ECO 401 Short Notes
1-22
What is Economics?
Economics is not a natural science, i.e. it is not concerned with studying the physical world like chemistry, biology. Social sciences are connected with the study of people in society.
Economics is the study of how we the people engage ourselves in production, distribution and consumption of good and services in a society.
The term economics came from the Greek for oikos (house) and nomos (custom or law), hence ‘rules of the household.
Branches of Economics
There two branches of Economics: 1: Normative Economic 2: Positive Economic
1: Normative Economic:
Normative economic is the branch of economics that incorporates value judgments about what the economy should be like or what particular policy actions should be recommended to achieve a desirable goal. Normative economics is known as statements of opinion which cannot be proved or disproved, and suggests what should be done to solve economic problems, i-e unemployment should be reduced. Normative economics discusses ‘what ought to be’.
2: Positive Economic
The analysis of facts and behavior in an economy or “the way things are”. Positive economic is sometimes defined as the economics of “what is”.
We the People:includes firms, households and the government.
Goods: are the things which are produced to be sold.
Services: involve doing something for the customers but not producing goods.
Factors of Production:
Factors of production are inputs into the production process. They are the resources needed to produce goods and services. The factors of production are:
- Land: includes the land used for agriculture or industrial purposes as well as natural resources taken from above or below the soil.
- Capital: consist of durable producer goods (machines, plants etc) that are in turn for production of other goods.
- Labor: consist of the manpower used in the process of production.
- Entrepreneurship: includes the managerial abilities that a person brings to the organization. Entrepreneurs can be owner or manager of firms.
- Scarcity: does not mean that a good is rare; scarcity exists because economic resources are unable to supply all the goods demanded. It is pervasive condition of human existence that exist because society has unlimited wants and needs, but limited resources used for their satisfaction.
Shortage of resources because economic resources are unable to supply all the goods demanded.
- Rationing: A process by which we limit the supply or amount of some economic factor which is scarcely available. The two primary methods of rationing are markets and governments. Rationing is needed due to the scarcity problem because wants and needs are unlimited, but resources are limited, available commodities must be rationed out to competing uses.
Economic System:
A free market/capitalist economy is a system in which the questions about what to produce, how to produce and for whom to produce are decided primarily by the demand and supply interactions in the market. There are different types of economic systems prevailing in the world:
- Dictatorship: A system in which economic decisions are taken by the dictator which may be an individual or a group of selected people.
- Command or planned economy: a mode of economic organization in which the key economic function – for whom, what, how to produce are principally determined by government directive.
- Free market/Capitalist Economy: a free market/capitalist economy is a system in which the questions about what to produce, how to produce and for whom to produce are decided primarily by the demand and supply interactions in the market. In free economy the only goods and services produced are those whose price in the market is at least equal to the producer’s cost of producing output. When a price greater then its cost of production producers reduce supply.
- Islamic Economic System: this system is based on Islamic values and Islamic rules i-e zakat, ushr, etc. Islam forbids both the taking and giving of interest.
Circular Flow of Goods & Income:
There are tow sectors in the circular flow of goods & services. One is household sector and the other is the business sector which includes firms.
Micro Economic:
The branch of economics that studies the parts of the economy, especially such topies as markets, prices, industries, demand, and supply. That is the branch of economic that studies how individuals, households, and firms make decisions to allocate limited resources typically in markets where goods or services are being bought and sold. Its also examines how these decisions and behaviors affect the supply and demand for goods and services, which determines prices, and how prices, in turn, determine the supply and demand of goods and services.
Macro Economic:
The branch of economic that studies the entire economy, especially such topics as aggregate production, unemployment, inflation, and business cycles. Microeconomics involves the “sum total of economic activity, dealing with the issues of growth, inflation, and unemployment and with national economic policies relating to these issues” and the effect of government actions (e.g., changing taxation levels) on them.
Cost and Benefit Analysis:
Rational Choice: is the choice based on pure reason and without succumbing the one’s emotions or whims. Consumers can decide about eh rational decision by using cost and benefit analysis. Rational choice is also the Optimal Choice.
Optimum: means producing the best possible results (also Optimal).
Equity in Economic: means a situation in which every thing is treated fairly or equally, i.e. according to its due share.
Nepotism: means doing unfair favors for near ones when in power.
Barter Trade: is non-monetary system of trade in which “goods” not money is exchanged. This was the system used in the world before the advent of coins and currency.
How Consumer decides about Optimal Choice?
The consumers decides about eh optimal choice by using the cost and benefits analysis which maximizes the benefits relative to the cost.
Marginal Cost: The increment to total costs of producing and additional unit of some good and service.
Marginal Benefit: the increment to total benefit derived from consuming an additional unit of good or service.
Production Possibility Frontier (PPF):
The maximum amount of goods and services which the country can produce in a given time with limited resources, given a specific state of technology.
PPF is the curve which joins all points showing the maximum amount of goods and services which the country can produce in a given time with limited resources, given a specific state of technology. A production possibilities frontier represents the boundary or frontier of the economy’s production capabilities.
Economic Growth: is an increase in the total output of a country over time. Is is the long-run expansion of the economy’s ability to produce output. When GDP of a country is increasing it means that country is growing economically. Economic growth is made possible by increasing it means that country is growing economically. Economic growth is made possible by increasing the quantity or quality of the economy’s resources (labor, capital, and entrepreneurship).
Perfect Competition: a situation in which no firm or consumer is big enough to affect the market price.
Good/Product/Commodity (Raw Martial) Markets: Market in which goods are bought and sold for the purpose of consumption. These markets used to exchange final good or service. Product markets exchange consumer goods purchased by the household sector, capital investment goods purchased by the business sector, and good purchased by government and foreign sector.
Factors Markets: used to exchange the services of a factor of production: labor, capital, land, and entrepreneurship. Markets in which factors of production are bought and sold, for the purpose of production.
Assumption: is a belief or feeling that something is true or that something will happen, although there is no proof. Economists make frequent use of assumptions in putting forward their theories.
Perfect Competition: refers to situation in which no firm or consumer is big enough to affect the market price.
Demand Analysis:
- Shortage: is a situation in which producers are unable to meet market demand for the product. Shortages cause process to raise prompting producers to produce more and consumers to demand less.
- Surplus: is a situation in which market demand falls short fo the quantity supplied; i.e. the producers are unable to sell all the produced goods in the market. Surpluses cause prices to fall prompting producers to supply less and consumers to demand more.
- Price Mechanism: is indicating and limit the supply device which prompts consumers and producers to adjust their demand and supply, respectively, in response to a shortage or surplus.
- Normal Goods: are goods whose quantity demanded goes up as consumer income increase
- Inferior Goods: are goods whose quantity demanded goes down as consumer income increase.
- Giffen Goods: Is sub category of inferior good. It is a rare type of good seldom seen in the real world, in which a change in price causes quantity demanded to change in the same direction (in violation of the law of demand). In other words, an increase in the price of Giffen good results in an increase in the quantity demanded.
- Substitution Effects: if price of any good increases, people reduce its consumption and substitute any other good whose price is not increased. This is substitution effect.
- Income Effect: when price of any good increase, consumer’s real income falls and its purchasing power also decreases. This is income Effect.
- Price Effect: price effect is the addition of income and substitution effect. Price Effect=Income Effect + Substitution Effect
- Compliments: are goods that go hand in hand with each another. Examples are Right Shoes and Left Shoe.
- Cash Crops: are the crops which are not used as food but as a raw material in factories e.g. cotton.
Demand: is the quantity of a good buyer wish to purchase at each conceivable price.
Law of Demand: the law of demand states that if the price of a certain commodity rises, its quantity demanded will go down, and vice versa.
Qd=a-b P
Market Demand Curve: is a graphic representation of a market demand which shows the quantities of a commodity that consumers are willing able to purchase during a period of time at various alternative prices, while holding constant everything else that effects demand. The market demand curve for a commodity is negative sloped, indicating that more of a commodity is purchased at a lower price.
Supply: is the quantity of a good that sellers wish to sell at each conceivable price.
Law of Supply: states that the quantity supplied will go up as the price goes up and vice versa. As output increase, cost will also increase. Higher price means more profit so firms will produce more of that products whose price has increase. New products will also emerge in the market. And total supply will also increase.
QS = c + d P
Problems of Identification or Determinants of Supply: problem of indentification arise when we can not determind that the change in the equilibrium quantities is either caused by a change in demanded or by changes in both demand and supply;
Determinants of Supply are:
- Costs of Production
- Profitability of alternative products (substitutes in supply)
- Profitability of goods in joint supply
- Nature and other random shocks
- Aims of producers
- Expectations of producers
Qd = Qs
Therefore,
100 - 10P = 40 + 20P
20P + 10P = 100 - 40
30P = 60
P = 60/30
P = 2
Putting the value of price in any of demand and supply equation,
Q = 100 – 10x2 (or 40 + 20x2)
Q = 100 – 20
Q = 80
Equilibrium can Shift if:
- Demand Curve Shifts
- Supply Curve Shifts
- Both Shifts
The symbol “Arrow Right Side” or “Arrow Up Side” shows increase and symbol “Arrow Left Side” or “Arrow Down Side” shows a decrease while the symbol “~” shows that the particular things remains same.
Government’s Role in Price-Determination & Equilibrium Analysis:
Identification problem is the problem of how to indentify demand & supply curve. This problem arises when both price and quantity.
Government can impact on equilibrium by two fundamental ways. The government intervenes in the market and mandate a maximum price (price ceiling) or minimum price (price floor) for a good or service.
Price Ceiling: a price ceiling is the maximum price limit that the government sets to ensure that prices don’t rise above that limit.
Price Floor: is the minimum price that government sets to support a desired commodity or service in a society.
RATIONING & SUPPLY SHOCK (ALTERATION OF EQUILIBRIUM PRICE BY THE GOVT)
There are two ways for this:
- Through Tax: Tax (to be paid by the producer) will increase the supply price, supply curve shifts left ward, Price increases & quantity decreases.
- Through Subsidy: subsidy (given to the producer) will decrease the supply price, supply curve shifts rightward, price decreases & quantity increases.
Social Cost: is the cost of an economic decision, whether private or public, borne by the society as a whole.
Marginal Social Cost: is the change in social costs caused by a unit change in output.
IMPORTANCE OF ELASTICITY IN OUR TODAY’S LIFE:
There is much more importance of the concept of elasticity in our life.
- The firm which uses advertising to change price uses the concept of elasticity of demand of its product.
- Mostly firms set the price of their product by viewing at the elasticity of demand of their product.
- The government collects revenues by imposing taxes. The good tax imposed by the government on the products is one for which either demand is inelastic.
- So if the government wants to put tax burden on the consumers then it will choose the product to tax with low price elasticity of demand.
- And if government wants to panelize the producers then it must choose the product with low price elasticity of supply.
Elasticity: is a term widely used in economic to denote the “responsiveness” of one variable to changes in another.” In proper words, it is the relative response of one variable to changes in another variable. The phrase “relative response” is best interpreted as the percentage change.
Types of Elasticity:
There are four major types of Elasticity:
- Price Elasticity of Demand
- Price Elasticity of Supply
- Income Elasticity of Demand
- Cross-Price Elasticity of Demand
Price Elasticity of Demand: is the percentage change in quantity demanded with respect to the percentage change in price.
Price Elasticity of Supply: is the percentage change in quantity supplied with respect to the percentage change in price.
Income Elasticity of Demand: is the percentage change in quantity demanded with respect to the percentage change in income of the consumer.
Cross-Price Elasticity of Demand: is the percentage change in quantity demanded of a specific good, with respect to the percentage change in the price of another related good.
Elastic and Inelastic Demand:
Slope and elasticity of demand have an inverse relationship. When slope is high elasticity of demand is low and vice versa.
When the slope of a demand curve is infinity, elasticity is zero (perfectly inelastic demand); and when the slope of a demand curve is zero, elasticity is infinite (perfectly elastic demand).
Note: that a straight line demand curve cannot have unit elasticity as the value of elasticity changes along the straight line demand curve.
Total Revenue and Elasticity:
Total revenue (TR) = Price * Quantity (P*Q)
Elastic Demand: means when price of any product increase, its quantity demand decreases more then the increase in price.
Inelastic Demand:of any product means that if price of that product increases there is very small effect on its quantity demand. As price increases, total revenue also increases in case of inelastic demand.
Arc Elasticity: measure the “average” elasticity between two points on the demand curve. The formula is simply (change in quantity/change in price)*(average price/average quantity).
The measure arc elasticity we take average values for Q and P respectively.
Point Elasticity: is used when the change in price is very small.
DETERMINANT’S OF PRICE ELASTICITY OF DEMAND
- Number of Close substitutes within the market: the more (and closer) substitutes available in the market the more elastic demand will be in reponse to a change in price. In this case, the substitution effect will be quite strong.
- Percentage of Income spent on a good: it may be the case that the smaller the proportion of income spent taken up with purchasing the good or service the more inelastic demand will be.
- Time Period under consideration: demand tends to be more elastic in the long run rather than in the short run.
Effects of Advertising on Demand Curve:
Advertising aims to:
- Change the slope of the demand curve-make it more inelastic. This is done by generating brand loyalty;
- Shift the demand curve to the right by tempting the people’s want for that specific product.
Determinants of Price Elasticity of supply:
- If costs increases, lower will be the supply. Lower the costs the more will be the supply.
- Amount of time given to quantity respond to a price increase or decrease. There may be intermediate time period, short term and long term period.
Income Elasticity of Demand: the relative response of a change in demand to a relative change in income.
If the sign of income elasticity of demand is positive, the good is normal and if sign is negative, the good is inferior.
Determinants of Income elasticity of Demand
The determinants of income elasticity of demand are:
- Degree of necessity of good.
- The rate at which the desire for good is satisfied as consumption increases
- the level of income of consumer
Short Run and Long Run:
Short Run is a period in which not all factors can adjust fully and therefore adjustment to shocks can only be partial.
Long Run is period over which all factors can be changed and full adjustment to shocks can take place.
Cross Price elasticity of Demand: is the percentage change in quantity demanded of a specific good, with respect to the percentage change in the price of another related good.
Determinants of Cross Price Elasticity of Demand:
- Time Period: the longer the time period, the more will be the elasticity.
- Tastes and Preferences: tastes and preferences can change.
Incidence of Taxation: A tax results in a vertical shift of the supply curve as it increases the cost of producing the taxed product.
SUPPLY SIDE AND DEMAND SIDE VIEWS ON THE VALUE OF GOOD:
According to the supply side view on the value of a good, the value of a good was determined by the labor content that had gone into producing good, either directly or indirectly.
According to the demand side view on the value of good, the value of a good was determined by its marginal utility.
UNCERTAINTY IN THE CONSUMPTION DECISION ANALYSIS
Uncertainty: is the possibility that any number of things could happen in the future. In other words, the future is not known.
A consumer’s response to uncertainty demands upon her attitude to risk: whether she is:
- Risk Averse
- Risk Loving
- Risk Neutral
Risk: means to take a chance after the probabilities have been assigned. Risk is the possibility of gain or loss. Risk the calculated probability of different events happening, is usually contrasted with uncertainty the possibility that any number of things could happen.
The odds ratio (OR):is the ratio of the probability of success to the probability of failure.
A risk neutral person: is one who buys a good when OR > 1. He is indifferent when OR =1 and will not buy when OR<1.
A risk loving person: will by if OR >1 or =1, but he might also by when OR is <1.
The total Utility curve: for a risk neutral person will be a straight line while that of a risk averse person will be convex. The greater the convexity (curvature) the more risk averse the person will be.
Risk Hedging: can be used to reduce the extent to which concerns about uncertainty affect our daily lives.
THE INDIFFERENCE CURVE APPROACH OR ORDINAL APPROACH:
This ordinal approach to utility consist in asking the question as the whether the consumer prefers one combination or bundle of goods to another combination or bundle of goods. Ordinal approaches do not require a “measurement” of the utility a person gains, rather, only a ranking of the various bundles in order of preference.
An Indifference Curve: is a line which charts out all the different points on which the consumer is indifferent with respect to the utility he derives (in other words it is a combination of all equi-utility points).
Marginal Rate of Substitution: the average slope of the indifference curve between any two points is given by the change in the quantity of goody Y divided by change in the quantity of good X. this is called the marginal rate of substitution (MRS).
A diminishing marginal rate of substitution (MRS) is related to the principle of diminishing marginal utility. MRS is equal to the ration of the marginal utility of X to the marginal utility of Y.
An indifference Map: shows a number of indifference curves corresponding to different levels of utility. A higher indifference cure corresponds to a higher level of utility. Indifference curves never intersect.
THE OPTIMUM CONSUMPTION POINT FOR THE CONSUMER: is where the budget line is tangent to the highest possible indifference curve. At such point, the slopes of the indifference curve and the budget line are equal.
Normal Goods and Giffen Good:
A normal good is one whose consumption increases when income increase, while inferior good is one whose consumption decreases with increase in income.
A giffen good is a sub-category of inferior goods; its consumption increases when it’s price increases. This is because of its very strong income effect.
Both normal and inferior goods have downward sloping demand curves.
The Income Consumption Curve (ICC)
Can be used to derive the Engel Curve, which shows the relationship between income and quantity demanded. Engel curve shows the positive relationship between income & quantity demanded of normal good. As income increases, quantity demanded for normal goods also increases.
Price Consumption Curve (PCC) traces out the optimal choice of consumption at different prices. The PCC can be used to derive the demand curve, which shows the relationship between price and quantity demanded.
The substitution Effect: of a price rise is always negative, while the income effect of a price rise on the consumption of a normal good is negative. The Income Effect for an inferior good is positive. The income effect of a Giffen good is so positive that it offsets the negative substitution effect.
Firm: A firm is any organized form of production, in which someone or collections of individuals are involved in the production of goods and services. An organization that combines resources for the production and supply of goods and services.
Traditional theory of the Firm: the traditional theory says that firm’s objective is to maximize the profit.
Types of Firms:
A firm can be Sole Proprietorship (one-person ownership), Partnership (a limited number of owners) or a limited company (a large number of changing shareholders).
Entrepreneurship: refers to the management skills, or the personal initiative used to combine resources in productive ways. It involves taking risks. It is the managerial function that combines land, labor, and capital in a cost-effective way and uncovers new opportunities to earn profit; includes willingness to take the risks associated with a business venture.
Production Function: a mathematical relation between the production of a good or service and the inputs used. A production function is usually expressed in this general form: Q=f(L,K), where Q=Quantity of production output, L=quantity of labor input, and K=Quantity of capital input. A production function is simply the relationship between inputs & outputs.
Mathematically it can be written by: Q=f(K,L,N,E,T,P…)
COBB DOUGLAS PRODUCTION FUNCTION:
IN ECONOMICS, THE Cobb-Douglas functional form of production function is widely used to represent the relationship of an output to inputs. It was proposed by Knut wicksell, and tested against statistical evidence by Paul Douglas and Charles Cobb in 1928.
Short Run: In terms of the macroeconomic analysis of the aggregate market, a period of time in which some prices, especially wages, are rigid, inflexible, or otherwise in the process of adjusting. Short-Run wage and price rigidity prevents some markets, especially resources markets and most notable labor markets, from achieving equilibrium. In term of the microeconomic analysis of production and supply, a period of time in which at least one input in the production process is variable and one is fixed. In the microeconomic analysis, the short run is primarily used to analyze production decisions for a firm.
Long Run: In term of the macroeconomic analysis of the aggregate market, a period of time in which all prices, especially wages, are flexible, and have achieved their equilibrium levels. In terms of the microeconomic analysis of production and supply, a period of time in which all input in the production process is variable.
The actual length of the short run and long run can vary considerably from industry to industry.
The Law of Diminishing Marginal Returns: states that as you increase the quantity of a variable factor together with a fixed factor, the returns (in terms of output) become less and less.
The total physical product (TPP) of a factor (F) is the latter’s total contribution to output measured in units of output produced
Average physical product (APP) is TPP per unit of the variable factor.
Marginal physical product (MPP) is the addition to TPP brought by employing an extra unit of the variable factor.
RELATIONSHIP BETWEEN APP AND MPP;
- If the MPP equals the APP, the APP will not change.
- if the MPP is above the APP, the APP product will rise.
- If the MPP is below the APP, the APP product will fall.
THERE ARE TWO THEORIES OF PRODUCTION
- Short Run Productivity theories: or the law of diminishing marginal returns. This theory states that as we increase the amount of a variable factor with a fixed factor, initially the output will increase but afterwards there will come a point when each extra unit of the variable factor produces less extra output than the previous unit
- Long Run productivity theory or returns to scale theory: in long run, all factors are variable. This theory includes constant, increasing & decreasing returns to scale.
A firm confronted with three more decision;
- Scale of production,
- Location, size of industry
- Optimum combination of inputs
The Scale of Production:
Returns to scale: refers to a technical property of production that examines changes in output subsequent to a proportional change all inputs (where all inputs increase by a constant). If output referred to simply as returns to scale. Constant returns arise when a 1% increase in all the factors causes a 1% increase in output.
Returns to scales and returns to factor: are two different conscepts, the latter related to the short term, the former to the long term.
Increasing returns to scale or (economies of scale) arise if , as firms become bigger and bigger, their costs per unit of output fall. This could be because of larger more efficient plants, financial economies, more efficient specialized labour, bulk dicounts on purchases etc.
THE LOCATION, SIZE OF DECISION
The location decision depends upon both the location of raw material suppliers and the location of the market. The nature of the product, transportation costs, availability of suitable land for production, stable power supply and good communications network, availability of qualified and skilled workers, level of wages, the cost of local services and availability of banking and financial facilities are among some other important factors. The size of an industry can lead to external economies and diseconomies of scale.
Economies of scale:
The increase in efficiency of production as the number of goods being produced increases. Typically, a company that achieves economies of scale lowers the average cost per unit through increased production since fixed costs are shared over an increased number of goods.
There are two types of economies of scale:
External economies - the cost per unit depends on the size of the industry, not the firm.
Internal economies - the cost per unit depends on size of the individual firm.
EXTERNAL ECONOMIES AND DISECONOMIES OF SCALE
External economies are benefits accruing to any one firm due to actions or the presence of other firms. For example, advertising by a rival industry, setting up of credit information bureaus by banks.
Diseconomies of scale
Diseconomies of scale are the forces that cause larger firms to produce goods and services at increased per-unit costs. They are less well known than what economists have long understood as "economies of scale", the forces which enable larger firms to produce goods and services at reduced per-unit costs.
ISOQUANT
An isoquant represents different combinations of factors of production that a firm can employ to produce the same level of output. Isoquant can be used to illustrate the concepts of returns to scale and returns to factor.
Isoquant Map:
Like an indifference map, an isoquant map consists of parallel isoquants that do not intersect. The higher the output level the further to the right an isoquant will be.
MARGINAL RATE OF TECHNICAL SUBSTITUTION (MRTS)
The slope of an isoquant is called marginal rate of technical substitution (MRTS). It is analogous to the term marginal rate of substitution (MRS) in consumer analysis. MRTS is the amount of one factor, e.g. capital, that can be replaced by a one unit increase in the other factor e.g. labor, if output is to be held constant.
The principle of diminishing MRTS is related to the law of diminishing returns.
SUNK COST
In economics and in business decision-making, sunk costs are costs that have already been incurred and which cannot be recovered to any significant degree. Sunk costs are sometimes contrasted with variable costs, which are the costs that will change due to the proposed course of action. In microeconomic theory, only variable costs are relevant to a decision.
VARIABLE COST (VC)
Costs, which vary with the level of activity (or output), are called variable costs. Variable cost is a cost of labor, material or overhead that changes according to the change in the volume of production units.
Fixed Cost (FC)
Costs, which do not vary with the level of activity or output, are called fixed costs. In long run, there are no fixed costs. Fixed cost does not vary depending on production or sales levels, such as rent, property tax, insurance, or interest expense.
Total Cost (TC)
Total cost (TC) is the sum of all fixed and variable costs. It plot as a vertical summation of the horizontal line total fixed cost (TFC) curve and the upward sloping total variable cost (TVC) curve. TC = FC + VC
Average Cost or Average total cost (AC or ATC)
Total cost per unit of output, found by dividing total cost by the quantity of output. Average total cost, usually abbreviated ATC, can be found in two ways. Because average total cost is total cost per unit of output, it can be found by dividing total cost by the quantity of output. Average variable cost plus average fixed cost equals average total cost.
AVC + AFC = ATC or AC
Average variable cost (AVC)
AVC is an economics term to describe the total cost a firm can vary (labor, etc.) divided by the total units of output.
AVC = TVC/Q
Average fixed cost (AFC)
AFC is total; fixed cost divided by the total units of output.
AFC = TFC/Q
MARGINAL COST (MC)
The change in total cost (or total variable cost) resulting from a change in the quantity of output produced by a firm in the short run. Marginal cost indicates how much total cost changes for a given change in the quantity of output.
RELATIONSHIP BETWEEN AC AND AVC
Initially, AC falls more rapidly than AVC because AC is a summation of AFC & AVC and since both are falling the effect of two falling curves is greater than the effect of one falling curve. After the turning point in AVC, both AC and AVC rise but the gap between them narrows because of same reasoning as given above.
There is an inverse relationship between costs and productivity, i.e. as productivity rises, costs fall and vice versa.
The equivalent of constant, increasing and decreasing returns to scale in terms of costs are economies of scale, diseconomies of scale and constant costs (or constant returns to scale).
i. In the case of economies of scale, long run total cost (LRTC) is an upward sloping curve but with falling slope. Note that the slope can never become zero or negative, though.
ii. In diseconomies of scale, LRTC is an upward sloping curve with an increasing slope.
iii. In constant costs, LRTC is a positively sloped straight line.
THE LONG-RUN AVERAGE COST CURVE (LRAC)
The long-run average cost (LRAC) curve for a typical firm is U shaped.
i. As a firm expands, it initially experiences economies of scale (due to productive efficiency, better utilization of resources etc.); in other words, it faces a downward sloping LRAC curve.
ii. After the scale of operation is increased further, however, the firm achieves constant costs
i.e., LRAC become flat.
iii. If the firm further increases its scale of operation, diseconomies of scale set in (due to problems with managing a very large organization etc.) and the LRAC assumes a positive slope.
Long-run marginal cost (LRMC):
In case a firm is enjoying economies of scale, each incremental unit will cost less than the preceding one i.e., LRMC will be falling. The opposite will be true for diseconomies of scale. In case of constant costs, each incremental unit will cost the same, i.e., the LRMC will be constant.
U shape of LRAC also called envelope Curve.
REVENUES
Revenues are the sale proceeds that accrue to a firm when it sells the goods it produces; in other words, they are the cash inflows that the firm received by way of selling its products.
Total Revenue (TR), Average Revenue (AR) and Marginal Revenue (MR):
Total revenue (TR), average revenue (AR) and marginal revenue (MR) concepts apply in the same way as they did to TC, AC and MC.
i. TR = P x Q.
ii. AR = TR/Q; AR is usually equal to price unless the firm is engaged in price discrimination.
iii. MR = ΔTR/ΔQ.
PRICE-TAKING FIRM
A firm that does not have the ability to influence market price is a price-taker. In perfect competition, the firm is price taker. There are large number of buyers and sellers and firm can not influence on the market price. Price is set by the forces of demand and supply.
PRICE-MAKING FIRM
A firm that influences the market price by how much it produces can be called a price-maker or price setter.
In Monopoly, firm is price maker. A monopoly or a firm within monopolistic competition has the power to influence the price it charges as the good it produces does not have perfect substitutes. A monopoly is a price maker as it holds a large amount of power over the price it charges.
PROFIT MAXIMIZATION
Firms are interested in profit maximization. Profit is the difference between total revenue & total cost. Higher the difference, higher is the level of profit. Economists say that when firms earn zero accounting profits, they actually earn normal economic profits because TC already includes the normal profits that owners of the firms need for themselves to stay in the business. Positive profits are, for this reason, called supernormal profits as they are over and above what the owners normally require as a return for their entrepreneurship. Profit = TR – TC
APPROACHES OF PROFIT MAXIMIZATION
Profit maximization can be studied using the TR-TC approach and the MR-MC approach.
i. In the TR-TC approach, it is assumed that firm is price maker and firm is operating in short run. Total profit is the vertical distance between TR and TC.
ii. In the MR-MC approach, two steps are followed to identify maximum profit. First: the profit-maximizing output is identified – this is the point where MR cuts MC. Second: the size of maximum profit is calculated using AC and AR curves.
Assumptions:
1. Demand curve is downward sloping
2. Firm is operating in the short run
If AC is always above AR, then firms will never be able to make a profit.
PROFIT MAXIMIZATION UNDER PERFECT COMPETITION IN THE SHORT RUN
The short run is the period where at least one factor of production is fixed. In the short run, a perfectly competitive firm can settle at equilibrium where it is making super normal profits, normal profits, loss, or where it decides to shut down.
In the short run, the firm’s supply curve is identical to the positive part of MC. The short run industry supply curve is simply the horizontal summation of the supply curves of individual firms.
PROFIT MAXIMIZATION UNDER PERFECT COMPETITION IN THE LONG RUN
In the long run, all the factors of production are variable. In the long run, any firm can enter or leave the industry. If there are supernormal profits in the short run, more firms will be attracted to the market and the increase in supply will push prices down to eliminate supernormal profit possibilities in the long run.
ALLOCATIVE EFFICIENCY AND PRODUCTIVE EFFICIENCY
Public interest is concerned with both allocative efficiency and productive efficiency.
a. Allocative efficiency: The optimal point of production for any individual firm is where MR=MC. The optimal point of production for any society is where price is equal to marginal cost. This is called the point of maximum allocative efficiency and is achieved in perfect competition (because
MR=MC, and MR=AR=P for a perfectly competitive price taking firm, therefore P=MC).
b. Productive efficiency: This is attained when firms produce at the bottom of their AC curves, that is, goods are produced in the most cost efficient manner. Perfectly competitive firms also achieve this in the long run because they produce at P=MC and this intersection point also happens to be the point of tangency with the lowest part of the AC curve. Thus P= AC minimum.
MONOPOLY
Monopoly defines the other pole or extreme of the market structure spectrum. Usually refers to a situation where there is a single producer in the market. However, it actually depends upon how narrowly you define the industry.
MONOPOLY POWER
Economists are often interested in how much monopoly power any firm (not necessarily a monopoly) has. Here monopoly stands for the extent to which the firm can raise prices without driving away all it customers. In other words, monopoly power and price elasticity of demand are inversely related.
LIMIT PRICING
If a firm is already established in the market, it got gradually the business tricks of how to run the business. A new entrant firm in the market has to face high costs. A monopolist firm knows about this fact very well that his costs are lower than the new entrant firm so he can take advantage of this situation.
New entrant firm should charge the same or lower price than the monopolist other wise people will not purchase from new entrant firm.
MONOPOLIES AND THE PUBLIC INTEREST
Disadvantages of monopolies:
i. Monopolists produce lower quantities at higher prices compared to perfectly competitive firms. This is because monopolists do not produce where P=MC (the point of allocative efficiency) nor at P= AC minimum (the point of cost efficiency).
ii. Monopolists earn supernormal profits compared to perfectly competitive firms
iii. Most of the “surplus” (producer + consumer surplus) accrues to monopolists.
iv. Monopolists do not pay sufficient attention to increasing efficiency in their production processes.
Advantages of monopolies:
i. Natural Monopolies are beneficial and efficient for society.
ii. Supernormal or monopoly profits can be invested in R&D, development of new innovative products and to sustain a price war when breaking into new foreign markets.
GOVERNMENT REGULATION
The government can regulate monopolies to ensure that they set a price where the AR curve intersects the MC curve. This will ensure allocative efficiency.
PRICE DISCRIMINATION (PD) happens when a producer charges different prices for the same product to different customers. A seller with a degree of monopoly power has the ability to price discriminate. This means being able to charge a different price to different customers.
TYPES OF PRICE DISCRIMINATION
PD can be of three types:
i. 1st degree PD
ii. 2nd degree PD
iii. 3rd degree PD
1ST DEGREE PD
In this type, everyone charged according to what he can pay. Seller can charge the highest price of any product from customers. First-degree price discrimination occurs when identical goods are sold at different prices to each individual consumer.
2ND DEGREE PD
In this type, different prices charged to customers who purchase different quantities. Example: Retail stores.
3RD DEGREE PD
In this type, seller charge different prices to different customers in different markets.Example: KFC, Pizza Hut, Mc Donald’s
Consequences of PD:
PD can allow firms making losses to make profits, firms to increase their supernormal profits if make supernormal profits; allow goods to be produced that would otherwise not be produced.
PRE-REQUISITES / CONDITIONS OF PRICE DISCRIMINATION
i. That markets should be independent (it should not be possible for the different customers to arbitrage the price differences in the market).
ii. Firms should have the flexibility to price discriminate (i.e. should have some control over prices, so perfect competition ruled out).
iii. Price elasticity of demand for different customers should be different.
BENEFITS OF PRICE DISCRIMINATION
Price discrimination can be both, beneficial or harmful for public interest depending on a number of factors (equity or fairness concerns, the production of goods otherwise not produced, the use to which price-discriminating firms put their supernormal profits to, etc.).
MONOPOLISTIC COMPETITION
Monopolistic competition is also characterized by a large number of buyers and sellers and absence of entry barriers. In these two respects it is like perfect competition. Firms are price-takers but not in the extreme sense of perfect competition. Products are differentiated and in this respect, it is different from perfect competition.
SHORT RUN AND LONG RUN UNDER MONOPOLISTIC COMPETITION:
In the short run, super normal profits are possible, but, in long run only normal profits can be earned.
OLIGOPOLY
Similar to monopoly in the sense that there are a small number of firms (about 2-20) in the market and, as such, barriers to entry exist. It is similar to perfect competition in the sense that firms compete with each other, often feverishly, which may result in prices very similar to those that would obtain under perfect competition. It is similar to monopolistic competition since there is a possibility of having differentiated products.
DIFFERENCE OF OLIGOPOLY WITH OTHER MARKET STRUCTURES
An oligopoly is a market form in which a market or industry is dominated by a small number of sellers (oligopolists). The word is derived from the Greek for few sellers.
• Because there are few participants in this type of market, each oligopolist is aware of the actions of the others. The decisions of one firm influence, and are influenced by the decisions of other firms. Strategic planning by oligopolists always involves taking into account the likely responses of the other market participants. This causes oligopolistic markets and industries to be at the highest risk for collusion.
• It is not possible to identify any single equilibrium in oligopoly. Theory of firm is not clearly discussed & established as the theory of firm in the other three market structures. Reason for that is the firms are interdependent.
COLLUSION
Collusion occurs when two or more firms decide to cooperate with each other in the setting of prices and/or quantities. Firms collude in order to maximize the profits of the industry as a whole by behaving like a single firm. In doing so, they try to increase their individual profits. In the study of economics and market competition, collusion takes place within an industry when rival companies cooperate for their mutual benefit. Collusion most often takes place within the market form of oligopoly, where the decision of a few firms to collude can significantly impact the market as a whole. Cartels are a special case of explicit collusion.
TWO POSSIBLE SCENARIOS OF OLIGOPOLY
This tension between collusion & competition give rise to two possible scenarios that the oligopolist firms can have:
1. Collusive oligopoly
2. Non-collusive oligopoly
1- COLLUSIVE OLIGOPOLY (CARTEL)
A collusive oligopoly (or cartel) can be formed by deciding upon market shares, advertising expenses, prices to be charged (identical or different) or production quotas, such as OPEC, are collusive oligopolies. A firm can collude in many different ways. For example, they can collude on the market share in total profits. Collusion can also be done in terms of how much advertising expenditures each firm would have to put.
Cartel
A cartel is a formal (explicit) agreement among firms. Cartels usually occur in an oligopolistic industry, where there are a small number of sellers and usually involve homogeneous products.
2- NON- COLLUSIVE OLIGOPOLY
If different firms in the oligopolistic structures do not cooperate with each other is known as non collusive oligopoly. In this case, collusion breaks down because the incentive to cheat is very high. This can arise, for instance, in a situation where there is a lure of very high profits so that individual firms cheat on their quota and try to increase output and profits.
Maximin strategy
Maximin strategy is a cautious (pessimistic) approach in which firms try to maximize the worst payoff they can make. It is the policy of adopting the safer side. It means the firm is trying to maximize the minimum profit that it will make.
Maximax strategy
A Maximax strategy involves choosing the strategy which maximizes the maximum payoff (optimistic). This policy arises from the optimistic approach that your rival will react most favorable to you. It means firm is going for the maximum possible profit.
Dominant strategy game:
Both these strategies leads towards the same strategy that is cutting down of price to Rs.1.8. this type of game is called the dominant strategy game. Given that both X & Y are tempted to lower price, they both end up tempting the lower profit i-e Rs.8 million each. If they collude and charge the same price, they will get profit of Rs.10 million each. Thus collusion rather than price war would be beneficial for both.
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