topic 1: lecture 3

Economics 1 (EC107) 2010-11: Micro (Term 1)

Robin Naylor, Department of Economics, Warwick

Topic 1: Lecture 3

•The circular flow model

Agent:

Households

Market:

Goods/Services

Market:

Inputs

Agent:

Firms

Demand

Demand

Supply

Supply

1

See Handout (contains whole of lectures 3-5)

Economics 1 (EC107) 2011-12: Micro (Term 1)


Topic 1: Lecture 3

•Demand

•Consider a Demand Relation:•What are the influences on Demand for a good . . . ?

X

px

D

apo

Xo

How does a change in some other influence affect the demand curve?

What does the slope of the demand curve tell us?

b

2


Topic 1: Lecture 3

We can write the demand relation as:

( | , , ,...)

Note the crucial difference between(i) A movement along the demand curve(ii) A shift in the demand curve

d dX X p p p Mx y z

3


Topic 1: Lecture 3

We can also write the (inverse) demand relation as:

( | , , ,...)

This is best thought of as the equation that determines the price the firm can charge for particular levels of output.

dp p X p p Mx x y z

4


Topic 1: Lecture 3

As a particular example of an inverse demand curve:1( ).

This can be re-written as.

How would you interpret the parameters 'a' and 'b'?How would you draw this demand curve?

dX a pb

dp a bX

5


Topic 1: Lecture 3

Supply

•Consider a Supply Relation:•What are the influences on Supply a good . . . ?

X

px

S

apo

Xo

How does a change in some other influence affect the Supply curve?

What does the slope of the Supply curve tell us?

b

6


Topic 1: Lecture 3

We can write the (inverse) supply relation as:

( | ,...).

This is best thought of as the equation that determines the price the firm requires in orderto induce it to supply particular levels of o

sp p X px x y

utput.Example:

.sp c dX

7


Topic 1: Lecture 3

Putting together Supply and Demand:

X

px

S

pe

Xe

What is meant by the ‘market equilibrium’?

What are the possible properties of a market equilibrium?

D

8


Topic 1: Lecture 3

Comparative Statics:

X

px

S

pe

Xe

What is the effect on market equilibrium of a shift in demand?

D

9


Topic 1: Lecture 3

Comparative Statics:

X

px

S

pe

Xe

What is the effect on market equilibrium of a shift in supply?

D

10


Topic 1: Lecture 3

Uniqueness of equilibrium and price bubbles:

X

px

S

pe

Xe

Suppose D is the Willingness to Pay for housing. It’s likely to depend on Consumer Confidence (CC). (i) What happens if CC rises? (ii) What might cause CC to rise? What is the implication of this?

D

11


Topic 1: Lecture 3

Putting together supply and demand:

(1) ,

(2) .

How many equations do we have?And how many unknowns?

dp a bX

sp c dX

12


Topic 1: Lecture 3

There is a 3rd equation:

(3) .

What is this equation, in terms of its Economic meaning?

We can now solve:

d sX X

13


Topic 1: Lecture 3

It is straightforward to show that:

and

.

In other words, . . .

a cXb d

ad bcpb d

14


Topic 1: Lecture 3

Knowing the values of the parameters givesus the values of price and quantity traded in equilibrium.

We can also carry out the comparative static exercises in order to see the effects of changes in the parameters on the equilibrium values of price and quantities.

How would you do this?

15


Topic 1: Lecture 4

Demand Analysis (or analysis of ‘Consumer Choice’)

Choice is based on . . .

. . . Preferences and

. . . Constraints

We’ll analyse each of these in turn.

16


Topic 1: Lecture 4

Demand Analysis: Preferences

Suppose your happiness depends on just 2 commodities

(that you might buy in the market):

e.g., ???

17


Topic 1: Lecture 4


E.g., Books and Food

We assume that you have preferences over these goods and that the nature of your preferences satisfies various properties:

(i) Non-satiation . . . . . . in words:

(ii) Ordinal Ranking

(iii) Transitivity

(iv) Completeness

18


Topic 1: Lecture 4


Non-satiation . . . in a diagram.

F

B

F1 F2

B1

19


Topic 1: Lecture 4Demand Analysis: PreferencesOur assumptions about the properties of preferences imply that we

can represent preferences using Indifference Curves. These ICs will have properties which depend upon the properties of the underlying preferences.

F

B

F1 F2

B1

We can show that an IC must slope downwards because of non-satiation.

20


Topic 1: Lecture 4Demand Analysis: PreferencesWe can show that ICs cannot cross under the assumptions we have

made about preferences:

F

B

IC1

IC2

21


Topic 1: Lecture 4Demand Analysis: PreferencesThe slope of the IC is the MRS between the 2 goods (refer to

earlier slides).

F

B

IC1

22


Topic 1: Lecture 4Demand Analysis: PreferencesIf the IC is linear, this means that the MRS is constant.

F

B

IC1

23


Topic 1: Lecture 4Demand Analysis: PreferencesIt is more common to assume that the MRS is diminishing: why is

this and what does it imply about the IC?

F

B

24


Topic 1: Lecture 4Demand Analysis: PreferencesIt is more common to assume that the MRS is diminishing: why is

this and what does it imply about the IC?

F

B

IC1

25


Topic 1: Lecture 4Demand Analysis: PreferencesWhat would it mean if the IC was upward-sloping?

F

B

IC1

26


Topic 1: Lecture 4Demand Analysis: PreferencesWhat would this mean?

F

B

IC1

27


Topic 1: Lecture 4Demand Analysis: PreferencesUnder the assumption of completeness, there is an IC passing

through every possible point:

F

B

IC1

IC2

28


Topic 1: Lecture 4Demand Analysis: PreferencesThe consumer would like to get to the highest possible IC: what

limits this?

F

B

IC1

IC2

ICn

29


Topic 1: Lecture 5

Demand Analysis: ConstraintsWe said that our understanding of Consumer Choice rests on the

analysis of Preferences and Constraints. Let’s now turn to consider Constraints.

X

Y

Xmax0

Ymax

30


Topic 1: Lecture 5

Demand Analysis: ConstraintsWe can represent a budget set and a budget frontier (or constraint)

X

Y

Xmax0

Ymax

31


Topic 1: Lecture 5

Demand Analysis: ConstraintsWe can represent a budget set and a budget frontier (or constraint)

X

Y

Xmax0

Ymax

What equation can we give this constraint?

32


Topic 1: Lecture 5

Demand Analysis: Constraints

The equation tells us that if we spend all our money income, M, on X and Y, our spending be equal to:

M xp ypx y

33


Topic 1: Lecture 5

Demand Analysis: Constraints

Re-arranging, the equation for the budget constraint is:

How do you interpret this equation? And Graphically?

y

pM xy xpp y

34


Topic 1: Lecture 5

Demand Analysis: ConstraintsThe equation of the budget constraint:

X

Y

Xmax0

Ymaxy

pM xy xpp y

35


Topic 1: Lecture 5

Demand Analysis: ConstraintsGiven the position of the budget constraint, what will be the

consumer’s choice of X and Y? This will depend on their preferences:

X

Y

Xmax0

Ymax

36


Topic 1: Lecture 5

Demand Analysis: Constrained choiceGiven the position of the budget constraint, what will be the


X

Y

Xmax0

Ymax

IC1 IC2

IC3

37


Topic 1: Lecture 5



X

Y

Xmax0

Ymax

ICmax

38


Topic 1: Lecture 5



X

Y

Xmax0

Ymax

X*

Y*a

39


Topic 1: Lecture 5

Demand Analysis: Constrained choiceSo, by bringing together preferences and constraints, we have a

model which predicts/explains the consumer’s choices (demands) for X and Y . . . given . . .?

X

Y

Xmax0

Ymax

X*

Y*a

40


Topic 1: Lecture 5

Demand Analysis: Comparative StaticsWhat will happen to the optimal choices of X and Y if there are

relevant changes to the parameters of the model?

X

Y

Xmax0

Ymax

X*

Y*a

What are the ‘relevant parameters’?

41


Topic 1: Lecture 5

Demand Analysis: Comparative StaticsWhat will happen to the optimal choices of X and Y if there are

relevant changes to the parameters of the model?

X

Y

Xmax0

Ymax

X*

Y*a

Consider a change in money income. How do we show this?

42


Topic 1: Lecture 5

Demand Analysis: Change in money income

X

Y

Xmax0

Ymax

X*

Y*a

43


Topic 1: Lecture 5


X

Y

Xmax0

Ymax

X*

Y* a

â

What can you say about the demand for X as M↑?

And the demand for Y?

44


Topic 1: Lecture 5


X

Y

Xmax0

Ymax

X*

Y* a

â



45


Topic 1: Lecture 5


X

Y

Xmax0

Ymax

X*

Y* a

â



46


Topic 1: Lecture 5


X

Y

Xmax0

Ymax

X*

Y* a â



47


Topic 1: Lecture 5


X

Y

Xmax0

Ymax

X*

Y* aâ



48


Topic 1: Lecture 6

Demand Analysis: Change in price of X

X

Y

Xmax0

Ymax

X*

Y*a

What can you say about the demand for X as Px↓?

49

See Handout


Topic 1: Lecture 6

Demand Analysis: Change in price of X (CASE 1)

X

Y

Xmax0

Ymax

X*

Y*a

What can you say about the demand for X as Px↓?

IC1 IC2

â

50


Topic 1: Lecture 6


X

Y

Xmax0

Ymax

X*

Y*a

What is the implication for the shape of the demand curve for X: in (Px, X)–space?

What is held constant along this demand curve?

IC1 IC2

â

51


Topic 1: Lecture 6


X

Y

Xmax0

Ymax

X*

Y*a


What is held constant along this demand curve?

IC1

IC2

â

52

See Handout


Topic 1: Lecture 6


X

Y

Xmax0

Ymax

X*

Y*a

What is the relationship between the price of X, its demand, and the demand for Y?

IC1

IC2

â

53


Topic 1: Lecture 6


X

Y

Xmax0

Ymax

X*

Y*a

IC1IC2

â


54

See Handout


Topic 1: Lecture 6


X

Y

Xmax0

Ymax

X*

Y*a

IC1IC2

â

What is the relationship between the price of X, its demand, and the demand for Y?

55


Topic 1: Lecture 6


X

Y

Xmax0

Ymax

X*

Y*a

IC1 IC2

â


56

See Handout


Topic 1: Lecture 6Demand Analysis: Change in price of X (CASE 3 Revisited)

X

Y

Xmax0

Ymax

X*

Y*a

â

There are 2 reasons for the rise in demand for X following the fall in its price:

(i) Disposable (or ‘real’) Income Effect

(ii) Relative Price Effect

57

See Handout


Topic 1: Lecture 6

Demand Analysis: Change in price of X (CASE 3 Revisited)

There are 2 reasons for the rise in demand for X following the fall in its price:

(i) Disposable (or ‘real’) Income Effect

The budget constraint shifts outwards and hence the individual can achieve higher ‘utility’; that is, move on to previously unobtainable Indifference Curves. They are able to buy more of both X and Y: whether or not they do so will depend on their preferences over X and Y. If X is normal, for example, the Real Income Effect will cause the individual to buy more X.


X is now relatively cheaper than previously relative to Y. The individual is therefore likely to switch from Y towards X, to some extent.

58

See Handout



X

Y

Xmax0

Ymax

X*

Y*a

â

We would now like to be able to distinguish between these two effects in the diagram.

(i) Real Income Effect


59

See Handout



X

Y

Xmax0

Ymax

X*

Y*a

â

Consider first the Relative Price Effect.

Suppose relative prices had changed, but that there had been no Real Income Effect of the price change.

What point in the diagram could represent such a position?

60



X

Y

Xmax0

Ymax

X*

Y*a

â

Consider first the Relative Price Effect.

Suppose relative prices had changed, but that there had been no Real Income Effect of the price change.

What point in the diagram could represent such a position? ‘b’

b

61



X

Y

Xmax0

Ymax

X*

Y*a

â

Relative Price Effect.

What change is causing the consumer equilibrium to move from ‘a’ to ‘b’?

What is not changing between ‘a’ and ‘b’?

Hence, ‘a’ to ‘b’ represents a pure relative price effect.

bAs ‘a’ and ‘b’ lie on the same IC, there is no ‘Real Income’ change in moving from ‘a’ to ‘b’.

62



X

Y

Xmax0

Ymax

X*

Y*a

â

Relative Price Effect.

‘a’ to ‘b’ represents a pure relative price effect. More commonly, we refer to it as a substitution effect

b

S

Xs

63



X

Y

Xmax0

Ymax

X*

Y*a

â

Real Income Effect.

We claimed that the Total Effect of the price change (i.e., from ‘a’ to ‘â’) is made up of a Relative Price (Substitution) Effect and a Real Income Effect.

b

S

Xs

As ‘a’ to ‘b’ is the substitution effect, can we show that ‘b’ to ‘â’ is the Real Income Effect?

64



X

Y

0

Ymax

X*

Y*a

â

Real Income Effect.

Compare ‘b’ and ‘â’. What have they got in common? What is different between them? Your answers should confirm for you that ‘b’ to ‘â’ captures the Real Income Effect.

b

S

Xs

As ‘a’ to ‘b’ is the substitution effect, can we show that ‘b’ to ‘â’ is the Real Income Effect?

I

X**

65


X

X

Px

Px

a

a

b

âThe total effect of the price change is to move the consumer’s choice from ‘a’ to ‘â’.

If we plot this into the lower diagram, what are we plotting?

Deriving demand curves

66

Topic 1Lecture 7

See Handout


X

X

Px

Px

a

a

b


If we plot this into the lower diagram, what are we plotting? â

67

Topic 1Lecture 7


X

X

Px

Px

a

a

b



?

68

Topic 1Lecture 7


X

X

Px

Px

a

a

b



What can you say about the slope of this curve? Must it be –ve?

CMIDC

69

Topic 1Lecture 7


X

X

Px

Px

a

a

b

âThe Substitution Effect of the price change is to move the consumer’s choice from ‘a’ to ‘b’.


b

S

S ?

70

Topic 1Lecture 7


X

X

Px

Px

a

a

b



b

S

S CUDC/CRIDC

71

Topic 1Lecture 7


X

X

Px

Px

a

a

b


b

S

S CUDC/CRIDC

Must this curve have a –ve slope?

72

Topic 1Lecture 7


X

X

Px

Px

a

a

b

â

The Substitution Effect of the price change is to move the consumer’s choice from ‘a’ to ‘b’.

b

S

S CRIDC

The Income Effect of the price change is to move the consumer’s choice from ‘b’ to ‘â’.

The Substitution Effect determines the CRIDC.

The Substitution Effect combined with the Income Effect determines the CMIDC.

I

I

73

Topic 1Lecture 7


X

X

Px

Px

a

a

b

â


b

S

S CRIDC




I

I

â

CMIDC

74

Topic 1Lecture 7


X

X

Px

Px

a

a

b

â


b

S

S CRIDC




I

I

â

CMIDC

The difference between the CRIDC and the CMIDC is the Income Effect.

In this diagram, X is a Normal Good.

Therefore, the CMIDC is more elastic than the CRIDC

75

Topic 1Lecture 7

See Handout


X

X

Px

Px

a

a

b

â


b

S

S CRIDC




I

I

â

CMIDC


In this diagram, X is a Weakly Inferior Good.

Therefore, the CMIDC is less elastic than the CRIDC

76

Topic 1Lecture 7

See Handout


X

X

Px

Px

a

a

b

â


b

S

S CRIDC




I

I

â

CMIDC ?


In this diagram, X is a Strongly Inferior Good.

Therefore, the CMIDC is +vely sloped.

77

Topic 1Lecture 7

See Handout


X

X

Px

Px

a

a

b

â


b

S

S CRIDC




I

I

â

CMIDC


In this diagram, X is a Strongly Inferior Good.

Therefore, the CMIDC is +vely sloped.

(Giffen Good)

78

Topic 1Lecture 7


Topic 1 Lecture 8

Market Demand

X

p

01 02 0M

D2D1

p p

?

79

See Handout


Topic 1 Lecture 8

Market Demand

X

p

01 02 0M

D2D1

p p

80


Topic 1 Lecture 8

Market Demand

Horizontal Summation (Why?)(Note: we’ll see a case of vertical summation later in the module)

Notice than in the 2-person case above, the market demand curve is ‘kinked’.

X

p

01 02 0M

D2D1

p p

DM

81


Topic 1 Lecture 8

Consumer Surplus

Interpret the ‘Marginal Willingness to Pay’ (Marginal Benefit, Marginal Valuation)

X0

p

p*

X*

S

D

82

See Handout


Topic 1 Lecture 8

Consumer Surplus

Consumer Surplus on ‘first unit’.

X0

p

p*

X*

S

D

83


Topic 1 Lecture 8

Consumer Surplus

Consumer Surplus on ‘all units’.

A

0

p

p*

X*

S

D

84


Topic 1 Lecture 8Demand Elasticity

We have already said that the Price Elasticity of Demand for a Good is a measure of the sensitivity or responsiveness of demand for a good to a change in its price. More precisely:

. . . Percentage change in demand Percentage change in price

. 100 or . .

. 100

Note: 0.

Consider the special case of the linear demand curve . . .

p e ddx dx

dx p dx px xdp dp x dp dp xp p

85

See Handout




or .

Consider the special case of the linear demand curve:

1, or;

1It follows that:

And h

p e ddx pdp x

ap a bx x pb bdxdp b

1ence that: . ,

where is the slope of the linear demand curve.

Can you work out what happens to as we move down along the demand curve?

pb x

b

86

See Handout




or .

Consider the following examples:(i) 0.

(ii) 1; implying . 1, or

(iii) 1< <0.(iv)

p e ddx pdp x

dx p dx dpdp x x p

< < 1.

How would you interpret each of these?

87

See Handout


Topic 1 Lecture 8

(i) 0.

(ii) 1; implying . 1, or

(iii) 1< <0.(iv) < < 1.

dx p dx dpdp x x p

1< <0

Demand Elasticity

0-1

< < 1

88

See Handout


Topic 1 Lecture 8

Notice that:

Inelastic demand: 1 0 and 1

Elastic demand: 1 and 1.

So, with elastic demand, is 'smaller' in the sense of being more negative,but is 'bigger' in the sense of the absolute val

ue, .

1< <0

Demand Elasticity

0-1

< < 1

89

See Handout


Topic 1 Lecture 9

Importance of Elasticity

Suppose the Government raises the indirect tax on this commodity. How do we show this?

X0

p

p*

X*

S

D

90

See Handout


Topic 1 Lecture 9


What is the Tax Revenue . . . ?

X0

p

p*

X*

S

D

ST

91


Topic 1 Lecture 9


What is the Tax Revenue?What is the Tax Burden?

X0

p

p*

X*

S

D

ST

AB

92


Topic 1 Lecture 9


What is the Tax Burden?How would the shares of the tax burden change with a different price elasticity of demand for the good?

X0

p

p*

X*

S

D

ST

AB

S

ST

0 X*

p

93


Topic 1 Lecture 9


What is the Tax Burden?How would the shares of the tax burden change with a different price elasticity of demand for the good?

X0

p

p*

X*

S

D

ST

AB

S

ST

0 X*

p

D

94


Topic 1 Lecture 9


How would the shares of the tax burden change with a different price elasticity of demand for the good? Why is this?

X0

p

p*

X*

S

D

ST

AB

S

ST

0 X*

p

D

AB

95


Topic 1 Lecture 10Applications of Consumer Choice Theory1. Labour Supply: The Income-Leisure Trade-off

Leisure

Income

IC

96

See Handout


Topic 1 Lecture 10

Labour Supply: The Income-Leisure Trade-off

Leisure

Income

IC

Tmax

Tmax

Time Constraint: Tmax

0Labour Supply

0

97


Topic 1 Lecture 10


Leisure

Income

Tmax

Tmax

Wage Constraint: w (wage per hour)

0Labour Supply

0

w

98


Topic 1 Lecture 10


Leisure

Income

Tmax

Tmax

Wage Constraint: w (wage per hour)

And Non-labour income, N.

0Labour Supply

0

w

N

99


Topic 1 Lecture 10


Leisure

Income

IC

Tmax

Tmax

Optimisation, given w, N and Tastes.

Total Income = Labour Income +

Non-Labour Income

Total Income = Y + N

0Labour Supply

0

w

N

L*

N

Y

100


Topic 1 Lecture 10


Leisure

Income

IC

Tmax

Tmax

Optimisation, given w, N and Tastes.

What happens to optimal Labour Supply if N rises (why might it?)?

0Labour Supply

0

w

N

L*

N

Y

101


Topic 1 Lecture 10


Leisure

Income

IC

Tmax

Tmax

What happens to optimal Labour Supply if N rises

0

N

102

See Handout


Topic 1 Lecture 10


Leisure

Income

IC

Tmax

Tmax

What happens to optimal Labour Supply if N rises?

Under what assumption?

Why?

0

N

IC*a

b

103


Topic 1 Lecture 10


Leisure

Income

IC

Tmax

Tmax

0Labour Supply

0

w

N

L*

N

Y

w

L, Labour

Supply

What happens to optimal Labour Supply if w rises?

a a

L*

w

104

See Handout


Topic 1 Lecture 10

Leisure

Income

IC

Tmax

Tmax

0Labour Supply

0

w

N

L*

w

L, Labour

Supply


a a

L*

105


Topic 1 Lecture 10

Leisure

Income

IC

Tmax

Tmax

0Labour Supply

0

w

L*

w

L, Labour

Supply


a a

L*

a*

106


Topic 1 Lecture 10

Leisure

Income

IC

Tmax

Tmax

0Labour Supply

0

L*

w

L, Labour

Supply

What is the implied shape of the Labour Supply curve in this case?

aa

L*

a* a*

107


Topic 1 Lecture 10

Leisure

Income

IC

Tmax

Tmax

0Labour Supply

0

L*

w

L, Labour

Supply

What is the implied shape of the Labour Supply curve in this case? And the elasticity of Labour Supply?

a Ls

L*

a*

108


Topic 1 Lecture 10

Leisure

Income

IC

Tmax

Tmax

0Labour Supply

0

L*

To understand how labour supply responds to a change in the wage rate, it is useful to exploit the distinction between Income and Substitution Effects.

To do this, we need to shift back the new Budget Line until it is just a tangent to the original Indifference Curve . . .

a

a*

109

See Handout


Topic 1 Lecture 10

Leisure

Income

Tmax

Tmax

0Labour Supply

0

L*


To do this, we need to shift back the new Budget Line until it is just a tangent to the original Indifference Curve . . .

a

a*

110


Topic 1 Lecture 10

Leisure

Income

Tmax

Tmax

0Labour Supply

0

L*


To do this, we need to shift back the new Budget Line until it is just a tangent to the original Indifference Curve . . . with the move from ‘a’ to ‘a*’ split into:

‘a’ –> ‘b’; Substitution Effect,

‘b’ –> ‘a*’; Income Effect.

a

a*b

S

I

111


Topic 1 Lecture 10

Leisure

Income

Tmax

Tmax

0Labour Supply

0

L*

a

a*b

S

I



When the Substitution and Income Effects just cancel each other out, the rise in the wage rate has no net effect on Labour Supply and the derived Labour Supply curve is vertical, as we have seen.

112


Topic 1 Lecture 10

Leisure

Income

Tmax

Tmax

0Labour Supply

0

L*



How would you interpret the Income Effect in words?

And the Substitution Effect

(Hint: exploit the concept of the Opportunity Cost)

a

a*b

S

I

113


Topic 1 Lecture 10

Leisure

Income

Tmax

Tmax

0Labour Supply

0

L*



When the Substitution and Income Effects just cancel each other out, the rise in the wage rate has no net effect on Labour Supply and the derived Labour Supply curve is vertical, as we have seen.

What about if the Substitution Effect dominates?

What is the shape of the Labour Supply curve in this case?

a

a*b

S

I

114


Topic 1 Lecture 10

Leisure

Income

Tmax

Tmax

0Labour Supply

0

L*

w

L, Labour

Supply


a Ls

L*

a*

I S

When the S-effect dominates the I-effect

a

a*

115


Topic 1 Lecture 10

Leisure

Income

Tmax

Tmax

0Labour Supply

0

L*

w

L, Labour

Supply


a

Ls

L*

a*

I S

When the S-effect dominates the I-effect

a

a*

S I

116

See Handout


Topic 1 Lecture 10

Leisure

Income

Tmax

Tmax

0Labour Supply

0

L*

w

L, Labour

Supply


a

Ls

L*

a*

I S

When the I-effect dominates the S-effect

a

a*

I S

117

See Handout


Topic 1 Lecture 10

I S

S I

Labour Supply: the evidence . . .

And for most people?And the implication for income tax cuts?

w

L

Ls

S I

118

See Handout


Topic 1 Lecture 11Applications of Consumer Choice Theory2. Inter-temporal Choice

I1 , C1

I0 , C0

Think of an ‘Endowment Point’ and add it to the diagram.

119

See Handout


Topic 1 Lecture 11Inter-temporal Choice

I1 , C1

I0 , C0

From the Endowment Point, where can Saving take you?

And Borrowing?

E

I0

I1

120



I1 , C1

I0 , C0


(And Borrowing?)

E

I0

I1

121



I1 , C1

I0 , C0


(And Borrowing?)

E

One Euro saved this period yields one Euro plus (one Euro times the rate of interest) next period. Or . . .

I0

I11

1+i

122



I1 , C1

I0 , C0


E

Or . . .

0 0 0 0( ) saved yields (1 )( ) next period.I C i I C

I0

I1

123


Topic 1 Lecture 11


0 0( )I C

Inter-temporal Choice

I1 , C1

I0 , C0


E

Or . . .I0

I1

0 0(1 )( )i I C

C0

C1

124


Topic 1 Lecture 11


0 0( )I C


I1 , C1

I0 , C0


What is the slope of the budget constraint?

E

Or . . .I0

I1

0 0(1 )( )i I C

C0

C1

125


Topic 1 Lecture 11

0 0 0 0( ) borrowed reduces consumption by (1 )( ) next period.C I i C I


I1 , C1

I0 , C0

From the Endowment Point, where can Borrowing take you?

E

Or . . .I0

I1

C0

C1

126

See Handout



I1 , C1

I0 , C0

From the Endowment Point, where can all possible Saving or Borrowing take you?

This is the inter-temporal budget constraint.

E

I0

I1

Slope = (1 )i

127



I1 , C1

I0 , C0

What is the value of C1?

(Note the value of the slope.)

E

I0

I1

(1 )i

C1

C0

1 1 0 0 +(1 )( ).C I i I C

128

See Handout



I1 , C1

I0 , C0

Re-arranging:

E

I0

I1

(1 )i

C1

C0

1 1 0 0

1 10 0

+(1 )( )

+(1 )

C I i I C

I CC Ii

129



I1 , C1

I0 , C0

This is the horizontal intercept of the budget constraint. What is its interpretation?

E

I0

I1

10 (1 )

IIi

C1

C0

1 10 0

1

10 0

+(1 )

If we now let =0, then:

+(1 )

I CC IiC

IC Ii

130


Topic 1 Lecture 11

10 (1 )

IIi


I1 , C1

I0 , C0

How would you show the effect on the inter-temporal budget constraint of a fall in the rate of interest?

E

I0

I1

C1

C0

(1 )i

131

See Handout


Topic 1 Lecture 11

10 (1 )

IIi


I1 , C1

I0 , C0

What happens to the Present Value of E after a fall in the rate of interest?

E

I0

I1

C1

C0

(1 )i

132



I1 , C1

I0 , C0

How would you represent an individual’s preferences over consumption today and tomorrow?

E

I0

I1

133

See Handout



I1 , C1

I0 , C0

What does the slope of the indifference curve represent?

If the MRTP is high (low), what does this mean?

E

I0

I1

134



I1 , C1

I0 , C0

Optimisation.

E

I0

I1

A

C0

C1

135

See Handout



I1 , C1

I0 , C0

Is this person saving or borrowing?

E

I0

I1

A

C0

C1

136



I1 , C1

I0 , C0

How will they respond to a fall in the rate of interest?

E

I0

I1

A

C0

C1

137



I1 , C1

I0 , C0

How will they respond to a fall in the rate of interest?

Consider the substitution effect.

E

I0

I1

A

C0

C1

138

See Handout



I1 , C1

I0 , C0

Borrowing is cheaper and so the borrower borrows more (Substitution effect).

They are also better off (why?): so there is an Income effect.

Which way does Income effect go?

E

I0

I1

A

C0

C1

139



I1 , C1

I0 , C0

Borrowing is cheaper and so the borrower borrows more (Substitution effect).

They are also better off (why?): so there is an Income effect.

Which way does Income effect go?

E

I0

I1

A

C0

C1

‘S’ ‘I’

B

140



I1 , C1

I0 , C0

So fall in the rate of interest leads Borrower to borrow more: unless Consumption today is a . . . . ‘?’ Good.

E

I0

I1

A

C0

C1

‘S’ ‘I’

B

141



I1 , C1

I0 , C0

How would you show the effect on a Borrower of a rise in the interest rate?Will the Borrower borrow more or less? On what does your answer depend?E

I0

I1

A

C0

C1

142

See Handout



I1 , C1

I0 , C0

How would you show the effect on a Saver of a rise in the interest rate?

Will the Saver save more or less? On what does your answer depend?E

I0

I1

A

C0

C1

143

See Handout



I1 , C1

I0 , C0

How would you show the effect on a Saver of a fall in the interest rate?

Will the Saver save more or less? On what does your answer depend?E

I0

I1

A

C0

C1

144

See Handout


Topic 1 Lecture 11Intertemporal Choice

10

1 20 2

We saw earlier that .(1 )

Suppose that there are more than the 2 periods:

... .(1 ) (1 ) (1 )

Suppose the stream of Income from an Investment is constant and net of costs:

nn

IPV Ii

II IPV Ii i i

NPV I

2 ... .(1 ) (1 ) (1 )

If the income is in Perpetuity, then we have the remarkably simple result that:

.

What is the implication of this for the effect of on Investment?

n

I I Ii i i

INPVi

i

145

See Handout


Topic 1 Lecture 12

Gains from Trade

Consider an industry in an Autarkic country:

X

p

Sd

Dd

Xd

pd

What is the extent of Consumer Surplus in this case?

146

See Handout


Topic 1 Lecture 12

Gains from Trade


X

p

Sd

Dd

Xd

pd

What is the extent of Consumer Surplus in this case?

A

147


Topic 1 Lecture 12

Gains from Trade


X

p

Sd

Dd

Xd

pd

And Producer Surplus in this case?

A

148


Topic 1 Lecture 12

Gains from Trade


X

p

Sd

Dd

Xd

pd

And Producer Surplus in this case?

A

B

149


Topic 1 Lecture 12

Gains from Trade


X

p

Sd

Dd

Xd

pd

Suppose that in the Rest of the World, the World Price of X, pw, was higher than pd.

What would this mean?

pw pw

150

See Handout


Topic 1 Lecture 12

Gains from Trade

Consider trade. Suppose the World Price exceeds the Domestic Autarkic price:

X

pSd

Dd

Xd

pd

Domestic Firms would not be prepared to sell any units at the low price of pd.

They will sell at the World Price by exporting to the Rest of the World at the World Price of pw.

Domestic Demand (and sales) are equal to Xdt at the world price.

pw pw

Xdt

151


Topic 1 Lecture 12

Gains from Trade


X

pSd

Dd

Xd

pd

Domestic Firms would not be prepared to sell any units at the low price of pd.

They will sell at the World Price by exporting to the Rest of the World at the World Price of pw.

Effectively, the Domestic Firms’ Supply curve becomes the one in bold. Be sure you can explain this to yourself.

pw pw

Xdt

152


Topic 1 Lecture 12

Gains from Trade


X

pSd

Dd

Xd

pd

Effectively, the Domestic Firms’ Supply curve becomes the one in bold. Be sure you can explain this to yourself.

Total Domestic Firm sales are given by Xt. Exports are equal to Xt – Xdt.

pw pw

Xdt Xt

153


Topic 1 Lecture 12

Gains from Trade


X

pSd

Dd

Xd

pd

What has happened to CS and PS, and hence total welfare, in this country under the equilibrium with trade compared to the total welfare (CS+PS) in this country under Autarky?

So Who Gains and Who Loses from Trade (and by how much in each case)?

Work it out for yourself.

pw pw

Xdt Xt

154

See Handout


Topic 1 Lecture 12

Gains from Trade


X

p

Sd

Dd

Xd

pd

Suppose that in the Rest of the World, the World Price of X, pw, was lower than pd.

What would this mean?

pw pw

155

See Handout


Topic 1 Lecture 12

Gains from Trade

Consider trade. Suppose the World Price is less than the Domestic Autarkic price:

X

p

Sd

Dd

Xd

pd

Domestic buyers would not be prepared to buy any units at the high price of pd.

They will want to buy at the World Price by importing from the Rest of the World at the World Price of pw.

Domestic Supply (and hence sales) are equal to Xdt at the world price.

pw pw

Xdt

156


Topic 1 Lecture 12

Gains from Trade


X

p

Sd

Dd

Xd

pd

Domestic buyers would not be prepared to buy any units at the high price of pd.

Effectively, the Domestic Buyers’ Demand curve becomes the one in bold. Be sure you can explain this to yourself.

pw pw

Xdt

157


Topic 1 Lecture 12

Gains from Trade


X

p

Sd

Dd

Xd

pd

Effectively, the Domestic Buyers’ Demand curve becomes the one in bold. Be sure you can explain this to yourself.

Total Domestic Buyers’ consumption is given by Xt. Imports are equal to Xt – Xdt.

pw pw

Xdt Xt

158


Topic 1 Lecture 12

Gains from Trade


X

p

Sd

Dd

Xd

pd

What has happened to CS and PS, and hence total welfare, in this country under the equilibrium with trade compared to the total welfare (CS+PS) in this country under Autarky?

So Who Gains and Who Loses from Trade (and by how much in each case)?

Work it out for yourself.

pw pw

Xdt Xt

159

See Handout


Topic 1 Lecture 12

Gains from Trade


X

p

Sd

Dd

Xd

pd

In the case of a country where there are imports, there might be calls for tariffs or import quotas.

What would be the welfare effects of each of these?

What factors influence the magnitudes of the effects?

pw pw

Xdt Xt

160

See Handout


Topic 1Key Concepts

• The circular flow model• A simple model of a market• Consumer choice: basic setup• Preferences, indifference curves and utility• Budget constraints• Consumer equilibrium: utility maximization• The algebra of consumer equilibrium• Income consumption curves• Price consumption and the derived demand curves

161

See Handout


Topic 1Key Concepts

• The algebra of deriving the demand curve• The compensated demand curve• Income and substitution effects of a price change• Normal, inferior and Giffen goods• Consumer surplus• Market demand • The price elasticity of demand• Tax incidence• Winners and Losers from Trade• Labour supply by the household• Capital supply by the household

162

See Handout


Topic 1Key Readings

• Frank, Chapters 1-5• Estrin, Laidler and Dietrich, Chapters 1-6

• Online resources:• http://www.bized.ac.uk/current/index.htm• http://www.bized.ac.uk/learn/economics/index.htm

163

See Handout

http://www.bized.ac.uk/current/index.htm

http://www.bized.ac.uk/learn/economics/index.htm


Topic 1Seminar Questions: weeks 3,5

(Note Questions in bold (i.e., 1, 2, 6, 8, 11,17) are the questions on which Seminars should focus. Other questions are preparatory and would be good self-study questions to address ahead of seminar meetings)

1. Explain what economists mean by the term ‘market equilibrium’.2. What is meant by the following properties of an equilibrium:

a. Existenceb. Uniquenessc. Stability

3. What is likely to happen to the demand curve if money incomes of consumers rise, ceteris paribus? (What is meant by ceteris paribus?)

4. What factors are held constant along the demand curve?5. What factors are held constant along the supply curve?6. Explain the difference between a movement along the demand curve and a shift of the

demand curve.

164

See Handout


Topic 1Seminar Questions weeks 5-7, continued

7. What are the comparative static properties of a typical market equilibrium (for example, what is likely to happen to the market equilibrium if there is an increase in consumers’ money income)?

8. What are the principal properties of indifference curves? How do these properties relate to the assumptions we make regarding the consumer’s underlying preferences?

9. Using indifference curve analysis, show how the demand for a good responds to a rise in money income, for each of the following cases:

a) A normal goodb) A necessityc) An inferior good

10. Using indifference curve analysis, show how the demand for a good might respond to a change in the price of that good.

11. Show how to decompose the effects of a price change into both income and substitution effects, for each of the possible cases you have considered.

12. Explain intuitively what income and substitution effects are.

165

See Handout


Topic 1Seminar Questions weeks 5-7, continued

13. Why is the market demand curve derived by horizontal (rather then by vertical) summation of the individuals demand curves?

14. Is the market demand curve necessarily kinked (like in the figure in the lecture notes)?15. Define what is meant by Consumer Surplus. How do you represent Consumer Surplus in a

diagram?16. Define what is meant by the (own-) price elasticity of demand for a good.17. What happens to the elasticity of demand as we move along the linear demand curve?18. If a proportional tax rate on labour income is cut, what are the possible implications for the

optimal labour supply choices of workers? Explain your answer using diagrams and be careful to distinguish between Income and Substitution Effects.

19. If the rate of interest rises, will savers save more? Will borrowers borrow less?

Further Self-study question suggestions: Try as many as you can of the discussion questions at the end of each of the chapters in Katz and Rosen (or

Morgan et al.) and of the problems at the end of each of the chapters in Estrin et al..

166

See Handout


167

Topic 2: Firm Behaviour. Lecture 13

•The circular flow model once more

Agent:

Households

Market:

Goods/Services

Market:

Inputs

Agent:

Firms

Demand

Demand

Supply

Supply

See Handout


168

Topic 2 Lecture 13Economic Profit, Revenue and Cost

Firm Objective: Profit-maximisation

Profit = Total Revenue – Total Cost

(Normal Profit if TR – TC = 0)

Total Cost includes the Opportunity Costs of the Owner (and hence is one reason for definitions of costs and profits to vary from the accountant’s definition)

Let’s look first and Revenues and then at Costs

See Handout


169

Revenues

The Firm’s Revenues depend on the Demand Curve it faces:

p=p(X)

e.g.: p = a – bX

Total Revenue is given by

TR = p(X)X

e.g.: TR = (a – bX)X = aX – bX2 Now draw the TR curve.

See HandoutTopic 2 Lecture 13


170

Topic 2 Lecture 13Revenues

TR = (a – bX)X = aX – bX2 Now draw the TR curve.

X

X

p

TR

TR Why does the TR curve rise and then fall . . . ?

See Handout


171


TR = (a – bX)X = aX – bX2

X

X

p

TR

TR

D

This has to do with price elasticity of demand . . .

Demand is elastic

Demand is inelastic

X=a/2b

See Handout


172

Topic 2 Lecture 13

2

First note that for the linear case:

.( )So, TR is maximised when 0.

( ) 2 .

( ) 0 2 0 / 2 .

( )What is the name we give to ?

TR aX bXd TR

dXd TR a bx

dXd TR a bX X a b

dXd TR

dX

See Handout


173


TR = (a – bX)X = aX – bX2

X

X

p

TR

TR

D

Demand is elastic

Demand is inelastic

X=a/2b

MR MR = a – 2bX

See Handout


174

Topic 2 Lecture 13Next, recall that:

.

In the general case, ( ) and hence: ( ) .

( ) ( )So, ( ) .

Or, .

Re-arranging terms, 1 .

1Or, 1 .

dX pdp X

p p XTR pX p X X

d TR dX dp XMR p X XdX dX dX

dpMR p XdX

dp XMR pdX p

MR p

See Handout


175

Topic 2 Lecture 13

1So, 1 .

In other words, is maximised when 0, which is when 1.Suppose demand is elastic ( 1): then we are in the upper part of the demand curve (look back at the diagram to see t

MR p

TR MR

his).

What happens if the firm lowers its price in order to sell an unit of ?There are two effects on :(i) + ve effect: an additional unit is sold at the new price ,(ii) ve effect: the price of

XTR

p each unit sold is now lower than previously.

Identify these 2 effects in terms of the equation for ;

.

If demand is elastic, then only a small price reduction is needed to sell an extra unit

MRdpMR p XdX

,

and the ve effect is relatively weak: the +ve effect dominates and 0 ( ) when 1.MR TR

See Handout


176

Topic 2 Lecture 13Now consider what happens in the lower portion of the demand curve, where demand is inelastic.

1Recall that: 1 .

Suppose demand is inelastic ( 1): then we are in the lower part of the dema

MR p

nd curve (look back at the diagram to see this).

What happens if the firm lowers its price in order to sell an unit of ?There are two effects on :(i) + ve effect: an additional unit is sold at the

XTR

new price ,(ii) ve effect: the price of each unit sold is now lower than previously.

.

If demand is inelastic, then a large price reduction is needed to sell an extra unit,

and the ve effe

p

dpMR p XdX

ct is relatively great: it dominates and 0 ( ) when 1.MR TR

See Handout


177

Topic 2 Lecture 13

Finally, consider what happens when demand is unit elastic.

1Recall that: 1 .

Suppose demand is unit elastic ( 1): then we are at the mid-point of the linear demand curve (look back at the

MR p

diagram to see this).

What happens if the firm lowers its price in order to sell an unit of ?There are two effects on :(i) + ve effect: an additional unit is sold at the new price ,(ii) ve effe

XTR

p ct: the price of each unit sold is now lower than previously.

.

If demand is unit elastic, then the + ve effect and the ve effect are just equal: 0 ( is unchanged) when 1.

dpMR p XdX

MR TR

See Handout


178


X

X

p

TR

TR

D

Demand is elastic

Demand is inelastic

X=a/2b

MR

The relationships between:

Demand

TR

MR

should all now be clear to you.

See Handout


179

Topic 2 Lecture 14

Putting Simple Costs and Revenues together

X

X

p

TR

TR

D

X=a/2b

MR

Suppose that your business has just one fixed cost to pay:

How would you show this on

the lower panel of the diagram?

And on the upper panel?

See Handout


180

Topic 2 Lecture 14


X

X

p

TR

TR

D

X=a/2b

MR


How would you show this on

the lower panel of the diagram?

And on the upper panel?

MC=0

TC


181

Topic 2 Lecture 14


X

X

p

TR

TR

D

X=a/2b

MR


What is the profit-maximising output level?

(Recall that = TR – TC.)

TC


182

Topic 2 Lecture 14


X

X

p

TR

TR

D

X=a/2b

MR

In this case, what is the profit-maximising output level?

TC

See Handout


183

Topic 2 Lecture 14


X

X

p

TR

TR

D

X=a/2b

MR

Now suppose that the firm has no fixed costs, but only has variable ‘running’ costs (e.g.?).

How would you show this in the diagram?


TC?

See Handout


184

Topic 2 Lecture 14


X

X

p

TR

TR

D

X=a/2b

MR


How would you show this in the upper panel?

TC


185

Topic 2 Lecture 14


X

X

p

TR

TR

D

X=a/2b

MR


How would you show this in the upper panel?

TC

MC


186

Topic 2 Lecture 14


X

X

p

TR

TR

D

X=a/2b

MR

What does this case represent in terms of costs?

What is the profit-maximising output level?

Where is the MC curve? How does it differ from the previous example?

TC

See Handout


187

Topic 2 Lecture 14


X

X

p

TR

TR

D

X=a/2b

MR

Notice that the general principle is that Profit is maximised when the vertical difference between TR and TC is maximised.

(Because = TR – TC).

TC

See Handout


188

Topic 2 Lecture 14


X

X

p

TR

TR

D

X=a/2b

MR



In the upper panel, this translates into the condition that . . . ?

Why?

TC


189

Topic 2 Lecture 14


X

X

p

TR

TR

DMR



In the upper panel, this translates into the condition that . . . ?

TC

MC


190

Topic 2 Lecture 14


X

X

p

TR

TR

DMR

What is the value of X when MR = MC?

Consider the linear demand case . . .

TC

MC

See Handout


191

Topic 2 Lecture 14

2

Recall that for the linear case:

.which implies that:

( ) 2 .

Now let .

Then it follows that implies that:

2 .2

TR aX bX

d TR MR a bxdX

MC c

MR MC

a ca bX c Xb

See Handout


192

Topic 2 Lecture 14


X

X

p

TR

TR

DMR

What if . . . ?

. . . when MR = MC,

TR < TC?TC

MC

2a cX

b

See Handout


193

Topic 2 Lecture 14


X

X

p

TR

TR

DMR

So the Profit-maximising condition is:

Choose X such that MR = MC,

so long as TR ≥ TC. TC

MC

2a cX

b

See Handout


194

Topic 2 Lecture 15• Isoquants, the Short-run production function, Marginal product of labour, and

firm’s costs.

Production isoquants and the MRTS

A household consumes x and y and derives Utility.x and y are inputs and utility is an output.We represent the relationship with indifference curves.

For a firm, K and L are inputs and X is the output.We represent the relationship with production isoquants.

Also think about concept of a trade-off alongthe Isoquant.

xK

L

U

y

X

Slope of IC is MRS

U = U(X, Y)

Slope of Iso-quant is MRTS

X = X(K, L)

See Handout


195

Topic 2 Lecture 15

Sometimes we abbreviate this to :( )X X L

In the short-run, K is fixed:

X

L

( , )X X K L

The short-run production function: X = X(L)

In the short-run the firm can vary only Labour inputs.

Labour costs are Variable.

Costs of Capital are Fixed.

See Handout


196

Topic 2 Lecture 15X

L


The slope of the short-run production function is positive, but it is decreasing . . .

See Handout


197

Topic 2 Lecture 15X

L


Slope of

X=X(L)

L

In terms of Economics, what is the slope of X(L)?

See Handout


198

Topic 2 Lecture 15X

L


MPPL

L

dLdX ( )

is the change in outputwhen one extra unit of L is employed.Here we are assuming diminishingMPPL (i.e., 'DRL').

X X L

dXMPPLdL

See Handout


199

Topic 2 Lecture 15Digression on the relationship between MPPL and MRTS:

Consider the production function:( , )

Totally differentiate:

(Interpret this in words)

Along the Iso-quant, dX = 0: thus,

X X K L

X XdX dL dKL K

X dLL

0, or,

=>

X dKK

XX X dK MPPLLdK dL MRTSXK L dL MPPK

K

See Handout

The textbook Estrin et al goes into this in much more detail.


200

Topic 2 Lecture 15X

L

X = X(L)

From the shape of the Short-run production function, we can infer the shape of the firm’s MPPL curve, as we have seen, and also:

(i) the shape of the firm’s Short-run Marginal Cost (MC) curve and

(ii) the shape of the firm’s Short-run Total Variable Cost (STVC) curve.

(For now, we are considering only the firm’s Variable Costs.)

DRL

See Handout


201

Topic 2 Lecture 15X

L

X = X(L)

From the shape of the Short-run production function, we can infer the shape of the firm’s MPPL curve and also:

(i) the shape of the firm’s Short-run Marginal Cost (MC) curve

DRL

See Handout


202

Topic 2 Lecture 15X

L

X = X(L) From the shape of the Short-run production function, we can infer the shape of the firm’s MPPL curve and also:


DRL

X

MC

dX1

dX2

X1

X2

X1 X2

What is the Marginal Cost of raising output by one unit from X1?

See Handout


203

Topic 2 Lecture 15X

L



DRL

X

MC

dX1

dX2

X1

X2

X1 X2

What is the Marginal Cost of raising output by one unit from X2 . . . . ?

= ?

dL1

See Handout


204

Topic 2 Lecture 15X

L



DRL

X

MC

dX1

dX2

X1

X2

X1 X2

What is the Marginal Cost of raising output by one unit from X2 . . . . ?

= ?

dL1 dL2

See Handout


205

Topic 2 Lecture 15X

L



DRL

X

MC

dX1

dX2

X1

X2

X1 X2

So:

MC(X1) = w.dL1 and

MC(X2) = w.dL2 =>Thus, MC1<MC2.

dL1 dL2

See Handout


206

Topic 2 Lecture 15X

L



DRL

X

MC

dX1

dX2

X1

X2

X1 X2

So:

MC(X1) = w.dL1 and


dL1 dL2

MC1

MC2

See Handout


207

Topic 2 Lecture 15X

L



DRL

X

MC

dX1

dX2

X1

X2

X1 X2

So:

MC(X1) = w.dL1 and


dL1 dL2

MC1

MC2

MC

See Handout


208

Topic 2 Lecture 15X

L

X = X(L) Three ways of showing the same thing . . .

. . . DRL

DRL

X

MC

dX1

dX2

X1

X2

X1 X2

dL1 dL2

MC1

MC2

MCMPPL

DRL DRL

MPPL

See Handout


209

Topic 2 Lecture 15X

L

X = X(L)

From the shape of the Short-run production function, we can also infer :

(ii) the shape of the firm’s Short-run Total Variable Cost (STVC) curve.

DRL

X

MCMC

X

STVC

?

DRL

See Handout


210

Topic 2 Lecture 15X

L

X = X(L)

The STVC shows us what happens to the firm’s total Labour costs as output (and hence labour employment) increases.

STVC certainly increasing: but is it linear? Or is it getting steeper? Or flatter?

As MC is rising under DRL, it follows that STVC is getting steeper: Why?

DRL

X

MCMC

X

STVC

?

DRL

DRL

See Handout


211

Topic 2 Lecture 15X

L

X = X(L)

As MC is rising under DRL, it follows that STVC is getting steeper: Why?

Mathematically, what is the relationship between STVC and MC?

DRL

X

MCMC

X

STVC STVC

DRL

DRL

DRL

See Handout


212

Topic 2 Lecture 15X

L

X = X(L)

DRL

X

MCMC

X

STVC STVC

DRL

DRL

DRL

L

MPPL

MPPLDRL

See Handout


213

Topic 2 Lecture 15X

L

X = X(L)

X

MC

?

X

STVC

?

IRL

IRL

IRL

L

MPPL

?

IRL

See Handout


214

Topic 2 Lecture 15X

L

X = X(L)

X

MC

?

X

STVC

?

CRL

CRL

CRL

L

MPPL

?

CRL

See Handout


215

Topic 2 Lecture 15X

L

X = X(L)

X

MC

?

X

STVC

?

DRL

L

MPPL

?

IRL

See Handout


216

Topic 2 Lecture 16

X

MC X

STVC

DRL

IRL

STVC

MC

See Handout


217

Topic 2 Lecture 16

X

MC X

STVC

DRL

IRL

STVC

MC

Define SAVC = STVC/X

How would you represent it in the diagram?

See Handout


218

Topic 2 Lecture 16

X

MC X

STVC

DRL

IRL

STVC

MC

Define SAVC = STVC/X

How would you represent it in the diagram?

At X1, which is greater, MC or SAVC?

And at X2?X1 X2

See Handout


219

Topic 2 Lecture 16

X

MC X

STVC

DRL

IRL

STVC

MC

At what point on STVC is MC=SAVC?

X1 X2

See Handout


220

Topic 2 Lecture 16

X

MC X

STVC

DRL

IRL

STVC

MC

At what point on STVC is MC=SAVC?

X1 X2 X3

To the right of X3, which is greater, MC or SAVC?

See Handout


221

Topic 2 Lecture 16

X

MC X

STVC

DRL

IRL

STVC

MC

X1 X2 X3

SAVC

See Handout


222

Topic 2 Lecture 16

MC MC SAVC SAVC

XWe now need to add the STFC to STVC to get STC (=STVC + STFC).

Then we can derive SAFC in the diagram above and hence SATC = SAVC + SAFC).

See Handout


223

Topic 2 Lecture 16

X

MC X

STVC STVC

MC

Add in STFC.

STC is just the vertical sum of STVC and STFC.

So MC can be derived from either STVC or STC: it’s the ‘marginal’ curve of both.

STFC

STVC + STFC = STCSee Handout


224

Topic 2 Lecture 16

X

MC X

STVC STVC

MC

What about SAFC?

STFC

STVC + STFC = STC

SAFC

See Handout


225

Topic 2 Lecture 16

MC MC SAVC SAVC

XSo we can now add SAFC in the diagram above and hence derive

SATC = SAVC + SAFC.

SAFC

See Handout


226

Topic 2 Lecture 16

MC MC

SAVC SAVC

XSo we can now add SAFC in the diagram above and hence derive

SATC = SAVC + SAFC.

SAFC

SATC

See Handout


227

Topic 2 Lecture 16

MC MC

SAVC SAVC

XThese are the 3 crucial short-run cost curves we’ll be using.

SATC

See Handout


228

Topic 2 Lecture 16

MC MC

SAVC SAVC

XNext, we’ll add a curve to the diagram to show the Demand Curve which the firm faces.

SATC

See Handout


229

Topic 2 Lecture 17

MC MC

SAVC SAVC

XNow we add a curve to the diagram to show the Demand Curve which the firm faces.

Where is the firm’s Marginal Revenue curve (see slide 173)?

SATC

D

See Handout


230

Topic 2 Lecture 17

MC MC

SAVC SAVC

X

SATC

D

MRWhat is the firm’s profit-maximising output?


231

Topic 2 Lecture 17

MC MC

SAVC SAVC

X

SATC

D


What is the Price? Super-normal Profit?


232

Topic 2 Lecture 17p

MC

SAVC

X

SATC

D


What is the Price? Super-normal Profit? STC? STVC? STFC?


233

Topic 2 Lecture 17

MC MC

SAVC SAVC

XNow add a curve to the diagram to show a lower Demand Curve . . .

SATC

See Handout


234

Topic 2 Lecture 17

MC MC

SAVC SAVC

XNow add a curve to the diagram to show a lower Demand Curve . . .

SATC


235

Topic 2 Lecture 17

MC MC

SAVC SAVC

XNow add the MR Curve to determine the profit-maximising market output by the firm and its chosen price. What can you say about the extent of profits?

SATC

MR D

X*

p*


236

Topic 2 Lecture 17

MC MC

SAVC SAVC

XWhat can you say about the extent of profits at X*?

What would be the extent of the loss if the firm produced nothing?

SATC

MR D

X*

p*A

See Handout


237

Topic 2 Lecture 17

MC MC

SAVC SAVC

XWhat would be the extent of the loss if the firm produced nothing (X = 0)?

So where does the firm produce: X = X* or X = 0?

SATC

MR D

X*

p*AB

SATC(X*)

SAVC(X*)


238

Topic 2 Lecture 17

p

MC

SAVC

XIn the previous slide, SATC(X*) > p* > SAVC(X*).

Now consider SATC(X*) > SAVC(X*) > p* .

SATC

MRD

X*

p*

SATC(X*)

SAVC(X*)

See Handout


239

Topic 2 Lecture 17

p

MC

SAVC

X

What is the extent of the loss if the firm produces nothing (X = 0)?It’s given by STFC: which is represented in the diagram by . . . ?Note: STFC = SAFC x X = (SATC – SAVC)X.

SATC

MRD

X*

p*

SATC(X*)

SAVC(X*)


240

Topic 2 Lecture 17

p

MC

SAVC

XSo, the loss associated with producing at X = X* now exceeds the loss associated with producing at X = 0: because p* < SAVC(X*).

This suggests the following (Shut-Down) Rule . . .

SATC

MRD

X*

p*

SATC(X*)

SAVC(X*)


241

Topic 2 Lecture 17

p

MC

SAVC

XProduce at X* (where MR = MC) so long as p* ≥ SAVC(X*): otherwise produce at X = 0 (i.e., shut-down production) and make minimal losses of STFC.

SATC

MRD

X*

p*

SATC(X*)

SAVC(X*)

See Handout


242

Topic 2 Lecture 17

p

LMC

XThere is no such thing as ‘LAFC’. Hence, LATC = LAVC. We call it LAC, for short.

An important matter is the relationship between the SATC curve and the LAC: see Morgan Katz and Rosen pages 345-349 and ESPECIALLY Estrin et al pages 177-180.

LAC

In the long-run, all inputs (K and L) are variable.

In the long-run, we talk about ‘returns to scale’ as both labour and capital inputs can be varied.

IRS DRS

See Handout


243

Topic 2 Lecture 17

p

LMC

XEnter if p* ≥ LAC(X*).

Exit if p* < LAC(X*).

LAC*

In the long-run, we get the entry/exit rules:

D

MR

p*

See Handout


244

Topic 2

• Frank, Chapters 9-10• Estrin, Laidler and Dietrich, Chapters 8 & 9.


245

Topic 2Key Concepts

Normal ProfitSuper (and sub) – normal ProfitBreak Even ProfitTotal RevenueMarginal RevenueTotal CostMarginal CostFixed CostTotal Variable CostShort-run Average Variable CostShort-run Average Fixed CostShort-run Average Total Cost


246

Topic 2Key Concepts

Profit MaximisationProduction IsoquantsMarginal Rate of Technical SubsttutionProduction FunctionShort-run Production FunctionMarginal Physical Product of LabourDecreasing (Increasing/Constant) Returns to Labour


247

Topic 2• Seminar Questions (For Term 1 week 9 – Term 2 week 11)

– 1. Assume that demand is linear. Explain why, when demand is elastic, a fall in price will lead to an increase in total revenue. Why, when demand is inelastic does the fall in price cause TR to fall?

– 2. Show in a diagram how to represent the Total Cost Curve for the following cases:• Fixed Costs, no Variable Costs• Variable Costs, no Fixed Costs• Both Fixed and Variable Costs

– 3. Profit is maximised when TR-TC is at a maximum: show how to find the profit-maximising level of output in a diagram with TR and TC.

– 4. Show how the MR curve relates to the TR curve– 5. Show how the MC curve relates to the TC curve


248

Topic 2• Seminar Questions (For Term 1 week 9 – Term 2 week 11)

– 6. Why are profits maximised when MR = MC?– 7. Suppose TR < TC when MR = MC: should the firm still produce at MR = MC?– 8. Show how the shapes of the following curves are all related to each other:

• Short-run Production Function• MPPL• SMC• STC

- 9. Show how the shapes of the following curves are related to each other:STFC, SAFC, SAVC, SATC, SMC

- 10. Explain what is meant by the short-run shut-down price


249

Topic 2

• Self-study Questions

1. Explain what is meant by the following terms

Normal ProfitSuper (and sub) – normal ProfitBreak Even ProfitTotal RevenueMarginal RevenueTotal CostMarginal CostFixed CostTotal Variable CostShort-run Average Variable CostShort-run Average Fixed CostShort-run Average Total Cost


250

Topic 2


2. Explain what is meant by the following terms

Profit MaximisationProduction IsoquantsMarginal Rate of Technical SubsttutionProduction FunctionShort-run Production FunctionMarginal Physical Product of LabourDecreasing (Increasing/Constant) Returns to Labour


251

Topic 3 Product Markets: Lecture 18

•The circular flow model

Agent:

Households

Market:

Goods/Services

Market:

Inputs

Agent:

Firms

Demand

Demand

Supply

Supply

(Topic 1)

(Topic 2)

(Topic 3) (Topic 4)

(Topic ‘0’ = Intro)(Topic 5 = Structure and efficiency)

See Handout


252

Topic 3 : Lecture 18

Markets differ by nature/extent of competition.

So far, we have assumed (implicitly) that there is just one firm in the market, confronting the entire market demand: a monopolist.

Now consider the extreme opposite case of ‘perfect competition’ – then we’ll look at the more realistic intermediate cases.

See Handout


253

Topic 3 : Lecture 18Perfect competition

All (the very many) firms are assumed identical and will set the same price (each is a price-taker) because:

a firm cannot charge more than the competitive market price (assuming homogeneous goods and perfect information)

a firm cannot charge less than the market price (free entry means that all firms will just break even at the market price)

each firm is so ‘small’ it does not affect market price. Hence:

See Handout


254


Consider the individual firm i:

x

p

pc pc = d

The firm is a price-taker at the market price. Demand is perfectly elastic.

See Handout


255


x

p

pc

Recall that:

.dpMR p XdX

pc = d = mr

Because the firm does not have to reduce price to sell an extra unit (because it is so ‘small’), the marginal revenue is equal to price. Hence, p = d = mr.

See Handout


256

Topic 3 Lecture 18

p MC

SAVC

xWhat is the firm’s chosen output level?

SATC

pc = d = mr pc

See Handout


257

Topic 3 Lecture 18

p MC

SAVC

xSuppose market price rises: now what is the firm’s chosen output? What can you say about the firm’s (short-run) supply curve?

SATC

pc = d = mr pc

See Handout


258

Topic 3 Lecture 18

p MC

SAVC

xSuppose market price falls: now what is the firm’s chosen output? What can you say about the firm’s (short-run) supply curve?

SATC

pc = d = mr pc

See Handout


259

Topic 3 Lecture 18

p MC = s

SAVC

xSuppose market price falls further: now what is the firm’s chosen output? What can you say about the firm’s (short-run) supply curve?

SATC

pc = d = mr pc

See Handout


260


Now consider the long run and also where market price comes from:

x

pcpc = d = mr

p S

D

X

Market price is where market supply meets market demand.

Market demand is exogenous.

What determines market supply?

p

Xc

The market price determines the demand curve faced by the individual firm.

And hence also mr.

See Handout


261


x

pc pc = d = mr

p S

D

X

Can you say where this market supply curve, S, comes from?

p

Xc

lmc = s lac

Here we add the firm’s cost curves (and hence its supply curve): for the long run.

The firm’s supply curve is given by . . . ?

See Handout


262


x

pc pc = d = mr

p

D

X

p

Xc = nx*

lmc = s lac

Recall that we are assuming that all firms are identical. This industry is in equilibrium: why? Define and explain.

x*

1

n

i iS lmc

This is the long-run industry supply curve for a fixed number of firms, n.

See Handout


263


x

pc pc = d = mr

p

D

X

p

Xc = nx*

lmc = s lac

We want to derive now the long-run industry supply curve when the number of firms is not fixed but is allowed to vary so as to yield industry equilibrium, whatever the level of demand.

x*

1

n

i iS lmc

Suppose there is an (exogenous) increase in the level of market demand.

See Handout


264


x

pc pc = d = mr

p

D’

X

p

Xc = nx*

lmc = s lac


x*

1

n

i iS lmc

D

The initial effect is that market price will rise so that demand and supply by the n firms is equal. Each firm is producing increased output. What can you say about profits? And industry equilibrium?

See Handout


265


x

pc pc = d = mr

p

D’

X

p

Xc = nx*

lmc = s lac


x*

1

n

i iS lmc

D

New firms will enter the industry (why?). How do we show this in the diagram?

See Handout


266


1

n E

i iS lmc

Perfect competition

x

pc pc = d = mr

p

D’

X

p

Xc = nx*

lmc = s lac


x*

D

New firms enter the industry.

Where does this process take us? (What are we assuming about new firms and about industry costs?)

1

n

i iS lmc

Xc = (n+E)x*

See Handout


267


1

n E

i iS lmc

Perfect competition

x

pc pc = d = mr

p

D’

X

p

Xc = nx*

lmc = s lac


x*

D

So, in the new equilibrium following the increase in demand: market output is higher; price is unchanged; each of the original firms has returned to its original actions, there are more firms.

1

n

i iS lmc

Xc = (n+E)x*

See Handout


268


1

n E

i iS lmc

Perfect competition

x

pc pc = d = mr

p

D’

X

p

Xc = nx*

lmc = s lac


x*

D

What does the long-run industry supply curve look like? It is perfectly elastic. Essentially, this is because new firms can enter the market without the effect of having to raise price.

1

n

i iS lmc

Xc = (n+E)x*

LRSS

See Handout


269


x

pc pc = d = mr

p

D’

X

p

Xc

lmci = s lac

xi

D

1

n

i iS lmc

What does the long-run industry supply curve look like when new firms are not equally efficient, but when – instead – new firms are less efficient than the original incumbents?

Originally, there is a marginal firm, i, which just breaks even. Then demand shifts and each of the original n firms raises output. So firm i now makes a supernormal profit. Then what happens?

See Handout


270


1

n E

i iS lmc

Perfect competition

x

pc pc = d = mr

p

D’

X

p

Xc

lac

D

New firms enter: the number is now n+E. Could this be the new equilibrium?

1

n

i iS lmc

LRSS??


lmci = s

xi

ab

See Handout


271


1

n E

i iS lmc

Perfect competition

x

pc pc = d = mr

p

D’

X

p

Xc = nx*

lmci,j = s laci

x*

D

Point ‘b’ will be an equilibrium if . . . ? And so the LRSS is where?

1

n

i iS lmc

Xc = (n+E)x*

LRSS??


ab

lacj

See Handout


272


1

n E

i iS lmc

Perfect competition

x

pc pc = d = mr

p

D’

X

p

Xc = nx*

lmci,j = s laci

x*

D

Point ‘b’ will be an equilibrium if . . . ? And so the LRSS is where? And the intuition?

What else would make the long-run industry supply curve upward-sloping (imperfectly elastic)?

1

n

i iS lmc

Xc = (n+E)x*

LRSS??


ab

lacj

See Handout


273

Topic 3 : Lecture 19Perfect competition and Consumer Surplus

X

p

pc

D

Consumer Surplus is given by? And Producer Surplus?

S

Xc

See Handout


274

Topic 3 : Lecture 19Monopoly and Consumer Surplus: Suppose a monopolist takes over the previously competitive industry.

X

p

pc

D

Consumer Surplus under Monopoly is given by? And Producer Surplus under Monopoly?

S

Xc

MCACThe Monopolist

faces the Market Demand Curve.

We assume that the Monopolist’s Cost Curves are simply the sum of those of the individual competitive firms.

See Handout


275

Topic 3 : Lecture 19Monopoly and Consumer Surplus: Suppose a monopolist takes over the previously competitive industry.

X

p

pc

D

Consumer Surplus under Monopoly is given by? And Producer Surplus under Monopoly?

S

Xc

MCAC

MR

pm

Xm

See Handout


276

Topic 3 Lecture 19

• Monopoly welfare loss: recap– A monopoly firm takes over. The Market Demand is now the same as

that for the individual firm: how much will it produce? Price?

DMR

LACLMCIdentify:

p, X, CS, PS under monopoly.

Compare PS and CS under Monopoly and under Perfect Competition.

p

X

S

See Handout


277

Topic 3 : Lecture 19Monopoly and Consumer Surplus: An alternative representation of the Deadweight Loss of Monopoly:

X

p

pc

D

S

Xc

MCAC

MR

pm

Xm

See Handout


278

Topic 3 Lecture 19

• Algebra of monopoly

Assume market demand is given by .Let the monopoly firm's costs be constant; .

The monopoly firm's profit is:( ) ( ) .

The firm's profits are maximised when 0. That is,

p a bXAC MC c

TR TC p c X a bX c X

X

2 0, or ( )/2 .

From this, one can work out the values of:Price, (super-normal) Profit, Consumer Surplus and Welfare, and compare these with the perfectly competitive levels.

a bX c X a c bX

See Handout


279

Topic 3 Lecture 19

• Monopolistic competition– Like Perfect Competition, there are many firms– Unlike Perfect Competition, each faces a downward-sloping demand

curve (why?)– Industry equilibrium is when each just breaks even:

LMC LAC

D

MR

X

p

Here the industry is not in equilibrium:

Why not?

What happens next?

See Handout


280

Topic 3 Lecture 19

• Monopolistic competition– Like Perfect Competition, there are many firms– Unlike Perfect Competition, each faces a downward-sloping demand

curve (why?)– Industry equilibrium is when each just breaks even:

LMC LAC

D

MRX

p

Here the industry is in equilibrium:

Why?

See Handout


281

Topic 3 Lecture 19

• Oligopoly

– Few firms (in our models, we’ll typically assume 2 for simplicity)

– Interdependent (Why?)

– Various possible behaviours• Collusive• Cournot (quantity) Competition

See Handout


282

Topic 3 Lecture 19

• Collusive Oligopoly

– Here the firms simply act as if they were a single monopolist– They determine profit-maximising output and each produce, say, half

of that output. The price is the monopoly price and the welfare loss, compared to perfect competition, is the monopoly welfare loss.

– Example: if p=a – bX and MC=AC=c, then each firm produces:

– It is not then difficult to work out market price, supernormal profits, Consumer Surplus, and Welfare (Loss)

1 2 / 2 ( ) / 4x x X a c b

See Handout


283

Topic 3 Lecture 19

• Oligopoly with Cournot Competition

1 1

Each firm chooses its own profit-maximising output given what the other firm is producing.Consider Firm 1 (of 2):

( ) .Note that market price, , is the same for both firms and depends on market

p c xp

1 2

1 1 2 1

12 1

1

1 2

output, ,where .Substituting,

.

The first-order condition for profit maximisation by Firm 1 is:

2 0, which implies that:

( ) / 2 .This is called Fi

p a bXX x x

a b x x c x

a c bx bxx

x a c bx b

rm 1's Best-Reply Function to Firm 2's chosen output level.

We can draw it.

See Handout


284

Topic 3 Lecture 19

1 1 2: ( ) / 2 .This is called Firm 1's Best-Reply Function to Firm 2's chosen output level.R x a c bx b

1R


1x

2x

See Handout


285

Topic 3 Lecture 19


1 2

2 1

Firm 1's Best-Reply Function to Firm 2's chosen output is given by:( ) / 2 .

Similarly, we can represent Firm 2's Best-Reply Function to Firm 1's chosen output:( ) / 2 .

We can draw both t

x a c bx b

x a c bx b

ogether:

See Handout


286

Topic 3 Lecture 19

1R


2R

1x

2x

See Handout


287

Topic 3 Lecture 19


1 2

2 1

Firm 1's Best-Reply Function:( ) / 2 .

Firm 2's Best-Reply Function:( ) / 2 .

The (oligopoly/duopoly) market is in equilibrium when each firm's output is the best reply to that of the othe

x a c bx b

x a c bx b

1 1

1 1

1

r: i.e., where the best reply functionsintersect. This is where the two best reply functions are satisfied simultaneously:solving, and using symmetry, we obtain:

( ) / 2 ,2 ( )3

x a c bx bbx a c bxbx

1

( )( ) /3

a cx a c b

See Handout


288

Topic 3 Lecture 19

• Oligopoly with Cournot Competition1 2

1 2

As ( ) / 3 ,it follows that:

2( ) /3

How does this compare with output under monopoly (and hencecollusive oligopoly)?How does it compare with output under perfect competition?

What can yo

x x a c b

X x x a c b

u conclude about the comparison of: Price Producer Surplus Consumer Surplus Total Welfareunder Cournot Oligopoly, Collusive Oligopoly, Monopoly and Perfect Competition?

See Handout


289

Topic 3 Lecture 19


It is straightforward to show that the 2 firms do better when colluding than when competing (eg in the Cournot way).

So why don't they always collude?

1. Legality2. Prisoners' Dilemma If Firm 2 is producing the collusively-agreed output, (a-c)/3b, what will Firm 1 want to produce?

See Handout


290

Topic 3

• Frank, Chapters 11-13• Estrin, Laidler and Dietrich, Chapters 11-13, 15, 16





291

Topic 3• Key Concepts

Perfect CompetitionPerfect Consumer InformationFree Entry and ExitHomogeneous ProductsPerfectly elastic demand for the competitive firm’s productMarket demand curve versus demand facing the individual firmCompetitive firm’s supply curve is given my its MC curve (section lying above SAVC curve in short run, LAC curve in log run)Determinants of Industry Long-run supply curve under Perfect CompetitionIndustry EquilibriumMonopolistic CompetitionMonopoly


292

Topic 3• Key Concepts

Welfare loss of monopolyOligopolyDuopolyCollusive oligopolyCournot CompetitionCournot equilibriumBest-reply functionsPrisoners’ DilemmaWelfare loss of oligopoly


293

Topic 3Seminar Questions

– 1. The firm in a perfectly competitive market faces a horizontal demand curve. Why?

– 2. The supply curve of a perfectly competitive firm is given by its Marginal Cost curve: explain and elaborate

– 3. What factors influence the shape of the Long-run industry supply curve in a perfectly competitive market?

– 4. What is ‘Monopoly Welfare Loss’? What determines its magnitude?– 5. What is the mechanism that drives industry equilibrium in a market with the

characteristics of monopolistic competition?– 6. In the case of linear market demand and constant marginal costs, how

does a Cournot equilibrium in a symmetric duopoly compare with a pure monopoly in terms or output, price, and Welfare?


294

The question is: “What is the firm’s demand for labour?”

I.e., what determines the firm’s profit-maximising level of labour demand?

Our answer to this question is that the profit-maximising firm will employ labour up to the level at which the addition to the firm’s total revenue (from the sale of the extra units produced when the firm takes on an extra unit of labour) is just equal to the addition to the firm’s total costs incurred by employing the extra unit of labour.

I.e., the profit-maximising employment rule is:

Marginal Revenue Product of Labour = Marginal Cost of Labour.

Topic 4 Lecture 20 See Handout


295

Topic 4 Lecture 20

Marginal Revenue Product of Labour = Marginal Cost of Labour.

What is the Marginal Revenue Product of Labour (MRPL)?

What is the Marginal Cost of Labour (MCL)?

If the product market is perfectly competitive, then:MRPL = ?

If the labour market is perfectly competitive, then:MCL = ?

See Handout


296

Topic 4 Lecture 20

Consider the Marginal Revenue Product of Labour (MRPL)

L

MRPL

p.MPL=MRPL

What does this assume?

See Handout


297

Topic 4 Lecture 20

Consider the Marginal Cost of Labour (MCL)

L

MCL

Ls = w = MCL

What does this assume?

See Handout


298

Topic 4 Lecture 20

Consider MCL and MRPL together

L

MCL

Ls = w = MCL

What is the firm’s chosen level of employment? Why?

MRPL

MRPL

See Handout


299

Topic 4 Lecture 20

Consider MCL and MRPL together

L

MCL

Ls = w = MCL

What happens to the firm’s chosen level of employment if the competitive wage shifts up?

MRPL

MRPL

What do you conclude about the firm’s demand for labour?

See Handout


300

Topic 4 Lecture 20

L

MCL

Ls = w = MCL

MRPL

MRPL

We have assumed perfect competition in both product and labour markets.

How is the analysis different for a monopolist?

See Handout


301

Topic 4 Lecture 20

L

MCL

Ls = w = MCL

MRPL

MRPL

We have assumed perfect competition in both product and labour markets.

How is the analysis different for a monopsonist?

See Handout


302

Topic 4 Lecture 20

L

MCL

Ls

MRPL

MRPL


See Handout


303

Topic 4 Lecture 20

L

MCL

Ls

MRPL

MRPL


MCL

See Handout


304

Topic 4 Lecture 20

L

MCL

Ls

MRPL

MRPL

What happens with the introduction of a Minimum Wage (MWL) under perfectly competitive markets?

See Handout


305

Topic 4 Lecture 20

L

MCL

Ls

MRPL

MRPL

What happens with the introduction of a Minimum Wage (MWL) under a monopsonist?

MCL

See Handout


306

Topic 4 Lecture 20

L

MCL

Ls

MRPL

MRPL

What happens with the introduction of a Minimum Wage (MWL) under a monopsonist?

MCL

See Handout


307

Topic 4 Lecture 20

L

MCL

Ls

MRPL

MRPL

What happens to the Labour Supply curve with the introduction of a Minimum Wage (MWL) under a monopsonist?

MCL

See Handout


308

Topic 4 Lecture 20

L

MCL

Ls

MRPL

MRPL

What happens to the MCL curve with the introduction of a Minimum Wage (MWL) under a monopsonist?

MCL

See Handout


309

Topic 4 Lecture 20

L

MCL

Ls

MRPL

MRPL

What happens to the Monopsonist’s chosen employment level with the introduction of a Minimum Wage (MWL)?

MCL

See Handout


310

Topic 4

Reading

• Frank, Chapters 14-15• Estrin, Laidler and Dietrich, Chapter 18





311

Topic 4

• Key Concepts

• Marginal product of labour• Marginal revenue product of labour• Marginal cost of labour• Deriving the demand for labour under perfect competition• Deriving the demand for labour under monopoly• MCL under perfect competition• MCL under monopsony• Minimum Wage Legislation under perfect competition• Minimum Wage Legislation under monopsony


312

Topic 4


1. Under the assumption of perfect competition in the labour market, the firm’s MCL is given by the (horizontal) labour supply curve that the firm faces. Explain this.

2. Even in a perfectly competitive labour market, the supply curve to the market is likely to be upward sloping. Explain why.

3. Under the assumption of perfect competition in the labour market, each firm’s labour demand curve is given by it’s MRPL curve. Explain why.

4. The MRPL curve of a firm in a perfectly competitive PRODUCT market is downward-sloping because of the assumption of decreasing returns to labour. Explain.

5. For a monopolist, the MRPL curve is downward sloping for two reasons: what are these two reasons?


313

Topic 4

• Seminar Questions

1. A monopsonist will employ fewer workers than would be employed in a perfectly competitive market. Show this.

2. A monopsonist will pay lower wages than would be paid in a perfectly competitive market. Show this.

3. The monopsonist has no well-defined labour demand curve. Explain this.4. The MCL curve of a monopsonist lies above its labour supply curve.

Explain why this is likely to be true. When would it not be true?5. In perfectly competitive labour markets, minimum wage legislation is

likely to cause job losses. Show this. 6. In a monopsony labour market, minimum wage legislation could

lead to the creation of jobs. Explain this.


314

Topic 5 Market structure, efficiency and failure

Lecture 21

X

p

D

X1

LAC1

Suppose Firm 1 is producing X1. If there are no other firms in the market, what price can Firm 1 charge? Will it make a super-normal profit?

LAC1

Note that output at X1 is called Minimum Efficient Scale (MES). Make sure you understand this.

See Handout


315

Topic 5 Lecture 21

X

p

DX1

LAC1,2

Firm 1 is producing X1.

Suppose now that Firm 2 enters the market and is identical to Firm 1 and produces the same amount, X1. What is total output?

What price can be charged?

Can each firm make a super-normal profit?

X1

2X1

LAC1,2

See Handout


316

Topic 5 Lecture 21

X

p

DX1

LAC1,2

Firm 1 is producing X1.

Suppose now that Firm 2 enters the market and is identical to Firm 1 and produces the same amount, X1. What is total output?

What price can be charged?

Can each firm make a super-normal profit?

X1

2X1

LAC1,2

See Handout


317

Topic 5 Lecture 21

X

p

D

3X1

LAC1

What if 3 identical firms are each producing X1?

Can they each at least break even?

X1X1 X1

See Handout


318

Topic 5 Lecture 21

X

p

D

LAC1

How many (identical) firms in this market can each produce X1 and each break even?

X1

See Handout


319

Topic 5 Lecture 21

X

p

D

LAC1

How many (identical) firms in this market can each produce X1 and each break even?

X1X1 X1

See Handout


320

Topic 5 Lecture 21

X

p

D

LAC1

Suppose now that there is a reduction in market demand.

How many firms (with identical costs as before), each producing X1, can at least break even?

X1D’

See Handout


321

Topic 5 Lecture 21

X

p

D

LAC1

What can you conclude about what determines the number of firms that we will find in a market?

From this analysis, we see three crucial determinants . . .

X1

See Handout


322

Topic 5 Lecture 21

X

p

D

LAC1

We have seen the importance of the extent of demand.

Now consider:

(i) MES

(ii) Minimum LAC

X1

LAC1’

X1 ’

LAC1

See Handout


323

Topic 5 Lecture 21

X

p

D

LAC1

What if the LAC curve shift upward, with no change in MES?

X1

LAC1

LAC1 ’

LAC1 ’

See Handout


324

Topic 5 Lecture 21

X

p

D

LAC1

What if the LAC curve shift upward, with no change in MES?

X1

LAC1

LAC1 ’

LAC1 ’

5X1 6X1

See Handout


325

Topic 5

Reading

• Frank, Chapter 12• See also Begg, Fischer and Dornbusch, Economics





326

Topic 5

• Key Concepts

1. Fixed costs2. Decreasing long-run average costs3. Minimum efficient scale (MES)4. Barriers to entry5. Determinants of market structure


327

Topic 5

• Seminar Questions

1. What is meant by Minimum Efficient Scale?2. If industry Fixed Costs are high, LAC is likely to be falling for a high level

of output (in other words, MES will be high): why is this?3. If market demand is low relative to MES, few firms can survive in an

industry. Explain this.4. What are the crucial economic influences on the determinants of market

structure?5. Show diagrammatically a situation in which only one firm can survive in

an industry given the relationship between the demand curve and the LAC. (This situation is called Natural Monopoly.)


328

Topic 5


1. Under Natural Monopoly, what will be the price and quantity choice of the monopolist?

2. Supernormal profits are likely to be high under Natural Monopoly. What can you say about welfare loss under Natural Monopoly?

3. What policies are open to a government wanting to reduce welfare losses associated with Natural Monopoly?

topic 1: lecture 3

Documents

department of economics

warwickrobin naylor

demand curve

market equilibrium

demand analysis

demand relation

supply curve

supply relation