Cape economics1 notes

Uploaded on

CAPE Economics Students, even though your syllabus is crap you must pass the subject, so here were my notes a lot of it in my words.

CAPE Economics Students, even though your syllabus is crap you must pass the subject, so here were my notes a lot of it in my words.

More in: Education
  • Full Name Full Name Comment goes here.
    Are you sure you want to
    Your message goes here
    Be the first to comment
No Downloads


Total Views
On Slideshare
From Embeds
Number of Embeds



Embeds 0

No embeds

Report content

Flagged as inappropriate Flag as inappropriate
Flag as inappropriate

Select your reason for flagging this presentation as inappropriate.

    No notes for slide


  • 1. Economics: What is it?If someone asks you to define economics, what are you going to tell them? Without running toyour book, let‟s look at the word eco-nomics itself. The prefix „eco‟ from the Latin word „oeco‟refers to household and „omics‟ is a general term for a broad discipline of science which analysescertain variables. So the word economics can be defined as:„...A social science that studies how individuals, governments, firms and nations make choices onallocating scarce resources to satisfy their unlimited wants‟ (Investopedia)„...The social science that deals with the production, distribution, and consumption of goods and servicesand the theory and management of economies or economic systems.‟ (American Heritage Dictionary)„... The study of how society uses its scarce resources.‟(The Economist)„...the branch of knowledge concerned with the production, consumption and transfer of wealth.‟ (OxfordDictionary) How is economics going to help me? Scenario 1: As a high school or college student, you about doing a number of different career options but why do you end up with one or two major interests?... Yes, you make a choice whether or not you want to be a Doctor, Lawyer, Entrepreneur, Accountant, Economist, among other professions. And economics has to do with making effective choices and how they impact you as an individual.This leads us to the first branch of economics. A group of concepts and explanations have beendeveloped to explain the choices that individuals and firms make and how they react to certainconditions that may occur. This branch of Economics is called „Microeconomics‟ or narroweconomics.
  • 2. Individuals and firms from the previous definitions are not the only ones who have to makeeconomic choices. Governments around the world have to make choices which affect theirpopulation. For larger countries such as the United States, United Kingdom, China, amongothers, their decisions affect the entire world. This branch of Economics is referred to as„Macroeconomics’ or wide economics.Throughout this course you will tested on many areas, the most popular type of questions relateto food and other consumer choices in microeconomics and the most popular questions inmacroeconomics are in relation to national economic effects and outcomes. You are alsorequired to construct and use diagrams to explain economic principles in both areas. Students arealso required to have comprehensive knowledge of Mathematics up to the CSEC level.You can use this text a as guide to completing the CAPE Economics programme. Unit 1 ofCAPE Economics requires students to attain mastery of Microeconomic concepts and principlesand apply them to real life models. In Unit 2 on the other hand students are required to attainmastery and apply Macroeconomic principles to real life principles. The basic modules of eachunit are:Unit 1: Microeconomics 1. Methodology: Demand and Supply 2. Market Structure, Market Failure and Market Intervention 3. Distribution TheoryUnit 2: Macroeconomics 1. Models of the Macro-economy 2. Macroeconomic problems and policies 3. Growth, Sustainable Development and Global RelationsNote: Each Unit is independent of the other so can be taken in any order.
  • 3. Even though Economics is in no way English language students are urged to write theirresponses in a logical format, so as to make an impression on CAPE examiners. It is alsoimportant for students to be abreast with current economic affairs in your territory as knowledgeof such will aid in your discussions in classes, lectures, tutorials and in exams.The CAPE economics assessmentJust like CSEC Economics the final exam is comprised of three papers. Paper 1 comprises of amultiple choice paper of 45 questions representing 15 questions from each module. This paper is1 ½ hrs in duration. Paper 2 comprises of six questions two from each module of which you‟llchoose one. So in total you should complete three questions in 2 ½ hrs, Papers 1 and 2 represent(80%) of the total assessment. Paper 3 represents the internal assessment which is a projectreport. Candidates should determine a topic with their teacher‟s consultation. Further details willbe provided later on in this text. Private candidates take an alternate mini case study paper takenon the same days as paper on a topic that is pre circulated by the Caribbean Examination Council(CXC); further information may be sourced in the syllabus.
  • 4. Unit 1MicroeconomicsModule 1Methodology: Demand and Supply  Central Problem of Economics  Theory of Consumer Demand  Theory of Supply  Market Equilibrium
  • 5. Central Problem of EconomicsNow that we understand what economics is many economists, (who are professionals who useeconomic theory in order to do their jobs), will tell you that they always have varying problemsto consider as they make predictions and are doing research. So it begs the question is there aproblem with economics. They answer to that is solely based on personal interpretation. Many ofmy peers while doing this course expressed that it had some difficulty and they regret, the choicethey made while doing this course. Many of them also stated which course they could have doneand how much it cost them to give it up. Many individuals , I am sure you and your parentsinvolved want to purchase a certain volume of item (unlimited wants) but only have a certainamount of money to purchase those wants (limited resources).If you were reading carefully above a few clues were given on the central problems involved ineconomics. Firstly we have choice, opportunity cost and scarcity. All other principles ineconomics are based on one or more of these terms.Because societies constantly face the three problems aforementioned, the societies need to beable to three interrelated questions: 1. What to produce- because an economy cannot possibly produce everything choices have to be made to decide in what quantities certain goods should be produced. 2. How to produce- because resources are scarce , we need to consider how to efficiently use our resources to maximise production. 3. For whom to produce-because all persons wants cannot be satisfied , so decisions have to be concerning how much of a person’s wants will be satisfiedScarcityThe concept of scarcity is simply defined as unlimited wants match my limited resources. Forexample; As a consumer you wish purchase a plot of farmland across 5 acres in one location. Butwhen you go to buy you find that you can only purchase 2.4 acres as the other areas aredeveloped. This shows that you wanted 5 acres of land but you were limited to the 2.4 acreswhich was available.
  • 6. Limited resourcesIn economics limited resources are characterized under four broad areas, known as Factors ofProduction. These areas comprise of all major branches of resources and are characterized as: 1. Land 2. Labour 3. Capital goods 4. Enterprise(Entrepreneurship)When considering the theory of scarcity two main goods come into play, free goods andeconomic goods.Free goods- In economics, free goods refer to items of consumption (such as air and fresh water)that are useful to people, are naturally in abundant supply, and needs no conscious effortto obtain.Economics goods- These are consumable items which are useful to people but scarce in relationto demand, so that human effort is required to obtain them.In an exam most timse you can be asked to define scarcity and another word, but alwaysremember that while you define you must give examples.Opportunity costsOpportunity cost can be defined as:“...the cost of an alternative that must be forgone in order to pursue a certain action. Put anotherway, the benefits you could have received by taking an alternative action.”(Investopedia)“... the value of the next-highest-valued alternative use of that resource.”(econlib)“...The difference in return between an investment one makes and another that one chose not tomake.”(Financial dictionary)The concept of opportunity cost as outlined by the definitions, indicate that a choice has to bemade in regards to which good or service should be bought or produced. The general task ofmaking these decisions is left to individuals, householder, firms and the government.
  • 7. As a student of economics one must be constantly aware of the choice you have to makeand what you give up for that choice to follow through. Future questions may ask you toidentify how opportunity cost is applied to various situations and what are theimplications of it.
  • 8. Production Possibility Frontier (PPF)The production possibility frontier is a curve depicting all maximum output possibilities for twoor more goods given a set of inputs (resources, labour, etc.). The PPF assumes that all inputsare used efficiently (Investopedia).The PPF is a graphical representation of the total potential output of two or more goodsconsidering the resources available (Mortley, 2012).To understand the PPF you must realise its two major assumptions:For this level the market only produces two (2) goods and all resources are specialised for theproduction of those goods.To understand how the frontier works you have to understand construct the frontier. 1. Draw a pair of axes labelled with each good. (for e.g. sugar and bauxite) 2. Calculate the maximum productive capacity for each good(for e.g. 1000 units) 3. Construct a schedule of the distribution between goods(this shows opportunity cost and accounts for the shape of the PPF) 4. Plot the points on the pair of axes 5. Construct the curve 6. Always give comments on the curve(and every other curve you draw throughout your life studying economics)
  • 9. A diagram showing the Production Possibility Frontier (PPF) for Sugar and Bauxite Sugar 1000 A 800 .D B 500 .C .E 700 900 1000 BauxiteNotes: 1. Any point outlined that is on or below the PPF (ie A, B, C, E) are considered to be attainable. 2. Any point outside of the curve(i.e. D) is considered to be unattainable 3. Points that are located on the PPF are as a result of the full utilization of the resources available. They are also regarded as efficient levels of production 4. Inefficient levels of production are production points either above or below the PPF being either attainable or unattainable based on the resources available.Analysis:At „A‟, 800 units of sugar and 700 units of bauxite are being produced. Increasing bauxiteproduction to 900 units requires a reduction of sugar by 300 units. That is, the additional 200units of bauxite required that the producer give up 300 units of sugar. This mode of analysis canbe used for all movements along the PPF.Any increase in technology or economic growth may push the PPF outwards. That is, an increasein the amount of resources available or an improvement in technology will cause the PPF to shiftto right so that combinations that were unattainable [„D‟] can now be produced.
  • 10. NB: Movements along the PPF are caused by an adjustment to the special resources from onegood to the other and Shifts in the PPF generally outwards are caused by increases in theresources available.Method of EconomicsPositive Economics – An approach to economics that seeks to understand behaviour and theoperations of systems without making judgements. It describes what exists and how it works.What determines the price in a market? The answer to this question would be the subject ofPositive economics.Normative Economics- An approach to economics that analyzes outcomes of economicbehaviour, evaluates them as good or bad, and may prescribe courses of action (policyeconomics). Should theGovernment subsidize Tertiary education? The answer to this questionwould be the subject of Normative economics.Economic Theory –A Statement or set of related statements about the cause and effect, actionand reaction.Model: A formal statement of a theory, usually a mathematical statement of a presumedrelationship between two or more variables.Variable: A measure that can change from time to time or from observation to observation.Rational choiceA rational choice is one that uses the available resources to most effectively satisfy the wants ofthe person making the choice. {Only the wants and preferences of the person making a choiceare relevant to determine its rationality.}Types of Economic SystemsYour instructor may ask you to do a research on this portion of the syllabus but the mostimportant points to note are the differences between the systems.There are four types of systems: 1. Traditional 2. Planned 3. Mixed 4. Market
  • 11. Theory of Consumer DemandUtilityNo is does not refer to utility bills like your electricity or water charges, but it solely based on theconcept of consumer satisfaction. So in economics , instead of saying the consumer was fully satisfiedwith his purchase. We use the word Utility.There are two main approaches to the utility concept: 1. The Cardinal Approach- This method assumes that a consumers utility can be quantified into units which are measured as UTILS. 2. The Ordinal Approach – This method assumes that consumer’s satisfaction cannot be measure but consumers will rank their consumption into bundles that represent the same level of satisfaction or utility. This level of satisfaction bundle is represented on an indifference curve(We will address Indifference Curve Analysis further on in the book)Total Utility – Simply Defined as the total level of satisfaction that a consumer receives from consuminga good or serviceMarginal Utility- this refers to the difference in the level of total utility based on a single unit change inthe unit of a good i.e. the satisfaction from each additional unit of good or service consumed.Pay keen attention to this concept as further analysis will have to be done on this areaThe formula to calculate Marginal Utility (MU) = ∆TU/∆ Consumption (since it is a one unit change)The revised formula for MU=∆TULaw of Diminishing Marginal ReturnsIf you are thirsty and you buy 10 bottles of Pepsi, after the first one you feel very satisfied, after thesecond you still feel satisfied but not as much as the first and the trend continues all the way to thetenth Pepsi. The law of diminishing returns states that the more of a good or service is consumed themarginal Utility increases at a decreasing rate. This implies that even though the total utility increasesafter a certain amount of goods the rate at which the consumers thirst is quench is far less than in thebeginning.The table below shows the results up to the 7th Pepsi. You can observe that even though the total utilityis increasing the marginal utility starts decreasing after the second Pepsi.
  • 12. Quantity of Pepsi’s Total Utility (TU) Marginal utility (MU) 0 0 - 1 100 100 2 290 190 3 350 170 4 420 150 5 500 80 6 550 50 7 570 20 Indifference Curve Analysis This is an approach to the study of consumer behaviour without the use of quantitative means. An indifference curve is a curve that shows all the combinations of goods that provide the consumer with the same level or satisfaction (utility).Good a Y IC2 W Z IC 1 X Good B Notes:  The consumer will be indifferent between W and X since they are on the same indifference curve  The consumer will prefer either Y or Z as they fall on a higher indifference curve and thus maximise utility  The indifference curves never meet
  • 13.  Each pair of axes can have thousands of indifference curves as consumer utilities and preference are so variegated. The Budget Constraint We are going to assume that:  There are only two goods  Prices are given….the consumers cannot affect the price of the good.  The consumer spends all his/her income on the two goods The budget line shows the boundary between what is affordable and what is not. It describes the limits to consumption choices and depends on the consumer’s income and prices. The household’s consumption choice is constrained by the household’s income and by the price of the goods and services. Graphical representation of the household budget line for goods A and B: Good A Al- upper limit for good A Al Bl- Upper limit for good B Bl Good BIf the price of good B decreases budget line will pivot as is become more affordable to purchase good BGood AAl Good B Bl0 Bl1
  • 14. If the level of household income increases the entire Budget line can shift outwards as it is now moreaffordable to purchases increased quantities of both goods.Good A Bl0 Bl2 Good BConsumer EquilibriumThe objective of each consumer is to maximise his or her utility subject to their budgetary constraint.This means that a consumer will decide to choose a bundle of products that he/she can afford. The consumer will choose to maximise their utility at the point where theGood A budget line is tangent to the Ic indifference curve i.e. at point Y Y 2 IC 0 IC1 Bl Good B
  • 15. Equi-Marginal PrincipleThis equality says that the consumer maximises utility at the point where the last dollar spent on eachgood yields the same Marginal Utility(MU). MUa/Pa=MUb/PbIf MUb/Pb>MUa/Pa then consumers will increase their consumption of good b and this would reducethe MU of good B according to the law of diminishing marginal utility.Income - Consumption curve and Engel CurveHow does a change in the consumer’s income affect the optimal choice?Cars Income consumption curve Food Income Engel curveThe Income consumption curve is the locus of consumer optimum points resulting when only theconsumer’s income variesThe Engel curve shows the amount of a good that the consumer would purchase per unit of time atvarious income levels
  • 16. Price consumption curve and demand curveThis curve is derived by changing the price of one good (B) and holding all others constant (ceterisParibus). The PCC for good B is the focus of consumer optimum points resulting when only the price ofgood B varies. The demand curve of for the good shows the quantity of good B that the consumer wouldpurchase per unit of time at varying prices. Cars Food Price Demand Curve FoodThe demand curve is plot of the demand function, X 1 ( P1 , P2 , M ) holding P2 , M constant X1 0 P1 X1 P1
  • 17. Income and Substitution EffectsWhenever the price of a good change there are two effects: 1) Substitution effect 2) Income effectSubstitution effect: this is the change in consumption due to the change in relative prices. When theprice of good changes one of the goods become relatively cheaper. Rational consumers will substitutetowards the cheaper good. To separate the substitution effect we hold utility constant; consequentlythe substitution effect is measured along the IC. The substitution effect is always negative; opposite theprice change.Income Effect: Results from a change in purchasing power. It can either be negative or positive;depending on whether the good is normal of inferior.Income and Substitution Effect for a Normal good 1) Substitution effect Negative Cars - P Food 2) Income effect Positive - M Food Substitution Effect 3) Income effect reinforces the sub Income Effect effect. FoodsIncome and Substitution Effect for an Inferior good 1) Sub effect NegativeCars - same as above Substitution Effect 2) Income effect Negative M Food Income Effect 3) Inc. effect < Sub. Effect 4) Inc. effect opposite Sub. effect Food
  • 18. Income and Substitution Effect for a Giffen good 1) Sub. effect negativeCars - same as above Substitution Effect 2) Inc. effect Negative - same as above Income Effect 3) Inc. effect > Sub effect 4) Inc. effect opposite Sub. effect FoodENSURE THAT GRAPHS ARE COMPLETELY,CAREFULLY LABELLED ANDTHAT A DESCRIPTIVE ANALYSIS IS ALWAYS GIVEN.
  • 19. Demand: Theory, Application and ElasticityThe quantity demandedof any good or service is the amount that people are willing and able tobuy during a specified period at a specified price.Quantity demanded is measured as an amount per unit of time – e.g. 2 socks per dayThe law of demandstates that there is a negative relationship between price and quantitydemanded; ceteris paribus, as the price of a good increases the quantity demanded must fall.Demandis the relationship between the quantity demanded and the price of a good when allother factors remain constant. The quantity demanded refers to a specific quantity at a specificprice while demand is a list of quantities at different prices illustrated by a demand schedule anddemand curve.Demand scheduleis a table showing how much of a good an individual would be willing to buyat different prices. Demand Schedule for Patty Qty Demanded [Patties Price [$/Patty] per day] A 20 0 B 15 1 C 10 2 D 5 3
  • 20. Demand Curve is graphical representation of how much of a good an individual would bewilling to buy at different prices.Demand Curve for Patties Price Qty/dayA change in the quantity demanded [movement along the demand curve] of a good is causedsolely by a change in the price of the good.Price  When the price of a good increase from P1 to P2 then the P2 A effective change is that the level P1 of quantity demanded will move B from B to A showing the negative relationship between quantity demanded and price.  When the price decreases from Q2 Q1 P2 to P1 then the quantity Qty/day demanded will move from A to B. Showing the reverse of the previous condition.A change in demand [shift the entire demand curve] is brought about by a change in the originalconditions; any factor other than price.
  • 21. Price If the overall level of demand increases the demand curve shifts to the right or from D1 to d3 If the overall level of demand decreases the demand curve will contract, or move to the left represented by a shift from D1 to D2 D2 D1 D3 Qty/dayFactors that affect demand:  Price of related goods: A change in the price of one good can affect the demand of a related good. The nature of this change depends on the nature of the relationship between the two goods; related goods can either be substitutes or compliments.Substitutes are goods that can be consumed in place of each other, e.g. butter and Margarine.The demandfor a good will increase/ (decrease) if there is an increase/ (decrease) in the price of one of its substitutes.This means that the demand for a good and the price of its substitute moves in the same direction.Complementsare goods that are consumed together, e.g. bun and cheese.The demand for a goodincreases/decreases if the price of its compliment decreases/increases. This means that the demand for agood and the price of its compliment move in opposite directions.  Income: The demand for a good is also affected by changes in the consumer‟s income. Where the increase in income leads to an increase in demand the good is classified as a normal good. If, however, the increase in income results in a decrease in demand then the good is classified as an inferior good.
  • 22.  Expectations: Expectations of future prices and income will affect the demand for goods and services.  Number of buyers: The greater the Number of buyers in a market the larger is the demand.  Preferences: A consumer‟s demand for a particular good will depend on that consumer‟s tastes and preferences. Whenever there is a change in preferences, the demand for one good will increase and the demand for another will decrease. Elasticity of DemandPrice elasticity of demand is a measure of the extent to which the quantity demanded of particular goodschange when there is a change in the price of the good, (ceteris paribus).Price elasticity of demand iscalculated by dividing the percentage change in quantity demanded by the percentage change in price: % in quantity dem anded % in priceCalculating the percentage changes: The Mid-Point Method new Q ty old Q ty % in Q ty *100 new Q ty old Q ty / 2 new price old price % in price *100 new price old price / 2Note: Due to the law of demand, the sign of the % change in demand will be opposite the sign of the %change in price. Therefore, the price elasticity of demand will always be negative. However, it iscustomary to express elasticity as a positive number.Elasticity and the shape of Demand curves
  • 23. The size of the elasticity measure is used to classify demand curves as either: Elastic, Inelastic or Unitaryelasticity.Demand is considered elastic if the percentage change in the qty demanded exceeds thepercentage change in price. In this case we say that demand is very responsive to price changes. There isone particular case where demand is so responsive to price changes that changes in price do not affect thedemand. In this case we say that demand is perfectly elastic.When demand is perfectly elastic any changein price will lead to an infinite change in quantity demanded.Perfectly elastic Demand CurvePrice Demand curveQtyDemand is considered inelastic if the percentage change in the qty demanded is less than the percentagechange in price. In this case we say that demand is not responsive to price changes. There is one particularcase where demand is very unresponsive to price changes. In this case we say that demand is perfectlyinelastic.When demand is perfectly inelastic price changes will not affect the quantity demand.Perfectly inelastic Demand CurvePrice Demand curve Qty
  • 24. When the percentage change in demand equals the percentage change in price we say that demand is unitelastic.Unit elastic Demand CurvePrice Demand curve QtyFactors that affect the Price Elasticity of Demand (PED)Availability of substitutes: The more close substitutes a good has the more elastic its demandwill be since consumers can easily switch to cheaper goods if its price should rise.The nature of the goods (luxury vs. necessity)the price elasticity of luxury goods is usuallymore elastic than that of necessities.The definition of the good (narrow or broad): The broader the definition of a good the lesselastic is its demand. The narrower is its definition the more elastic is its demand. For example,the demand for vegetables is very inelastic compared to the demand for canned carrots, which ismore elastic.Passage of time: the demand for some products is more elastic in the long run than in the shortrun and vice-versa.Fraction of income spent on the good: goods that consume a large proportion of income tendto have more price elastic than goods that don‟t. for example, a 10% increase in the price of saltwould barely affect its demand, while a 10% increase in the price of cars would have asignificant effect on the demand for cars.
  • 25. Total Revenue and Price Elasticity of DemandA major concern to the producer is the effect that a price change will have on total revenues.Total revenue is equal to price times quantity. Therefore, a price increase, will have twoopposing effects;  Revenues will increase, since each unit sold goes for a higher price  Revenues will decrease, since fewer units will be sold at the higher price.Price A - Increase in revenues due to price increase B - Decrease in revenues A due to reduced quantity B D QtyIf area A is larger than area B, then the increase in price will increase revenues. Demand isinelastic. If area A is smaller than area B, then the increase in price will decrease revenues.Demand is elastic. If area A is equal to area B, then the increase in price will not affect revenues.Demand is unit elastic.The total effect will therefore depend on which change is greater. Now, if demand is elastic, thenthe increase in price will lead to a greater than proportional decrease in quantity demanded. Thissuggests that where demand is elastic, a price increase will lead to a fall in revenues.When demand is inelastic, the increase in price will lead to a less than proportional decrease inquantity demanded. This suggests that a price increase where demand is inelastic will increase
  • 26. revenues. For example, if price increases by 10% and quantity demanded falls by 5%, thenrevenues will increase and we say that demand is inelastic.Where demand is unit elastic the increase in price will lead to an equal proportional reduction indemand suggesting that revenues will not change. For example, if price increases by 10% andquantity demanded falls by 10%, then revenues will remain unchanged and we say that demandis unit elastic.Cross Elasticity of DemandCross elasticity of demand is a measure of the extent to which the demand for a good changeswhen the price of another good changes, ceteris paribus. Cross elasticity of demand is calculatedby dividing the percentage change in quantity demanded of good A by the percentage change inprice of good B: % in quantity dem anded good A % in price of good B Now, this measure of elasticity falls into three ranges:  [CED< 0]; implies that good A and good B are Complements. For example, an increase in the price of bun may reduce the demand for cheese  [CED> 0]; implies that good A and good B are Substitutes. For example, an increase in the price of tea may increase the demand for coffee  [CED= 0]; implies that good A and good B are unrelated.Income Elasticity of DemandIncome elasticity of demand is a measure of the extent to which the demand for a good changeswhen income changes, ceteris paribus. Income elasticity of demand is calculated by dividing thepercentage change in quantity demanded by the percentage change in income: % in q u a n tity d em a n d ed % in in co m eNow, this measure of elasticity falls into three ranges:  income elastic [YED<1]; implies normal good  income inelastic [0 < YED< 1]; implies normal good  [YED< 0]; inferior good
  • 27. Theory of SupplyProductionProduction can be defined as the creation of value; or the design of articleshaving exchange value. We generally start out by looking at production in the short run.Short run: - this is a time frame in which the quantities of some resources are fixed. Examplesare technology and capital.Long run: - this is a time frame in which all the factors of production are variable.Fixed factors: - factors that cannot be varied in the short runVariable factors: - factors that can be varied in the short run to increase or decrease the level ofproduction.Production function - The production function relates the output of a firm to the amount ofinputs, typically capital and labour.Assume the following:  Production is in the short run  Only one factor of production is variableWe have three fundamental questions to answer.  What is the relationship between the quantity of inputs used and the quantity of production?  What is the relationship between the input decisions of the firm and its cost structure?  How do firms select the optimal quantity of a particular resource?
  • 28. Total product: - is the total quantity of a good produced in a given period. TP is an output rate –the number of units produced per unit of time. Example, the TP schedule lists the max quantitiesof bottled water per hr that a firm can produce with its existing plant at each quantity of labour. Labour (TP) (MP) (AP) Gallons/hr gallons/L 0 0 0 1 1 1 1 2 3 2 1.5 3 6 3 2 4 8 2 2 5 9 1 1.8 6 9 0 1.5 7 8 -1 1.1 Graph of Total Product 9 8 7 6 5 4 (TP)gallons/Hr 3 2 1 0 0 1 2 3 4 5 6 7Marginal Product: - is the change in total product that results from a one unit change in thequantity of labour employed holding all other inputs constant. TP MP L
  • 29. Graph of Marginal Product 3 2.5 2 1.5 1 Marginal Product 0.5 0 -0.5 -1 0 1 2 3 4 5 6 7 Graph of Average Product 2 1.8 1.6 1.4 1.2 1 Average Product 0.8 0.6 0.4 0.2 0 0 1 2 3 4 5 6 7Graph of TP, MP and AP 10 8 6 tp product 4 mp ap 2 0 0 1 2 3 4 5 6 7 -2 labour
  • 30. The Theory of CostsWhat is the relationship between the input decisions of the firm and its cost structure?(Assumeshort term conditions)Total Cost (TC):- this is the cost of all the factors of production used by the firm. It can bedivided into two categories: total fixed cost and total variable cost.Total Fixed Cost (TFC):- this is the cost of a firm‟s fixed factors such as land, capital andentrepreneurship. Since, in the short run, these factors do not vary with output, TFC does notchange as output changes.Total Variable Cost (TVC):- this is the cost of a firm‟s variable factors of production – labour.Since the variable factor must change for output to change in the short run, TVC changes asoutput changes. Worker/Hr Gallons/Hr TFC TVC TC MC AC AFC AVC 0 0 10 0.00 10.00 0.00 0.00 0.00 1 1 10 6.00 16.00 6.00 16.00 10.00 6.00 1.6 2 10 9.60 19.60 3.60 9.80 5.00 4.80 2 3 10 12.00 22.00 2.40 7.33 3.33 4.00 2.35 4 10 14.10 24.10 2.10 6.03 2.50 3.53 2.7 5 10 16.20 26.20 2.10 5.24 2.00 3.24 3 6 10 18.00 28.00 1.80 4.67 1.67 3.00 3.4 7 10 20.40 30.40 2.40 4.34 1.43 2.91 4 8 10 24.00 34.00 3.60 4.25 1.25 3.00 5 9 10 30.00 40.00 6.00 4.44 1.11 3.33
  • 31. Graph of TVC, TFC and TC 45 40 35 30 TFC Costs 25 TVC 20 TC 15 10 5 0 1 2 3 4 5 6 7 8 9 10 Gallons/HrTVC and TC increase at a decreasing rate at low levels of output and then starts to increase at anincreasing rate at higher levels of output. However, to fully understand the pattern of TVC andTC we need to examine the Marginal and Average costs.Marginal Costs: - is the change in TC that results from a one unit change in output. TC MC QAverage Cost: - is the total cost per unit of output. It can be expressed as average fixed cost plusaverage variable cost. TC AC ( AFC AVC ) Q TFCAverage Fixed Cost: - is TFC per unit of output. AFC QAverage Variable Cost: - is TVC per unit of output. TVC AVC Q Graph of MC, AVC, AFC and AC
  • 32. 18.00 16.00 14.00 12.00 MC 10.00 AC Costs 8.00 AFC 6.00 AVC 4.00 2.00 0.00 0 1 2 3 4 5 6 7 8 9 Gallons/HrThe AVC and AC curves are u-shaped.The vertical distance between the two is the AFC, which shrinks as output increases becauseAFC shanks as output increases.The MC curve is also U-shaped and intersects the AVC & AC at their Minimum points.When MC < AC, AC decreases. When MC > AC, AC increases.Why the AVC and AC are curves U-shaped?The shape of the AVC and AC arises from two opposing forces.  Spreading TFC over a larger output  Decreasing marginal returnsWhen output increases TFC is spread over a larger output, thus AFC decreases (slopesdownward). However, as output increases VC increase at a faster rate than output, thus AVC willincrease (slope upward).Initial increases in output will cause both AFC and AVC to fall;however, as output continues to increase AVC will begin to rise while AFC continues to fall.Since AFC approaches zero as output increases, AC will eventually take the shape of the AVCcurve.
  • 33. Relationship between Cost and Product Curves Graph of MP and AP 3.5 3 2.5 2AP and MP 1.5 MP 1 AP 0.5 0 -0.5 0 1 2 3 4 5 6 7 -1 -1.5 Workers Graph of MC and AVC
  • 34. 7.00 6.00 5.00 4.00 Costs MC 3.00 AVC 2.00 1.00 0.00 0 1 2 3 4 5 6 7 8 9 Gallons/HrAt low levels of employment and output:  As the firm hires more labour, MP & AP rise and output thus rises faster than costs so that AVC & MC falls.  At the Maximum of MP, MC is at its minimum. As still more labour is employed MP falls MC rises.  AP will continue to rise up to the point where MP = AP (at this point AP is at its maximum). If the firm continues to hire labour after this point then MP < AP and this will cause AP to fall.  When AP is at its max AVC will be at its min. The subsequent fall in AP will cause AVC to rise.Shifts in the Cost CurvesThe discussion so far has revealed that the position of the firms short run cost curves isdependent on the technology used by the firm as well as the price of the factors of production.Long Run AnalysisWe now relax the short run assumption.Recall that in the long run a firm can vary all the factors of production.The question that must be answered is, how does this variation affects the cost structure of thefirm?
  • 35. For example, suppose the firm is able to vary its plant size, how would this affect its AVC? Would AVC increase, decrease or remain the same?All three possibilities exist. When a firm increases its plant size it may experience:  Economies of Scale  Diseconomies of Scale  Constant returns to scale
  • 36. Economies of Scale: - this occurs when an equal percentage increase in both plant size andlabour is matched by a larger percentage increase in output thus leading to a reduction in AC.Diseconomies of Scale: - this occurs when an equal percentage increase in both plant size andlabour is matched by a smaller percentage increase in output thus leading to an increase in AC.Constant returns to scale: - this occurs when an equal percentage increase in both plant sizeand labour is matched by a similar percentage increase in output thus leading to constant AC.The Long Run AC Curve:-shows the lowest AC at which it is possible to produce each outputwhen the firm has had sufficient time to change both its labour force and its plant size.Increasing Marginal Returns: - this occurs when the marginal product of an additional workerexceeds the MP of the previous worker. IMR usually occurs when a small # of workers areemployed and arise from increased specialization and division of labour in the productionprocess.Decreasing Marginal Returns: - this occurs when the MP of an additional worker is less thanthe MP of the previous worker. DMR arise from the fact that more and more of the variablefactor (labour) is added to the fixed factors.The law of Diminishing Marginal Returns: - this law states that as additional quantities of thevariable resources are combined with a given amount of fixed resources, a point is eventuallyreached where each additional unit of the variable resource yields a smaller MP.Average Product: - is the total product per worker employed. TP AP LAP is largest when it is equal to MP. That is, MP cuts AP at the max of AP.When MP > AP, AP will increaseWhen MP < AP, AP will decrease
  • 37. Supply: Theory, Application and ElasticityThe quantity supplied of a good or service is the amount that producers are willing to and able tosell during a specified period at a specified price.It is measured in quantity supplied per unit oftime.The law of supply states that there is a positive relationship between price and quantity supplied.  an increase in price is usually followed by an increase in qty supplied  a decrease in price is usually followed by a decrease in qty suppliedSupply is the relationship between the quantity supplied and the price of a good when all otherfactors remain constant. The quantity supplied refers to a specific quantity at a specific pricewhile supply is a list of quantities at different prices illustrated by a supply schedule and supplycurve.A Supply schedule is a table showing how much of a good an individual would be willing tosupply at different prices. Supply Schedule for Patty Qty Supplied [Patties Price [$/Patty] per day] A 20 3 B 15 2 C 10 1 D 5 0
  • 38. A supply Curve is graphical representation of how much of a good an individual would bewilling to supply at different prices.Supply Curve for Patty Price Qty/dayA change in the quantity [movement along the supply curve] supplied of a good is caused solely by achange in the price of the good.A change in supply [shift the entire supply curve] is brought about by a change in the original conditions;any factor other than price.Price S1 Key S0 - Green: decrease in supply S2 - Purple: increase in supply - Red: increase in quantity supplied - Blue: decrease in quantity supplied Qty
  • 39. Factors that affect Supply:Prices of related goods: A change in the price of one good can affect the supply of a relatedgood. The nature of this change depends on the nature of the relationship between the two goods;related goods can either be substitutes in production or compliments in production.Substitutes in Production are goods that can be produced in place of each other, eg., butter andMilk. The supply of a good will increase/ (decrease) if there is a decrease/ (increase) in the priceof one of its substitutes in production. This means that the supply for a good and the price of itssubstitute in production moves in opposite direction.Complements in productionare goods that can be produced together, e.g., beef and cow hide[used to make leather]. The supply of a good will increase/decrease if the price of its complimentin production increases/decreases. This means that the supply of a good and the price of itscomplement in production move in the same direction.Prices of resources and other inputs: The supply of a good will change if there is a change inthe price of one of its inputs [input prices affect the cost of production]. The more it costs toproduce a good the less will be supplied at each price and vice-versa {ceteris paribus.}Productivity: This is defined as output per unit of input. An increase in productivity leads to areduction in costs and thus leads to an increase in supply. A decrease has the opposite effect. Themain source of productivity changes is technological change; however, some natural events alsoaffect productivity.Expectations: Expectations about future prices have a big influence on supply.Number of sellers: The greater the number of sellers in a market, the larger is the supply.
  • 40. The Price Elasticity of Supply(PES)Price elasticity of supply is a measure of the extent to which the quantity supplied of a particulargood changes when there is change in the price of the good, ceteris paribus. Price elasticity ofsupply is calculated by dividing the percentage change in quantity supplied by the percentagechange in price: % in quantity supplied % in priceElasticity and the shapes of Supply curvesThe size of the elasticity measure is used to classify supply curves as either: Elastic, Inelastic orUnitary elasticity.Supply is considered elastic if the percentage change in the qty supplied exceeds the percentagechange in price. In this case we say that supply is very responsive to price changes. There is oneparticular case where supply is very responsive to price changes. In this case we say that supplyis perfectly elastic. When supply is perfectly elastic any change in price will cause quantitysupplied to fall to zero.Perfectly elastic Supply CurvePrice Supply curve QtySupply is considered inelastic if the percentage change in the qty supplied is less than thepercentage change in price. In this case we say that supply is not responsive to price changes.There is one particular case where supply is very unresponsive to price changes in this case wesay that supply is perfectly inelastic .When supply is perfectly inelastic any change in price willnot affect quantity supplied.
  • 41. Perfectly inelastic supply CurvePrice Supply curve QtyWhen the percentage change in supply equals the percentage change in price we say that supply is unitelastic.Unit elastic supply CurvePrice Supply curve Qty
  • 42. Consumer SurplusOnly the marginal consumer is willing to pay just the market price in typical supply and demandequilibrium. Consumers would be willing to pay more than the market prices which is whatmakes the demand curve slope downward. The amount that these consumers would be willing topay, but do not have to pay is known as the consumer surplus.The diagram below is borrowedfrom Who Pays a Sales Tax?, which applies this concept ( SurplusThe supply curve slopes upward because, given a market price, there are producers who canproduce profitably at a price below that market price. The revenues to producers that exceed theminimum amount that they would have to receive is known as the producer surplus.
  • 43. MARKET EQUILIBRIUM Market equilibrium occurs when the quantity demanded equals the quantity supplied. - The equilibrium price is the price at which the quantity demanded equals the quantity supplied. - The equilibrium quantity is the quantity bought and sold at the equilibrium price. Graphical Representation of EquilibriumPrice Supply $ 5 Market Equilibrium Demand 50 Qty/day Note that at equilibrium, quantity supplied is equal to quantity demanded. Whenever this equilibrium is disturbed, market forces will restore it. Price is the regulator that pulls the market toward its equilibrium. - If the price is above the equilibrium price, then there is a surplus or excess supply; quantity supplied exceeds quantity demanded. In this case the price will fall to restore equilibrium - If the price is below the equilibrium, then there is a shortage or excess demand; the quantity demanded exceeds the quantity supplied. In this case the price will increase to restore equilibrium. The law of market forces states that, when there is a shortage the price rises and when there is a surplus the price falls; in both cases the move is such that equilibrium is restored.
  • 44. Illustration of Surplus and ShortagePrice Surplus Supply Quantity demanded = 40 $ 8 Quantity supplied = 65 Market 5 Equilibrium Surplus = (65 – 40) = 25 Price will fall to $5, where qty demanded = qty supplied. Demand 40 65 Qty/day 50Price Shortage Supply Quantity demanded = 65 $ Quantity supplied = 40 Market Shortage = (65 – 40) = 25 5 Equilibrium 3 Price will increase to $5, where qty demanded = qty supplied. Demand 40 65 50 Qty/day
  • 45. The Effects of Changes in Demand So An increase in Demand - shifts the demand curve to D1 - raises price D1 - raises qty supplied - increases equilibrium qty D0 A decrease in Demand So - shifts the demand curve to D2 - lowers price - lowers qty supplied - decreases equilibrium qty D0 D2The effects of changes in supply S0 S1 An increase in Supply - shifts the supply curve to S1 - lowers price - raises qty demanded - increases equilibrium qty D0 S2 So A decrease in supply - shifts the supply curve to S2 - raises price - lowers qty demanded - decreases equilibrium qty D0
  • 46. The effects of simultaneous changes in supply and demandIncrease in supply and demand S0 S1 Effect of an increase in: Variables Demand Supply Total Effect Price Raise Falls Ambiguous Quantity Raise Raise Increases D1Decrease in supply and demand Effect of A Decrease in: Variables Demand Supply Total effect Price Falls Raise Ambiguous Quantity Falls Falls Decrease
  • 47. Increase in demand and decrease in supply Variables Increased Decreased Total Demand Supply Effect Price Raises Raises Increase Quantity Raises Lowers AmbiguousDecrease in Demand and Increase in Supply Decrease Increased Variables Total Effect Demand Supply Price Lowers Lowers Decrease Variables Lowers Raises Ambiguous
  • 48. Module 2Market Structure, Market Failure and Intervention  Market Structure  Market Failure  Intervention
  • 49. Market StructureThe FirmThe objective for this portion of the course is basically to examine the market system, which isthe process by which scarce resources are allocated. We have shown thus far that resources areallocated through the market via a pricing mechanism. Therefore, we want to find out how areprices determined. So far we have discovered that prices are determined by the interaction ofdemand and supply.The objective of any firm is to maximize profits, which is the difference between total revenue(from the sale of output) and the opportunity cost of attracting resources to the firm. But theother goals of the firm are growth, satisficing, sales and revenue maximization and marketdominance.Profits: 1. Accounting Profit: - total revenue minus explicit costs. Accounting profit ignores the opportunity costs of using one‟s resources. 2. Economic profit: - total revenue minus all costs (both explicit and implicit). Economic profit accounts for opportunity cost. 3. Normal profit: - the accounting profit earned when all resources used by the firm earn their opportunity cost.Accounting profit above normal profit is economic profit.Howdo firms select the optimal quantity of a particular resource?Assume: Perfect competition ( Variable input (labour) wage rate (w) Fixed factor (capital) interest rate (r)
  • 50. DefinitionsProduction Function: - identifies the maximum quantities of a particular good or service that can Be produced per period of time with various combinations of resources, for a given level of technology. Output InputIsocost Lines: - gives all the combinations of factors that yield the same cost. TC w*L r *C TCWith labour alone: TC w*L L w TCWith capital alone: TC r *C C r Graph of Isocost Line Capital Labour
  • 51. rise TC / r wSlope Ratio of the factor prices run TC / w rIsoquant Line: - gives all the combinations of inputs that yield the same level of output. Graph of Isoquant Line Capital LabourProperties:1. Convex to the origin 3. Negatively sloped2. Do not intersect 4. Further from origin yields higher level of outputSlope: the slope of the isoquant is called the Marginal Rate of Technical Substitution (MRTS). MP L MRTS MP CThe MRTS is the rate at which the labour can be substituted for capital without affectingoutput.The objective of the firm is to maximize profits. There are circumstances under whichmaximizing profits is the same as minimizing costs. Therefore, the firm will choose its inputssuch that profit is maximized or cost is minimized.Now, how does the firm goes about achievingthese objectives?
  • 52. Minimizing costs1. For a given level of output, the firm will choose the lowest isocost curve that is tangent to thegiven isoquant in order to minimize costs.Maximizing profits2. For a given cost, the firm will choose the highest isoquant that is tangent to the given isocost in order tomaximize profits. Capital LabourTherefore, the input decision is determined by the slopes of the isocost and isoquant curves, i.e.,the firm will choose its inputs such that the slope of the isocost curve is equal to the slope of theisoquant curve. w MP L r MP CThis point is characterized as a point of tangency.
  • 53. Profit Maximization under Perfect CompetitionThe firm‟s objective is to maximize economic profit, this is achieved by: Deciding how muchto produce [in the short run] and deciding whether or not to enter or exit a market [in the longrun]Note that firms in a perfectly competitive market are price takers; they can sell as much as theycan at the prevailing market price.Revenue ConceptsTotal Revenue [TR]: is equal to price multiplied by quantity. It is the revenue earned from thesale of the firm‟s output. TRTR QtyMarginal Revenue [MR]: is the change in total revenue that results from a one unit increase inthe quantity sold. Note that under perfect competition MR is equal to price. This is due to the factthat the firm can sell any amount at the market price, therefore, if the firm sells an additional unitof output it does so at the market price and thus TR increases by that amount. But the increase inTR is the MR, which also happens to be the price. Price MR Qty
  • 54. Profit Maximizing OutputRecall that as output increases, TR increases. But TC also increases; and because of decreasingmarginal returns, TC eventually increases faster than TR.The firm‟s objective then is to find the output level at which the difference between TR and TCis maximized. This occurs when the vertical distance between TR and TC is greatest. TC TR TC & TR QtyMarginal AnalysisAnother way to identify the profit maximizing level of output is to use marginal analysis; that is,consider the MR and the MC at each output level. Recall that as output increases MR remainsconstant but MC eventually increases. 1. If MR exceeds MC, then the extra revenue from selling one more unit exceeds the extra cost incurred to produce it. This implies that economic profit will increase if output increases. 2. If MR is less than MC, then the extra revenue from selling one more unit is less than the extra cost incurred to produce it. This implies that economic profit will decrease if output increases. 3. Therefore economic profit is maximized at the output level where MR is equal to MC. MR &MC MC MR
  • 55. OutputThe profit maximizing qty is the qty supplied at the specified price. If the price were higher theqty supplied would increase; if the price were lower the qty supplied would decrease hence the“law of supply”. Illustrate by shifting the MR curve up and down and show that themaximizing qty would increase and decrease respectively.Exit and Temporary shutdown conditions [Short Run]In the short run firms may be making an economic loss which they believe is temporary. If this isso they may decide to stay in operation or shut down temporarily. To make this decision, thefirm will compare the loss it would make in the two situations. If the firm decided to shut down itwould make a profit equal to the negative of the fixed costs of operation. If the firm decided toproduce some output it would make a profit equal to TR minus (TFC + TVC).First PossibilityThe firm will shut down if the profit it makes from shutting down is greater than the profit itmakes from staying in operation. TFC TR TFC TVC TFC TFC TVC TR Show that in this case P<AVC [TR=P*Q] TVC TRThat is, if TR is less than TVC then the loss would be greater than TFC. As such it would suitethe firm to shut down since the loss incurred would be less than if it continued operation.Price MC ATC AVC MR=P
  • 56. OutputSecond PossibilityThe firm will stay in operation if the profit it makes from staying in operation is greater than theprofit it makes from shutting down. TFC TR TFC TVC TFC TFC TVC TR Show that in this case P>AVC [TR=P*Q] TVC TRThat is, if TR is greater than TVC then the loss would be less than TFC. As such it would suitethe firm to continue operating since the loss incurred would be less than if it shut down. Price MC ATC AVC MR=P OutputTherefore, as long as the firm can cover its variable costs it will stay in business in the short run. That is,as long as the price is greater than the minimum AVC the firm can maximize profit by producing whereMC=MR=P. If price is below AVC the firm shuts down. This implies that the firm‟s supply curve is theportion of the MC curve above the minimum of the AVC curve.
  • 57. Price shutdown point Supply curve AVC MR=P OutputThe market supply curve is the horizontal summation of the individual firm‟s supply curves. Price Qty
  • 58. Market Equilibrium and SR profit maximization Price MC S ATC MR=PD QtyPrice is determined by the market demand and supply……each firm is then able to sell all theycan at that price…….thus the demand curve facing each firm is flat [perfectly elastic].Perfect competition in the long runIn the long run firm‟s make zero economic profit; i.e., they only make normal profit.If economic profit existed in the short run it will act as an incentive for 1. new firms to enter the market OR 2. for existing firms to expand productionIn either case market supply will increase…..this will cause a reduction in the market price andhence profits.This process of entry and or expansion will continue until economic profit has been completelyeroded and all that is left s normal profit. That is firms will continue to enter until the marketprice is equal to ATC.If economic loss existed in the short run it will act as an incentive for 1. firms to exit the market OR 2. for existing firms to cut productionIn either case market supply will decrease…..this will cause an increase in the market price andhence profits.This process of exit and or contraction will continue until economic losses have been completelyeroded and all that is left s normal profit. That is firms will continue to exit until the market priceis equal to ATC.
  • 59. Market structures:There are four types of market Structures: - Perfect Competition - Monopoly/Monopsony - Monopolistic Competition - Oligopoly - The Cob Web ModelPerfect CompetitionThis type of market structure exists when: - there are many buyers and sellers in the market - all the sellers sell homogeneous products - there exists perfect information among the buyers and sellers about prices and availability of resources - no barriers to entryWhen these conditions exists in a market no one individual [buyer/seller], has any control overprices. Prices are determined by the market demand and supply and so the participants areconsidered price takers.MonopolyThis type of market structure exists when: - one firm sells a good/service that has no close substitutes - Barriers to entry existsTR is the same for the monopolist, however, since the firm is the only supplier in the market thedemand curve facing the monopolist is also the market demand curve. Therefore, unlike for theperfectly competitive firm, the demand curve facing the monopolist is downward sloping. This isdue to the fact that if the monopolist wants to increase quantity sold he must reduce the price of
  • 60. MonopolyTR is the same for the monopolist, however, since the firm is the only supplier in the market thedemand curve facing the monopolist is also the market demand curve. Therefore, unlike for theperfectly competitive firm, the demand curve facing the monopolist is downward sloping. This isdue to the fact that if the monopolist wants to increase quantity sold he must reduce the price ofthe good. Price Loss Gain D = AR QtyAverage Revenue [AR] is to revenue per unit sold. TRAR QSince TR P *QTR P AR P QNote that this is the same for the perfectly competitive firm. The AR curve is the same as thedemand curve.The relationship between P and MR is different in monopoly than in Perfect competition.Specifically, for the monopolist the MR is less than P. As the firm increase output MR falls. Thisoccurs for two reasons: 1. the amount received from selling another unit declines [since price drops] 2. the revenue forgone by selling all units at this lower price increases [since all units must now be sold at the lower price]
  • 61. These two effects causes the MR to fall as the price falls along a given demand curve.Price D Qty MRMarginal Revenue and ElasticityWhere demand is elastic, MR is positive; so TR increases as price falls. Where demand isinelastic, MR is negative; so TR decreases as price falls. Where demand is unit elastic, MR zero;TR is maximizedThe profit maximizing Level of outputThe rule for identifying the Profit maximizing level of output is the same for the monopolist asfor the perfectly competitive firm. The monopolist will increase output as long as the additionaloutput adds more to TR than to TC. That is, output will be increased as long as MR is greaterthan MC. Therefore, profit is maximized at the output level where the rising MC curve intersectsthe MR curve. Since MC is never negative, it will never intersect MR where MR is negative.Thus the monopolist will only produce where the demand curve is elastic. Price MC ATC Profit D MR Qty
  • 62. Short Run shut down conditionThe monopolist will continue to operate in the short run as long as price is greater than AVC. Price Loss ATC AVC MC D=AR MR QtyLong Run Profit MaximizationSince by definition, monopoly means one seller monopoly profits can persist in the long run. - Barriers to entryMonopoly and PCA monopoly will produce less and charge a higher price than under perfect competition. Price Pm MC Pc MR D=AR Am QC Qty MR
  • 63. The Inefficiency of the monopoly Perfect MonopolyPrice S=MC Price S=MC Pm dead weight loss to societyPc Qty QtyQc D=MB Qm Qc D=MB MRResources are efficiently allocated when the Marginal Benefit [MB] = Marginal Cost[MC]…that is, the society achieves allocative efficiency when the amount consumers are willingto pay for an extra unit of output is equal to the cost of producing the extra unit output.Recall that the marginal willingness of consumers to pay is given by the MB or demand curve[that is, the marginal willingness to pay is P]…..therefore, the condition for allocative efficiencycan be written as MC=P. - Under the competitive equilibrium, firms produce where MR=MC. Since MR=P… implies that MB=P=MC….so that resources are being used efficiently. - Under the monopoly equilibrium, the firm produces where MR=MC. Since MR<P… implies that MB=P>MC…. so that resources are being used inefficiently. A dead weight loss occurs due to the underproduction that takes place, which causes total surplus to be less than its maximum value.
  • 64. Monopolistic CompetitionThis type of market structure exists when: - Many buyers and sellers - Few barriers to entry - compete on product quality, price and marketing - consumers face wide choice of differentiated products - Each firms seeks to maximise profitsOligopoly - small number of firms - products may be similar or differentiated - barriers to entryAlternative types of Oligopolistic behaviour - Cartels - Price Leadership - Quantity Leadership - Bertrand - CournotCartelsThis refers to a group of firms that agree to coordinate their pricing and production decisions soas to act as a single monopolist and earn monopoly profits. Eg., OPEC. There is always thetemptation to cheat on the cartel agreementPrice LeadershipThis refers to a situation where a dominant firm in the market set the price and the others followthe lead and try to avoid a price war.Assumptions: - the industry is made up of one or few large firms and a number of smaller ones - the dominant firm maximizes profits subject to the constraint of the market demand and the behaviour of the smaller firms
  • 65. - The dominant firm allows the smaller firms to sell all they want at the price set and then supply the difference. - There is no price fixing.Quantity LeadershipCournot: Exists where there are two firms in the market; both firms choose their production levelsimultaneously.Bertrand: Exists where there are two firms in the market; both firms choose their price levelsimultaneously
  • 66. The Cob Web ModelComparative Static: - comparing the new equilibrium with the originalDynamic Analysis:- the study of the behaviour of systems in states of disequilibriumSupply lag: - delay between the decision to change quantity supplied and it actually beingchanged.The Cob Web model can only hold if certain conditions are met. - production is completely determined by the producers‟ response to price under perfect competition - the time needed to adjust production is at least one period - price is set by the supply availableStable adjustment: - one which will take the market to its equilibrium; the actual price andquantity will tend towards their equilibrium values. In this case the demand curve will be flatterthan the supply curve.Unstable Adjustment: - one which will not take the market to its equilibrium; the actual price andquantity will tend away from their equilibrium values In this case the demand curve will besteeper than the supply curveNb: You may not need this for your CAPE course but it is good to note
  • 67. Industrial concentrationIndustrial concentration occurs when a small number of companies sell a large percentage of anindustrys product. There are two methods 1. Concentration Ratio- This refers to the percentage of the market by each large firm. CRn = S1 + S2 + S3+ S4 +...+SnThe model typically has 4 firms which possess the market share. If one firm takes up 75-90% ofthe market it can be classified as a natural monopoly 2. Herfindahl-Hirschman Index - the percentage of an industry‟s output produced by its four largest firms. This method specifically deals with 4 firms. 2 iApply the industrial concentration methods to the market structures mainly in relation to thenumber and power of firms.
  • 68. Market FailurePareto EfficiencyPareto efficiency is an economic state where resources are allocated in the most efficient manner.Pareto efficiency is obtained when a distribution strategy exists where one partys situationcannot be improved without making another partys situation worse. Pareto efficiency does notimply equality or fairness. (Investopedia)Market failure: This occurs when the interaction of demand and supply in a market does notlead to *Productive or *Allocative Efficiency*Productive efficiency: This refers to using the least possible amount of scarce resources toproduce a particular amount of produce*Allocative Efficiency: This refers to producing those products that are most wanted byconsumers given the costs of productionReasons for market failure: 1. Public goods 2. Merit and Demerit Goods 3. Externalities 4. Asymmetric Information: Adverse selection and moral hazard 5. Imperfect marketTypes of goodsPublic goods: these are goods that bar no one from consumption (non-exclusive) and theconsumption of the good by one consumer does not impede another consumer from consumption(Non-rivalrous). E.g. National Defence, Lighthouses, Roadways (*Quasi-public Goods)*Quasi-public goods: These are goods that are intermediate between public and private goods.Private goods: These are goods that bar some consumers from consumption mainly throughprice and there is a limited quantity to be consumed. Therefore private goods are exclusive andrivalrous.Merit and Demerit goods: Merit Goods are those which offer benefit to the society for e.g.Education , Healthcare and Affordable Housing, which if the market was left on its own it wouldunder-produce these goods. Demerit Goods are those goods which are more harmful to society
  • 69. than not, for e.g. Tobacco and Alcohol. If the market was left on its own it would over producethese goods.ExternalitiesExternalities represent the external costs and benefits of any productive activity. These can beclassified as: A. Production Externalities(positive and negative) -This exists when an external cost or benefit arising from production must be borne by someone other than the producer of the good B. Consumption Externalities(positive and negative) –This exists when an external cost or benefit arising from the consumption of a good must be borne by someone other than the consumer of the goodCosts and BenefitsMarginal Social Cost: the sum of the marginal private costs and the marginal external costs MES= MC+MECMarginal external cost: The cost of producing additional units of output borne by individualsother than the product of the good or serviceMarginal social benefit: The sum of the marginal private benefit and the marginal externalbenefit. MSB=MB+MEBMarginal Benefit: The benefit of producing an additional unit of output that is borne by theproducer.Marginal External Benefit: The benefit of producing an additional unit of output that is borneby individuals other than the producer of the good or service.
  • 70. Asymmetric InformationWhen individuals do not have the correct information when making transactions, distorted orwavered decision will be made: there are two types market failures due to asymmetricinformation: 1. Moral Hazard- Hidden actions or morally hazardous behaviour by one party in a transaction, very popular in the insurance industry. 2. Adverse Selection- This occurs when asymmetric information arises from a hidden attribute of a good or service. Applies to sales where the sellers or the buyers know more than the other about the good.InterventionWhen the market does fail, the task is left up to the government to intervene. The government can usemany methods to stimulate the market from a point of failure to recovery.The government can implement measures to control market failure such as: - Regulations - Anti-trust policies - Taxation - Privatisation and deregulation in some industries to offset cost and other factors - State ownership of resources - Subsides to firms to spur on production - Legislation - Market creation(tradable permits)Government intervention according to many economic theorists can be detrimental if the governmentdoes not allow the natural market to settle problems on its own. Many times as governments intervenesome consumers may suffer. But there are benefits to government interventions as many consumersand producers who have been affected my market intervention do reap the benefits from some of theactions of government aforementioned.In the Caribbean our smaller economies are heavily reliant on government intervention but the privatesectors should be given leverage and support where needed.
  • 71. Private Sector InterventionWhen the private sector is allowed a hand in market failure intervention, they have many methods theycan use. According to this course they can use: - Corporate Code of Conduct - Corporate Social Security - Voluntary Agreements - Corporate Ethics
  • 72. Module 3Distribution Theory  Demand for and Supply of Factors  Wage differentials  Income inequality, Poverty: Theory and Alleviation
  • 73. The Demand for and Supply of FactorsDo you remember the factors of production Land, labour Capital and Enterprise? These factorsof production also had rewards that are related to them.Factors of Production Factor rewardsLand Rent: Income earned for the usage of the landLabour Wages: Income earned for productive activityCapital *Interest:Enterprise Profit: the returns to owners of resourcesDerived Demand:A term used in economic analysis that describes the demand placed on one good or service as aresult of changes in the price for some other related good or service. It is a demand for somephysical or intangible thing where a market exists for both related goods and services inquestion. The derived demand can have a significant impact on the derived goods market price(Investopedia).Labour marketLabour is treated like any other good in the market, except demand comes from the firm insteadof the consumer. The price a firm pays for labour is known as the wage. In addition to a wage,workers also commonly receive fringe benefits such as insurance and vacation time.Real wage: Wage adjusted for inflation.
  • 74. Perfectly competitive labour market 1. Everyone is a wage taker-neither employers nor employees set wage rates 2. Freedom of Entry- No restrictions on the movement of labour 3. There is Perfect Knowledge- workers are fully aware of what jobs are available and the wages and employers know what labour is available and how productive it is. 4. Homogenous Labour-workers are categorized in accordance with their productivityy=wage rateA: Labour Market B: Employee C:Firm SL SL Sl W* Dl W* L* L* L* x=Labour Diagram C shows how individual firms hace toDiagram A shows the Diagram B shows how accept the going wage rate.interaction between the individual workers have to the supply of labour to themarket demand and supply accept the going wage employers is infinitelyof labour which determines rate. In this case the elasticthe going wage rate (W*) demand is perfectly elastic.and the employment level(L*)
  • 75. Supply of LabourThe supply curve for the labour market shows how much labour workers or households willprovide at each wage.There are two alternatives for each household‟s time: leisure andworkingat home.As the market wage changes, decisions concerning work will also change. There aretwo effects of a wage change, which work in opposite directions:Substitution effect: If the marginal benefit of leisure or working at home is higher than themarket wage, the household should choose either leisure or working at home. This means that asthe wage rises (falls), households are more (less) likely to choose the labor market.Income effect: As the wage rises (falls), households are less (more) likely to spend more time inlabour market. With a higher (lower) wage, they can work less (more) to make the same income.The relative strengths of the income and substitution effects will determine the shape of thehousehold‟s labour supply curve.  If the substitution effect is stronger, the curve will be upward sloping.  If the income effect is stronger, the curve will be downward sloping.  If the substitution and income effects are equal, the curve will be vertical.Most people have a backward-bending labour supply curve, which is upward sloping for lowwages, vertical or nearly vertical at higher wages, and bends backward with a downward slopefor the highest wages.Market labour supply, on the other hand, is a straight, upward sloping line. It is not backward-bending because, as a whole, more workers will be attracted to higher-paying jobs.Backward-Bending Labour Supply
  • 76. Demand of LabourThe demand curve for the labour market shows how much labour firms will buy at each wage.Firms must determine how much labour is needed for a profit-maximizing level of production.Marginal revenue product (MRP): Revenue increase resulting from the purchase of anadditional unit of labour.The firm maximizes profits by purchasing additional labour until the MRP is equal tothe market wage.If the costs of any factors necessary to produce a good change, the MRP will be affected and theamount of labour demanded by the firm will also change.Adding up all the firms‟ labour demand curves will equal the market labour demand curve.If demand increases (decreases) for a good that a particular type of labour produces, the demandfor that type of labour will also increase (decrease).Wage Rate MC AC=W(Supply) MRP=D Employment levelThe profit maximising firm will hire labour until MRP=AC
  • 77. Labour EquilibriumAs with other goods, the supply and demand for labour create anequilibrium wage rate andquantity in the market when they are equal.There are several possible inefficiencies, which maycause the wage to differ from equilibrium:Income tax: Workers pay a tax on their income, and it affects the amount of time they arewilling to work.Minimum wage: The government sets in the market a minimum wage, which firms are forced topay.  If the minimum wage is lower than the market equilibrium wage, then there is no impact because firms will pay the equilibrium wage.  If the minimum wage is higher than the market equilibrium wage, labour supplied will be higher than labour demanded, and some workers will be unable to find jobs.Discrimination: Firms may choose to hire or set wages based on factors that are not related toproductivity, such as race, age, or gender. Non-profit maximizing decisions are inefficient.Unions By bargaining with firms for higher wages, unions decrease demand for labor. Someworkers will then move to non-union firms, which can compete with lower costs because theypay lower wages. However, union firms often have other benefits that offset the higher cost oflabour, such as lower turnover.
  • 78. Transfer Earnings and Economic RentTransfer earnings are the minimum payment to the Factors of Production which is just adequate tocompensate the ownerEconomic Rent refers to the payment made to any Factor of Production in excess of the minimum(Transfer Earnings)
  • 79. Capital MarketThe supply of capital expenditure comes from all sources from which it can be borrowed usuallyfrom savings. Savings represent the amount available from a pool of borrowers. The cost ofcapital is usually expressed as interest rates. The Marginal Efficiency of Capital (MEC) is themarginal revenue product relating to capital.Interest (R) Sk r1 Dk(MEC) K1 Capital (k)*Interest rates are determined through the market interaction between the supply of capital andthe MEC.Determinants of the Supply of capital 1. Interest rates- as interest rates increase savings also increase so there is a positive relationship 2. Price Level- As price increases the amount of goods and services which can be affected by saved funds decreasing. As a result individual uses forgo buying to stock up on wealth 3. Size of Income- If income increases savings increase so there is a positive relationship.Wage DifferentialsWage differentials can be defined as the difference in the wage rate between the different typesor classifications of workers. Wages may differ based on four main discriminating factors;Qualifications (Human capital –Education), Race, Gender and MobilityImperfections in the Labour MarketIn the real world labour markets are rarely perfectly competitive. This is because workers orfirms usually have the power to set and influence wages and therefore wages may be set to levelsdifferent than anticipated by MRP theory.
  • 80. Different Imperfections in the Labour Market1. Monopsony:This occurs when there is just one buyer of labour in a market.Even if there is more than one employer, firms may still have the ability to set wages. Thereforethey have Monopsony powerThe marginal cost of employing one more worker will be higher than the average cost because toemploy one extra worker the firm has to increase the wages of all workers.To maximise the level of profit the firm employs Q2 of workers whereMC = MRPTherefore the firm only has to pay a wage of W2. This is less than the competitive wage.2. Trades Unions:Under certain conditions Trades unions can bargain for wages above the competitive equilibriumThis can be achieved by restricting the supply of labour (e.g. Closed shops) or threatening to goon strike.
  • 81. Trades Unions can cause higher wages, however in competitive markets this can have the effectof causing unemployment of Q1 – Q2However Trades Unions can be beneficial ifThey operate in an industry with a Monopsonistic employerThey help to increased productivity by bringing in new working practices3. DiscriminationFirms may not be rational but pay some workers different wages on the grounds of age, race, orgender4. Difficult to measure productivityThe theory of MRP assumes firms can measure the MPP of a worker however in practice this isdifficult because in many jobs, especially in the service sector productivity cannot be measuredpreciselye.g. How do we measure productivity of nurses and teachers?Therefore wages may be set due to different reasons other than MRP5. Firms may be Non Profit MaximizersIf demand for a product falls, MRP theory suggest wages are likely to fall. However firms maybe reluctant to cut wages or make people redundant therefore they may keep paying high wagesdespite this.
  • 82. 6. Wages will vary due to geographical differences:In the North, wages tend to be lower because there is less demand and higher unemployment. Inthe South, wages tend to be higher for the opposite reason.In theory, workers from the north could move to the south to take advantage of betteremployment opportunities. However there are likely to be geographical immobilities - e.g. It isdifficult for workers to move)This is because:I) They are attached to their local communitiesii) Difficult to find housing in the southiii) Ignorance of Jobs elsewhere7. Poor informationWorkers or firms may suffer from poor information. E.g. Workers may be unaware of better paidjobs elsewhere. This enables firms to have monopsony power.
  • 83. Income inequality, Poverty: Theory and AlleviationIncome inequalityThe concept of income inequality refers to the extent to which income is distributed in an unevenmanner among a population. It can also be seen as the gap between the rich and everyone else.The ultimate result is that income distribution has never or will never be totally equal.Size and functional distribution of incomeThe size distribution of income is one of two ways to measure inequality in income, under thismethod, individual and household income is collected and arranged in ascending order. The datais, then, divided among groups. Most common method is to divide data into "quintiles" (i.e. infive groups, each representing 20% of data) and/or “deciles" (i.e. in ten groups, each representing10% of data) in percentage form. Then, it is determined that what percentage of total income isreceived by each income group.The other method is functional distribution of income, which is the method where the incomewithin the economy is divided among the owners of the factors of production (FOP), namelyinterest, wages, rent and profit.
  • 84. Lorenz Curve and Gini CoefficientLorenz curve: A Lorenz curve shows the degree of inequality that exists in the distributions oftwo variables, and is often used to illustrate the extent that income or wealth are distributedunequally in a particular society.This Lorenz curve illustrates the degree of inequality in the distribution of income. A Ginicoefficient can be calculated using areas on this Lorenz curve. The 45 degree line would reflectabsolutely even distribution of income. The pink shaded area A between the line of perfectequality and Lorenz curve reflects inequality. The blue area underneath the Lorenz curve is B,and the Gini coefficient can now be calculated as A/(A+B). Gini coefficients are often expressedas percentagesGini coefficient: A Gini coefficient is a summary numerical measure of how unequally onevariable is related to another. The Gini coefficient is a number between 0 and 1, where perfectequality has a Gini coefficient of zero, and absolute inequality yields a Gini coefficient of 1.Although Gini coefficients are used primarily to summarize distributions of income, they are alsoused to summarize inequalities in market shares by firms in an industry, or in the distribution ofwealth (
  • 85. Income inequality AlleviationIncome inequality on the other hand can be alleviated through government intervention. as theareas of income inequality are assessed, a government would have to make a choice to find themost suitable method of alleviation for persons who are being either over compensated orundercompensated but more so the latter. The CAPE syllabus emphasises three methods thegovernment can use to alleviate income inequality, namely; taxes, subsidies and transfers.TaxesTaxes are mandatory payments made to the government either on income or consumption. In thiscase we will deal with income taxes. Many governments use a standard rate tax system, whereeveryone pays the same percentage of their individual income over to the government, e.g. 25%(Jamaica) once they earn a certain amount of income (Income Tax Threshold). The governmentcan take two actions to alleviate income inequality to some extent. The first could be toimplement a progressive tax system where persons who earn a higher incomeSubsidiesSubsidies are allowance by governments to firms or individuals to either promote production orconsumption. The government can provide subsidies to firms in an attempt to get them toincrease their supply of goods at services at lower cost so that everyone will be able to affordthem. Also the government may subsidies certain services like education and healthcare to allowfor lower income earners to have access to these services.
  • 86. PovertyAbsolute PovertyThis measures the actual number of people within an economy who are unable to afford certainbasic goods and services such as food and shelter. This occurs because their level of income fallsbelow the poverty line or threshold. According to the UNDP the worldwide poverty line is$2.00USD / person/day.Relative PovertyThis measures the extent to which an individual‟s financial resources fall below the average levelof income within the economy. For e.g. If the average level of income $3,000 USD /month thenan individual who earns $1,700USD / month would be classified as relatively poor where theymay not be classified as absolutely poor.Factors that contribute to poverty:  Unemployment  Non-ownership of resources- whether or not a person is employed, ownership of the Factors of production may provide sufficient income to afford a higher standard of living. Persons who do not own any of the factors are disadvantaged and may be lead into poverty.  Uneven distribution of income- the size distribution of income has major bearing on the poverty rate  Inflation- As the price of goods increase, persons whose income is constant will be able to afford less.  Large number of dependents- Large families with low increase generally tend towards poverty overtime  Single parent/female –headed households- With only one4 income or no constant income these household structures may suffer.  Discrimination- Persons who are too old, too young , disabled or of a different gender may be overlooked for the jobs available thus leading to little or no income to them or their families which can lead to poverty  Social and Physical environment-Drought, Inner City or tent city communities may lead to persons being out of work thus having little or no income which can lead to poverty.
  • 87. Persons who are most susceptible to poverty A. Persons with special needs : I. Physically challenged II. Elderly III. Youth IV. Single Parent Families V. Indigenous People B. Reasons- Limited access to employment, level of training, Legislation, Availability of Income to share among familyWays to measure poverty 1. Basic needs- What is it that the general population needs as basic items and what percentage is able to comfortably afford them 2. Poverty Line (threshold)- Persons who earn income below this line or do not earn any income at all and are not on benefits will be classified as poor or impoverished 3. Head count- areas that have households with many members and a small income may be classifies as impoverished 4. UNDP Human development index- The Human Development Index (HDI) is a composite statistic used to rank countries by level of "human development" (the standard of living and/or quality of life).Strategies to alleviate povertyTransfer payments-A redistribution of Income within the income by governmentFree education and healthcareHousingMinimum wage legislationEqual employment opportunitiesGovernment employment creation(special works programme
  • 88. Cost of povertyUnemployed human resourcesLower potential outputInefficient allocation of government expenditureSocial and Environmental costsEconomic benefits of povertyProvision of Education and Health leading to development of human CapitalImprovement of well-being as measured by the UNDP HDIMore equitable distribution of income