Microeconomic Concepts:Elasticity : Microeconomic Concepts:Elasticity Prepared by: CA Tarun Mahajan Prepared by: CA Tarun Mahajan
Price Elasticity of Demand : Price Elasticity of Demand The price elasticity of demand measures the change in the quantity demanded in response to a change in market price (i.e., a movement along a demand curve). Prepared by: CA Tarun Mahajan
Elasticity : Price Elasticity of Demand along Demand curve : Elasticity : Price Elasticity of Demand along Demand curve Price Elasticity is different at different points along a demand curve
Price Elasticity between price 2 and 3 :
[ (6-7)/ 6.5 ] / [( 3-2)/2.5] = -0.385
Price Elasticity between price 5 and 6 :
[ (3-4)/ 3.5 ] / [( 6-5)/5.5] = -1.572
At pt. (a) in a higher price range the price elasticity is greater then at point (b). 1 2 3 4 5 6 7 1 2 3 4 Price Qty Point (a) Point (b) 5 6 Prepared by: CA Tarun Mahajan
Price Elasticity of Demand : Price Elasticity of Demand If a small percentage price change results in a large percentage change in quantity demanded, the demand for that good is said to be highly elastic. Here The absolute value of price elasticity is greater than one. Luxury goods are an example of an elastic good.
If a large percentage price change results in a small percentage change in quantity demanded, demand is relatively inelastic. The absolute value of price elasticity is less than one. Fuel and salt are examples of relatively inelastic good.
A perfectly elastic demand curve is horizontal, and its elasticity is infinite. If the price increases, quantity demanded goes to zero.
A perfectly inelastic demand curve is vertical, and elasticity is zero. If the price changes, there will be no change in the quantity demanded. Prepared by: CA Tarun Mahajan
Price Elasticity of Demand : Price Elasticity of Demand Qty. Price Elastic Qty. Price Inelastic Qty. Price Perfectly Elastic Perfectly inelastic Prepared by: CA Tarun Mahajan
Elasticity of demand & total revenue. : Elasticity of demand & total revenue. It is important that you notice that price elasticity of demand changes as you move along the demand curve. Elasticity is not simply the slope of the demand curve
The price elasticity of demand curve is downward sloping from left to right. Total revenue is maximized at the price and quantity where demand is unit elastic (price elasticity = –1).
Up on the demand curve where demand is elastic, total revenue decreases when the price is increased.
Down on the demand curve where demand is inelastic, total revenue decreases when the price is reduced. Prepared by: CA Tarun Mahajan
Factors influencing price elasticity : Factors influencing price elasticity Availability of substitutes: If good substitutes are available, a price increase in one product will induce consumers to switch to a substitute good.
Relative amount of income spent on the good: When the portion of consumer budgets spent on a particular good is relatively small, demand for that good will tend to be relatively inelastic.
Time since the price change: The price elasticity of demand for most products is greater in the long run than in the short run. Prepared by: CA Tarun Mahajan
Cross & Income Elasticity : Cross & Income Elasticity Cross elasticity of demand measures the change in the demand for a good in response to the change in price of a substitute or complementary good. The formula for calculating cross elasticity of demand is:
Cross elasticity of demand = percent change in quantity demanded / percent change in price of substitute or complement
The income elasticity of demand measures the sensitivity of the quantity of a good or service demanded to a change in a consumer’s income. The formula for income elasticity of demand is:
Income elasticity of demand = percent change in quantity demanded / percent change in income Prepared by: CA Tarun Mahajan
Elasticity : Determinants of Elasticity of Demand : Elasticity : Determinants of Elasticity of Demand Cross Elasticity Income Elasticity Prepared by: CA Tarun Mahajan
Price elasticity of supply : Price elasticity of supply The price elasticity of supply is similar to the price elasticity of demand. It is a measure of the responsiveness of the quantity supplied to changes in price. That is:
Price elasticity of supply = percent change in quantity supplied / percent change in price Prepared by: CA Tarun Mahajan
Factors influencing elasticity of supply : Factors influencing elasticity of supply Available resource substitutions: When a good or service can only be produced using unique or rare inputs, the elasticity of supply will be low.
Supply decision time frame: Three time-dependent supply curves must be considered when evaluating how the length of time following a price change affects the elasticity of supply:
Momentary supply refers to the change in the quantity of a good supplied immediately following the price change. When producers cannot change the output of a good immediately, the momentary supply curve is vertical or nearly vertical, and the good is highly inelastic.
Short-term supply refers to the shape a supply curve takes on as the sequence of long-term adjustments are made to the production process.
Long-term supply refers to the shape of the supply curve after all of the possible ways of adjusting supply have been employed. Prepared by: CA Tarun Mahajan
Efficiency & Elasticity : Efficiency & Elasticity Prepared by: CA Tarun Mahajan Prepared by: CA Tarun Mahajan
Marginal Cost & Benefit : Marginal Cost & Benefit Marginal benefit is the benefit an individual gets from consuming an additional unit of a good or service. Marginal benefit is quantified as the maximum price that a consumer is willing to pay for one additional unit of a good or service. In most cases, the marginal benefit of a good or service decreases as the quantity consumed increases.
Marginal cost is the cost of producing one more unit of output. Marginal cost is referred to as an opportunity cost because it represents the value (in their next-highest-valued use) of the resources required to produce an additional unit of output.
At the quantity of production where the marginal cost equals marginal benefit, the total value created by producing a good is at a maximum. We refer to this as the optimal quantity of production and say that productive resources are being allocated efficiently. Prepared by: CA Tarun Mahajan
Consumer Surplus : Consumer Surplus Consumer surplus is the difference between the total value consumers place on the quantity of a good produced and the total amount they must pay for that quantity.
Consumer surplus depends on consumers’ demand (marginal benefit) curves.
For example, at a given market price, the consumer surplus for a pizza to a pizza lover will be greater than the consumer surplus for the average pizza consumer. Prepared by: CA Tarun Mahajan
Producer Surplus : Producer Surplus Just as the marginal benefit curve is equal to the demand curve for a good or service, the marginal cost curve for a good or service is the same as the supply curve for that good or service.
Whenever the market price for a good or service exceeds the marginal cost of producing it, producers realize a producer surplus. Producer surplus is formally defined as the sum of the differences between the price received for each unit of good produced and the opportunity cost of each unit for the total units produced. Prepared by: CA Tarun Mahajan
Slide 16 : The optimum quantity (where marginal cost equals marginal benefit) is also the quantity of production that maximizes total consumer surplus and producer surplus.
At this point quantity supplied and quantity demanded are equal and it maximizes the sum of consumer and producer surplus and brings about an efficient allocation of resources to the production of the good. Prepared by: CA Tarun Mahajan
Slide 17 : 1000 2000 3000 Qty. Marginal Benefit & Cost $30
$20
$10 Marginal benefit more than marginal cost: Increase output Marginal cost more than marginal benefit: decrease output Marginal Cost Marginal Benefit Prepared by: CA Tarun Mahajan
Efficient Market: Optimal Resource Utilization : Efficient Market: Optimal Resource Utilization Changes in consumer tastes and advances in technology lead to a constant reallocation of productive resources in an economy from one use to another, as the maximum benefit to society can be achieved by the production of a different mix of goods and services.
For example when mobile phones were introduced they were expensive and sold as a luxury. Technological advances in production reduced the cost of producing phones, supply increased and prices fell. The (equilibrium) quantity demanded increased, resulting in more resources being devoted to the production of microwave ovens. These resources were removed from the production of other goods and services. Prepared by: CA Tarun Mahajan
Obstacle to efficiency : Obstacle to efficiency Some of the obstacles to the efficient allocation of productive resources are:
Price controls: Like Rent control and minimum wage are examples of price ceiling and price floor.
Taxes and trade restrictions: Taxes increase the price that buyers pay and reduce the price that sellers receive. Subsidies lead to production of more than efficient quantity of the goods. Quotas lead to production of less than efficient qty. of goods.
Monopoly: Seller will produce qty. that is less than efficient level. Prepared by: CA Tarun Mahajan
Obstacle to efficiency : Obstacle to efficiency External costs: say pollution caused by production. It may result in over allocation of resources to production by polluting firm.
External benefits: say solar energy used by a shopping mall may save environment. If not considered it will result in allocation of less than optimum resources.
Public goods and common resources: National defense is an example. It will result in less than efficient quantity of public goods. This is often referred to as free riders. Prepared by: CA Tarun Mahajan
utilitarianism and the symmetry principle : utilitarianism and the symmetry principle utilitarianism—that the value of an economy is maximized when each person owns an equal amount of the resources. Proponents of utilitarianism argue that: (1) everyone wants and needs the same things and has the same capacity to enjoy life, and (2) the marginal benefit of a dollar is greater for the poor than the rich.
The symmetry principle holds that people in similar situations should be treated similarly. Economically speaking, this means equality of opportunity. Prepared by: CA Tarun Mahajan
Market in Action : Market in Action Prepared by: CA Tarun Mahajan Prepared by: CA Tarun Mahajan
Market equilibrium and outside shocks : Market equilibrium and outside shocks Market equilibrium occurs at the price where the quantity supplied is equal to the quantity demanded.
If an outside shock (like natural disaster) temporarily interrupt supply, quantity reduces and price rises.
In long run producers can adjust their capacity. Hence Increased price motivates them for higher production.
Therefore we can say that in long run both price and quantity can return to their equilibrium levels prior to the outside shock.
An example will be increase in rent after earthquake. Prepared by: CA Tarun Mahajan
Price Ceiling : Price Ceiling A price ceiling is an upper limit on the price which a seller can charge. If the ceiling is below the equilibrium price, the result will be a shortage at the ceiling price.
The reduction in quantity exchanged due to the price ceiling leads to a deadweight loss in efficiency.
In the long run, price ceilings lead to the following:
Consumers may have to wait in long lines to make purchases. They pay a price in terms of the time they spend in line.
Suppliers may engage in discrimination, such as selling to friends and relatives first.
Suppliers "officially" sell at the ceiling price, but take bribes to do so.
Suppliers may also reduce the quality of the goods produced to a level commensurate with the ceiling price. Prepared by: CA Tarun Mahajan
Price Ceiling : Price Ceiling Price ceiling leads to black market. black market refers to economic activity that takes place illegally. A black market is generally inefficient because:
Contracts are not as enforceable.
The risk of prosecution increases the prices required by suppliers.
Quality control deteriorates, which leads to more defective products. Prepared by: CA Tarun Mahajan
Price Floor : Price Floor A price floor is a minimum price that a buyer can offer for a good, service, or resource. When a price floor is set above the equilibrium price, there will be a surplus (excess supply) at the floor price.
There is a loss of efficiency (DWL) because the quantity actually transacted with the price floor is less than the unrestricted equilibrium quantity.
The minimum wage is an example of a price floor.
It result is increased unemployment because even when there is a large number of unemployed low-skilled workers willing to work at a wage lower than the minimum, firms cannot legally hire them. Furthermore, firms may decrease the quality or quantity of the nonmonetary benefits they previously offered to workers, such as pleasant, safe working conditions and on-the-job training. Prepared by: CA Tarun Mahajan
Impact of Taxes : Impact of Taxes The tax is the difference between what buyers pay and what sellers ultimately receive per unit.
Statutory incidence refers to who is legally responsible for paying the tax. The actual incidence of a tax refers to who actually bears the burden of the tax.
Whether a tax is imposed on buyers (sales tax) or it is imposed on seller (excise duty), in both the cases:
tax burden is shared by both the parties.
If the demand is more elastic than supply, seller will have a greater burden of tax.
If the supply is more elastic than demand, buyers will have a higher burden of tax.
it also results in deadweight loss, due to reduced level of activity. Prepared by: CA Tarun Mahajan
Slide 28 : Prepared by: CA Tarun Mahajan Quantity Price D S Stax Qtax QE PE Ptax PS Tax from buyers Tax from sellers DWL Impact of Tax (on producers)
Subsidies, Quotas & illegal goods : Subsidies, Quotas & illegal goods Subsidies are payments made by governments to producers. It is reverse to tax. It will result in more production hence employing more resources to the subsidized product. While the same resources can be more valuable in some other sectors. It will also result in deadweight loss.
Production quotas are used to regulate markets by imposing an upper limit on the quantity of a good that may be produced over a specified time period. It results in reduced level of activity and increased price.
When people get caught dealing illegal goods, such as drugs or guns, they are penalized. As the severity of the penalty or the likelihood of getting caught increases, the total costs of illegal trade increase and volume reduces. Prepared by: CA Tarun Mahajan
Organizing Production : Organizing Production Prepared by: CA Tarun Mahajan Prepared by: CA Tarun Mahajan
Opportunity Cost & Economic Benefits : Opportunity Cost & Economic Benefits Opportunity cost is the return that a firm’s resources could have earned elsewhere in their next most valuable use. Opportunity cost includes both explicit and implicit costs.
Explicit costs are observable, measurable expenses such as the dollar cost of production inputs and the interest cost of renting (borrowing) capital.
Implicit costs are not explicitly observable and fall into two categories: (1) the opportunity cost to a firm of using its own capital and (2) the opportunity cost of the time and financial resources of the firm’s owners.
Economic profit considers both explicit and implicit costs. When the firm’s revenues are just equal to its opportunity costs (explicit and implicit costs, including a normal profit), economic profits are zero.(But the proposal is still acceptable) Prepared by: CA Tarun Mahajan
Firm’s Constraints : Firm’s Constraints Technology constraints: by employing additional technological resources a firm can increase its production and revenue but the firm must incur additional costs also.
Information constraints: More information may be made available, but the cost of obtaining it may exceed its value.
Market constraints: Profits are also constrained by how much consumers are willing to pay for a firm’s product or service and by the prices and marketing activities of its competitors.
Technological efficiency refers to using the least amount of specific inputs to produce a given output.
Economic efficiency refers to producing a given output at the lowest possible cost. Prepared by: CA Tarun Mahajan
Command & Incentive system : Command & Incentive system In a command system, managers spend much of their time processing information about the performance of the people who report to them.
An incentive system is a means of organizing production whereby senior management creates a system of rewards intended to motivate workers to perform in such a way as to maximize profits.
The principal-agent problem refers to the problems that arise when the incentives workers (agents) are not the same as the incentives of their firm’s owners (principals). In many corporations, agents have their own goals, which may be different than those of the principals. Three methods are commonly used to reduce the principal-agent problem by better aligning the motivations of agents with those of principals: (1) ownership, (2) incentive pay, and (3) long-term contracts. Prepared by: CA Tarun Mahajan
Business Organizations : Business Organizations A proprietorship is a form of business organization with a single owner who has unlimited liability for the firm’s debts. Income flows through to the proprietor (owner) who pays taxes on it as personal income.
Advantages: Easy to establish, simple decision making process, and profits are only taxed once.
Disadvantages: Decisions are not checked by a group consensus, the owner’s entire wealth is exposed to risk, the business may cease to exist when the owner dies, and raising capital can be difficult and relatively expensive. Prepared by: CA Tarun Mahajan
Slide 35 : A partnership form of business organization involves two or more owners who both have unlimited liability. A partnership’s taxable income is allocated (as personal income) to the partners based on their proportional ownership of the partnership.
Advantages: Easy to establish, decision making is diversified among partners, may survive even if a partner leaves or dies, and profits are only taxed once.
Disadvantages: It can be difficult to achieve consensus decisions, owners’ entire wealth is exposed to risk, and there may be a capital shortfall when a partner dies or leaves for other reasons, limitations on the ability to raise large amounts of capital. Prepared by: CA Tarun Mahajan
Slide 36 : A corporation is owned by its stockholders, and their liability is legally limited to the amount of money they have invested in the firm. The firm is a legal entity that pays (corporate) income taxes. Corporations account for the largest share of revenue by far among the three types of business organization.
Advantages: Owners have limited liability, large amounts of relatively inexpensive capital are available, management expertise is not limited to that of the owners, a corporation’s life is not limited to that of the owners, and long-term labor contracts can be used to reduce costs.
Disadvantages: Relatively complex management structure may make the decision-making process slow and costly, and double taxation—corporate earnings are taxed when earned and again when distributed to owners as dividends. Prepared by: CA Tarun Mahajan
Four types of market : Four types of market Perfect competition exists when all the firms in the market produce identical products. There is a large number of independent firms, each seller is small relative to the total market, and there are no barriers to entry or exit. Furthermore, each of the many buyers and sellers knows the prices of the competing products in the market.
Monopolistic competition is the term used to describe markets where a large number of competitors produce (slightly) differentiated products. Product differentiation gives a degree of market power to firms under monopolistic competition because each firm produces a slightly different product. Prepared by: CA Tarun Mahajan
Slide 38 : Oligopoly is a market structure characterized by a small number of producers selling products that may be similar or differentiated. There is interdependence among competitors in that the decisions made by one firm affect the demand, price, and profit of others in the industry. Also, significant barriers to entry exist which often include large economies of scale. The U.S. auto and soft drink industries are examples of oligopoly markets.
Monopoly markets are characterized by a single seller of a specific, well-defined product that has no good substitutes. Barriers to entry are high in monopoly markets. Whether a monopoly exists often depends on how we define the product. Microsoft Corp. certainly has a monopoly of sorts on the Windows® operating system and related software. Prepared by: CA Tarun Mahajan
Concentration Measurement : Concentration Measurement The four-firm concentration ratio is the percentage of total industry sales made by the four largest firms in an industry. A highly competitive industry may have a four-firm concentration ratio near zero, while the ratio is 100% for a monopoly. A four-firm concentration ratio below 40% is considered an indication of a competitive market, and a four-firm ratio greater than 60% indicates an oligopoly.
The Herfindahl-Hirschman Index (HHI) is calculated by summing the squared percentage market shares of the 50 largest firms in an industry (or all of the firms in the industry if there are less than 50). The HHI is very low in a highly competitive industry and increases to 10,000 (= 1002) for an industry with only one firm. An HHI between 1,000 and 1,800 is considered moderately competitive, while an HHI greater than 1,800 indicates a market that is not competitive. Prepared by: CA Tarun Mahajan
Market Coordination Vs. Firm Coordination : Market Coordination Vs. Firm Coordination Market Coordination means getting done your work by outsourcing the things.
Firm coordination means building your own team to perform the work.
Which of the above is better, depends upon the facts of each case. Prepared by: CA Tarun Mahajan
Output and Cost : Output and Cost Prepared by: CA Tarun Mahajan Prepared by: CA Tarun Mahajan
Short run vs. long run : Short run vs. long run The short run is defined as a time period for which quantities of some resources are fixed.
In the long run, a firm can adjust its input quantities, production methods, and plant size.
Typically, labor and raw materials as variable in the short run, while plant size, capital equipment, and technology are constant. All of these factors become variable in the long run.
Total product is the total output of goods with a given input.
Marginal product is the increase in total product from using one additional unit of input.
Average product is total output divided by the units of a variable input. The average product curve is at its maximum at the point where the marginal product curve intersects it from above. Prepared by: CA Tarun Mahajan
Slide 43 : Prepared by: CA Tarun Mahajan The marginal product curve for an input typically shows increasing marginal returns initially, and diminishing marginal returns at some point. Diminishing marginal returns describes a situation where the marginal product of an input decreases as additional units of that input are employed.
Slide 44 : Prepared by: CA Tarun Mahajan
Relationship between output & cost : Relationship between output & cost Total cost, TC, is the sum of all costs associated with the generation of output. Total cost is made up of total fixed cost and total variable cost.
Marginal cost, MC, is the increase in total cost for one additional unit of output.
Average cost is the average cost per unit of output at a given level of output. Since there are three types of costs, there are three corresponding average costs. These are:
Average fixed cost.
Average variable cost.
Average total cost. Prepared by: CA Tarun Mahajan
Slide 46 : Prepared by: CA Tarun Mahajan Output per day Cost per Unit MC ATC AVC ATC=AFC+AVC AFC x x
Slide 47 : The law of diminishing returns states that at some point, as more and more of one resource (e.g., labor) is added to the production process, holding the quantity of other inputs constant, the output continues to increase, but at a decreasing rate.
For example, if an acre of corn needs to be picked, the addition of a second and third worker is highly productive. If you already have 300 workers in the field, the additional output from adding the 301st worker is lower than that of the second worker.
The marginal product of capital is the increase in output from using one additional unit of capital, holding the quantity of labor constant.
Diminishing marginal product of capital means that at a constant level of labor, output increases as capital is added, but at some point, the increase in output from adding one more unit of capital begins to decrease. Prepared by: CA Tarun Mahajan
Slide 48 : Short-run cost curves are plant-size specific, whereas long-run cost curves show minimum average unit costs for different firm sizes (scale of operations). There is often a trade-off between the size of the firm and unit costs in the long run.
Economies of scale are present when unit costs fall as plant size increases.
Diseconomies of scale are present when costs rise as plant size increases., Prepared by: CA Tarun Mahajan Output Average Unit Cost Q = Optimal Output Diseconomies of scale Economies of scale
Perfect Competition : Perfect Competition Prepared by: CA Tarun Mahajan Prepared by: CA Tarun Mahajan
Price takers : Price takers Price takers are firms that face horizontal demand curves. They can sell all of their output at the prevailing market price, but if they set their output price higher than the market price, they would sell nothing.
Producer firms in perfect competition have no influence over market price. Market supply and demand determine price. Hence they are termed as price takers. Prepared by: CA Tarun Mahajan Quantity Price P D
Assumptions of perfect competition : Assumptions of perfect competition Perfect competition assumes the following:
All the firms in the market produce identical products.
There is a large number of independent firms.
Each seller is small relative to the size of the total market.
There are no barriers to entry or exit.
All firms maximize economic profit by producing and selling the quantity for which marginal revenue equals marginal cost. For a price taker in a perfectly competitive market, this is the same as producing and selling the output for which marginal revenue equals (market) price. Prepared by: CA Tarun Mahajan Quantity Price P D MC Q
Economic profit : Economic profit Economic profit equals total revenues less the opportunity cost of production, which includes the cost of a normal return to all factors of production, including invested capital.
In a perfectly competitive market, a firm will not earn economic profits for any significant period of time. The assumption is that new firms will enter the industry to earn profits, increasing market supply and eventually reducing market price so that it just equals a firm’s average total cost (ATC). In equilibrium, each firm is producing the quantity for which P = MR = MC = ATC, so that no firm earns economic profits Prepared by: CA Tarun Mahajan
Short run supply curve in perfect competition : Short run supply curve in perfect competition A firm will be shut down if the market price is below P1. Because it is not even able to recover its variable cost.
Between P1 & P2 it will be able to recover not only the variable cost but also a part of fixed cost. Hence it can survive in short run.
At P2 it will recover both fixed and variable cost and earn a normal profit but no economic profit.
Above P2 it will earn economic profit.
Hence we can conclude that in short run P1 will be the supply price. Prepared by: CA Tarun Mahajan
Effect of a permanent Change in demand : Effect of a permanent Change in demand If an industry is characterized by firms earning economic profits, new firms will enter the market. This will cause industry supply to increase (the industry supply curve shifts downward and to the right), increasing equilibrium output and decreasing equilibrium price. Even though industry output increases, however, individual firms will produce less because as price falls, each individual firm will move down its own supply curve. The end result is that a firm’s total revenue and economic profit will decrease.
If firms in an industry are experiencing economic losses, some of these firms will exit the market. This will decrease industry supply and increase equilibrium price. Each remaining firm in the industry will move up its individual supply curve and increase production at the higher market price. This will cause total revenues to increase, reducing any economic losses the remaining firms had been experiencing. Prepared by: CA Tarun Mahajan
Change in Technology : Change in Technology Technological changes usually require firms to invest in additional fixed assets (e.g., plant and equipment). Once individual firms have implemented technological changes, their costs decline and their supply (cost) curve shifts to the right. At the lower costs, firms are willing to supply a given quantity at a reduced price, or provide more of a product at a higher price. In either case, the lower cost structure for the individual firms shifts the industry supply curve to the right. With a given demand, and this repositioned industry supply curve, the industry supplies more of a given product at a lower price. Prepared by: CA Tarun Mahajan
Monopoly : Monopoly Prepared by: CA Tarun Mahajan Prepared by: CA Tarun Mahajan
Slide 57 : A monopoly is characterized by one seller of a specific, well-defined product that has no good substitutes. To maintain monopoly position, barriers to entry to the market should be high.
Patents, copyrights, and government granted franchises are legal barriers to entry that can result in a monopoly.
Also when there are large economies of scale, it means that the average cost of production decreases as a single firm produces greater and greater output. We say that the industry is a natural monopoly.
A monopoly faces a downward sloping demand curve for its product. So monopoly firm must lower its price in order to sell a greater quantity. Here the firm will decide the price & qty. at which profit is maximum. Prepared by: CA Tarun Mahajan
Slide 58 : To maximize profit, monopolists will expand output until marginal revenue (MR) equals marginal cost (MC). Due to high entry barriers, monopolist profits do not attract new market entrants. Therefore, long-run positive economic profits can exist.
Monopolists are price searchers and have imperfect information regarding market demand. They must experiment with different prices to find the one that maximizes profit. Prepared by: CA Tarun Mahajan
Price Discrimination : Price Discrimination Price discrimination is the practice of charging different consumers different prices for the same product or service.
For price discrimination to work, the seller must:
Face a downward-sloping demand curve.
Have at least two identifiable groups of customers with different price elasticities of demand for the product.
Be able to prevent the customers paying the lower price from reselling the product to the customers paying the higher price.
Under perfect price discrimination monopolist will charge each consumer, they are willing to pay for each unit. With perfect price discrimination there would be no consumer surplus. It would all be captured by the monopolist. Prepared by: CA Tarun Mahajan
Redistribution of consumer & producer surplus : Redistribution of consumer & producer surplus Under perfect competition, the industry supply curve is the sum of the supply curves of the many competing firms in the industry. The perfect competition equilibrium price and quantity are at the intersection of the industry supply curve and the market demand curve. Since each firm is small relative to the industry, there is nothing to be gained by attempting to decrease output in an effort to increase price. A monopolist facing the same demand curve, and with the same marginal cost curve will maximize profit by producing where MC = MR.
The important thing to note here is that when compared to a perfectly competitive industry, the monopoly firm will produce less total output and charge a higher price.
Monopoly creates a deadweight loss relative to perfect competition because monopolies produce a quantity that does not maximize the sum of consumer surplus and producer surplus. A further loss of efficiency results from rent seeking when producers spend time and resources to try to acquire or establish a monopoly. Prepared by: CA Tarun Mahajan
Slide 61 : Gains from monopoly: Under natural monopoly fixed cost are very high while marginal cost are low. If two firms each (rather than one firm) produced approximately one-half of the entire output, average cost for each firm would be much higher than for a single producer producing all the output.
Economies of scope can also lead to a natural monopoly, especially in an industry where economies of scale also exist. Economies of scope occur when a firm expands the range of goods it produces such that its average total cost is reduced. Prepared by: CA Tarun Mahajan
Regulating monopoly : Regulating monopoly Since monopolists produce less than the optimal quantity, government regulation may be aimed at improving resource allocation by regulating the prices monopolies may charge. This may be done through average cost pricing or marginal cost pricing.
Average cost pricing is the most common form of regulation. It forces monopolists to reduce price to where the firm’s ATC intersects the market demand curve. This will:
Increase output and decrease price.
Increase social welfare (allocative efficiency).
Ensure the monopolist a normal profit since price = ATC.
Marginal cost pricing forces the monopolist to reduce price to the point where the firm’s MC curve intersects the market demand curve, which increases output and reduces price but causes the monopolist to incur a loss since price is below ATC. Such a solution requires a government subsidy in order to provide the firm with a normal profit and prevent it from leaving the market entirely. Prepared by: CA Tarun Mahajan
Monopolistic Competition & Oligopoly : Monopolistic Competition & Oligopoly Prepared by: CA Tarun Mahajan Prepared by: CA Tarun Mahajan
Characteristics of monopolistic competition : Characteristics of monopolistic competition A large number of independent sellers:
Each seller produces a differentiated product, so every firm has a product that is slightly different from its competitors (at least in the minds of consumers). The competing products are close substitutes for one another.
Firms compete on price, quality, and marketing as a result of product differentiation. Quality is a significant product differentiating characteristic. There is usually a strong correlation between quality and the price that firms can charge. Marketing is a must in order to inform the market about a product’s (differentiating) characteristics.
Low barriers to entry so that firms are free to enter and exit the market. If firms in the industry are earning economic profits, new firms can be expected to enter the industry. Prepared by: CA Tarun Mahajan
Characteristics of Oligopoly : Characteristics of Oligopoly A small number of sellers.
Interdependence among competitors.
Significant barriers to entry which often include large economies of scale.
Products may be similar or differentiated.
There are two traditional oligopoly models:
the dominant firm oligopoly model, is based on the assumptions that one of the firms in an oligopoly market has a significant cost advantage over its competitors and that this dominant firm produces a relatively large proportion of the industry’s output. Under this model, the dominant firm sets the price in the oligopoly market, and the remaining firms are essentially price takers, with little power to set their own prices. Prepared by: CA Tarun Mahajan
Kinked demand curve model : Kinked demand curve model This model says that each firm believes that it faces a demand curve that is more elastic above a given price (the kink in the demand curve) than it is below the given price.
Hence an increase in a firm’s product price will not be followed by its competitors, but a decrease in price will. Prepared by: CA Tarun Mahajan Price Quantity More elastic Less elastic Pk Qk
profit-maximizing output under monopolistic competition and oligopoly : profit-maximizing output under monopolistic competition and oligopoly In short run firms will produce a qty where MR=MC. Here ATC
Efficiency of Monopolistic competition : Efficiency of Monopolistic competition Efficiency of monopolistic competition is unclear.
On one hand advertising will enables consumers to make better purchasing decisions.
But on the other hand it will also cost the consumers.
Whether the perception of increased utility from using a particular product is worth the additional cost of advertising is a question probably better left to consumers of the products. Prepared by: CA Tarun Mahajan
Innovation and Advertising : Innovation and Advertising Firms that bring new and innovative products to the market are confronted with less-elastic demand curves, enabling them to increase price and earn economic profits. However, close substitutes and imitations will eventually erode the initial economic profit from an innovative product. Thus, firms in monopolistic competition must continually look for innovative product features that will make their products relatively more desirable to some consumers than those of the competition.
Advertising costs increase the average total cost curve for a firm in monopolistic competition. The increase to average total cost attributable to advertising decreases as output increases because more fixed advertising dollars are being averaged over a larger quantity. In fact, if advertising leads to enough of an increase in output (sales), it can actually decrease a firm’s average total cost. Prepared by: CA Tarun Mahajan
Prisoners’ Dilemma : Prisoners’ Dilemma Oligopoly firms are in a Prisoners’ Dilemma type of situation because they can each earn a greater profit if they agree to share a restricted output quantity, but only if neither cheats on the agreement. Oligopolists maximize their total profits by joining together (colluding) and operating as a single seller (monopolist).
If both of them honor the agreement than both will earn economic profits.
If only one of them honors, it will have economic loss while cheater will have economic loss.
If both of them cheats, both will have zero economic profit. Prepared by: CA Tarun Mahajan
Demand & Supply in Factor (of production) Market : Demand & Supply in Factor (of production) Market Prepared by: CA Tarun Mahajan Prepared by: CA Tarun Mahajan
Slide 72 : The demand for a productive resource depends on the demand for the final goods Thus, it is a derived demand.
The marginal product of a resource is the additional output of a final product produced by using one more unit of a productive input (resource) and holding the quantities of other inputs constant.
The marginal revenue is the addition to total revenue from selling one more unit of output. For a price taker, marginal revenue is equal to price. For a producer facing a downward sloping demand curve, marginal revenue is less than price, since price must be reduced in order to sell additional units of output.
The marginal revenue product (MRP) is the addition to total revenue gained by selling the marginal product (additional output) from employing one more unit of a productive resource. If marginal product is 2 unit and marginal revenue is $10 per unit then MRP if $20. Prepared by: CA Tarun Mahajan
Elasticity of demand for labor : Elasticity of demand for labor An increase in the price of the firm’s output will increase the demand for labor, i.e., the demand curve for labor (the MRP curve) shifts upward.
The demand for labor is more elastic in the long run than in the short run..
The elasticity of labor will be greater for firms with production processes that are more labor-intensive. Because labor represents a large proportion of the total cost of the service it provides.
Another factor affecting the elasticity of demand for labor is the degree to which labor and capital can be substituted. The elasticity of demand for assembly workers is much more elastic than the demand for airline pilots and flight attendants as a result of this difference in the opportunities to substitute capital for labor in production. Prepared by: CA Tarun Mahajan
Elasticity of supply of labor : Elasticity of supply of labor Substitution Effect: Wages are the opportunity cost of leisure. The higher the wage rate, the more hours of leisure a worker will forego and the more hours of labor he will supply.
As a worker’s income increases, his demand for the leisure also increases. Thus an income effect limits how much labor a worker is willing to substitute for leisure.
For the labor market as a whole, the substitution effect causes the labor supply curve to slope upward, but the income effect makes the curve "bend backward" at some (maximum) quantity of labor supplied.
Factors other than the wage rate that affect the supply of labor (shift the labor supply curve) include the size of the adult population Prepared by: CA Tarun Mahajan
Physical vs. Financial Capital : Physical vs. Financial Capital Physical capital is the physical assets of a firm, including property, plant, and equipment, as well as its inventory of finished goods and goods in process. The greater the demand for physical capital, the greater the demand for the financial capital (money raised through issuing securities) necessary to purchase the physical capital.
A firm will invest in more physical capital when the returns, based on the present value of the future marginal revenue product of additional physical capital, are greater than the cost of the financial capital required to fund the additional physical capital. (i.e., NPV is positive) Prepared by: CA Tarun Mahajan
Factors influencing supply of capital : Factors influencing supply of capital At higher rates of interest, individuals are willing to save more because they will receive greater future amounts.
Increases in current income induce individuals to save more (increase the supply of capital), while decreases in current income have the opposite effect.
An increase in expected future incomes will decrease the current supply of capital. On the other hand workers anticipating a decline in their incomes in retirement are motivated to save more now to smooth out their consumption over time.
Changes in current income and expected future income will shift the supply of capital curve; that is, at each interest rate, more or less capital will be supplied. Prepared by: CA Tarun Mahajan
Renewable vs. non-renewable natural resources : Renewable vs. non-renewable natural resources assume you own two wells. One well is an oil well and one is a water well. When you take a barrel of oil out of the oil well, it’s gone forever—a non-renewable resource. When you take water out of the water well at a sustainable rate, it will be replaced by nature—a renewable resource.
For non-renewable natural resources, supply is elastic at the present value of the expected future price, while for renewable natural resources, supply is inelastic at the sustainable quantity of production. Prepared by: CA Tarun Mahajan Price D Q P Non Renewable Resource Quantity S Price D Q P Renewable Resource Quantity S
Opportunity cost vs. economic rent : Opportunity cost vs. economic rent Opportunity cost is the amount required to induce a person to do particular work or, alternatively, as the amount necessary to bid a factor of production away from its next highest-valued alternative use.
Economic rent is the difference between a factor of production’s earnings and opportunity cost. It is similar to the concept of producer’s surplus and depends largely on the shape of the supply curve for the resource.:
When the supply curve is perfectly elastic, as it is with a non-renewable resource, there is no economic rent.
When the supply is perfectly inelastic, as it is with a renewable resource, the entire payment for the factor is economic rent.
For an upward sloping supply curve economic rent is part of the total payment for the factor of production. Prepared by: CA Tarun Mahajan
Slide 79 : Prepared by: CA Tarun Mahajan Price D Q P Perfectly elastic supply Quantity S Price D Q P Perfectly inelastic supply Quantity S No Economic Rent Economic Rent Price D Q P Upward sloping supply curve Quantity S Economic Rent