Economics ss4
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Economics ss4 Economics ss4 Presentation Transcript

  • ECONOMICSIntroduction to Economics Lecturer: Linh Tran February 2011 1
  • Introduction: Overview of Economics  What is Economics? Why do we need to study this?  What are the links between Economics & other subjects?  What topics will we learn for CFA L1? Schedule? 2
  • Introduction: Overview of Economics CONTENT OF LEVEL 1 3
  • Introduction: Overview of Economics LINKS BETWEEN ECONOMICS AND OTHER SUBJECTS 4
  • Introduction: Overview of Economics SCHEDULE Week 1 Week 2 Saturday  28‐Jan Saturday  4‐Feb SS4 Introduction to Microeconomics LOS16 The Firm and Market StructuresAM LOS13 Demand & Supply Economics:  Introduction Break Break LOS14 Demand & Supply Economics: Consumer  SS5 Introduction to MacroeconomicsPM Demand LOS17 Aggregate Output, Price and Economic  LOS15 Demand & Supply Analysis: The Firm Growth Week 3 Week 4 Saturday  11‐Feb Saturday  18‐Feb LOS18 Understanding Business Cycles SS6 Economics in a Global ContextAM LOS20 International Trade & Capital Flows Break Break LOS19 Monetary & Fiscal Policy LOS21 Currency Exchange RatesPM Revision 5
  • ECONOMICSSS4: Microeconomics AnalysisLOS13: Demand & Supply Analysis: Introduction Lecturer: Linh Tran January 2012
  • Overview of Microeconomics OVERVIEW THE PURPOSE OF MICROECONOMICS 7
  • Reading 13: Demand & Supply Analysis: Introduction MIND MAP 8
  • Reading 13: Demand & Supply Analysis: Introduction  TYPES OF MARKETS Factor Market Goods Market • For factors of production: land, labor, • For finished goods & services physical capital, materials, Capital Market intermediate goods • For long-term financial capital (equity, bond) Sell labor services, land, entrepreneurial risk-taking ability Save money => capital to “sell” to firms (i.e. lend/invest) FIRMS HOUSEHOLDS Sell finished goods & services Raise funds (debt/equity) to invest in productive assets 9
  • Reading 13: Demand & Supply Analysis: Introduction  DEMAND FUNCTION • Demand: the willingness & ability of consumers to purchase a given amount of a good/service at given values of variables • Demand Function: represents buyers behavior Variables/Factors influenced: ________________________________ Example: Exercise: Interpret the sign & magnitude for each coefficient:  Own-price (Px)  Income (I)  Price of other goods (Py) 10
  • Reading 13: Demand & Supply Analysis: Introduction  DEMAND CURVE “Law of Demand” • Holding other factors constant (ceteris paribus) Curve is downward sloping • Inverse demand function: i.e. Price as a function of quantity demanded e.g. When I = 50, Py = 20 Source: CFA Curriculum 2012 Demand Curve: shows both the HIGHEST PRICE willing to pay for each quantity, or the HIGHEST QUANTITY willing to purchase at each price 11
  • Reading 13: Demand & Supply Analysis: Introduction  SHIFTS & MOVEMENTS ALONG THE DEMAND CURVE Movement Along the Curve Shift of the Curve Px Px 29.5 28 Change in quantity demanded 28 Change in demand as as price changes other variables change 8 3 3 Qx 8 10 11.2 10 11.2 11.8 Qx e.g. e.g. • Holding other factors constant • Other factors change (e.g. Income, (ceteris paribus) Price of other goods…) • Slope does not change 12
  • Reading 13: Demand & Supply Analysis: Introduction  SUPPLY FUNCTION • Supply: the willingness & ability of firms to sell a good/service at given values of variables • Supply Function: represents sellers behavior Variables/Factors influenced: _________________________________ Output price, costs of input, technology level Example: Exercise: Interpret the sign & magnitude for each coefficient: o Own-price (Px) o Wage (W) 13
  • Reading 13: Demand & Supply Analysis: Introduction  SUPPLY CURVE “Law of Supply” • Holding other factors constant Curve is upward sloping i.e. (ceteris paribus) • Inverse supply function: Price as a function of quantity supplied e.g. Wage = 15, then Source: CFA Curriculum 2012 Supply Curve: shows both the HIGHEST PRICE willingly accepted for each quantity, or the HIGHEST QUANTITY willingly supplied at each price 14
  • Reading 13: Demand & Supply Analysis: Introduction  SHIFTS & MOVEMENTS ALONG THE SUPPLY CURVE Movement Along the Curve Shift of the Curve Changes in quantity supplied as Changes in supply as other price changes variables change Px Px 3.1 4 3 3 1.1 1 1 ‐250 500 750 Qx ‐275 ‐250 475 500 11.8 Qx e.g. e.g. • Other factors change (e.g. Wage, Price of • Holding other factors constant other goods…) (ceteris paribus) • Slope does not change 15
  • Reading 13: Demand & Supply Analysis: Introduction  AGGREGATING THE DEMAND & SUPPLY FUNCTIONS • Aggregating rule: Sum up Demand/Supply Functions of each individual/firm => Sum horizontally (quantity), not vertically (price) Example: 1000 identical buyers, each has demand function:  Derive the market aggregate demand function?  Derive the inverse market demand function, hold I = 50, Py = 20  Determine the slope of the market demand curve 16
  • Reading 13: Demand & Supply Analysis: Introduction  AGGREGATING THE DEMAND & SUPPLY FUNCTIONS Graphic Illustration Px Px 28 28 2 identical buyers 8 8 8 11.2 Qx 8 11.2 24 33.6 Qx e.g. e.g. • Sum up horizontally (quantity), not vertically (price) • Market curve is less steep than individual curve 17
  • Reading 13: Demand & Supply Analysis: Introduction  MARKET EQUILIBRIUM & MECHANISM • Equilibrium: Is where Supply meets Demand Demand: curve: Px  28  2.5Q d x Px Excess supply S Supply curve: Px  1  0 .004Q s x 28 Question: Find equilibrium point? o Solve for Px, Qx such that: 1 D Excess demand Q xd  Q xs ‐250 11.2 Qx o Pe = ________, Qe = _________ • Mechanism to move towards equilibrium: o If P < Pe: Demand exceeds supply => increase P o If P > Pe: Supply exceeds demand => reduce P 18
  • Reading 13: Demand & Supply Analysis: Introduction • Exercise: Market Mechanism: Excess Demand/Supply In the local market for e-books, the aggregate demand & supply are given by: Q d  6, 360  4 00 Px x Q s   1,116  3 00 Px x 1. Determine the amount of excess demand or supply if price = $12 2. Determine the amount of excess demand or supply if price = $18 19
  • Reading 13: Demand & Supply Analysis: Introduction  STABILITY OF EQUILIBRIUM • Stable Equilibrium: • Unstable Equilibrium: o Market can automatically return to o Once pushed away, market will not equilibrium after shocks return to its old equilibrium o Normal condition o Bubble condition Excess supply or demand? Excess supply or Price or ? demand? Price or ? Source: CFA Curriculum 2012 Source: CFA Curriculum 2012 20
  • Reading 13: Demand & Supply Analysis: Introduction  STABILITY OF EQUILIBRIUM: MULTIBLE EQUILIBRIA • Non-linear supply curve o Example: Labor supply • 2 equilibria points: o Stable: Where Demand intersects Supply from above o Unstable: Where Supply intersects Demand from above Source: CFA Curriculum 2012 21
  • Reading 13: Demand & Supply Analysis: Introduction  AUCTION • One of the most traditional methods to determine equilibrium price • Types o Common Value Auction  Auctioned item has an actual value that is the same for every bidders  Bidders have to estimate that true value.  Example: oil lease contract o Private Value Auction  Each bidder have a subjective value of the item that is unique  Example: unique price of art 22
  • Reading 13: Demand & Supply Analysis: Introduction  AUCTION MECHANISMS • Ascending price (or English) auction: o Begin at low price & raise it incrementally o Open outcry => can learn about the true value by observing other bids • First price sealed bid auction o Submit bidding price in envelop => Cannot observe bid o Tend to submit conservative bid to avoid Winner’s curse • Second price sealed bid (or Vickery) auction o To induce bidders to reveal their reservation prices o Winner pays the price equal to the second-highest bid o If bidding increments are small => Same result as English auction 23
  • Reading 13: Demand & Supply Analysis: Introduction  AUCTION MECHANISMS • Descending price (or Dutch) auction: o Start with a very high price => lower until there is a willing buyer o Demand curve is negative-slope o Multiple-unit format:  Quoted price is per-unit  Transactions could occurs at different prices for different buyer o Modified Dutch Auctions: common practice in securities markets  Establish a single price for all purchasers which clears the market  Example: Auction of U.S. T-bill 24
  • Reading 13: Demand & Supply Analysis: Introduction • Example: Auction of U.S. Treasury bill Auction of $90 billion T-bill with both competitive & non-competitive  Non-competitive bids: willing to purchase at whatever the price  What is the winning price? $99.9095  Source: CFA Curriculum 2012  Bidders at that price will have their orders partially filled. How much is filled? (30%) 25
  • Reading 13: Demand & Supply Analysis: Introduction  CONSUMER SURPLUS = VALUE – EXPENDITURE Is the difference between the amount a consumer is willing to pay (Value) and the amount he must pay for it (Price) Demand curve is also marginal value curve Source: Schweser 2012 26
  • Reading 13: Demand & Supply Analysis: Introduction  PRODUCER SURPLUS = REVENUE – VARIABLE COST Is the excess of market price (Price) over the variable cost of production (Cost) Supply curve is also marginal cost curve TS  CS  PS Source: Schweser 2012 27
  • Reading 13: Demand & Supply Analysis: Introduction • Example: Calculating Consumer & Producer Surplus o A market demand function is given by the equation: Q d  180  2P Determine the value of consumer surplus if price = $65. o A market supply function is given by the equation: Q s  -15  P Determine the value of producer surplus if price = $65. o Calculate total surplus at price = $65 Source: Schweser 2012 28
  • Reading 13: Demand & Supply Analysis: Introduction  UNDER/OVERPRODUCTION & DEADWEIGHT LOSS Inefficient resource allocation occurs when the sum of producer & consumer surplus is not maximized => Create deadweight loss (decrease in total surplus) to the society Source: Schweser 2012 Source: Schweser 2012 Underproduction Overproduction To the Left of the equilibrium To the Right of the equilibrium 29
  • Reading 13: Demand & Supply Analysis: Introduction  CAUSES OF DEMAND/SUPPLY IMBALANCE • Imposition by governments: as quantity consumed/produced is not the efficient quantity that maximizes total benefit => deadweight loss o Price regulation (price floors/ceilings) o Taxes, subsidies & quotas • Free markets do not lead to maximization of total surplus: o Public goods o External costs o External benefits o Public goods & common resources => “free-rider” problem 30
  • Reading 13: Demand & Supply Analysis: Introduction  GOVERNMENT REGULATION & INTERVENTION • Why intervene? o To correct for negative/positive externalities: market does not reflect the true social benefit/costs (e.g. public goods) o Social consideration: child labor law, human-trafficking • Means: o Price regulation: Price ceiling & price floor o Per-unit tax: On Consumers (Excise tax) & On Producers o Other means:  Volume control: Tariffs on imported goods, quotas on import/exports  Trade banning 31
  • Reading 13: Demand & Supply Analysis: Introduction  MARKET INTERFERENCE: PRICE FLOOR Long-run Effects -Excess supply -Substitution away from the price- controlled goods Source: Schweser 2012 Example: Minimum Wage in the Labor Market: 1. Excess Supply of Labor -> Unemployment 2. Producers substitute Labor for Capital 3. Non-monetary benefits, working conditions, on-the-job training 32
  • Reading 13: Demand & Supply Analysis: Introduction • Example: Price floor A market has demand & supply function o Qd = 180 – 2P Qs = -15 + P Calculate the amount of deadweight loss that would result from a price floor imposed at a level of 72 P S Solution: 90 72 - Solve for equilibrium price & quantity 65 - Draw the demand & supply curve 51 15 D - Find the quantity demanded at price floor 72: QF ‐15 36 50 130 Q - Find the price that would lead to supplier supply at QF - Calculate deadweight loss (area of shaded triangle) 33
  • Reading 13: Demand & Supply Analysis: Introduction  MARKET INTERFERENCE: PRICE CEILING Example: Rent ceilings in the Housing Market Price ceiling transfer surplus (area a) from Long run Impacts sellers to buyers, but create deadweight loss - Long waiting time to to society purchase (Opportunity cost) - Sellers discriminate a - Sellers take bribe - Sellers reduce quantity Source: Schweser 2012 34
  • Reading 13: Demand & Supply Analysis: Introduction  MARKET INTERFERENCE: TAX OR ? OR ? Tax Imposition: Equilibrium Price Equilibrium Quantity Tax Incidence: Statutory vs. Actual Incidence Price Tax on producers Price Tax on consumers Stax D D Tax S Dtax DWL S Ptax Ptax Revenue from buyers Revenue from buyers PE E PE E Revenue from sellers Revenue from sellers PS PS Tax DWL Qtax QE Quantity Qtax QE Quantity Conclusion: Actual incidence is Independent on Who would pay 35
  • Reading 13: Demand & Supply Analysis: Introduction • Exercise: Calculate Effect of per-unit tax on Sellers Market demand curve: Q d  180  2P Market supply curve: Q s  -15  P Where price is measured in $ per unit. A tax of $2 per unit is imposed on sellers. 1. Calculate the effect on the price paid by buyers & price received by sellers 2. Demonstrate that the effect would be unchanged if the tax has been imposed on the buyers instead of sellers. Hint: 1. Calculate pre-tax equilibrium price & quantity 2. Find the inverted supply & demand functions 3. Find the new equilibrium price & quantity 4. Find the tax burden bear by each party in each case & compare 36
  • Reading 13: Demand & Supply Analysis: Introduction  TAX AND ELASTICITY OF SUPPLY & DEMAND • Supply Curve is more steep => Sellers bear a higher burden • Demand Curve is more steep => Buyers bear a higher burden Source: Schweser 2012 37
  • Reading 13: Demand & Supply Analysis: Introduction  SUBSIDIES LEADS TO OVERPRODUCTION • Subsidy is payment made by governments to producers (farmers) • With Subsidy: o Supply Curve shifts o Quantity o Equilibrium price Source: Schweser 2012 38
  • Reading 13: Demand & Supply Analysis: Introduction  QUOTAS LEADS TO UNDERPRODUCTION • Quota is an upper limit imposed on the quantity of a good that may be produced over a specific period by the governments • With Quota: o Supply Curve shifts o Quantity o Equilibrium price Source: Schweser 2012 39
  • Reading 13: Demand & Supply Analysis: Introduction  ELASTICITY: PRICE ELASTICITY OF DEMAND (PED) • As the price of a normal good increases, quantity demanded decreases (PED < 0) o Elastic demand: % increase in price leads to a larger % decrease in quantity demanded o Inelastic demand: % increase in price leads to a smaller % decrease in quantity demanded 40
  • Reading 13: Demand & Supply Analysis: Introduction  PED GRAPHICAL ILLUSTRATIONS Source: Schweser 2012 41
  • Reading 13: Demand & Supply Analysis: Introduction  ELASTICITY & REVENUE ΔQ x Px Reminder: Formula for PED   (A): Elasticity = … ΔPx Q x => Elastic/Inelastic?   1. (B): Elasticity = …  2. Price elasticity changes along the curve (C): Elasticity = … => Elastic/Inelastic?   Q: At which point is total revenue (P x Q) is maximized? A: At point B, where elasticity = -1 Total expenditure Quantity 42
  • Reading 13: Demand & Supply Analysis: Introduction  FACTORS THAT INFLUENCE PED • Availability and closeness of Substitutes o Example? • Proportion of income spent on the item o Example? • Time since the previous price change o Example? o LR demand is much more elastic than SR demand => more time to adjust • Necessity of the goods: o If goods is discretionary => less likely to reduce demand when price increases => less elastic (example: staples 43
  • Reading 13: Demand & Supply Analysis: Introduction  INCOME ELASTICITY OF DEMAND (YED) • Shows the sensitivity of quantity demanded in relation to changes in income • Elasticity > 0 : Normal goods: Income Demand o Necessity: 0 < YED <1 e.g. o Luxury: 1 < YED e.g. • Elasticity < 0 : Inferior goods: Income Demand e.g. 44
  • Reading 13: Demand & Supply Analysis: Introduction  CROSS PRICE ELASTICITY OF DEMAND (XED) • Shows the relationship between demand of good X in relation to price of another good Y • XED > 0 : Goods are substitutes e.g. • XED < 0: Goods are complements e.g. 45
  • Reading 13: Demand & Supply Analysis: Introduction • Exercise: Calculating PED, YED & XED An individual consumer’s monthly demand for downloadable e-book is given by the d equationQ d  2  0 .4 Peb  0.0005I  0.15P hb , where Q eb equals the number of e- eb books demanded each month, I is the household monthly income, Peb is the price of e- books and Phb is the price of hardbound books. Assume that price of e-book is $10.68, household income is $2,300, and the price of hardbound books is $21.40. 1. Determine the value of own-price elasticity of demand for e-books. 2. Determine the income elasticity of demand for e-books. 3. Determine the cross-price elasticity of demand for e-books with respect to the price of hardbound books. 46
  • ECONOMICS SS4: Microeconomic AnalysisReading 14: Demand & Supply Analysis: Consumer Demand Lecturer: Linh Tran January 2011
  • Reading 14: Demand & Supply Analysis: Consumer Demand MIND MAP 48
  • Reading 14: Demand & Supply Analysis: Consumer Demand  CONSUMER CHOICE THEORY • Two building blocks: o Consumer preferences: What consumer would like to consume between two goods/basket of goods? Develop Indifference curve (willingness to consume) o Budget constraint: What can be consumed with limited income? Draw Budget constraint line to determine which set of bundles is possible for consumption (Ability to consume) • By changing price & income => build up consumer demand curve 49
  • Reading 14: Demand & Supply Analysis: Consumer Demand  UTILITY THEORY • Axioms of Consumer Choice Theory: o Completeness: Must prefer either A or B or indifferent between A & B o Transitivity: A > B, B > C => A > C o Non-satiation: More is better, for at least one good • Utility Function: U  f(Qx1 ,Qx2 ,...,Qxn ) o An “assignment rule” that translates each basket of goods & services into a number that rank orders the baskets according to that particular consumer’s preference o That number = Utility of that basket (measured in utils, level of happiness) o Utility function is ordinal ranking (differences of utility do not matter) 50
  • Reading 14: Demand & Supply Analysis: Consumer Demand  INDIFFERENCE CURVE: GRAPHIC ILLUSTRATION • Non-satiation axiom: Must lie in QI & III • Convex indifference curve I IV II III • Marginal rate of substitution: Source: CFA Curriculum 2012 o MRUBW = How much wine is willing to give up to obtain a small increment of bread, holding utility constant o If diminishing as wine decreases => Indifference curve is Convex 51
  • Reading 14: Demand & Supply Analysis: Consumer Demand  INDIFFERENCE CURVE MAPS Wine Wine Increase utility Q: Can indifference curves cross? a c b Bread Bread o Completeness: Every point will have at least one indifference curve passing through o Transitivity: Two indifference curves cannot cross (a~b, a~c => b~c, but c>b) 52
  • Reading 14: Demand & Supply Analysis: Consumer Demand  GAIN FROM VOLUNTARY EXCHANGE • Two consumers (A&B) with different preferences o At a, MRSBW(A) = 0.8, MRSBW(B) = 1.25 Wine Q: Determine whether B would accept the trade of 1 of A’s bread in exchange for 1 of its wine. A: …………………………….. Q: Who has a relatively stronger preference for breads? a A’s indifference curve A: ……………………… Q: Until when will trade stop? B’s indifference curve Bread A: …………………………….. 53
  • Reading 14: Demand & Supply Analysis: Consumer Demand  BUDGET CONSTRAINT • Ability to consume/produce: is limited due to Scarcity of resources Wine (limited income, resources, time…) I PB • Budget constraint: PB QB  P QW  I I/PW QW   QB W PW PW o No saving => PB QB  PW QW  I Slope of the line • Changing prices & income: Wine I/PB Bread Wine Wine Increase in the Decrease in the Increase in price of bread price of wine income Bread Bread Bread 54
  • Reading 14: Demand & Supply Analysis: Consumer Demand  THE PRODUCTION/INVESTMENT OPPORTUNITY SET • Firms/investor face the same constraint as consumers • Production opportunity frontier: maximum number of units of one good it can produce, for any given number of the other goods • Investment opportunity Frontier: risk-free assets & diversified stock port. Juice per year Return Diversified 1 billion stock portfolio 10 billion Risk-free rate of return Milk per year Risk level 55
  • Reading 14: Demand & Supply Analysis: Consumer Demand  DETERMINATION OF CONSUMER’S BUNDLE OF GOODS Wine • Consumer equilibrium is achieved at (a) o This is the tangency point of the curve & line b  Highest indifference curve reached  Not violating budget constraint a Wa • At point a: MRUBW = PB/PW c • At point b: MRUBW < PB/PW Ba Bread Willing to give up some wine to obtain more bread • Similarly, at point c: MRUBW > PB/PW Willing to give up …………………. to obtain more …………………. 56
  • Reading 14: Demand & Supply Analysis: Consumer Demand  DERIVING A DEMAND CURVE • Can derive a demand curve for good A by changing the price of that good while keeping other prices & income constant. • Law of Demand: o As price decreases, quantity demanded increase Is this always true??? Source: CFA Curriculum 2012 57
  • Reading 14: Demand & Supply Analysis: Consumer Demand  SUBSTITUTION EFFECT & INCOME EFFECT • Pure substitution effect: always purchasing more when price falls & purchasing less when price rises. Why?? o Good A becomes relatively less costly as compared to other goods => Gets substituted for other goods in the consumption basket (Diminishing MRU) • Income effect: when price falls, real income rises => Amount of goods that can be purchased increases o Normal goods: increase in income => increase in quantity demanded o Inferior goods: increase in income => less quantity demanded 58
  • Reading 14: Demand & Supply Analysis: Consumer Demand  SUBSTITUTION & INCOME EFFECT: GRAPHS Wine Normal Goods Inferior Goods Wine c a a c b b Ba Bread Bread Bb Bc Ba Bc Bb Substitution effect Substitution effect Income effect Income effect Substitution & income effects are in the Substitution & income effects are in opposite same direction direction, but income < substitution 59
  • Reading 14: Demand & Supply Analysis: Consumer Demand  GIFFEN GOODS & VEBLEN GOODS Wine Giffen Goods Veblen Goods o Substitution & income o Conspicuous consumption: derive c are in opposite direction utility out of being known by others to o Income > substitution consume a so-called high status good a b o Value a good more if it had a higher price => Price DOES matter (signal the status of who consumes it) Bc Bread => Violate the axioms of choice (why? Ba BbSubstitution effect Income effect o Consumer would be more inclined to purchase Veblen Goods if its price rises For both cases: results in a positive demand curve 60
  • ECONOMICS SS4: Microeconomic AnalysisReading 15: Demand & Supply Analysis: The Firm Lecturer: Linh Tran February 2011
  • Reading 15: Demand & Supply Analysis: The Firm MIND MAP 62
  • Reading 15: Demand & Supply Analysis: The Firm  ACCOUNTING PROFIT, ECONOMIC PROFIT, NORMAL PROFIT • Accounting Profit = Total revenue – Total accounting (explicit) costs o Is Net income/bottom line in income statement o Includes interest paid on debt financing, but no payment to equity owners • Economic/Abnormal Profit = Accounting profit – Implicit opportunity costs o or: Economic profit = Total revenue – Total economic costs o Implicit costs: opportunity cost of equity owner’s supplied resources:  Private firm: opportunity cost of supplied capital & time/entrepreneur ability  Public firm: opportunity cost of equity owner’s investment in the firm • Normal Profit: accounting profit that makes economic profit zero (= implicit cost) o This is what an individual firm should earn in Equilibrium o The firm cover all cost of productions => no incentive to leave/enter the industry 63
  • Reading 15: Demand & Supply Analysis: The Firm • Exercise: Calculating Accounting profit & economic profit o Given the following information, calculate the accounting profit for ABC Co. Account Amount Total revenue $300,000 Expenses Fiberglass $100,000 Electricity 30,000 Wages paid 55,000 Interest paid on debt 5,000 o Assume the owner took a pay reduction of $50,000 to start the company & also invested in the business & could have earned $30,000 per year if he has invested the funds elsewhere. Calculate the economic profit 64
  • Reading 15: Demand & Supply Analysis: The Firm  SOURCES OF ECONOMIC PROFIT • Due to firm’s ability o Competitive advantage (difficult to copy technology/innovation) o Exceptional managerial efficiency or skill • Due to nature of competitiveness in the market o Exclusive access to less-expensive inputs o Fixed supply of an output, commodity, resources o Preferential treatment under government policy o Have monopoly power (price control) o Market barriers to entry that limit competition • Due to large increases in demand where supply is unable to respond fully 65
  • Reading 15: Demand & Supply Analysis: The Firm  ECONOMIC RENT • Arise when: o A particular resource/good is fixed in supply (vertical supply curve) o Market price > Cost to bring the good into the market & sustain its use (normal profit) =>Economic rent > 0 o Firm can earn significant economic profits • Example: o Limited availability in nature (land, specialty commodities ) o Constrained by government (e.g. telecommunication resources) 66
  • Reading 15: Demand & Supply Analysis: The Firm • Economic rent illustration: Gold demand & supply Economic rent is higher when supply is inelastic Source: Schweser 2012 Year 2006 2007 2008 % change 2006 - 2008 Supply (metric tons) 3,569 3,475 3,508 -1.7 Demand (metric tons) 3,423 3,552 3,805 +11.2 Avg. spot price (US$) 603.92 695.39 871.65 +44.3 Source: GFMS & World Gold Council 67
  • Reading 15: Demand & Supply Analysis: The Firm  COMPARING MEASURE OF PROFIT • Normal profit is fixed in the SR, but will vary with required rate of return on equity investment in the LR • Relationship between accounting profit & normal profit Relation between Accounting Firm’s Market Economic Profit profit and Normal profit Value or Equity Accounting profit > Normal profit Economic profit > 0 and firm is able to Positive effect protect economic profit over the LR Accounting profit = Normal profit Economic profit = 0 No effect Accounting profit < Normal profit Economic profit < 0 implies economic Negative effect loss 68
  • Reading 15: Demand & Supply Analysis: The Firm  TOTAL, AVERAGE AND MARGIN REVENUE • Total revenue (TR) = P x Q • Average revenue (AR) = TR / Q • Marginal revenue (MR): increase in total revenue from selling one more unit. Quantity Price Total revenue Average revenue Marginal Revenue (a) (b) (c) = (a)*(b) (d) = (c)/(a) 1 70 70 70 70 2 65 130 65 60 3 60 4 55 5 50 6 45 7 40 69
  • Reading 15: Demand & Supply Analysis: The Firm  PERFECT COMPETITION: TR, AR AND MR • Horizontal demand curve • All units are sold at the same price regardless of quantity: AR=MR=Price Source: CFA Curriculum 2012 70
  • Reading 15: Demand & Supply Analysis: The Firm  IMPERFECT COMPETITION: TR, AR, MR Revenue • Downward-sloping demand curve TR • Firms are price searchers (to sell a greater quantity => must reduce price) Q0 Q1 Quantity of Output • MR < Price (for Q >1) & MR  AR Revenue, Price (Why???) • Decrease in MR is more than P = AR - Demand MR decrease in AR Q0 Q1 Quantity of Output 71
  • Reading 15: Demand & Supply Analysis: The Firm  FACTORS OF PRODUCTION • Inputs to the firm’s production include: o Land o Capital (facilities, equipment, machinery) o Labor (skilled & unskilled) o Materials (raw materials, manufactured inputs) • Production function: Q = f(K,L) (subject toK  0, L  0 ) Holding capital constant: Total Product/Quantity B o L0 L1: increasing MP of labor Q2 TP o L1 L2: decreasing MP of labor A o L1 …: MP of labor <0 Q1 At B, Total Product is maximized L0 L1 L2 Quantity of Labor 72
  • Reading 15: Demand & Supply Analysis: The Firm  OUTPUT & TOTAL COST Total Cost (TC) = Total Fixed Cost (TFC) + Total Variable Cost (TVC) o Total fixed cost (TFC)  Equals cost of fixed inputs & normal profit  Is independent of firm’s output level in the SR  Example: rent, PPE o Total variable cost (TVC)  Equals cost of all variable production inputs Source: CFA Curriculum 2012  TVC increases as output increases  Example: labor, raw material 73
  • Reading 15: Demand & Supply Analysis: The Firm  AVERAGE & MARGINAL COST CURVES • AFC slopes downwards • Vertical difference between ATC & AVC is equal to AFC (x) • ATC & AVC are U-shaped • MC initially, then , due to diminishing returns of labor • MC intersects AVC & ATC at their Shirts minimum point Source: Schweser 2012 per day 74
  • Reading 15: Demand & Supply Analysis: The Firm • Exercise: Calculate AFC, AVC, ATC & MC Q TFC* TVC AFC AVC TC ATC MC (1) (2) (3) (4)=(2)/(1) (5)=(3)/(1) (6)=(2)+(3) (7)=(4)+(5) 0 5,000 0 -- -- 5,000 -- -- 1 5,000 2,000 5,000 2,000 7,000 7,000 2,000 2 5,000 3,800 2,500 1,900 8,800 4,400 1,800 3 5,000 5,400 4 5,000 8,000 5 5,000 11,000 6 5,000 15,000 7 5,000 21,000 8 5,000 28,800 *: Include all opportunity cost 75
  • Reading 15: Demand & Supply Analysis: The Firm  SHUTDOWN AND BREAK-EVEN POINTS OF PRODUCTION • Shutdown point: Where AR = AVC o If AR < AVC: Firm stops production but still have to pay fixed costs o If AVC<AR<ATC: firm starts to produce to cover variable cost & some fixed cost. But does not break-even => only survives in the short run So: Short run supply curve is the MC curve that lies above the AVC curve • Break-even point: Where price = AR = MR = ATC, or TR = TC Revenue‐Cost relationship Short‐run Decision Long‐term Decision TR >=TC Stay in market Stay in market TR>TVC but TR <TC Stay in market Exit market TR < TVC Shut down production to zero Exit market 76
  • Reading 15: Demand & Supply Analysis: The Firm • Perfection competition: shutdown and break-even points Find shutdown point & break-even point in the following diagram Source: CFA Curriculum 2012 77
  • Reading 15: Demand & Supply Analysis: The Firm  OUTPUT OPTIMIZATION & PROFIT-MAXIMIZATION • Profit maximization occurs when: o Difference between TR & TC is the greatest o MR = MC o Revenue of the output from the last unit of input employed = the cost of employing that input unit 78
  • Reading 15: Demand & Supply Analysis: The Firm • Illustration: Perfect Competition: Break-even & Profit maximizing In a perfect competition market: TR is a straight line Source: CFA Curriculum 2012 79
  • Reading 15: Demand & Supply Analysis: The Firm • Example: Breakeven Analysis & Profit Maximization Q Price TR TC Profit In an imperfect competition market: (1) (2) (3)=(1)*(2) (4) (5)=(3)-(4) Q1: What is the breakeven point? 0 10,000 0 100,000 (100,000) 10 9,750 97,500 170,000 (72,500) 20 9,500 190,000 240,000 (50,000) Q2: Where is the region of profitability? 30 9,250 277,500 300,000 40 9,000 360,000 50 8,750 420,000 Q3: What is the profit-maximizing point? 60 8,500 480,000 70 8,250 550,000 80 8,000 640,000 Q4: Where does economic loss occur? 90 7,750 710,000 100 7,500 800,000 *: Include all opportunity cost 80
  • Reading 15: Demand & Supply Analysis: The Firm  LONG-RUN & SHORT-RUN COST CURVES • Short run cost curves: apply to a specific size of plant (some input quantities are fixed) • Long run cost curves: indicate the optimal quantity at different plant sizes (everything can be adjusted). • Firms can have the same LRATC but at different positions, depending on Source: Schweser 2012 their operating size 81
  • Reading 15: Demand & Supply Analysis: The Firm  ECONOMIES OF SCALE Long Run Cost Curve = planning curve 1. Increasing bureaucracy 1. Mass production 2. Difficult to motivate workforce 2. Specialization 3. Barriers to innovation & entrepreneur activities 3. Experience 4. Principal-agent problem 82
  • Reading 15: Demand & Supply Analysis: The Firm • Illustration: Long-run profit maximization & Minimum efficient scale under Perfect Competition Source: CFA Curriculum 2012 83
  • Reading 15: Demand & Supply Analysis: The Firm  INCREASING, DECREASING & CONSTANT COST INDUSTRY • LR Industry supply: Relationship between quantity & output prices o Firms are able to enter/exit based on level of ST profit o Changes in output influence resource (input) prices in the LR o Shapes depend on resources costs, technological level, production efficiency & economies of scale of resource supplier Source: CFA Curriculum 2012 84
  • Reading 15: Demand & Supply Analysis: The Firm  TOTAL, MARGINAL & AVERAGE PRODUCT OF LABOR • Productivity: measured in terms of output per workers/labor hour • Cost minimizing/profit maximizing goal => maximize productivity • Measuring productivity: o Total Product : TP = Q (L, K) (K fixed) TP Q o Average Product : AP   L L TP Q o Marginal Product: AP   L L (assume other inputs are fixed) measured productivity of an individual additional worker 85
  • Reading 15: Demand & Supply Analysis: The Firm • Example: Calculate Total, marginal & average product of labor 86
  • Reading 15: Demand & Supply Analysis: The Firm  DIMINISHING MARGINAL PRODUCT OF LABOR Diminishing marginal returns to labor occur Maximum MP Source: Schweser 2012 Marginal product, holding other inputs constant, first increases then decreases 87
  • Reading 15: Demand & Supply Analysis: The Firm  COST CURVES & PRODUCT CURVES Source: Schweser 2012 88
  • Reading 15: Demand & Supply Analysis: The Firm  CHOOSING INPUTS TO MINIMIZE COST MPinput • Firms want to maximize output per monetary unit of input costs: Priceinput • When using n different resources, the least cost optimization formula is: MP1 MP2 MPn   ...  Price1 Price 2 Price n o i.e. Additional output per dollar spent to employ one additional unit of each input must be the same. • Example: with two inputs Labor & Capital o PL = $75, PK = $600, MPL= 5 units, MPK = 30 units o Compute MPK/PK & L/PL o What input to be reduced to reduce cost of production? 89
  • Reading 15: Demand & Supply Analysis: The Firm  MARGINAL REVENUE PRODUCT • Marginal Product: Addition output of a final product produced from one more unit of a productive input, holding other inputs constant • Marginal Revenue: Additional revenue gained from selling one more unit of output • Marginal Revenue Product (MRP) Additional revenue gained from selling the marginal product from employing one more unit of a productive input, holding other inputs constant • MRP = Marginal Product x Marginal Revenue = Marginal Product x Product Price (assume perfect competition)
  • Reading 15: Demand & Supply Analysis: The Firm  PROFIT MAXIMIZING UTILIZATION OF AN INPUT • Profit-maximizing quantity of an input i: MRPi = Pi o Firms can increase profits by employing another unit of input i as long as MRPi > Pi • With cost minimizing condition: MP1  MR output MP2  MR output MPn  MR output   ...  Price1 Price 2 Price n MRP1 MRP2 MRPn =>   ...  1 P1 P2 Pn
  • ECONOMICS SS4: Microeconomic AnalysisReading 16:The Firms and Market Structures Lecturer: Linh Tran February 2011
  • Reading 16:The Firms and Market Structures MIND MAP 93
  • Reading 16:The Firms and Market Structures  CHARACTERISTICS OF DIFFERENT MARKET STRUCTURES • Differentiate based on o Number of firms and their relative sizes o Elasticity of the demand curves they face o Ways that they compete with other firms for sales o Ease/difficulty with which firms can enter/exit the market Increasing degree of competition Monopoly Oligopoly Monopolistic Perfect Competition Competition 94
  • Reading 16:The Firms and Market Structures  CHARACTERISTICS SUMMARY Perfect Monopolistic Oligopoly Monopoly Competition Competition # of sellers Many firms Many firms Few firms Single firm Barriers to entry Very low Low High Very high Nature of Very good Good substitutes Very good No good substitute substitutes but differentiated substitutes or substitute product differentiated Nature of Price only Price, marketing, Price, marketing, Advertising competition features features Pricing power None Some Some to significant Significant 95
  • Reading 16:The Firms and Market Structures  PERFECT COMPETITION: CHARACTERISTICS 1. Homogeneous products 2. Large number of independent firms; each small relative to the total market 3. No barriers to entry or exit 4. Market supply & demand determine market price Example: 96
  • Reading 16:The Firms and Market Structures  PERFECT COMPETITION: FIRMS ARE PRICE TAKERS 1. No influence over market price 2. “Take” the equilibrium price as given 3. Firm’s demand curve is perfectly elastic => horizontal MR = Price as all additional units are sold at the same (market) price Source: Schweser 2012 97
  • Reading 16:The Firms and Market Structures  PERFECT COMPETITION: MARKET & FIRM DEMAND CURVE Source: Schweser 2012 98
  • Reading 16:The Firms and Market Structures  PERFECT COMPETITION: SHORT RUN PROFIT Source: Schweser 2012 Economic profit > 0 when ??? Q: What happens next? 99
  • Reading 16:The Firms and Market Structures  EQUILIBRIUM IN PERFECT COMPETITION A: New firms enter the market, market supply , price so that P = ATC Source: Schweser 2012 No Economic Profit!! 100
  • Reading 16:The Firms and Market Structures  PERFECT COMPETITION: SHORT-RUN LOSS Q: will it continue operation? Minimizing loss when AVC < P < ATC Shutdown point: P = AVC P < AVC: shutdown, only pay fixed cost Source: Schweser 2012 Economic Loss when ??? 101
  • Reading 16:The Firms and Market Structures  PERFECT COMPETITION: FIRM & INDUSTRY SR SUPPLY CURVES Source: Schweser 2012 Market supply curve = horizontal sum of all firm supply curves 102
  • Reading 16:The Firms and Market Structures  INCREASE IN DEMAND Price Price SR Industry  MC = SR Firm Supply supply P2 P2 D2 P1 D2 P1 D1 D1 Q1  Q2  Quantity Q1 Firm Q2 Firm Quantity Economic profit -> New firm enters -> Industry supply curve shift outwards -> equilibrium price, equilibrium output Individual firms move down its supply curve-> economic profit Economic loss -> …??? 103
  • Reading 16:The Firms and Market Structures  PERMANENT DEMAND CHANGES Source: Schweser 2012 104
  • Reading 16:The Firms and Market Structures  DEMAND CHANGES & TECHNOLOGICAL IMPROVEMENT Long run equilibrium price after a permanent increase in demand can be: •Lower (economies of scale) (input •Higher (diseconomies of scale) (input prices fall) => LR supply curve is prices increase) => LR supply curve is Source: Schweser 2012 105
  • Reading 16:The Firms and Market Structures  PERFECT COMPETITION: TECHNOLOGICAL CHANGES • After adjustments take place for some firms -> Firm & industry’s supply curve shift to the right -> Higher quantity, lower price • Short run: Economic profit for early adopters • Long run: o Price = min ATC for new technology o Zero economic profit 106
  • Reading 16:The Firms and Market Structures  MONOPOLISTIC COMPETITION: CHARACTERISTICS • A large number of independent firms o Small market share, no power over price o Only need to care about market price o No collusion • Differentiated products (substitutes to each other) • Firms compete on price, quality, and marketing • Low barriers to entry & exit • Downward-sloping, highly elastic demand curve Example: ??? 107
  • Reading 16:The Firms and Market Structures  MONOPOLISTIC COMPETITION: OUTPUT DECISION Short run Output decision for a firm Long run Output decision for a firm Price Price MC Short run profit MC Firms enter, price ATC fall ATC P* ATC* P = ATC* D MC = MR D MR MR Q Quantity Q Quantity No positive economic profits in the long run! 108
  • Reading 16:The Firms and Market Structures  MONOPOLISTIC COMPETITION VS. PERFECT COMPETITION Source: Schweser 2012 Mark up = P – ATC > 0 Excess capacity: Q < efficient quantity (at min ATC) 109
  • Reading 16:The Firms and Market Structures  EFFICIENCY OF MONOPOLISTIC COMPETITION • Allocative efficiency is not clear: o Social cost of not producing where P = MC => Mark up for producers o Long run average cost is not minimized => Excess capacity o Additional costs of advertising, innovation & building brand names • However, there are some benefits: o Increased Product diversity, greater Product innovations o More information from Brand names & advertising => signal quality for better decision making (?) Q: Does the benefit from advertising, innovation, differentiation of products justify its costs?? 110
  • Reading 16:The Firms and Market Structures  INNOVATION, ADVERTISING & BRANDING • Innovation & Product Development o Less elastic demand => can increase price & earn economic profits o But this advantage will be erode over time. (Why ?) o Firms must continually look for new innovation => additional costs • Advertising & Branding o To inform the unique features & quality of their products o Advertising cost for firms in monopolistic competition is the greatest. But if advertising can greatly increase sales, ATC may fall because AFC falls o Brand names are invaluable assets as it signals the quality 111
  • Reading 16:The Firms and Market Structures  OLIGOPOLY: CHARACTERISTICS • A small number of sellers • Interdependence among competitors o Highly dependent upon the action of others • Significant barriers to entry (economies of scale) • Products may be similar or differentiated Example: ??? 112
  • Reading 16:The Firms and Market Structures  OLIGOPOLY MODELS • Kinked-demand curve model o Competitor will NOT follow a price INCREASE o Competitor WILL follow a price DECREASE • Cournot Model o 2 firms (duopoly), with identical & constant marginal cost of production o Must determine quantity based on assumptions about other’s quantity • Nash equilibrium model (Prisoner’s dilemma) • Stackelberg dominant firm model 113
  • Reading 16:The Firms and Market Structures  OLIGOPOLY: KINKED-DEMAND MODEL Firms will not follow price Price MR (P > P*) increase MCB Current Price P* MCA MR (P < P*) Firms will follow price decrease Demand Q* Quantity Profit‐maximizing output • Shortcoming: Model is incomplete as what determine the market price (kinked price) is outside the scope of the model 114
  • Reading 16:The Firms and Market Structures  COURNOT DUOPOLY MODEL • 2 firms (A & B) are identical, have constant marginal costs of production o Previous quantities produced can be observed QA & QB • Equilibrium mechanism: o A assumes B will keep produce QB for the next period o A derives its own demand curve (= market demand – QB) & marginal revnue o A determines its profit-maximizing quantity & B does the same • Results: o Adjust until Q A = QB = Q/2 o Perfect competition price < Equilibrium price < Monopoly price o If more firms are added: price falls to MC => perfect competition 115
  • Reading 16:The Firms and Market Structures  PRISONERS’ DILEMMA & OLIGOPOLY Prisoner B Why??? Optimal solution Keeps silent Confesses Keeps A gets 10 years Actual Each gets 6 months silent B is free result Prisoner A A is free Confesses Each gets 2 years B gets 10 years Firm B For Firms Honors Cheats Both earns (+) economic A has economic loss Honors profits B earns increased profits Firm A A earns increased profits Both earns ZERO economic Cheats B has economic loss profits What will be the final result? 116
  • Reading 16:The Firms and Market Structures  TWO-FIRM OLIGOPOLY WITH & WITHOUT COLLUSIONS Without Collusion Source: Schweser 2012 117
  • Reading 16:The Firms and Market Structures  TWO-FIRM OLIGOPOLY WITH & WITHOUT COLLUSIONS With Collusion: Both firms collude to behave like a monopoly Source: Schweser 2012 => Price fixing to earns Economic Profit 118
  • Reading 16:The Firms and Market Structures  OLIGOPOLY: WHEN COLLUSION IS POSSIBLE? • Cheating is easy to detect • Fewer firms in the market • Threat of new entrants is low • Enforcement of anti-collusion laws & penalties for colluding are weak 119
  • Reading 16:The Firms and Market Structures  DOMINANT FIRM OLIGOPOLY • A dominant firm (DF) with cost- Price MCCF advantage & a large market share MCDF => Acts like a monopoly, is a price- setter, produces where MC = MR P* Market • Other competitive firms (CF) are Demand price-follower and produce where DDF MC = P MRDF QCF QDF Quantity 120
  • Reading 16:The Firms and Market Structures  MONOPOLY: CHARACTERISTICS • One seller of a specific, well-defined product that has no good substitute. • Barriers to entry are high, due to: o Economies of scale (natural monopoly e.g. electric utility) o Government licensing (patents, e.g. pharmaceutical) & legal barriers (e.g. broadcasting station, utility) o Resource control 121
  • Reading 16:The Firms and Market Structures  MONOPOLY: PRICING • Monopoly faces a downward-sloping demand curve, unlike perfect competition • In order to increase quantity , a monopoly must reduce price as there is a trade-off between price & quantity • Price-setting strategy to maximize profit to firm: 1. Single-price 2. Price discrimination (if resell is impossible) 122
  • Reading 16:The Firms and Market Structures  MONOPOLY: COSTS, PRICE AND REVENUE Optimal quantity Q* is in the elastic range of the demand curve MC = MR Source: Schweser 2012 Monopolists are price searchers and have imperfect information regarding market demand 123
  • Reading 16:The Firms and Market Structures  MONOPOLY: PRICE DISCRIMINATION Price discrimination: charging different customers different prices for the same produce or service. Examples: tickets When is it possible? • Have a downward-sloping demand curve • Have at least 2 identifiable customer groups with different price elasticities of demand for the product • Can prevent customers from reselling the product 124
  • Reading 16:The Firms and Market Structures  MONOPOLY: PRICE DISCRIMINATION - GRAPHS Efficient  quantity A Source: Schweser 2012 DWL due to the reduction in Can capture the higher-elastic- quantity & the increase in price demand group at a lower price $90 125
  • Reading 16:The Firms and Market Structures  MONOPOLY: PERFECT PRICE DISCRIMINATION With perfect price discrimination: • Charge each customer the maximum amount they would pay for • Produce the same quantity as under perfect competition (point A) (Capture all points on the demand curve ) • No Deadweight Loss • No consumer surplus, the entire surplus goes to the monopoly 126
  • Reading 16:The Firms and Market Structures  MONOPOLY VS. PERFECT COMPETITION Perfect competition: QPC & PPC Monopoly: QMON< QPC & PMON> PPC =>Deadweight loss, as (Producer surplus + Consumer surplus) is not maximized Source: Schweser 2012 Rent seeking: producers spend time & resources to seek for monopoly power 127
  • Reading 16:The Firms and Market Structures  NATURAL MONOPOLY Significant economies of scale: • Fixed costs are very high & variable costs are low • ATC decreases as output increases => ATC is minimized only when there is one firm • Example ??? Economies of scope • Production uses same capital resources • ATC declines as ranges of goods produced increases • Example ??? 128
  • Reading 16:The Firms and Market Structures  REGULATING MONOPOLIES Regulate the prices the monopoly may charges: 1. Average cost pricing: • Reduce price to where ATC intersects D • Increase output & social welfare • Economic profit = 0 A 2. Marginal cost pricing • Reduce price to where MC B intersects D Source: Schweser 2012 • Efficient regulation • May require subsidy, if MC < ATC Problems with regulation: • Lack of information • Quality regulation • Cost shifting • Special interest effect 129
  • Reading 16:The Firms and Market Structures  IDENTIFYING MARKET STRUCTURE • Econometric method: To estimate the elasticity of supply & demand by regression methods (cross-sectional or time series) o But requires lots of data • Simpler method: Concentration ratio & HHI Index o N-firm concentration ratio: sum of the % market share of the top N largest firms 0% 40% 60% 100% Competitive Perfect Oligopoly market Monopoly Competition 130
  • Reading 16:The Firms and Market Structures  IDENTIFYING MARKET STRUCTURE (cont.) • Simpler method: o Herfindahl-Hirschman Index (HHI): sum of the squared % market share of the top 50 largest firms • Limitations of Concentration Ration o N-Concentration Ratio is insensitive to mergers of two large firms o Both N-Concentration Ratio & HHI do not consider barriers to entry & potential competition 131