What is Economics? The Science of Choice. It studies the distribution of scarce resources among...

What is Economics?

• The Science of Choice.

• It studies the distribution of scarce resources among unlimited wants.

• Why do we say “scarce resources”• labour, land, capital and entreprenourship

Economic questions:

What goods and services should be produced and in what quantities?

How should they be produced?

Who consumes the goods and services?

Self Interest vs. Social Interest• “Could it be possible that when each and

one of us makes choices that are in our own best interest, it turns out that these choices are also the best for society as a whole”

• How to answer this question?

• There has been progress in some issues like:

– Privatization– Globalization– The New Economy– 9/11

– Corporate Scandals– HIV/AIDS– Natural Resources– Water Shortages– Unemployment– Deficits and Debts

Economic Way of Thinking:

Choice, Tradeoff, and Choice, Tradeoff, and Opportunity Cost.Opportunity Cost.

“Because the resources available are scarce, individuals must choose among their wants, and by doing so they face an opportunity cost.“

“There is no free lunch.”

“Opportunity Cost is the highest-valued alternative forgone, not all the possible alternatives forgone”

Margins and Incentives.Margins and Incentives.

“The important thing is the benefit of a bit more or a bit less.”

– Marginal Benefit

– Marginal Cost

– The way to decide MGB = MGC

– Incentives affect these margins• higher wages, lower prices.

• MacroMacro is the study of the aggregated economy.

• MicroMicro is the study of the components of the economy.

What is the difference?

Imagine a football team:– MACRO:MACRO: It might be having a winning or

loosing season.– MICRO:MICRO: The statistics of the offense and the

defense.

There is Macro and Microeconomics:

Three important concepts:

• Normative Statements: What it ought to be, these statements depend on values and cannot be tested.

• More foreign aid should be given to African countries, so they can reduce the levels of poverty.

• Positive Statements: What it is. These statements say what is currently believed about the way the world operates.

• Poverty levels in African countries are high.

• Ceteris Paribus!!

Resources and Wants• Economics studies the distribution of

scarce/limited resources among unlimited wants.

• What are those scarce/limited resources:– Labour: Time and effort.

– Land: natural resources (air, water, surface, and minerals)

– Capital: goods that were produced and that now are used to produce more goods.

(planes, buses, trucks, highways, production lines)

– Entrepreneurship: ideas, management.

• Also because scarcity of resources, there are certain combinations of goods and services that can be produced, and some that cannot.

• The boundary between these two sets is defined by the Production Possibility Frontier (PPF).

• In other words, the PPF shows the different combinations of goods and services that can be produced, using ALL the available resources.

Overhead transparency of Figure 2.1

• Production Efficiency

• Trade-off: give something to get something•

• Opportunity Cost: it is a ratioThe decrease in the qty produced of one good

The increase in the qty produced of another good

• Increasing Opportunity Cost: The PPF is bowed outward because resources are not all equally productive in all activities. Example: Football and Soccer players

– Marginal Cost: Is the opportunity cost of producing one more unit of a good or service. (Usually increasing)

– Marginal Benefit: Is the benefit that a person receives from getting one more unit of a good or service. (Usually decreasing)



What is the difference between the two concepts? (marginal benefit and opportunity cost)

• Both are measured in units of a good (forgone)

• But they are different:

– Opportunity Cost of good A: how much of good B an individual MUST forgo to get another unit of good A.

– Marginal Benefit of good A: amount of good B that an individual is WILLING to forgo to get one more unit of good A.

Marginal Benefit = Marginal Cost

• The goods and services that are produced are the ones that are valued the most. Nothing more or no other good can be produced, without giving up something that is valued even higher.

The efficient use of resources?


Economic Growth:• Defined as the expansion of production.• What influences economic growth:

– Technological Change: better ways to produce something

– Capital Accumulation: the growth of capital resources.

– New Natural Resources (very rare, like oil on the moon)

• An example: Figure 2.5 (page 38) and computers factory example.

• First we need to get a couple of concepts under our belts:– Specialization: Concentrating on the production

of only one or some goods.

– Comparative Advantage: to be able to produce something at a lower opportunity cost. Sometimes depends on the characteristics of the economy (like: geographical features)

– The best way to understand this is with an exercise.

Gains from Trade:

• Graphs 2.7 and 2.8• If each individual produces a combination instead

of specializing in one good, then the benefits are less than when both agents specialize and trade between them.

– Absolute advantage: One agent can produce more goods than anybody else with the same resources.

– Productivity makes some changes, but it is not possible for anyone to have a comparative advantage in everything.

– Dynamic Comparative Advantage: Learning by doing.

Gains from Trade:

• Property Rights

• Markets

• Circular Flows in the Market Economy– (figure 2.10)

• Coordinating Decision.

The Market Economy: It is all about incentives

Demand and Supply: How Markets Work?

• Prices and quantities demanded fluctuate, but in different ways, sometimes together and other times in different directions.

Price and Opportunity Cost:

There is a relation between them that is called a relative price.

Demand and supply determine relative prices, and in our studies the word price means relative price!!

DEMAND

• The good is wanted, can be afforded and there is a definite plan to buy it.

• The quantity demanded of a good or service is the amount that consumers plan to buy during a given time period at a particular price.

• The quantity demanded is measured as an amount per unit of time

• There are many factors that affect the buying plans / demand:– price of the good– prices of related goods– expected future prices– income– population– preferences

• Lets take a look at the first factor

The law of Demand: Other things remaining the same, the higher the price of a good, the smaller is the quantity demanded.

DEMAND

Why higher prices means lower demand?The answer for this comes from two logical effects that everybody knows already, but they do not know their names:

• Substitution effect: When the price of a good rises, other things being the same, its relative price (opportunity cost) rises. And consumers start looking for substitutes, buying less of the original good.

• Income effect: Facing higher prices, with unchanged income, people cannot afford to buy all the things they previously bought. The quantities demanded of at least some goods and services must be decreased. (Normally, the good whose price has increased is one of those bought in smaller quantity).

DEMAND

Demand: this term refers to the ENTIRE relationship between the quantity demanded and the price of a good, and it is illustrated by a demand curve and a demand schedule.

Demand Curve: It showsshows the relationship between the price of a good and the quantity demanded, when all other influences on consumers’ planed purchases remain the same.

Demand Schedule: It listslists the quantities demanded at each different price when all the other influences on consumers’ planned purchases remain the same.

We graph the demand schedule as a demand curve with the We graph the demand schedule as a demand curve with the quantity demanded on the horizontal axis and price on the quantity demanded on the horizontal axis and price on the vertical axis. (figure 3.1)vertical axis. (figure 3.1)

DEMAND

Quantity demanded:Refers to a point on the demand curve, the quantity demanded at a particular price.

A Change in DEMAND:DEMAND: When any factor that influences the buying plans changes, other than the price of the good, there is a change in demand. If demand increases, then the demand curve shifts to the right and the quantity demanded is greater at each and every price. (figure 3.2)

DEMAND

What factors bring a change in demand?• Prices of related goods

– substitutes

– complements

• Expected future prices– if good can be stored (special cases)

• Income– normal good

– inferior good

• Population– size

– structure

• Preferences

DEMAND

A Change in the Quantity Demanded Vs a Change in Demand: (figure 3.3)

Movement along the demand curve shows a change in the quantity demanded.

Shifts of the demand curve shows a change in demand.

So what happens when the factors or the price change? (table 3.1)

DEMAND

• The good can be produced, profit can be made from producing it and there is a definite plan to produce it and sell it.

• The quantity supplied of a good or service is the amount that producers plant to sell during a given time period at a particular price.

• The quantity supplied is measured as an amount per unit of time

SUPPLY

• There are many factors that affect the selling plans / supply:– price of the good– prices of the resources used to produced the good.– prices of related goods produced– expected future prices– number of suppliers– technology

• Lets take a look at the first factor

The law of Supply: Other things remaining the same, the higher the price of a good, the greater is the quantity supplied.

Supply

Why higher prices means greater supply?

The answer comes from a well known term, increasing marginal cost. As the quantity produced of any good increases, the marginal cost of producing the good increases.

So, when the price increases, producers are willing to incur in higher marginal costs to increase production. The higher price brings forth an increase in the quantity supplied.

SUPPLY

Supply: this term refers to the ENTIRE relationship between the quantity supplied and the price of a good, and it is illustrated by a supply curve and a supply schedule.

Supply Curve: It showsshows the relationship between the price of a good and the quantity supplied, when all other influences on producers’ planed sales remain the same.

Supply Schedule: It listslists the quantities supplied at each different price when all the other influences on producers’ planned sales remain the same.

We graph the supply schedule as a supply curve with the We graph the supply schedule as a supply curve with the quantity supplied on the horizontal axis and price on the quantity supplied on the horizontal axis and price on the vertical axis. (figure 3.4)vertical axis. (figure 3.4)

SUPPLY

Quantity supplied:Refers to a point on the supply curve, the quantity supplied at a particular price.

A Change in SUPPLY:SUPPLY: When any factor that influences the selling plans changes, other than the price of the good, there is a change in supply. If supply increases, then the supply curve shifts to the right and the quantity supplied is greater at each and every price. (figure 3.5)

SUPPLY

What factors bring a change in supply?• Prices of productive resources

• Prices of related goods produced– substitutes in production

– complements in production

• Expected future prices

• Number of producers– size

– structure (could be)

• Technology

SUPPLY

A Change in the Quantity Supplied Vs a Change in Supply: (figure 3.6)

Movement along the supply curve shows a change in the quantity supplied.

Shifts of the supply curve shows a change in supply.

So what happens when the factors or the price change? (table 3.2)

SUPPLY

• Equilibrium price

Price at which the quantity demanded equals the quantity supplied

• Equilibrium quantity

Quantity bought and sold at the equilibrium price.

• Price is what regulates the market• price as a regulator• price adjustments

MARKET EQUILIBRIUM (figure 3.7)

• A shortage forces the price up

• A surplus forces the price down

• The best deal available for buyers and sellers

In equilibrium, buyers pay the highest price In equilibrium, buyers pay the highest price they are willing to pay for the last unit bought they are willing to pay for the last unit bought and sellers receive the lowest price at which and sellers receive the lowest price at which they are willing to supply the last unit sold.they are willing to supply the last unit sold.

MARKET EQUILIBRIUM (figure 3.7)

A Change in Demand: There is a shift (left or right) of the demand curve, and there is an increase or decrease in the quantity supplied. But there is no change in supply, the supply curve does not move!.

• If the demand increases, both price and quantity supplied increase

• If the demand decreases, both price and quantity supplied decrease

A Change in Supply: There is a shift (left or right) of the supply curve, and there is an increase or decrease in the quantity demanded. But there is no change in demand, the demand curve does not move!.

• If the supply increases, price falls and quantity demanded increases

• If the supply decreases, price rises and quantity demanded decreases

MARKET EQUILIBRIUM (figure 3.8 and 3.9)

If both, demand and supply, change:

– Change in the same direction:• If both increase: the quantity increases and price increases, decreases

or remains constant

• if both decrease:the quantity decreases and price increases, decreases or remains constant

– Change in opposite direction:• If demand decreases and supply increases: the price falls and

quantity increases, decreases or remains constant

• if demand increases and supply decreases: the rice rises and the quantity increases, decreases or remains constant

– Some examples

MARKET EQUILIBRIUM (figure 3.10 and 3.11)

A Mathematical Note:

Demand and Supply Curves: The equation of the lines

Demand SupplyP = a - bQd P = c + dQs

What information is contained in these two expressions?

What is a, b, c and d?

MARKET EQUILIBRIUM

Solving a system of equations: two equations for two unknown variables.

A simple Example:P = 800 - 2Qd (this is the _______ curve, why? ____________)

P = 200 + 1Qs (this is the _______ curve, why? ____________)

Solving the system we get: P* and Q* (* means equilibrium)

MARKET EQUILIBRIUM

ElasticityThe elasticity is a unit free measure of responsiveness, and there are many kinds of elasticities that are used in economics:– Price elasticity of demand– Cross elasticity of demand– Income elasticity of demand– Elasticity of supply

Why does it matter? (some examples and figure 4.1)

Price Elasticity of Demand• This is a units free measure of the responsiveness of the

quantity demanded of a good to a change in its price when all other influences on buyers’ plans remain the same.

• Why do we use a units free measure?

• How to calculate the price elasticity of demand (figure 4.2):– We want to get a relation between percentage changes of quantity

demanded and percentage changes in price (so this is a ratio).

Price Elasticity of demand = % change in Quantity demanded % change in price

NOTE:NOTE: The changes in price and quantity demanded are expressed as percentage changes of the average price and the average quantity, we do it to get a more precise measurement. We ignore the minus sign, because we are interested in the magnitude of the price elasticity of demand (we use the absolute value)

Inelastic or elastic demand, what is this??? (figure 4.3)

This is just a simple way of expressing the degree of responsiveness of the demand towards price changes.

– Perfectly elastic demand: price changes but quantity does not, elasticity is 0.

– Unit elastic: percentage change in price is equal to the percentage change in quantity demanded, so the elasticity is equal to 1.

– Inelastic demand: between the two above, the percentage change in price is greater than the percentage change in quantity demanded, so the elasticity is between 0 and 1.

– Perfectly elastic demand: quantity demanded changes by an infinite amount in response of a tiny price change, so the elasticity is equal to infinite.

– Elastic demand: this is between unit elastic and perfectly elastic, and it means that the percentage change in quantity demanded is greater than the percentage change in price, so the price elasticity is greater than 1.

Elasticity Along a Straight Line: An Example (figure 4.4)

Price Elasticity of Demand

Another way to look at this is from the revenue generated by the sale of a good, this is call the Total Revenue Test. (figure 4.5)

• If demand is elastic, a 1 percent price cut increases the quantity demanded sold by more than 1 percent and total revenue increases.

• If demand is unit elastic, a 1 percent price cut increases the quantity by 1 percent and total revenue does not change.

• If demand is inelastic, a 1 percent price cut increases the quantity demanded by less than 1 percent and total revenue decreases.

Your expenditure and your elasticity

If your demand is inelastic, then a 1 percent price cut increases the quantity you buy by less than 1 % and your expenditure on the item decreases.

For unit elastic and elastic it is very straight forward, the first one doesn’t change your expenditure on the item, while the later increases it.


What influences the Elasticity of Demand?• Closeness of substitutes

• It depends on how we define them.

• Necessities (Inelastic)

• Luxuries (Elastic)

• Proportion of income spent on the item• It is just like saying: size matters doesn’t it. (cars and candies)

• Time elapsed since a price change• give me some time and I will find another thing that looks like that or

can be used for the same thing.


This is a measure of responsiveness of the demand for a good to a change in price of a substitute or complement, other things remaining the same.

Cross Elasticity of demand = % change in Quantity demanded

% change in price of a substitute

or complement

NOTE: The cross elasticity is positive for substitutes and NOTE: The cross elasticity is positive for substitutes and negative for complements.negative for complements.

Cross Elasticity of Demand (figure 4.7)

This is a measure of responsiveness of the demand for a good to a change in income, other things remaining the same.

Income Elasticity of demand = % change in Quantity demanded

% change in income

NOTE: The income elasticity can be positive or negative:NOTE: The income elasticity can be positive or negative:

» Greater than one:Greater than one: income elastic, normal good. income elastic, normal good.» Between zero and one:Between zero and one: income inelastic, normal good. income inelastic, normal good.» Less than zero:Less than zero: inferior good inferior good

Income Elasticity of Demand (do graphs)

Elasticity of Supply• Measures the responsiveness of the quantity supplied to a

change in the price of a good when all other influences on selling plans remain the same.

• How to calculate the elasticity of supply (figure 4.9):– We want to get a relation between percentage changes of quantity

supplied and percentage changes in price (so this is a ratio).

Elasticity of supply = % change in Quantity supplied % change in price

Degrees of Elasticity of Supply: (figure 4.10)• Perfectly elastic• Unit elastic• Perfectly elastic

What influences the elasticity of supply?

– Resource substitution possibilities

– Time frame for the supply decision:

» Momentary supply» Lon run supply» Short run supply

Elasticity of Supply

Efficiency and EquityMore with less may not be more efficient.

An allocation is said to be efficient if the goods and services produced are the ones that are valued the most.

Efficiency has something to do with value, and value is related to feelings

Is the current situation fair?

Efficiency

Do you remember these terms?• Marginal Benefit: is the benefit that a person receives from

consuming one more unit of a good or service and it is measured as the maximum amount that a person is willing to pay for one more unit of it. (usually decreasing)

• Marginal Cost: is the opportunity cost of producing one more unit of a good or service and it is measured as the value of the best alternative forgone. (usually increasing)

• Inefficient Allocations: if marginal benefit exceeds marginal cost or if the opposite happens.

• Efficient Allocations: marginal benefit equals marginal cost. (figure 5.1)

Consumer Surplus

• What do we mean with the term value of the goodvalue of the good or serviceor service?It is simply the marginal benefit of a good or service.

Recall that the marginal benefit can be expressed as the maximum price that people are willing to pay for another unit of the good or service. And this willingness determines the demand for the good or service.

And also recall that a demand curve tells us the quantity of other goods and services that people are willing to forgo to get an additional unit of a good.

So we can conclude that a demand curve is a marginal So we can conclude that a demand curve is a marginal benefit curve. (figure 5.2)benefit curve. (figure 5.2)

If people buy something for less than it is worth to them, they receive a consumer surplus. (figure 5.3)

Consumer surplus = the value of the good - the price paid for it

Consumer Surplus

• What do we mean with the term cost of cost of producing the goodproducing the good or serviceor service?

It is simply the marginal cost, the minimum price that producers must receive to induce them to produce another unit of the good or service, this minimum acceptable price determines supply.

A supply curve tells us the quantity of other good and services that sellers must forgo to produce one more unit of the good or service.

So we can conclude that a supply curve is a marginal So we can conclude that a supply curve is a marginal cost curve. (figure 5.4)cost curve. (figure 5.4)

Producer Surplus

When a firm sells something for more than it costs to produce, the firm obtains a producer surplus. (figure 5.5)

Producer surplus = price of a good - opportunity cost of producing it.

Producer Surplus

Efficient Competitive Markets?

Why do we say, that markets are efficient when marginal cost equals marginal benefit? (figure 5.6)

• It maximizes the consumer and producer surplus.

• Any other allocation than the one in equilibrium puts the forces of supply and demand to work and the equilibrium allocation will be the final result.

• Resources are allocated efficiently (where they create the greatest possible value)

The invisible hand is working!!The invisible hand is working!!

Obstacles to efficiency:– Price ceilings and floors: incorrect quantities (chpt.6)

– Taxes, subsidies and Quotas: distortions on market prices (example: prices received by producers are lower than those paid by buyers) (chpt.6)

– Monopoly: larger profits, wrong quantity supplied (chpt. 12)

– Public goods: the free rider problem (chpt. 16)

– External costs and external benefits: – External costs: is a cost not borne by the producer but borne by

other people.

– External benefit: benefit that accrues to people other than the buyer of a good.

In consequence we have overproduction or In consequence we have overproduction or underproductionunderproduction


And this two problems decreases the total surplus (producer surplus plus consumer surplus).

• Figure (5.7)

• Deadweight loss: is the decrease in consumer surplus and producer surplus that results from an inefficient level of production.The deadweight loss is borne by the entire society, it is a social loss.


Fair Competitive Markets?

• It is not fair if the result is not fair.– Utilitarianism

– The big tradeoff

– Make the poorest as well off as possible

• a bigger piece of a smaller pie can be less than a smaller piece of a bigger pie.

• It is not fair if the rules are not fair.– The symmetry principle: Behave toward other people in the way you expect

them to behave toward you.

– The two basic rules for fairness:

• The state must enforce laws that establish and protect private property.

• Private property may be transferred from one person to another only by voluntary exchange.

• Why some things are more expensive than others, even when the ones that are cheap are the ones that we need the most?

• What makes the demand for some goods price elastic, while the demanders for others is price inelastic?

Acquisition of Customers: Utility and Demand

These are delimited by two things mainly:• Consumption possibilities (figure 7.1): Consumers have a

certain amount of income to spend and cannot influence the prices of good and services that they buy.

• THE BUDGET LINE IS A CONSTRAINT ON CHOICES. (IT TELLS WHAT CAN BE AND WHAT CAN NOT BE AFFORDED)

• Preferences: How do consumers distribute their incomes? Well it depends on what they like and what they do not, in other words their “PREFERENCES”

• Economists use the term of UTILITY to describe PREFERENCES• The benefit that a persons derives from the consumption of a good or

service is called UTILITY. (abstract concept!!)

Household Consumption Choices

• TOTAL UTILITY: Total benefit that a persons derives from the consumption of goods and services. It depends on the level of consumption, more generally means more utility.

• MARGINAL UTILITY: Is the change in total utility that results from one unit increase in the quantity of a good consumed. (figure 7.2)

• Marginal Utility is positive but diminishes as the consumption of the good increases (again you get tired of the goods)

• That is why we have DIMINISHING MARGINAL UTILITY

UTILITY (table 7.1)

• The Household’s income and the prices she/he faces limit her/his choices, and her/his preferences determined the amount of utility that she/he gets from each affordable combination. But the main objective is to choose the combination that MAXIMIZES UTILITY!.

• Just find out what is the total utility of each combination and choose the one that gives the highest number and that will be the best the consumer can do given the prices and her/his income. (table 7.2)

• CONSUMER EQUILIBRIUM: Is a situation in which a consumer has allocated all his or her available income in the way that, given prices and income, maximizes his or her utility.

MAXIMIZING UTILITY

• EQUALIZING MARGINAL UTILITY PER DOLLAR SPENT:“Total utility is maximized when all the consumer´s

available income is spent and when the marginal utility per dollar spent is equal for all goods”

Marginal Utility from X = Marginal Utility from Y Price of X Price of Y

EXAMPLETABLE 7.3 AND FIGURE 7.3

“As always, if the marginal utility of the last dollar spent on X exceeds the marginal utility per dollar spent on Y, buy more X and less of Y. (VICEVERSA)”

MAXIMIZING UTILITY

• After a change on prices or income, to find the new utility maximizing combination follow the next three steps:

– Determine the new combinations that exhaust new income at the new prices.

– Calculate the marginal utilities per dollar spent.

– Determine the combination that makes the marginal utilities per dollar spent on X and Y equal.

Predictions of Marginal Utility

Change in Prices:• If price of X falls:

• Table 7.4• Figure 7.4

• If price of Y rises• Table 7.5• Figure 7.5

• This tells us that:– When price of a good rises, the quantity demanded of the good

decreases.– When the price of one good rises, the demand for another good

that can serve as a substitute increases.


• If income increases• Table 7.6

• This tells us that:– With more income the consumer always buys more of a normal

good and less of an inferior good.

• Table 7.7: A summary.


• Marginal Utility theory explains how an individual household spends its income and enables us to derive an individual household’s demand curve.

• Before during the first part of the course we used market demand curves

• But Market demand can be derived from individual demand curves (figure 7.6)

“The market demand is the horizontal sum of the individual demand curves and is formed by adding the quantities demanded by each individual at each price”

Individual and Market Demand

• Consumer Efficiency and Consumer Surplus

“Marginal benefit is the maximum price that a consumer is willing to pay for an extra unit of a god or service when utility is maximized”

• The paradox of Value: Everything comes from the equality of the marginal utilities per dollar spent.

Efficiency, Price and Values

• Why do changes in prices or income change demand and quantity demanded?

• Here we will study what effects do these changes have, how and why?

POSSIBILITIES, PREFERENCES AND CHOICES

• The budget line, again!! (figure 8.1)

• Divisible goods and indivisible goods

• The budget line “equation”:

Expenditure = Income

PxQx + PyQy = Y

Qx= (Y/Px) - (PyQy/Px)

• Real Income • Relative Price• Change in Prices and Changes in Income (figure 8.2)

Consumption Possibilities

• A preference Map: this is based on the assumption that people can sort all the possible combinations of goods into three groups: preferred, not preferred and indifferent.

• Indifference Curve: is a line that shows combinations of goods among which a consumer is indifferent. (figure 8.3)

Preferences and Indifference Curves

• Is the rate at which a person will give up good y (measured on the y-axis) to get more of good x (measured on the x-axis), and at the same time remain indifferent. It is measured by the slope of the indifference curve.– Steep curve, high substitution– Flat curve, low substitution

• Diminishing Marginal Rate of Substitution

• Degree of Substitution (figure 8.5)– Close substitutes: easily substituted for each other.– Complements:can not be substituted for each other at all.

Marginal Rate of Substitution (MRS): (figure 8.4)

• Assume we start at equilibrium (huh!!)– What is equilibrium here?!! (figure 8.6)

• Is on her budget line• Is on her highest attainable indifference curve• Has a marginal rate of substitution between y and x equal to the

relative price of y and x.

• What happens when prices change? (figure 8.7)• Find the demand curve.

• What happens when income changes? (figure 8.8)• Income effect• Less consumption of all goods (if they are normal goods), remember

that income changes switch the demand curve!!

Predicting Consumer Behavior

• Substitution Effect: is the effect of a change in price on the quantity bought when the consumer (hypothetically) remains indifferent between the original and the new situation.

• Income Effect: is the effect of a change in income on consumption.

• Analysis of figure 8.9 (very important!!!)

• The case of inferior goods: remember that the income effect is negative in this case!!

Substitution and Income Effect

• Using this model to explain the labor supply:

• More work means more income

• Figure 8.10

• The labor supply curve

• Higher wage has both a substitution effect and an income effect

Work and Leisure Choices

• A Firm is an institution that hires productive resources and that organizes those resources to produce and sell goods and services.

• The main goal of any firm is to maximize profit.

• To measure profits, first we need to review one concept that we have been using before (Opportunity Cost) and understand 4 new ones (Explicit Costs, Implicit Costs, Economic Depreciation, Cost of owner’s resources)

ORGANIZING PRODUCTION

• The opportunity cost of any action is the highest-valued alternative forgone.

• The firm’s opportunity costs are:– Explicit Costs: are paid in money. Money that could have been used in something

else.

– Implicit Costs: when it forgoes an alternative action but does not make a payment.• Using own capital (because it could be rented to another firm), this is also called

the implicit rental rate of capital, which is made up of:– Economic Depreciation: change in the market value of capital over time.– Interest forgone: the funds used to buy own capital could have been used in

something different and they would have yielded a return.

• Using owner’s time and financial resources: – Usually the entrepreneurial ability, the return on entrepreneurship is profit and

the average return for supplying entrepreneurial ability is called normal profit, and this is a part of a firm’s opportunity cost because it is the cost of a forgone alternative, like running another firm.

Opportunity Cost

• The Economic Profit is simply the result of the next subtraction: Total Revenue - Opportunity Cost

• Where the Opportunity Cost is equal to the sum of its implicit costs and explicit costs.

• Economic Accounting (table 9.1)

• How do firm’s achieve their objective of profit maximization:– By answering the five questions:

• What goods to produce• How to produce them• How to organize and compensate managers and workers• How to market and price its products• What to produce itself and what to buy from other firms

Economic Profit and Economic Accounting

• The must take in to account their constraints, which are:– Technology Constraints:

• A technology is any method of producing a good or service. It includes the detailed designs of machines, the layout of the workplace and the organization of the firm. You can produce up to a certain amount with the current technology!!

– Information Constraints:• We never have enough information about the present and future

buying plans of customers and competitors and suppliers.

– Market Constraints• What each firm can sell, the price it can obtain the resources that it can

buy and the prices it pays form them are constrained by the willingness to pay of its customers, by the prices and marketing efforts of other firms, but the willingness of people to work and invest in the firm.

But how do firms answer this questions?

• Technological Efficiency: When a firm produces a given output by using the least inputs. (table 9.2)

• Economic Efficiency: When a firm produces a given output at lest cost. (table 9.3)

• A Technologically Inefficient method is never economically efficient!!

• Technological efficiency depends only on what is feasible, economic efficiency depends on the relative cost of resources

Technology and Economic Efficiency

• Command Systems: A method of organizing productions that uses a managerial hierarchy

• Incentive Systems: Instead of keeping a very close eye on workers, the managers use a market-like mechanism inside the firm, creating compensation schemes that will induce workers to perform in ways that maximize profit. The case of supervision Vs no supervision and the effect on costs!

• Mixing the systems: Use commands when it is easy to monitor performance or when a small deviation from ideal performance is very costly, and use incentives when monitoring performance is either not possible or too costly.

Information and Organization

• Principal Agent Problem: is the problem of devising compensation rules that induce an agent to act in the best interest of a principal. (the brokerage house example, the extra hours example and the bank tellers example)

• Coping with the principal agent problem: – Ownership: Give them a piece of the pie!!– Incentive pay: Pay related to performance– Long Term-Contracts: maximize profit over a sustained period.

• These three ways of coping with the principal agent problem give rise to different types of business organization.


• Types of Business Organization:– Proprietorship: single owner, with unlimited liability– Partnership: two or more owners who have unlimited liability– Corporation: Firm owned by one or more limited liability

stockholders, limited liability means that the owners have legal liability only for the value of the initial investment.

• Pros and Cons of Different Types of Firms:– Table 9.4


• Some are highly competitive, with profits hard to come by, some are almost free from competition and firms earn large profits. Some markets are dominated by fierce advertising campaigns in which each firm seeks to persuade buyers that it has the best products, and some markets display a warlike character.

• Economist identify four market types: (table 9.6)– Perfect competition (identical product)– Monopolistic Competition (differentiated product)– Oligopoly (either identical or differentiated product)– Monopoly (No close substitutes)

Market an the Competitive Environment

• We have what is called the Measures of Concentration:– The four-firm concentration ration: Is the % of the value of sales accounted

by the four largest firms in an industry (0 for perfect competition to 100 for Monopoly)

– The Herfindahl-Hirschman Index: Is the square of the % market share of each firm summed over the largest 50 firms (or summed over all the firms if there are fewer than 50) in the market.

• In perfect competition the HHI index is small and large for monopoly.• In the 80´s the Federal Trade Commission used it to classify markets and said

that a market with an HHI between 1000 and 1800 is regarded as a competitive market and an HHI higher than 1800 is regarded as as being un-competitive.

– Figure 9.2 for the US Economy.– Limitations of Concentration Measures

• Geographical scope of the market• Barriers to entry and firm turnover• Correspondence between a market and an industry.

How to determine Market Type in Reality?

• Market coordination

• Why Firms?– Transaction Costs– Economies of Scale– Economies of Scope– Economies of Team Production

Markets and Firms

• All firms must decide how much to produce and how to produce it.

• How do firms make these decisions?

• First, the objective is to maximize profits, but to do that the firms must decide the quantity to produce, the quantities of resources to hire and the price at which sell the output.

• Decisions about the quantity to produce and the price to charge depend on the type of market in which the firm operates. But decisions about how to produce a given output do not depend on the type of market. These decisions are similar for all firms in all type of markets.

OUTPUT AND COSTS

• The actions that a firm can take to influence the relationship between output and cost depend on how soon the firm wants to act.– The short run: is the time frame in which the quantities of some resources

are fixed. For most of the firms, the fixed resources are the firm’s buildings and capital. (the management organization and the technology it uses are also fixed in the short run) We call the collection of fixed resources, the firm’s plant.To increase output in the short run, a firm must increase the quantity of variable inputs it uses. Labor is usually the variable input.

– The long run: is the time frame in which the quantities of all resources can be varied. That is, the long run is a period in which the firm can change its plant and the amount of labor that is used.

– Long run decisions are not easily reversed, short run decisions are easily reversed, these is the result of the cost of buying a new plant, these are called the sunk costs.

Decision Time Frames

• To increase output in the short run a firm must increase the quantity of labor employed

• As usual we can analyze the relation between production and labor with the following concepts: (Table 10.1)– Total Product: Total quantity produced– Marginal Product of Labor: is the increase in total product that

results from a one unit increase in the quantity of labor employed.First increases and then begins to decrease

– Average Product of Labor: Total product divided by the quantity of labor employed.First increases and then begins to decrease

Short Run Technology Constraint

• Total Product: it is similar to the Production Possibility Frontier, it separates the attainable from the unattainable. And points on the curve

are technologically efficient.• Marginal Product: The height of this curve measures the slope of

the total product curve at a point. We plot the marginal product at the midpoint because it is the result of going from x1 units of labor to x2 units of labor.

• Increasing Marginal Returns: these occur when the marginal product of an additional worker exceeds the marginal product of the previous worker.

• Diminishing Marginal Returns: these occur when the marginal product of an additional worker is less than the marginal product of the previous worker. They arise from the fact that more and more workers are using the same capital and working in the same space.

• Law of Diminishing Returns: As firms uses more of a variable input, with a given quantity of fixed inputs, the marginal product of the variable input eventually diminishes

Product Curves (figure 10.1 and 10.2)

• Average Product: The marginal product curve, cuts the average product curve at the point of maximum average product. So, for employment levels where the marginal product exceeds average product, average product is increasing. This is a LOGICAL result, right? A very good example is the Marginal Grade and GPA.

Product Curves (figure 10.3)

• To produce more output in the short run, a firm must employ more labor, which means that it must increase its costs.

• As always we can analyze the costs with the following concepts:

• Total Cost• Marginal Cost• Average Cost

Short Run Cost

• TOTAL COST: Is the cost of all the productive resources that a firm uses, including the cost of land, capital, labor and the cost of entrepreneurship, which is normal profit.

• Total Cost is divided in two: (figure 10.4)– Total Fixed Cost: Cost of all fixed inputs, it is horizontal because

total fixed cost does not change when output changes.– Total Variable Cost: Cost of all the firm’s variable inputs.

• The vertical distance between the TVC and TC curve is total fixed cost.

• Total Variable Cost and Total Cost increase at a decreasing rate at small levels of output and then begin to increase at an increasing rate as output increases, to understand this we need to take a look at marginal cost.

Short Run Cost

• MARGINAL COST: is the increase in total cost that results from a one unit increase in output. We calculate it by the increase in total cost divided by the increase in output.

• The Marginal Cost curve is “U” shaped because of the Law of Diminishing Returns!, which tells us that each additional worker produces a successively smaller addition to output, so to get an additional unit of output, ever more workers are required. (figure 10.5)

• The marginal cost curve tells us how total cost change as output changes.

Short Run Cost

• AVERAGE COST: – Average Fixed Cost: Total fixed cost per unit of output. Slopes

downward.– Average Variable Cost: Total variable cost per unit of output. “U”

shaped– Average Total Cost: Total cost per unit of output. “U” shaped.

• The Marginal Cost curve intersects the average variable cost curve and the average total cost curve at their minimum points.

• The distance between ATC and AVC is equal to the AFC and it shrinks as output increases, since AFC declines with increasing output.

Short Run Cost

• Cost Curves and Product Curves (figure 10.6)– what are the relations?

• Shifts in the Cost Curves:– Technology– Prices of Productive Resources.

Short Run Cost

• In the long run, a firm can vary both the quantity of labor and the quantity of capital.

• Long run cost is the cost of production when a firm uses the economically efficient quantities of labor and capital, there are no fixed costs in the long run.

• The behavior of the long run cost depends on the firm’s production function, which is the relationship between the maximum output attainable and the quantities of both labor and capital.

Long Run Cost

• Diminishing Returns, happen at each level of capital utilization.

• Diminishing Marginal Product of Capital: Diminishing returns also occur as the quantity of labor increases. Marginal product of capital is the change in total product divided by the change in capital when the quantity of labor is constant.

• Short run cost and Long Run Cost. (table 10.3 and figure 10.7)

• Each short-run average total cost curve is U shaped• For each short-run average total cost curve, the larger the plant, the

greater is the output at which average total cost is a minimum.

Long Run Cost

• The economically efficient plant size for producing a given output is the one that has the lowest average total cost.

• The Long run average cost curve: is the relationship between the lowest attainable average total cost and output when both the plant size and labor are varied.(Figure 10.8)

• The Long run average cost curve is derived from the short run average total cost curves.

Long Run Cost

• Some more concepts that we need to know:

– Economies of Scale: are features of a firm’s technology that lead to falling long run average cost as output increases. When economies of scale are present the LRAC curve slopes downward. The percentage increase in output exceeds the percentage increase in all inputs; the main source of economies of scale is greater specialization.

– Diseconomies of Scale: are features of a firm’s technology that lead to rising long-run average cost as output increases. When diseconomies of scale are present the LRAC curve slopes upwards. The percentage increase in output is less than the percentage increase in all inputs; the main source of diseconomies of scales is the difficulty of managing a very large enterprise.

– Constant Returns to Scale: are features of a firm’s technology that lead to constant long-run average cost as output increases. When constant returns to scale are present, the LARC curve is horizontal. The percentage increase in output equals the percentage increase in inputs.

– Minimum Efficient Scale: is the smallest quantity of output at which long-run average cost reaches its lowest level and as we will see it plays a role in determining market structure.

Long Run Cost

• How does competition affect prices and profits?

• What causes some firms to enter and industry and others to leave it?

• What are the effects on profits and prices of new firms entering and old firms leaving an industry?

PERFECT COMPETITION

• Perfect Competition is an industry in which:– Many firms sell identical products to many buyers– There are no restrictions on entry into the industry– Established firms have no advantage over new ones– Sellers and buyers are well informed about prices.

• How Perfect Competition Arises– If the minimum efficient scale of a single producer is small relative

to the demand for the good or service– If each firm is perceived to produce a good or service that has no

unique characteristics so that consumers do not care which firm they buy from

NOTE: Minimum efficient scale is the smallest quantity of output at which long run average cost reaches its lowest level.

Competition

• Economic Profit and Revenue: (figure 11.1)

• Economic Profit = Total Revenue - Total Cost– Total Revenue = Q*P

– Total Cost = the opportunity cost of production, which includes normal profit.

– Marginal Revenue: is the change in total revenue that results from a one unit increase in the quantity sold.

• In Perfect Competition Marginal Revenue = Price !!!

Competition

• The revenue curves summarize the market constraints faced by a perfectly competitive firm. Firms also have a technology constraint which is described by the product curves.

• Short Run Decisions: • Whether to produce or to shut down• If the decision is to produce, what quantity to produce.

• Long Run Decisions:• Whether to increase or decrease its plant size• Whether to stay in the industry or leave it.

Firm’s Decisions in Perfect Comp.

• Profit Maximizing Output: (figure 11.2)A Perfectly competitive firm maximizes economic profit by choosing its output level.

• We can look at the Total Revenue (TR) and the Total Cost (TC) and see where does the firm gets the highest economic profit.

• An output where TR = TC, is called a break-even point, the firm’s economic profit is zero, but because normal profit is part of total cost, the firm makes normal profit at a break-even point.

• Graphically, economic profit is measured by the vertical distance between the total revenue and total cost curves.

• The profit curve is at a maximum when TR exceeds TC by the largest amount!.


• As always we could also look at this with the Marginal Analysis (figure 11.3)

• Marginal Revenue = Marginal Cost Max. Econ. Profit

• Marginal Revenue > Marginal Cost Sell more The extra revenue from selling one more unit exceeds the extra cost incurred to produce it. The firm makes an economic profit on the marginal unit.

• Marginal Revenue < Marginal Cost Decrease outputThe extra revenue from selling one more unit is less than the extra cost incurred to produce it. The firm incurs an economic profit loss on the marginal unit.


• The firm’s short run supply curve (figure 11.5)– It shows how the firm’s profit maximizing output varies as the market price

varies, other things remaining the same.

– Temporary Shot down: In the short run Total Fixed Cost can not be avoided, if a firm shuts down it produces no output and it incurs in a loss equal to total fixed cost.

• Shot down point: is the output and price at which the firm just covers its total variable costs.

– The short run supply curve: if the price is above the minimum average variable cost, the firm maximizes profit by producing the output at which marginal cost equals price. We can determine the output produced at each price from the marginal cost curve.

– The short run Industry supply curve: it shows the quantity supplied by the industry at each price when the plant size of each firm and the number of firms remain constant. It is the sum of the quantities supplied by all firms in the industry at that price. (figure 11.6)


• Short Run Equilibrium: Industry demand and industry supply determine the market price and industry output.

• A Change in Demand: these type of changes bring changes to the short run industry equilibrium. (figure 11.7)

• Profit and Loses in the Short run (figure 11.4)– If price exceeds average total cost, a firm makes an economic

profit.– If price is less than average total cost, a firm incurs an economic

loss.– If price equals average total cost, a firm breaks even, but it makes

normal profit.

Output, price, and profit in Perfect Competition

• Long Run Adjustments: Industry adjust in two ways.1 Entry and exit (figure 11.8)

– Temporary economic profit or temporary economic loss, like the win or loss at a casino, do not trigger entry or exit. But the prospect of persistent economic profit or loss does.

– Entry and exit influence price, the quantity produced and the economic profit.

» Economic profit is a signal for new firms to enter the industry.

- As new firms enter and industry, the price falls and the

economic profit of each existing firm decreases.

» Economic loss is a signal for some firms to exit the industry.

- As firms exit and industry, the price rises and the

economic loss of each remaining firm decreases.


2 Changes in plant size (figure 11.9)– A firm changes its plant size if, by doing so, it can lower its costs and

increase its economic profit.

• Long Run Equilibrium: it occurs in a competitive industry when economic profit is zero (when firms earn normal profit).


• Permanent changes in Demand:• Why do these happen?• What are the effects in the equilibrium price, quantity and number

of firms in the market?• Adjustment process:

– (Figure 11.10)

• Technological Change:• It takes time• Adjustment process:

– Two forces are at work in an industry undergoing technological change. Firms that adopt the new technology make an economic profit. So there is entry by new-technology firms. Firms that stick with the old technology incur economic losses. They either exit the industry or switch to the new technology. As old-technology firms disappear and new technology firms enter, the price falls and the quantity produced increases. Eventually, the industry arrives at a long-run equilibrium in which all firms use the new technology and make a zero economic profit.

Changing Tastes and Advancing Technology

• Some important concepts:– External Economies: these are factors beyond the control of an

individual firm that lower it costs as the industry output increases.

– External Diseconomies: are factors outside the control of a firm that

raise the firm’s costs as industry output increases.

– NOTE: With no external economies or diseconomies a firm’s cost remain constant as the industry output changes.

– Long Run Industry Supply curve: shows how the quantity supplied by an industry varies as the market price varies after all the possible adjustments have been made. The slope of this curve is affected by the existence of external economies or diseconomies (figure 11.11)

– Constant slope if none are present

– Upward sloping if external diseconomies are present

– Downward sloping if external economies are present.

Changing Tastes and Advancing Technology

• Efficient Use of Resources: this happen when we produce the goods and services that people value most highly. If someone can become better off without anyone else becoming worse off, resources are not being used efficiently.

• Choices, Equilibrium and Efficiency. (figure 11.12)– Choices:

• Consumers allocate their budgets to get the most value possible out of them. And we derive a consumer’s demand curve by finding how the best budget allocation changes as the price of a good changes.

• Competitive firms produce the quantity that maximizes profit. And we derive the firm’s supply curve by finding the profit maximizing quantity at each price.

– Equilibrium: • quantity demanded = quantity supplied• price paid = consumer’s marginal benefit• price received = producers marginal cost

– Efficiency: • In absence of external benefits and external costs, competitive markets are in equilibrium,

when resources can not be reallocated to increase value.

Competition and Efficiency

• Efficiency of Perfect Competition• Perfect competition achieves efficiency if there are no external benefits

or external costs. But there are three main obstacles to efficiency:

» Monopoly: Restricts output below its competitive equilibrium

» Public Goods: If left to competitive markets, too small a quantity would be produced.

» External Costs and External Benefits: the quantity is efficient in the market, but it harms or benefits other markets or society.

Competition and Efficiency

Market Power• This is the ability to influence the market and in particular the market

price, by influencing the total quantity offered for sale.

• Monopoly: is an industry that produces a good or service for which no close substitute exists and in which there is one supplier that is protected from competition by a barrier preventing the entry of new firms.

• How Monopoly arises:• No close substitute

• Barriers to entry– Legal Barriers

» Public Franchise, government license, patent and copyright

– Natural Barriers (figure 12.1): a firm can supply the entire market at a lower price than two or more firms can.

MONOPOLY

• Monopoly Price Setting Strategies:

– Price discrimination:Which means that a firm sells different units of a good or service for different prices. When a firm price discriminates, it looks as if it is doing its customers a favor, but in fact it is charging them the highest possible price for each unit sold and making the largest possible profit.

– Single price:Selling each unit of output for the same price to all of its customers.

Market Power

• Price, Total Revenue and Marginal Revenue analysis.– Total Revenue (TR): price times quantity sold– Marginal Revenue (MR): is the change in total revenue resulting

from a one unit increase in the quantity sold.– Different from the marginal revenue of perfect competition, why?

» In a Monopoly, since there is only one supplier, changes in quantity affect the price. So as the supplier satisfies one more unit demanded the price will fall (figure 12.2), notice that we are not talking about the quantity supplied, just quantity demanded.

• Marginal Revenue and the Price Elasticity of Demand (figure 12.3).

• Elastic Demand

• Unit Elastic Demand

• Inelastic Demand.

– This analysis tells us that profit maximizing monopolies never produce an output in the inelastic range of its demand curve. Why?

Single Price Monopoly’s Output and Price Decision

• Output and Price Decision: (figure 12.4 and table 12.1)

– A monopoly, like a competitive firm, maximizes profit by producing the output at which marginal cost equals marginal benefit, in fact ALL FIRMS MAXIMIZE PROFIT WHEN MARGINAL BENEFIT EQUALS MARGINAL COST!!

– For the monopoly, once we get that the quantity that will maximize profit is for the quantity that makes Marginal Revenue equals Marginal Cost, then we can see that price will be set higher than Marginal Cost, given the consumers willingness to pay for that quantity.

– By following this strategy the monopolist earns economic profits, which in the competitive market would be the signal for the entry of new firms, but in this case there are barriers for entry that permit the existence of economic profits.

Single Price Monopoly’s Output and Price Decision

• How would you compare these two types of markets?– Quantities? Price? How? (figure 12.5)

• A single-price monopoly, restricts its output and charges a higher price.

– Efficiency? (figure 12.6)• By restricting output, then we have an underproduction, you must know how to solve

this one, right? …. Hint: consumer and producer surplus in addition to the deadweight loss!!

– Redistribution of Surpluses: some consumer surplus goes to the monopoly

– Rent seeking: (figure 12.7)– Buy a Monopoly

– Create a Monopoly

NOTE: The average total cost curve, which includes the fixed cost of rent seeking, shifts upward until it just touches the demand curve, economic profit is zero, now there is more deadweight loss!!

Single Price Monopoly Vs. Perfect Competition

• Price discrimination is charging different prices for a single good or service because of differences in buyer’s willingness to pay and not because of differences in production costs.

• To be able to price discriminate, a monopoly must:• Identify and separate different buyers type.• Sell a product that cannot be resold.

• At first sight it appears that price discrimination is against all logic, why?

• Well, instead of decreasing profits it is actually increasing them, nice trick right?

Price Discrimination

• Price Discrimination and Consumer Surplus:– What would happen if we could sell each unit at the exact price that

the consumer of that unit is willing to pay, what would happen to consumer surplus in this case?

• Discrimination Among Units of a good: Charges each buyer a different price on each unit of a good bought. (usually this does not happen, because discounts reflect the lower costs of production! Huh? , what?

• Discrimination Among Groups of Buyers: Price discrimination on the basis of age, employment status, or some other EASILY distinguished characteristic. (Now, this is what usually happens!)

– How do profits behave under this new context? (figure 12.8 and 12.9)

– An extreme case, Perfect Price Discrimination (figure 12.10)

Price Discrimination

• Efficiency and Rent seeking with price discrimination.– So, perfect price discrimination achieves efficiency!!

• The more perfectly the monopoly can price discriminate, the The more perfectly the monopoly can price discriminate, the closer its output gets to the competitive output and the more closer its output gets to the competitive output and the more efficient is the outcomeefficient is the outcome

• It is as efficient as perfect competition, but it is not as good, why?» Consumer surplusConsumer surplus

» Rent seeking activities waste resourcesRent seeking activities waste resources

Price Discrimination Monopoly Vs. Perfect Competition

• If it is so bad, why does it exists? Do we do anything about it?

• Yes, there are laws that actually limit monopoly power and regulate the prices that monopolies are permitted to charge, but monopoly also brings some benefits: what??? HOW??

– Incentives to innovation

» Do innovations come faster with monopolies or with competition, well we can not tell, but one thing is for sure the process of diffusion is faster, new firms jump in the wagon faster.

– Economies of Scale and Scope:

» Where significant economies of scale or scope exist, it is usually worth putting up with the monopoly and regulating its prices.

Monopoly Policy Issues

• Regulating Natural Monopoly* (figure 12.11)– Profit maximization: Marginal Revenue = Marginal Cost

– But for efficiency, an efficient regulator would like to have Marginal Benefit = Marginal Cost, which is the same as setting price equals Marginal Cost. This is called the Marginal Cost pricing rule, and it gives us an efficient outcome but the natural monopoly is incurring an economic loss.

• A way to fix this is to price discriminate, charging higher prices to some consumers and the marginal cost to others.

• Another way is know as the two part tariff: fixed with variable fees.

• Government subsidies, but these would require a tax from somewhere else, and these taxes cause a deadweight loss in that market, so at the end we would try to minimize the total deadweight loss.

• Follow the average cost pricing rule: The outcome is better for consumers than with the unregulated case. (the firm earns normal profit.

Monopoly Policy Issues

• Coupons, fliers and price wars, what do they mean and why do the exist?

• What are the decisions of the firms under these market structures?

• How deep is our knowledge and understanding of these markets?

Monopolistic Competition and Oligopoly

• Sometimes firms are competitive, but not as fiercely so as perfect competition firms. In this type of market firms posses some market power to set their prices, just as monopolies do!

• The characteristics of this type of market:– Large number of firms– Differentiated product– Competition on product quality, price and marketing– Free entry and exit.

MONOPOLISTIC COMPETITION

• Implications of having a large number of firms: – Small market share

– Ignore other firms

– Collusion is impossible

• Product differentiation

• Competing in:– Quality– Price: because of product differentiation, a firm in monopolistic

competition faces a downward-sloping demand curve. (like monopoly!!)

– Marketing: convince that yours is better.

• Free entry and exit, implies that there are no economic profits in the long run (incentives to go in or out exist)

MONOPOLISTIC COMPETITION

• SHORT RUN• The marginal revenue curve is derived in the same way as in the single price

monopolist case! (figure 13.2)• In the short run the firm behaves as a single price monopolist, it produces the quantity

at which marginal revenue equals marginal cost and then charges the highest price possible for this quantity.

• Economic Profit and Economic Loss in the Short Run. (figures 13.2 and 13.3)

• LONG RUN• Zero economic profits!!• What is the adjustment process? (figure 13.4)

• Efficiency (figure 13.5)• Marginal Cost equals marginal benefit, but in this market, even though the firms make

zero economic profit in the long run equilibrium, the monopolistically competitive industry produces an output at which price equals average total cost, but exceeds marginal cost, so there is an excess capacity in the long run equilibrium.

• Output capacity: is the output at which average total cost is a minimum.• The firms could sell more by lowering their prices, but they would incur losses.• This market structure is inefficient, just like monopoly, but the inefficiency arises from

the product differentiation, so this loss must be weighed against the gain of greater product variety.

Decisions and results.

• Innovation and Product Development:– Innovation is a necessity if a firm wants to enjoy economic profit

• Imitations

– Innovations increase the firm’s demand temporarily.– Is Innovation efficient? Isn’t it just a waste of resources?

• Marketing– Convince and emphasize the product differentiation, even if the

differences are small.– What about the total costs of the firm? Do they increase with the

expenditures in marketing campaigns? What kind of costs are they?

– If advertisement increases the quantity sold by a large amount, then it can lower the average total cost. So what? (figure 13.5)

Product Developing and Marketing

• Selling Costs and Demand– The Mark Up

– The effects on elasticity of demand

• Advertising to Signal Quality• Brand Names• Efficiency and Advertising of Brand Names

Product Developing and Marketing

• Characteristics:• Small number of firms• Natural or legal barriers to entry• Decisions depend on the decisions made by other firms

• The current models:• Natural Oligopoly• Kinked demand curve model (figure 13.11)

– If the firm raises its price, others will not follow.– If it cuts its price, so will the others.– The kink in the Demand curve causes a break in the marginal revenue curve.

• Dominant firm oligopoly (figure 13.12)– When one firm has a big cost advantage (the dominant one) over the other

firms and produces a large part of the industry output.

• These models do not match what is happening out there, so the new fashion in economics is the use of Game theory to explain these type of markets.

OLIGOPOLY

• It is used to analyze strategic behavior (behavior that takes in to account the behavior of others and the mutual recognition of interdependence).

• Game theory seeks to understand oligopoly as well as other forms of economics, political, social and even biological rivalries.

• What must exist in order to have a game?

• The prisoners’ dilemma:– rules– strategies– Payoffs: Payoff matrix– Equilibrium– Nash Equilibrium– Dominant strategy equilibrium– The Dilemma– A Bad outcome

Game Theory

• An Oligopoly Price-Fixing Game: “The Duopoly example”– Collusive agreement: “Cartel”

• Strategies: Comply and Cheat• Actions: There are four of them

– Cost and Demand conditions (figure 13.13)

– If they collude (figure 13.14)

– If one firm cheats on a collusive agreement (figure 13.15)

– If both firms cheat (figure 13.16)

A better “economics” example

– If both firms cheat (figure 13.16)

– The payoff matrix (Table 13.2)

– Equilibrium


– Research and Development Game (Table 13.3)

– John Nash and Adam Smith: The Game of Chicken (Table 13.4)

– Repeated Games: The opportunity to penalize– Cooperative Equilibrium: players make and share the monopoly profit.

– How to make this happen? (Table 13.5)

» Tit for tat Strategy

» Trigger strategy

– Price Wars


• Sequential entry games: Contestable Markets:

• Danger of the existence of entry incentives.• The HHI signal is wrong?• The Entry deterrence Game (figure 13.17)

–Payoffs

–Equilibrium

Two other Oligopoly games

• The economic theory of the government explains the economic roles of governments, the economic choices that they make, and the consequences of those choices.

• The government roles:– Establish and maintain property rights and set rules for the

redistribution of income and wealth.

– Provide mechanisms for allocating scarce resources when the market economy results in inefficiencies (Market Failures)

Economic Theory of the Government

Economic problems that governments and public choices address:

1. Monopoly and Oligopoly – Regulation and Antitrust laws

2. The provision of Public Goods

3. The use of Common Resources

4. Externalities

5. Income redistribution


Monopoly and Oligopoly Regulation:

Government intervenes in monopoly and oligopoly markets to influence prices, quantities produced, and the distribution of the gains from economic activity in two main ways:

– Regulation– Antitrust Law


Economic Theory of Regulation: There is always demand and supply.

– Demand for regulation

– Supply for regulation

– Equilibrium: Social Interest Theory Vs. Capture Theory


• The Cable Company Example (A Natural Monopoly)

– Regulation in the Social Interests: Marginal Cost = Price

• Marginal Cost Pricing Rule (figure 14.2)• Average Cost Pricing Rule (figure 14.3)

– Rate of Return Regulation: It is already part of the opportunity cost for the natural monopoly

• Inflating Cost (figure 14.4)


– Price Cap Regulation: A surprising result of an effective price ceiling. (Why???) (figure 14.5)

• Cartel Regulation: An Example (figure 14.6)– Social Interest– Capture Theory– Cases


• Antitrust Law– Policy Debates

• Resale price maintenance• Tying arrangements• Predatory Pricing

– The Microsoft Case– Merger Rules– Social Interest


• Externalities

– Positive Production Externalities

– Negative Production Externalities

– Positive Consumption Externalities

– Negative Consumption Externalities


• Production and Pollution how much?– Taking into account all costs (private and external)

– Figure 15.3

– Property Rights (Figure 15.4)

– The Caose theorem

• Government actions in the face of external costs (figure 15.5)


• Positive Externalities: An Example

– Education

– Figure 15.6

– Figure 15.7

• Government actions in the face of external costs (figure 15.8)

– Public provision or Private subsidies


• Provision of Public Goods– Classification of Goods (figure 16.1)

– The Free Rider Problem and the problem of the commons

– The benefit of a public good and the free rider problem (figure 16.2)• Individual Marginal Benefits• Economy’s Marginal Benefits• Economy’s marginal benefit vs. market demand• The efficient quantity of a public good (figure 16.3)


– The efficient quantity of a public good (figure 16.3)

– Private provision Vs. Public Provision

• Common Resources– The original problem– A current example (Table 16.1)

• Over fishing• Efficient use of the commons

– Property rights– quotas


• Why do differences in wages exist?

• How do return on savings influence the allocation of savings across the many industries and activities that use our capital resources?

• What causes the differences in the cost of the land?

DEMAND AND SUPPLY IN RESOURCE MARKET

• Goods and services are produced using the four economic resources: labor, capital, land and entrepreneurship.

• Incomes are determined by resource prices and the quantities used.– the wage rate for labor– the interest rate for capital– the rental rate for land– the rate of normal profit for entrepreneurship

• Because the price - quantity relation exist, then we can use the usual law of demand and supply to analyze the resource markets.

Resource Prices and Income

• The demand for labor is a derived demand, since it depends on the quantity that is produced.

• Maximizing profit behavior: marginal benefit = marginal cost

– We have: Marginal revenue earned by hiring one more worker = marginal cost of that worker.– The change in total revenue that results from employing one or unit of labor is called the

marginal revenue product of labor. (table 14.1)• You have marginal revenue and marginal product so multiply them to get the marginal

revenue product. (marginal revenue per worker)• Diminishing Marginal Revenue product is caused by the characteristic of decreasing

marginal product!

Labor Market

• The labor demand curve:• A firm’s marginal revenue product curve is also its demand for labor

curve!!• If the wage rate is less than the marginal revenue product a firm

benefits if it hires one more unit of labor• if the wage rates is higher than the marginal revenue product a firm

can increase its profit by employing one fewer worker.• Then MRP = W is the profit maximizing condition.

• So we have two profit maximizing conditions: MRP = W and MR = MC, what is the connection? (table 14.2)

• Changes in the demand for labor: (table 14.3)• Movements along the demand curve for labor• Shifts in the demand curve for labor

Labor Market

• Market demand of labor

• Elasticity of demand for labor: it measures the responsiveness of the quantity of labor demanded to the wage rate.

• It depends on:– labor intensity of the production process

» the greater the degree of labor intensity, the more elastic is the demand for labor.

– elasticity of demand for the product

» the greater is the elasticity of demand for the good, the greater larger is the elasticity of demand for the labor used to produce it.

– substitutability of capital for labor

Labor Market

• The supply of labor • Substitution effect• Income effect• Backward-bending supply of labor curve• Market supply of labor• Changes in the supply of labor:

– Adult population

– Technological change and capital accumulation in home production

• Market Equilibrium (figure 14.2)

Labor Market

• Wage differentials (figure 18.7)– The demand for High-Skilled and Low-

Skilled labor

– The Supply of High-Skilled and Low-Skilled labor

– Wage Rates of H-S and L-S labor

• Do Education and training pay?

• Inequality explained by Human Capital Differences

Labor Market

• Trends in Inequality Explained by Human Capital trends (figure 18.8)

• Discrimination– A simple setup (figure 18.9)

– Counteracting forces

– Differences in the degree of specialization

Labor Market

• Through this market the firms get the financial resources to buy physical capital resources. These financial resources come from saving, and the price of capital, which adjusts the market, is the interest rate.

• Demand for capital:– If the marginal product of capital exceeds the cost of capital, then

the firm buys more capital. The problem is that the payment of capital must be made today but the revenue comes in the future.

– To solve this problem, the firm must calculate the present value of the future marginal products and compare this value to the existing cost of capital and make the decision.

Capital Markets

• Discounting and Present Value• The savings example:

next period value = deposit * (1+r)

two periods ahead value = next period * (1+r)

= [deposit * (1+r)] * (1+r) = deposit * (1+r)^2

• So the future value in the t-th period is equal to

future value in the t-th period = deposit * (1+ r)^t

• Moving terms around we can get the present valuePresent value = deposit = [future value in the t-th period] / (1+r)^t

Capital Markets

• Net present Value (NPV) = Present Value - Cost

• If the NPV exceeds the cost then buy the capital.

• The effect of higher interest rates.

• The example of Taxfile’s Investment Decision (table 14.5)

• Demand curve for capital:– Law of demand– Changes in demand

• Population growth• Technological change

Capital Markets

• The Supply of Capital– It results from people’s decision to save money and these are

determined by:• income• expected future income• interest rate

– Supply curve of capital• changes in the supply of capital

• Equilibrium in the Capital Markets (figure 14.6)

Capital Markets

• All natural resources are called LAND, and they fall in to two categories:– Nonexhaustible (land, rivers, lakes and rain)– Exhaustible (oil, coal and natural gas)

– The supply of a Nonexhaustible natural resource: it is perfectly inelastic (figure14.7)

– The supply of an exhaustible natural resource: perfectly elastic (figure 14.8)

– Price and Hotelling Principle

Land and Exhaustible Natural Resource Markets

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