.g.Gum price increase barely

The more time consumershave to adjust to a price

change, or the longer that agood can be stored without

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or housing, generally haveinelastic demand. Luxuries,

such as exotic vacations,generally have elastic

demand.

noticeable, price in rentsignificantly noticeable

losing its value, the moreelastic is the demand for thatgood. E.g. When price of PC

fall demand increasedslightly, but as people become

more dependent on PCquantity increased

significantly. Demand become elastic

CROSS ELASTICITY OF DEMANDThe concept of cross elasticity of demand is used for measuring the responsiveness of quantity

demanded of a good to changes in the price of related goods. Cross elasticity of demand isdefined as:

"The percentage change in the demand of one good as a result of the percentage change in the price of another good".

Formula

Exy = % Change in Quantity Demanded of Good X

% Change in Price of Good Y

The numerical value of cross elasticity depends on whether the two goods in question aresubstitutes, complements or unrelated.

Types and Example:Substitute Goods

When two goods are substitute of each other,such as coke and Pepsi, an increase in the

price of one good will lead to an increase indemand for the other good. The numerical

value of goods is positive

Complementary Goods. However, in case of complementary goods such as car and petrol,cricket bat and ball, a rise in the price of one

good say cricket bat by 7% will bring a fall inthe demand for the balls (say by 6%). The

cross elasticity of demand which are

complementary to each other is, therefore,6% / 7% = 0.85 (negative).E.g. Coke and Pepsi close substitutes. increase

in the price of Pepsi good Y by 10% andincreases the demand for Coke good X by 5%,

the cross elasticity of demand would be:

Exy = %qx / %py = 0.2

Since Exy is positive (E > 0), therefore, Cokeand Pepsi are close substitutes.

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INCOME ELASTICITY OF DEMAND The income elasticity of demand measures how the quantity demanded of a good responds to a

change in income, other things remaining the same.

"The ratio of percentage change in the quantity of a good purchased, per unit of time to a percentage change in the income of a consumer".

Ey = Percentage Change in Quantity DemandPercentage Change in Income

Simplified formula:

Ey = q X P =changep Q

If the income elasticity of demand is greater than 1, demand is income elastic and the good is anormal good. If the income elasticity of demand is greater than zero but less than 1, demand isincome inelastic and the good is a normal good. If the income elasticity of demand is less than

zero (negative) the good is an inferior good.

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Increase quantity of pizza demanded when the price of burger (a substitute for pizza) rises.

The figure also shows the decrease in the quantityof pizza demanded when the price of a soft drink (a complement of pizza) rises.


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increase in demand bringsA large rise in price

A small increase in the quantity supplied

increase in demand bringsA small rise in price

A large increase in the quantity supplied

THE ELASTICITY OF SUPPLY

Measures the responsiveness of the quantity supplied to a change in the price of a good whenall other influences on selling plans remain the same.

Es = Percentage change in quantity suppliedPercentage change in price

FACTORS THAT INFLUENCE THE ELASTICITY OF SUPPLYResource substitution possibilities Time Frame for Supply Decision

The easier it is to substitute among theresources used to produce a good or service,

the greater is its elasticity of supply.

The more time that passes after a pricechange, the greater is the elasticity of supply.

Momentary supply is perfectly inelastic .The quantity supplied immediately following

a price change is constant.Short-run supply is somewhat elastic .

Long-run supply is the most elastic .

WEEK 3

FIRMInstitution that hires factors of production and organises them to produce and sell goods and

services

FIRMS GOALTo maximise profit, if failed then eliminated or bought out by other.

MEASURING A FIRMS PROFITAccountants measure a firms profit to ensure

that the firm pays the correct amount of taxand to show its investors how their funds are

being used

Economists measure a firms profit to enablethem to predict the firms decisions, and the

goal of these decisions is to maximise

economic profitProfit equals total revenue minus total cost Economic profit is equal to total revenue

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minus total cost, with total cost measured asthe opportunity cost of production.

FIRMS OPPORTUNITY COSTValue of the firms best alternative use of its resources

(Real alternative forgone (lost))

TWO TYPES OF OPPORTUNITY COST:Explicit costs Implicit costs

Amount paid for resources that could be spenddeferent resources to produce deferent goods

when it uses,1. Its own capital . (when instead it could

rented capital to another firm) Implicit rentalrate opportunity cost of use ur own capital.

2. Its owners time and financial resources .(Cost of owners resources )

Owner might supply both entrepreneurshipand labour. Return to entrepreneurship is

profit. Profit that an entrepreneur can expectto receive on average is called normal profit . Normal profit represe4nt the cost of forgone

alternative (running another firm)

ECONOMIC PROFITEquals a firms total revenue minus its total opportunity cost of production.

DECISION TIME FRAMESFirm makes many decisions to achieve its main objective: PROFIT MAXIMISATION

Some critical and irreversible and some easily reversedDECISIONS CAN BE PLACED INTO TWO TIME FRAMES

Short run Long runResources used in production are fixed.

Capital called firms plant is fixed. Short-rundecisions are easily reversed.

Is a time frame in which the quantities of allresourcesincluding the plant sizecan be

varied. Not easily reversed.

Firms technology, buildings and capital. E.g.In T-shirt firms plant machines to produce

shirts

E.g. T-shirt shop to buy more machines or hiremore staff

SUNK COSTWhen made Long Term decision the firm must live with it for some time. Cost incurred by the

firm and cannot be changed.If a firms plant has no resale value, the amount paid for it is a sunk cost.

Short-Run Technology Constraint Long-Run CostTo increase output in the short run, a

firm must increase the amount of labour employed.

Three concepts describe the

In the long run, all inputs are variable and all costsare variable.

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relationship between output and thequantity of labour employed:

1. Total product - total output producedin a given period using different

amounts of labour holding fixed allother factors of production.

THE PRODUCTION FUNCTIONBehaviour of long-run cost depends upon the firms

production function.The firms production function is the relationship between the maximum output attainable and the

quantities of both capital and labour.2. Marginal product - change in total product that results from a one-unit

increase in the quantity of labour employed, with all other inputs

remaining the same. Calculated: labour increase 2 to 3 workers, production

increase 10 to 13 shirts. Change in total product (3 shirt) divided by change inlabour (1) = marginal product of third

worker 3 shirts

3. Average product - total productdivided by the quantity of labour

employed. E.g. 3 workers, produce 13shirts 13/3=4.33 shirt per worker

As the size of the plant increases, the output that agiven quantity of labour can produce increases. But

as the quantity of labour increases, diminishingreturns occur for each plant

MARGINAL PRODUCT CURVE DIMINISHING MARGINAL PRODUCT OFCAPITAL

The increase in output resulting from a one-unitincrease in the amount of capital employed (number of machines), holding constant the amount of labour

employed.A firms production function exhibits diminishing

marginal returns to labour (for a given plant) as wellas diminishing marginal returns to capital (for aquantity of labour). For each plant, diminishing

marginal product of labour creates a set of short run,U-shaped costs curves for MC, AVC, and ATC.

E.g. The first worker hired produces 4units. The second worker hired produces

6 units of output and total product becomes 10 units.

The third worker hired produces 3 unitsof output and total product becomes 13

units

SHORT-RUN COST AND LONG-RUN COSTThe average cost of producing a given output varies

and depends on the firms plant. The larger the plant, the greater is the output at which ATC is at aminimum. The firm has 4 different plants: 1, 2, 3, or 4 machines. Each plant has a short-run ATC curve.The firm can compare the ATC for each output at

different plants.

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ATC1 is the ATC curve for a plant with 1 machineATC4 is the ATC curve for a plant with 4machinesThe long-run average cost curve is made up fromthe lowest ATC for each output level.So, we want to decide which plant has the lowestcost for producing each output level.Lets find the least-cost way of producing a givenoutput level.Suppose that the firm wants to produce 13 T-shirts aday.

Almost all production processes are likethe one shown here and have:

Increasing marginal returns occur when marginal product of worker

increase marginal product of previousworker. E.g. if only one worker he haveto do everything, if hire another one we

can dived and specialise workers

13 T-shirts a day cost $7.69 each on ATC1.13 T-shirts a day cost $6.80 each on ATC2.13 T-shirts a day cost $7.69 each on ATC3.13 T-shirts a day cost $9.50 each on ATC4.

Diminishing marginal returns occursmarginal product of worker less thatmarginal product of previous worker.E.g. because more workers use the samemachine and have to wait for their turn,therefore reducing productivity.

LONG-RUN AVERAGE COST CURVE(LRAC)

Is the relationship between the lowest attainableaverage total cost and output when both the plant

and labour are varied.The long-run average cost curve is a planning curvethat tells the firm the plant that minimises the cost of

producing a given output range.Once the firm has chosen its plant, the firm incursthe costs that correspond to the ATC curve for that

plantLAW OF DIMINISHING RETURNSAs a firm uses more of a variable input

with a given quantity of fixed inputs, themarginal product of the variable input

eventually diminishes.

ECONOMIES AND DISECONOMIES OFSCALE

Economies of scale features of a firms technologythat make ATC fall as output increases. E.g. if Ford

produces 100 p/week each worker have too do many

tasks and the capital (machines) but if Ford makes10K cars a week each worker specialises in one task

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and becomes proficient

Diseconomies of scale features of a firmstechnology that make ATC rise as output increases.Constant returns to scale are features of a firms

technology that keep ATC constant as outputincreases

AVERAGE PRODUCT CURVE Illustrates economies and diseconomies of scale

Average product curve and itsrelationship with the marginal product

curve.When marginal product exceeds average

product, average product increases.

When marginal product is belowaverage product, average productdecreases.

When marginal product equals average product, average product is at its

maximum.Short-Run Technology Constraint

MINIMUM EFFICIENT SCALEthe smallest quantity of output at which the long-run

average cost reaches its lowest level.If the long-run average cost curve is U-shaped, theminimum point identifies the minimum efficient

scale output level.

To produce more output in the shortrun, the firm must employ morelabour, which means that it must

increase its costs . We describe the way

a firms costs change as total productchanges by using three cost conceptsand three types of cost curve:

Total costis the cost of all resources used. We

divide TC into two categories:Total fixed cost (TFC)

Is the cost of the firms fixed inputs.Fixed costs do not change with output.

Total variable cost (TVC)Is the cost of the firms variable inputs.Variable costs do change with output

That is: TC = TFC + TVC

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E.g. Machine Rent (TFC) $25 p/day,TVC number of workers 3 x by $25,therefore if Sam produces 13 Shirts aday and have 3 workers TVC = $75 is

TFC + TVC=TC (25+75=100)

total cost curves

Total fixed cost is the same at eachoutput level. Total variable cost

increases as output increases. Total cost,which is the sum of TFC and TVC alsoincreases as output increases. The totalvariable cost curve gets its shape from

the total product curve.The TP curve becomes steeper at low

output levels and less steep at highoutput levels.

In contrast, the TVC curve becomes lesssteep at low output levels and steeper at

high output levels.MARGINAL COST

MC=TC/QIncrease in total cost those resultsfrom a one-unit increase in total

product.Over the output range with increasingmarginal returns, marginal cost falls asoutput increases. Over the output range

with diminishing marginal returns,marginal cost rises as output increases.

AVERAGE COSTAverage cost measures can be derivedfrom each of the total cost measures:

Average fixed cost (AFC=TFC/Q)Average variable cost (AVC=TVC/Q)

Average total cost (ATC=TC/Q)Total cost: TC = TFC + TVC

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AFC curve shows that average fixedcost falls as output increases.

AVC curve is U-shaped. As outputincreases, average variable cost falls to a

minimum and then increases.MC curve is very special.

The range of outputs over which AVC isfalling, MC is below AVC.

The range of outputs over which AVC isrising, MC is above AVC.

The output at which AVC is at theminimum, MC equals AVC. Similarly,the range of outputs over which ATC is

falling, MC is below ATC.The range of outputs over which ATC is

rising, MC is above ATC.At the minimum ATC, MC equals ATC.

Why the ATC Is U-ShapedAVC curve is U-shaped because:

Initially, marginal product exceedsaverage product, which brings rising

average product and falling AVC.Eventually, marginal product falls below

average product, which brings fallingaverage product and rising AVC. TheATC curve is U-shaped for the samereasons. In addition, ATC falls at lowoutput levels because AFC is falling

steeply.

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COST CURVES AND PRODUCTCURVES

SHIFTS IN COST CURVESThe position of a firms cost curves

depend on two factorsTechnology

An increase in productivity shifts theaverage and marginal product curves

upward and the average and marginalcost curves downward .

Prices of factors of productionAn increase in a fixed cost shifts the

(TC ) and average total (ATC ) curvesupward but does not shift the (MC )

curve .An increase in a variable cost shifts the

(TC ), (ATC ), and (MC ) curvesupward

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COMPACT GLOSSARY OF COSTTerm Symbol Definition EquationFixed Cost Cost that is independent of the

output levelVariable Cost Cost that varies with the output

level, cost of variable inputTotal Fixed Cost TFC Cost of fixed inputsTotal Variable Cost TVC Cost of variable inputsTotal Cost TC Cost of all inputs TC=TFC+TVCTotal Product(output)

TP Total Quantity Produced (Q)

Marginal Cost MC Change in total cost resulting froma one unit increase in total product

MC=TC/Q

Average Fixed Cost AFC Total fixed cost per unit of output AFC=TFC/QAverage Variable

Cost

AVC Total variable cost per unit of

output

AVC = TVC/Q

Average Total Cost ATC Total cost per unit of output ATC=AFC+AVC

WEEK 4

PERFECT COMPETITIONMany firms sell identical goods & services

No restriction to enter market New & old firms have same price

Everyone well informed about prices

HOW PERFECT COMPETITION ARISESWhen firms minimum efficient scale is small relative to market demand so there is room for

many firms in the industry.And when each firm is perceived to produce a good or service that has no unique

characteristics, so consumers dont care which firm they buy from.E.g. Food industry

PRICE TAKERSIs firm that cant influence the market price because it produces an insignificant part of the

market

Each firms output is a perfect substitute for the output of the other firms, so the demand for each firms output is perfectly elastic.

ECONOMIC PROFIT AND REVENUEGoal of each firm is to maximise economic profit, which is equal:

Total Revenue Total Cost . Total Cost is opportunity cost of production, which includesnormal profit .

Total Revenue (TR=P x Q)Marginal Revenue (MR=TR / Q) change in TR that result from one unit increase in Q sold

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a) Shows that market demandand market supply determinethe market price that the firm

must take.

(b) Shows the firms totalrevenue curve (TR).

(c) Shows the marginalrevenue curve (MR). The firm

can sell any quantity itchooses at the market price,so marginal revenue equals

price and the demand curvefor the firms product is

horizontal at the market price.

The demand for a firms product is perfectly elastic because one firms T-shirt is a perfectsubstitute for the T-shirt of another firm .

The market demand is not perfectly elastic because a T-shirt is a substitute for some othergood .

A perfectly competitive firms goal is to make maximum economic profit , given theconstraints it faces.

So the firm must decide:1. How to produce at minimum cost.

(operating with plant that minimises long run average cost by being on its long run average costcurve)

2. What quantity to produce. (firm output)3. Whether to enter or exit a market.

PROFIT-MAXIMISING OUTPUT

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A perfectly competitive firm chooses the output that maximises its economic profit.One way to find the profit-maximising output is to look at the firms total revenue and

total cost curves.

MARGINAL ANALYSISFirm can use marginal analysis to determine the profit-maximising output which

compares Marginal Revenue (MR) & Marginal Cost (MC)

TEMPORARY SHUTDOWN DECISIONIf the firm makes an economic loss it may decide to exit the market or to stay in the market.

If the firm decides to stay in the market, it must decide whether to produce something or to shutdown temporarily.

The decision will be the one that minimises the firms loss

Loss Comparison

31

a show TR & TCb shows TR-TC=Economic Profit (EP)At low output levels Economic Loss it cantcover its fixed costs.

At intermediate output levels = EP

At high output levels = Economic Lossnowthe firm faces steeply rising costs because of diminishing returns.

The firm maximises EP when it produces 9T-shirts a day

If MR > MC, economic profit increasesif output increases.

If MR < MC, economic profitdecreases if output increases.

The profit maximizing level of output isthat where MR = MC.


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The firms loss = Total fixed cost (TFC) + Total variable cost (TVC) - Total revenue (TR).Economic loss = TFC + TVC TR

TFC + (AVC - P) Q

If the firm shuts down, Q is 0 and the firm still has to pay its TFC. So the firm incurs an

economic loss equal to TFC. This economic loss is the largest that the firm must bear

The Shutdown PointThe price and quantity at which it is indifferent between producing and shutting down

This point is where AVC is at its minimumIt is also the point MC curve crosses the AVC curve

At the shutdown point, the firm is indifferent between producing and shutting downtemporarily.

The firm incurs a loss = to TFC from either action .

THE FIRMS SUPPLY CURVEA perfectly competitive firms supply curve shows how the firms profit-

maximising output varies as the market price varies, other things remaining thesame.

Because the firm produces the output at which marginal cost equals marginalrevenue, and because marginal revenue equals price, the firms supply curve is

linked to its marginal cost curve.

But at a price below the shutdown point, the firm produces nothing.

32

shows the shutdown pointMinimum AVC is $17 a T-shirt. If the price is

$17, the profit-maximising output is 7 T-shirts aday. The firm incurs a loss equal to TFC. Thefirm is at the shutdown point. If the price is

between $17 and $20.14, the firm produces thequantity at which marginal cost equals price. Thefirm covers all its variable cost and at least part

of its fixed cost.It incurs a loss that is less than TFC


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Short-run market supply curveShows the quantity supplied by all firms in the market at each price when each firms plant and

the number of firms remain the sameThe quantity supplied by the market at any given price is the sum of the quantities supplied

by all the firms in the market at that price .At a price equal to minimum AVC, the shutdown price, some firms will produce the shutdown

quantity and others will produce zero.

The market supply curve is perfectly elastic

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If price equals minimum AVC, $17 in thisexample, the firm is indifferent between producingnothing and producing at the shutdown point, T.

If the price is $25, the firm produces 9 T-shirts aday, the quantity at which P = MC. If the price is $31, the firm produces 10 T-shirts aday, the quantity at which P = MC.

The blue curve in part (b) traces the firms short-run supply curve


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Short-run equilibrium

Short-run market supply and market demanddetermine the market price and output

Change in DemandAn increase in demand bring a rightward shiftof the market demand curve: The price rises

and the quantity increases.

A decrease in demand bring a leftward shift of the market demand curve: The price falls and

the quantity decreases

Three Possible Short-Run Outcomes

Output, Price, and Profit in the Long Run

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At $17 all firms are indifferent between shutting or not as none make profit. As price goes up quantity& profits increases.


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In short-run equilibrium, a firm may make an economic profit , break even , or incur an economic loss .

Only one of them is a long-run equilibrium because firms can enter or exit the marketENTRY AND EXIT

New firms come into market the number of firms increases and firm. Firms enter anindustry in which existing firms make an

economic profit

Firms exit an industry in which they incur aneconomic loss.

A CLOSER LOOK AT ENTRY A CLOSER LOOK AT EXITWhen the market price is $25 a T-shirt, firms

in the market are making economic profit

New firms have an incentive to enter themarket as long as firms are making economic

profits.When they do, the market supply increases

and the market price falls. In the long run, themarket supply increases, the market price falls

and firms make zero economic profit.

When the market price is $17 a T-shirt, firmsin the market are incurring an economic loss

Firms have an incentive to exit the market aslong as they are incurring economic losses.

When they do, the market supply decreasesand the market price rises. In the long run, themarket supply decreases, the market price rises

until firms make zero economic profit

CHOICES, EQUILIBRIUM, AND EFFICIENCY

We can describe an efficient use of resources in terms of the choices of consumers andfirms coordinated in market equilibrium.

Choices Equilibrium and EfficiencyA consumers demand curve shows how the

best budget allocation changes as the price of good changes.

So consumers get the most value out of their resources at all points along their demand

curves.With no external benefits, the market demand

curve is the marginal social benefit curve

In competitive equilibrium, resources are usedefficientlythe quantity demanded equals thequantity supplied, so marginal social benefit

equals marginal social cost.

The gains from trade for consumers ismeasured by consumer surplus the area

below demand, above price and to the left of the quantity transacted in the market.The gains from trade for producers is

measured by producer surplus the areaabove the supply curve, below price and to theleft of the quantity transacted in the market.

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Total gains from trade equal total surplus consumer surplus plus producer surplus.

WEEK 5 (Chapter 10)

MONOPOLYThat produces a good or service for which no close substitute exists

In which there is one supplier that is protected from competition by a barrier preventing theentry of new firms.

HOW MONOPOLY ARISES No close substitutes Barriers to entry

Monopoly sells a good that has no closesubstitutes.

market in which competition and entry arerestricted by the granting of a:

1 Public franchise (Australia Post).2 Government licence controls entry in professions such as law, medicine, and

dentistry.3 Patent or copyright (pharmaceuticals).

MONOPOLYS GOAL AND CONSTRAINTSTo maximise economic profit

Economic profit (EP) is = total revenue - minus total cost.EP=TR TC

Total revenue Total costamount received from selling the firms

product.opportunity cost of the firms production,

which includes the cost of the labour, capital,land (raw materials), and entrepreneurship

used by the firm

A monopoly faces two sets of constraints in the pursuit of maximum profit.Market Demand Technology and Cost

Monopoly is the only seller in a market, thedemand curve that it faces is the market

demand curve.Monopoly sells a good or service that has noclose substitute, so the demand curve for the

firms good or service slopes downward.The lover the price the large quantity demand

and greater quantity monopoly sells.To sell large Q must set lower P

To produce its good or service, a monopolymust set up its production plant and equipment

and hire the labour and other resourcesneeded. Because a monopoly experiences

economies of scale, it has a high fixed cost of its plant and a low marginal cost. The greater

the quantity produced, the more units over which the monopoly spreads its high fixedcost, so the lower is its average total cost of

production

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A SINGLE-PRICE MONOPOLYS OUTPUT AND PRICE

Demand curve, D, facing amonopoly electricity

producer. The ATC curveshows the ATC of producinga kilowatt hour of electricity,which is the TC of operating

the plant, divided by thenumber of units produced.

ATC=TC/Q

Monopolys economic profit.Economic profit = TR-TC.

The blue rectangle shows themonopolys profit if it

produces 2 megawatt hours.The price charged by amonopoly exceeds theaverage total cost of producing the good .

Producer surplus made by amonopoly electricity

producer. The monopolys profit is shown by the blue

rectangle. The monopoly sellsfor a price that exceeds ATC

PRICE AND MARGINAL REVENUETotal revenue (TR) Marginal revenue (MR)

TR=P x Q MR= TR / QFor a single-price monopoly, marginalrevenue is less than price at each level of

output. That is, MR < P .

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Economic Profit = TR-TCAs output increases, economic profit increases at small output levels, reaches a maximum, and

then decreases.

MARGINAL REVENUE EQUALS MARGINAL COST

38

Illustrates the relationship between price andmarginal revenue and derives the marginalrevenue curve.Suppose Paula, a hairdresser in Augathella,

has a monopoly and sets a price of $16 andsells 2 units. Now suppose the firm cuts the price to $14 tosell 3 units. It loses $4 of total revenue on the2 units it was selling at $16 each. And it gains$14 of total revenue on the 3rd unit. So totalrevenue increases by $10, which is marginalrevenueThe marginal revenue curve, MR, passesthrough the red dot midway between 2 and 3units and at $10.You can see that MR < P at each quantity


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COMPARING PRICE AND OUTPUT

Efficiency Comparison

39

Paulas marginal revenue (MR) andmarginal cost (MC).

When Paulas increases outputfrom 2 to 3 haircuts, MR is $10 and

MC is $8. MR exceeds MC by $2and Paulas economic profitincreases by that amount. If Paulas

increases output from 3 to 4haircuts, MR is $6 and MC is $8.

MC exceeds MR by $2, soeconomic profit decreases by thatamount. The monopoly producesthe profit-maximising quantity,

where MR = MC.The monopoly produces the output

at which MR equals MC and setsthe price at which it can sell that

quantity.The ATC curve tells us the average

total cost.Economic profit is the profit per unit multiplied by the quantity producedthe blue rectangle.

Price and quantity produced in competitiveequilibrium .

A single-price monopoly produces 3,000haircuts an hour and sells them at $14 ahaircut.

Compared with competition, monopoly produces a smaller output and charges a

higher price

Efficiency of perfect competition.The market demand curve is the marginalsocial benefit curve, MSB, and the market

supply curve is the marginal social cost curve,MSC.So competitive equilibrium is efficient:MSB = MSC.


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GAINS FROM MONOPOLYThe main reason why monopoly exists is that it has potential advantages over a

competitive market.Incentives to innovation Economies of scale and economies of scope

Firms developing new product or processobtain exclusive right of product or process

Increase in the range of goods producedlowers average total cost

NATURAL MONOPOLY REGULATIONRegulation Social interest theory Capture theory

rules administrated by agovernment agency to

influence prices, quantities,entry

political and regulatory process relentlessly seeks outinefficiency and regulates to

eliminate deadweight loss

regulation serves the self-interest of the producer, who

captures the regulator

Two theories about howregulation works are: =>

Efficient Regulation of a Natural Monopoly

E.g. Distribution of Electricity-natural monopolyWhen demand and cost conditions create natural monopoly, the quantity produced is less than

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Consumer surplus is the area below thedemand curve and above the price.Under competition total surplus is maximised and the quantity produced is efficientThe inefficiency of monopoly.Because price exceeds marginal social cost,marginal social benefit exceeds marginalsocial cost. A deadweight loss arises.

Some of the lost consumer surplus (bluerectangle) goes to the monopoly as producer surplus. This portion of the loss of consumer surplus is not a loss to society.


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the efficient quantity. How can government regulate natural monopoly so that it produces theefficient quantity.

Marginal cost pricing ruleis a regulation that sets the price equal to the monopolys marginal cost. The quantity

demanded at a price equal to marginal cost is the efficient quantity.Two possible ways of enabling a regulated monopoly to avoid an economic loss are:

Average Cost Pricing Government Subsidysets the price equal to average total cost. Themonopoly produces the quantity at which the

ATC curve cuts the demand curve.The monopoly makes zero economic profit

breaks even

Direct payment to a firm equal to its economicloss. To pay a subsidy, the government must

raise the revenue by taxing some other activity. But taxes themselves generate

deadweight loss

Which is the better option, average cost pricing or marginal cost pricing with agovernment subsidy?

The answer depends on the relative magnitudes of the two deadweight losses.The smaller deadweight loss is the second-best solution to regulating a natural monopoly.

Price Cap Regulation

Price ceiling, e.g. the Australia Post stamp price. The rule specifies the highest price that

the firm is permitted to charge. This type of regulation gives the firm an incentive tooperate efficiently and keep costs under

control.Unregulated, a natural monopoly profit-

maximises .A price cap sets the maximum price.

The firm has an incentive to minimise costand produce the quantity on the demand curve

at the price cap.The price cap regulation lowers the price and

increases the quantity

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Chapter 15

Monopolistic competition1 A large number of firms compete.

2 Each firm produces a differentiated product.3 Firms compete on product quality, price, and marketing.

4 Firms are free to enter and exit the industry

Each firm has only a smallmarket share and therefore

has limited market power toinfluence the price of its

product

Each firm is sensitive to theaverage market price, but no

firm pays attention to theactions of others. So no onefirms actions directly affect

the actions of others

Collusion, or conspiring to fix prices, is impossible

PRODUCT DIFFERENTIATIONif the firm makes a product that is slightly different from the products of competing firms

E.g. Running ShoesProduct differentiation enables firms to compete in three areas: quality, price, marketing, and

brandingQuality includes design,reliability, and service

Because firms producedifferentiated products, thedemand for each firms

product is downward sloping.But there is a tradeoff

between price and quality

Because products aredifferentiated a firm must

market its product. Marketingtakes the two main forms:advertising and packaging

ENTRY AND EXITThere are no barriers to entry in monopolistic competition, so firms cannot make an

economic profit in the long run.Producers of audio and video equipment, clothing, jewellery, computers, and sporting goods

operate in a monopolistically competitive environment.

FIRMS SHORT-RUN OUTPUT ANDPRICE DECISION

LONG RUN: ZERO ECONOMICPROFIT

A firm that has decided the quality of its

product and its marketing program producesthe profit-maximising quantity at which itsmarginal revenue equals its marginal cost

(MR = MC).Price is determined from the demand curve for the firms product and is the highest price thatthe firm can charge for the profit-maximising

quantity.

In the long run, economic profit induces entry.

And entry continues as long as firms in theindustry earn an economic profitas long as

(P > ATC). In the long run, a firm inmonopolistic competition maximises its profit

by producing the quantity at which itsmarginal revenue equals its marginal cost, MR

= MC

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As firms enter the industry, each existing firmloses some of its market share. The demand

for its product decreases and the demandcurve for its product shifts leftward.

The decrease in demand decreases the quantity

at which MR = MC and lowers the maximum price that the firm can charge to sell this

quantity.Price and quantity fall with firm entry until P= ATC and firms earn zero economic profit.

The firm in monopolistic competition operateslike a single-price monopoly. The firm

produces the quantity at which MR equals MCand sells that quantity for the highest possible price. It earns an economic profit (as in this

example) when P > ATC.

PROFIT MAXIMISING MIGHT BE LOSSMINIMISING

A firm might incur an economic loss in theshort run. Here is an example. At the profit-maximising quantity, P < ATC and the firm

incurs an economic loss.

MONOPOLISTIC COMPETITION AND PERFECT COMPETITION Two keydifferences between monopolistic competition and perfect competition are:

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Excess capacity Mark-upA firm has excess capacity if it produces lessthan the quantity at which ATC is a minimum

A firms mark-up is the amount by which its price exceeds its marginal cost

E.g. Real estate u can get more customers if udrop a price. But then u occur loses

MONOPOLISTIC COMPETITION EFFICIENT?

Price = marginal social benefit (MSB).The firms marginal cost = marginal social cost (MSC).

Under monopolistic competition price exceeds marginal cost, so marginal social benefitexceeds marginal social cost.

So the firm in monopolistic competition in the long run produces less than the efficientquantity

WEEK 6 (Chapter 16)Oligopoly

Is a market structure in which: Natural or legal barriers prevent the entry of

new firmsA small number of large firms compete

Because an oligopoly market has a smallnumber of firms, the firms are interdependent

Interdependence: With a small number of firms, each firms profit depends on every

firms actions.and face a temptation to

Cartel: A cartel is an illegal group of firmsacting together to limit output, raise price, andincrease profit.Firms in oligopoly face the temptation to form

a cartel, but aside from being illegal, cartelsoften break downcooperate.

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An oligopoly situation where there is a naturalduopolya market with two firms.

THE KINKED DEMAND CURVE MODELKey assumption:

In the kinked demand curve model of oligopoly, each firm believes that if it raises its price, itscompetitors will not follow, but if it lowers its price all of its competitors will follow

This means the firm faces two different demand curves and their associated marginal revenuecurves

Above the kink, demand is relatively elastic because all other firms prices remainunchanged. Below the kink, demand is

relatively inelastic because all other firms prices change in line with the price of the firm

shown in the figure. The kink in the demandcurve means that the MR curve is

discontinuous at the current quantityshown by that gap AB in the figure. Fluctuations inMC within the discontinuous portion of theMR curve leave profit-maximising quantityand price unchanged. For example, if costs

increased so that the MC curve shifted upwardfrom MC0 to MC1, the profit-maximising

price and quantity would not change.

Game theoryis a tool for studying strategic behaviour, which is behaviour that takes into

account the expected behaviour of others and the mutual recognition of interdependence.

All games have four features:

Rulesthe actions the players may take, and the consequences of those actionsPrisoners Dilemma game, two prisoners (Art and Bob) have been caught committing a petty

crime. Each is held in a separate cell and hence they cannot communicate with each other.If one of them confesses, he will get a 1-year sentence for cooperating while his accomplice

gets a 10-year sentenceIf both confess each receives 3 years in jail.

If neither confesses, each receives a 2-year sentenceStrategies

are all the possible actions of each player Art and Bob each have two possible actions:

Confess to crime or Deny committed crime.With two players and two actions for each player,

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there are four possible outcomes:1. Both confess.

2. Both deny.3. Art confesses and Bob denies.4. Bob confesses and Art denies.

PayoffsEach prisoner can work out what happens to himcan work out his payoffin each of the

four possible outcomes.We can tabulate these outcomes in a payoff matrix.

Payoff matrix is a table that shows the payoffs for every possible action by each player for every possible action by the other player.

A dominant strategy is a strategy which is best no matter what the other player does. In thegame above this is for both players to confess.

Formulas

Average Total Cost (ATC) = Total Cost / Q (Output is quantity produced or 'Q')

Average Variable Cost (AVC) = Total Variable Cost / Q Average Fixed Cost

(AFC) = ATC - AVC

Total Cost (TC) = (AVC + AFC) X Output (Which is Q)

Total Variable Cost (TVC) = AVC X Output

Total Fixed Cost (TFC) = TC - TVC

Marginal Cost (MC) = Change in Total Costs / Change in Output

Marginal Product (MP) = Change in Total Product / Change in Variable Factor

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Marginal Revenue (MR) = Change in Total Revenue / Change in Q

Average Product (AP) = TP / Variable Factor

Total Revenue (TR) = Price X Quantity

Average Revenue (AR) = TR / Output

Total Product (TP) = AP X Variable Factor

Economic Profit = TR - TC > 0

A Loss = TR - TC < 0Break Even Point = AR = ATC

Profit Maximizing Condition = MR = MC

Explicit Costs = Payments to non-owners of the firm for the resources theysupply

economics study notes

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