Demand, Supply and market equilibrium

1. A2 Micro Business Economics Diagrams
Advice on drawing diagrams in the exam
• The right size for a diagram is ½ of a side of A4 – don’t make them too small – if needed,
move onto a new side of paper rather than squeezing a diagram in at the bottom of a page
• Avoid wrapping text around the diagram – leave a line between the text and your page
• Avoid directional arrows they clutter up the diagram and add little to it
• Remember to label each curve clearly so that it is clear which curves are shifting
• Remember to label carefully and accurately both the x and the y axis
• Draw diagrams to the right technical level; don’t resort to simple supply and demand analysis
when more complex cost and revenue curves are required (remember that this is A2!)
Diagrams included in this revision document
1. The law of diminishing returns
2. Fixed and variable costs in the short run
3. Changes in variable costs and the effect on the profit maximising price, output and profit
4. The long run minimum efficient scale
5. Economies and diseconomies of scale in long run production and the effect on profits
6. A natural monopoly and economic efficiency
7. Understanding average, marginal and total revenue
8. Different objectives of businesses – effect on price, output and profit
9. The shut down price for a business in the short run
10. Short and long run in perfect competition and comparison with pure monopoly
11. Entry barriers for a monopolist and economies of scale with a monopoly
12. Price discrimination (i) peak and off-peak pricing (ii) 3rd
degree discrimination
13. Oligopoly – the kinked demand curve model
14. Game theory – price collusion and the economics of a cartel
15. Elasticity of demand and pricing power for a business in imperfect competition

2. Total
Output
(Q)
Units of Labour Employed (L)
(Q)
Slope of the curve gives the
marginal product of labour
Diminishing returns are
apparent here – total output is
rising but at a decreasing rate
I.e. the marginal product of
labour is increasing
The short run is a period of time where at least one factor of production is assumed to be
in fixed supply i.e. it cannot be changed.
In the short run, the law of diminishing returns states that as we add more units of a
variable input (i.e. labour or raw materials) to fixed amounts of land and capital, the
change in total output will at first rise and then fall.
In many industries as a business expands in the long run, it is more likely to experience
increasing returns leading to lower unit costs of production.

3. Fixed and variable costs in the short run
Costs
Output (Q)
Total Fixed Cost
Average Fixed
Cost
10
£2000
£1000
20
Fixed costs (FC) are independent of output and must be paid out even if the
production stops. Capital-intensive industries with a high ratio of fixed to variable
costs offer scope for economies of scale. AFC = Fixed Costs (FC) / Output (Q).
Costs
Output (Q)
Average Fixed
Cost
Marginal Cost
(MC)
Average Total
Cost (AC)
Average
Variable Cost
(AVC)
• These are the “traditional” short run cost curves
• Marginal cost cuts both AVC and ATC at the minimum point of each
• Your diagrams need to be accurate so it is worth practising them as often as
possible to improve your accuracy

4. Changes in variable costs and the effect on the profit maximising price; output and profit
Costs
Output (Q)
AC1
MC1
AC2
Costs
Output (Q)
AC1
MC1
AC2
Higher variable costs – the effect on equilibrium prices and profits (ceteris paribus)
AR
MR
AC1
AC2
P1
P2
Q1
Q2
Profit after cost rise
Important: A rise in fixed costs has no effect on marginal cost – it simply causes an upward
shift in the average cost curve. But a rise in variable cost causes a shift in both MC and AC

5. Long run minimum efficient scale of production (MES)
Cost
per
unit in
the
long
run
LRAC
MES
Rising LRAC – Diseconomies of Scale
(Decreasing Returns to Scale)
In the long run, all factors of production are variable. How the output of a business
responds to a change in factor inputs is called returns to scale. Economies of scale are
the cost advantages exploited by expanding the scale of production in the long run.
The effect is to reduce long run average costs over a range of output.
The minimum efficient scale (MES) is the scale of production where internal economies
of scale have been fully exploited. The MES corresponds to the lowest point on LRAC
and is an output range over which a business achieves productive efficiency. The MES
will differ from industry to industry as we can see from the diagram below.
LRAC1 - Low MES –
characteristic of a
competitive market
LRAC3 - High MES –
characteristic of a
natural monopoly
LRAC2
MES2
Output (Q)
Falling LRAC – Economies of Scale (Increasing
Returns to Scale)
Costs
per
unit in
the
long
run
(ATC)
Output (Q)
LRAC1
LRAC3
MES1 MES3

6. Economies and dis-economies of scale in long run and the effect on profits
Deriving the long run average cost curve – the envelope of a series of short run average cost curves
Lower costs allows a profit
maximising firm to charge a
lower price (P2) but make
higher total profits because of
the fall in AC per unit
Costs
Output (Q)
SRAC1
SRAC3
AR
(Demand)
MR
MC1
MC2
P1
P2
Q1 Q2
Profit at Price P1
Profit at Price P2
Costs
Output (Q)
SRAC1
SRAC2
SRAC3
Q1 Q2 Q3
AC1
AC2
AC3
LRAC

7. Natural monopoly and economic efficiency
Demand (AR)
Revenue
Cost and
Profit
Output
(Q)
MR
LRMC
LRAC
P1
AC1
Q1 Q2
P2
AC2
Profit at
price P1
Loss at
price P2
A natural monopoly – splitting infrastructure from the final delivery of services
A natural monopoly occurs in an industry where LRAC falls over a wide range of output levels such
that there may be room only for one supplier to fully exploit all of the internal economies of scale,
reach the minimum efficient scale and therefore achieve productive efficiency.
The major utilities such as gas, electricity and water are often put forward as examples of industries
with strong "natural tendencies" towards being a natural monopoly in part because of the huge fixed
costs of building and maintaining nationwide networks / infrastructures of cables and pipes.
In fact we can make an important distinction between the supply and distribution of services such as
gas and electricity and web services.
Often a monopolistic firm is in charge of maintaining a network but a regulator will seek to inject
competition into the market by allowing new firms to come in a use the existing network and compete
for customer contracts in the delivery of services. Good examples include the liberalisation of postal
services and also the decision by OFCOM to force British Telecom to open up its networks to
household and business customers so that rival firms can compete for the market demand in
telecommunication services.

8. Understanding average, marginal and total revenue
Output
(Q)
Revenue
Total Revenue
(TR)
Marginal Revenue
(MR)
Average Revenue
(Demand) AR
Total revenue is
maximized when
MR = 0
Price elasticity of
demand = 1 at this
output
Ped >1 for a price
fall along this
length of AR
Output (Q)
AR
(Demand)
MR
Q1
P1
Total revenue is maximised at price P1 where
marginal revenue is zero
A rise in price to P2 causes a reduction in total
revenue
P2
Q2
Total revenue at price P2
Average and
marginal
revenue

9. Different objectives of businesses – effect on price, output and profit
Costs
Output (Q)
SRAC
AR
(Demand)
MR
MC
Q1
P1
AC1
Profit Max at Price P1
P2
AC2
Q2
Revenue Max at Price P2
It is now widely accepted that modern businesses depart frequently from pure profit
maximisation pricing strategies as part of competition within markets. The objectives and
strategies of firms will vary with market conditions and with the aims of the different
stakeholders that are part of the decision-making process in modern corporations.
The normal profit maximising output is at Q1 (where marginal revenue = marginal cost)
Total revenue is maximised at output Q2 where marginal revenue is zero. This gives a lower
level of total profits, although supernormal profits are still being earned.
If shareholders insist on the business achieving a normal rate of profit as a minimum then
the managers of a business have the discretion to vary price anywhere above P3
At any output beyond Q3 (where average revenue and average cost intersect) losses are
made (i.e. sub-normal profits).
Be aware of the reasons for firms moving away from profit maximisation and also the effects
of different price strategies on consumer and producer welfare and economic efficiency.
Q3
P3

10. The shut down price for a business in the short run
Costs,
Revenues
Output (Q)
ATC
MC = supply
AVC
P1
The Shut Down Price
P2
Break-Even Price
Q1
The shut down price for a business in the short run
The theory of the firm assumes that a business needs to make at least normal profit in
the long run to justify remaining in an industry but this is not a strict requirement in the
short term.
In the short run the firm will continue to produce as long as total revenue covers total
variable costs or put another way, so long as price per unit > or equal to average
variable cost (AR = AVC).
The reason for this is as follows. A business’s fixed costs must be paid regardless of
the level of output. If we make an assumption that these costs are sunk costs (i.e. they
cannot be covered if the firm shuts down) then the loss per unit would be greater if the
firm were to shut down, provided variable costs are covered.
In the short run, the supply curve for a competitive firm is the marginal cost curve
above average variable cost.
P2

11. Short and long run in perfect competition
Output (Q)
Output (Q)
Market Demand and Supply Individual Firm’s Costs and Revenues
Price (P) Price (P)
Market
Demand
Market
Supply
(MS)
P1
Q1
AR1 = MR1
MC (Supply)
AC
P1
Q3
P2 P2
AR2 = MR2
Q2
MS2
P
2
Long run
equilibrium
output
No barriers to entry and super normal profits encourage the entry of new firms shifting
market supply & price downward until price falls back to P2. Normal profits are restored.
Output (Q)
Competitive Market Pure Monopoly
Price (P) Price (P)
Market
Supply
Market
Demand
Market
Supply
Monopoly
Demand
Q1 Q1
MR
P comp
P mon
Q2

12. Entry barriers for a monopolist and monopoly with economies of scale
LRAC = LRMC
(Existing Monopolist)
Monopoly
Demand
(AR)
MR
Q1
Revenue
Cost and
Profit
Output
(Q)
P1
Pc
Qc
B
A
C
AC = MC (Potential
Entrant into the
market)
D
Monopoly
Supply with
Scale
Economies
Output (Q)
Competitive Market Pure Monopoly
Price (P) Price (P)
Market
Supply
Market
Demand
Competitive
Supply (MC)
Monopoly
Demand
Q1 Q1
MR
P comp
P mon
Q2

13. Price discrimination (i) peak and off-peak pricing (ii) 3rd
degree discrimination
Supply (Marginal
Cost)
Off-Peak
Demand
Peak Demand
MR Off-Peak
MR Peak
Price Off-Peak
Price Peak
Output Off-Peak Output Peak
Price (P) and
Costs
Output
Market
A
Market
B
MC=A
C
Quantit
y
Quantit
y
Pric
e Pric
e
P
a
P
b
MR
a
MR
b
AR
b
AR
a
Profit from selling to
market A – with a
relatively elastic
demand – and
charging a lower price
Demand in segment B of
the market is relatively
inelastic. A higher unit
price is charged
MC=A
C
Q
b
Q
a

14. Oligopoly – the kinked demand curve model
Assume we start out at P1 and Q1:
Will a firm benefit from raising price above P1?
Will it benefit from cutting price below P1?
Raising price above P1
Demand is relatively elastic
Firm loses market share and some
total revenue
Reducing price below P1
Demand is relatively inelastic
Little gain in market share – other firms
have followed suit
Total revenue may still fall
Costs
Revenues
Output (Q)
P1
Q1
MR
AR
MC1
An oligopoly is a market dominated by a few producers, each of which has control over
the market. It is an industry where there is a high level of market concentration. However,
oligopoly is best defined by the conduct (or behaviour) of firms within a market
rather than its market structure.
The kinked demand curve model assumes that a business might face a dual demand
curve for its product based on the likely reactions of other firms in the market to a
change in its price or another variable. The common assumption is that firms in an
oligopoly are looking to protect and maintain market share and that rival firms are
unlikely to match another’s price increase but may match a price fall. I.e. rival firms within
an oligopoly react asymmetrically to a change in the price of another firm.
The kinked demand curve model therefore makes a prediction that a business might
reach a stable profit-maximizing equilibrium at price P1 and output Q1 and have little
incentive to alter prices. Even a shift in the marginal cost curve (MC1) in the diagram
above might not be enough to change the profit maximizing equilibrium.
The kinked demand curve model predicts periods of relative price stability under an
oligopoly with businesses focusing on non-price competition as a means of
reinforcing their market position and increasing their supernormal profits.

15. Game theory – price collusion and the economics of a cartel
Individual
Firm
Industr
yy
Firms
Output
MC
(industry)
Deman
d
M
R
P(cartel
)
M
C
A
C
Quot
a
Industr
y
Output
P(cartel
)
A
C
Collusion is a desire to achieve joint-profit maximization within a market or prevent price and
revenue instability in an industry.
Price fixing represents an attempt by suppliers to control supply and fix price at a level close to
the level we would expect from a monopoly.
To fix prices, the producers in the market must be able to exert control over market supply. In
the diagram below a producer cartel is assumed to fix the cartel price at output Qm and price
Pm. The distribution of the cartel output may be allocated on the basis of an output quota
system or another process of negotiation.
Although the cartel as a whole is maximizing profits, the individual firm’s output quota is
unlikely to be at their profit maximizing point. For any one firm, within the cartel, expanding
output and selling at a price that slightly undercuts the cartel price can achieve extra profits.
Unfortunately if one firm does this, it is in each firm’s interests to do exactly the same. If all
firms break the terms of their cartel agreement, the result will be an excess supply in the
market and a sharp fall in the price. Under these circumstances, a cartel agreement might
break down.
Collusive behaviour is often predicted by game theory
Game theory is concerned with predicting the outcome of games of strategy in which the
participants (for example two or more businesses competing in a market) have incomplete
information about the others' intentions. Collusive behaviour reduces some of the uncertainty
that is characteristic of oligopolistic markets.

16. Elasticity of demand and pricing power for a business in imperfect competition
Price
and
Costs
Output (Q)
SRAC
AR
(Monopoly)
MR
MC
Q1
P1
AC1
Low Price Elasticity of Demand
SRAC
MR
MC
P1
AC1
Q2
Price
and
Costs
Low Price Elasticity of Demand
AR
(Contestable
market)
The importance of price elasticity of demand in theory of the firm
Price elasticity of demand is a concept that was introduced at AS level. Horizontal synopticity
requires you to apply the concept in theory of the firm diagrams. A good example of when this
can be done is on questions on contestable markets
Highly contestable markets
Baumol defined contestable markets as existing where “an entrant has access to all
production techniques available to the incumbents, is not prohibited from wooing the
incumbent’s customers, and entry decisions can be reversed without cost.”
For a contestable market to exist there must be low barriers to entry and exit so that there is
always the potential for new suppliers to come into a market to provide fresh competition to
existing suppliers. For a perfectly contestable market, entry into and exit out of the market
must be costless.
When a market is contestable there are likely to be a large number of competing suppliers; the
cross-price elasticity of demand will be high because of strong substitution effects when
relative prices in a market change. Hence we can draw the average revenue curve to be price
elastic.
This reduces the potential for a business to charge a price that is well above the marginal cost
of production. Profit margins are lower, output is higher and consumer welfare is great than it
would be with a monopolist exploiting an inelastic demand curve (see left hand diagram).