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  1. 1. 1 MICROECONOMICS1: Microeconomics is concerned with the individual parts of the economy. It is concerned with the demand and supply of particular goods and services and resources. It focuses in other words on individual markets. Scarcity: The excess of human wants over what can actually be produced to fulfill these wants (limited resources vs. unlimited human wants) Human wants are unlimited. On the other hand the means of fulfilling these human wants are limited, because the world only has a limited amount of resources (or, factors of production). As a result, choices have to be made. The opportunity cost of a choice is the value of the next best alternative sacrificed Resources (Factors of Production) a. Land and raw materials (Natural Resources): These are inputs into production that are provided by nature e.g.: unimproved land and mineral deposits in the ground, forests, pastures etc. The world’s land area and raw materials is limited. Some resources are non-renewable. If they are used now, they will not be available in the future e.g. oil, coal deposits. Their rate of depletion is very important. In general one can argue that their rate of depletion has to be such that future generations are not disadvantaged. Other resources are renewable e.g. forests (timber), fish; in general living things that will reproduce themselves naturally. (related topic: sustainable development; see Smith and Rees, search the internet) b. Labor (human resources): All forms of human input, both physical and mental, into current production. The labor force is, at any point in time, limited both in number and in skills. A basic determinant of the amount of a nation’s labor is population. Birth rates, death rates and the balance of migration movements into and out of a country determine the size of the population. Note that the whole population is not available for use in production. Only the people of working age are (16-65 years old), but many choose not to work (school, early retirement, family). The total number of people available for work is referred to collectively as the labor force or working population. The fraction of the total population who are in the labor force defines activity rate or the participation rate (Note: Human capital refers to the training, education and skills embodied in the labor force; government investment in human capital is perhaps the most significant type of policy especially for a developing nation.) 1 These notes have been prepared by C.H. Ziogas for use by the Higher Level Economics students of the IB program at the Moraitis School. This is a 1st draft version. c.h. ziogas (ziogas11@yahoo.com) The IB @ The Moraitis School (This is a DRAFT copy)
  2. 2. 2 c. Capital: Physical capital includes manufactured resources (produced means of production, or man made aids to production, or, goods that are used to produce other goods). The world has a limited stock of capital: limited supply of factories, machines, transportation and other equipment. The productivity of capital is limited by the state of technology. Fixed Capital provides a stream of services during its lifetime and comprises mainly plant and equipment. e.g.: machines, tools, equipment and buildings. Working Capital (also, circulating capital) circulates through the production process. E.g.: stock of raw materials (e.g. mozzarella for Pizza Hut) that a firm is waiting to use, goods in the process of being produced and all stocks of finished goods waiting to be sold. Note that the meaning of capital in economics is different than that used in ordinary speech where people refer to money as capital (= financial capital) d. Entrepreneurship Close to, but different from, management. When a new venture is being contemplated, risks exist. They involve the unknown future. Someone must assess these risks and make judgments about whether or not to undertake them. The people who do so are called entrepreneurs. Today much effort goes into research and development that lies behind new products (product innovation) and new processes (process innovation). Entrepreneurship refers to the willingness and ability to take risks and mobilize the remaining factors of production. Note that the minimum return (reward) required securing and maintaining the factor entrepreneurship in a specific line of business is known as normal profit. Positive and Normative Economic Statements: Normative Economic Statements: they are value judgments, opinions, statements that can NOT be proven right or wrong, that can not be tested against fact (data), that cannot be falsified. e.g.: ‘inflation is rising too fast’ or ‘the income distribution is not fair’. Key words in normative statements include: ought to be, should be, too much, too little, fair, unfair etc. Positive Economic Statements: statements that can be proven, at least in principle, right or wrong. They can be tested against facts (data) and they can be falsified. e.g.: ‘a minimum wage policy will increase unemployment among unskilled workers’. Free Goods (in contrast to economic goods): goods that have a zero opportunity cost of production (very few real world examples; perhaps sea water and air); Note that free goods in the economist’s sense are NOT goods with a zero price. Competitive Market: A market is considered competitive if: there are very many (infinite many) small) firms in it, if the good is homogeneous (i.e. it is considered identical across firms so consumers are indifferent as to whether they buy the good from firm A or from firm c.h. ziogas (ziogas11@yahoo.com) The IB @ The Moraitis School (This is a DRAFT copy)
  3. 3. 3 B) and if no entry or exit barriers exist (i.e. free entry and exit into and from the industry). Exit is free if there are no ‘sunk’ costs involved. Sunk costs refer to costs that cannot be recouped (recovered) upon exit. (Related concept: contestable markets later in these notes) Consumer Sovereignty …..the idea that in a free, competitive market economy it is consumers that “dictate” to firms which goods and services and in what amounts will be produced. Paul Samuelson (the first Nobel prize in Economics) characteristically wrote about the “dollar” votes that consumers cast every time they buy a product. The idea is that if demand for a good rises, more of it will be produced given that the price and firm profits rise whereas if demand decreases then less will be produced since the price will drop and firm profits will decrease and may even turn into losses. Complete consumer sovereignty presupposes that consumer preferences are independent of firms. In reality, firms, through advertising, are in a position to manipulate consumer preferences often creating demand for new products or increasing it. One may not claim though that there is complete producer sovereignty. Even in the face of the huge in size modern multinational corporations producer sovereignty is far from complete. The bankruptcies of many giants testify to this. (see demand later) Fundamental Questions of Economics (that all societies face, independently of their level of development or the economic system adopted) Scarcity necessitates choice and thus answers to the following questions: a. What (i.e. which goods) will be produced and in what quantities? b. How will each good be produced (using, say, a labor-intensive or capitalintensive technology?) c. For whom? (the distribution problem) The Production Possibility Frontier (or, Curve or, Boundary) A PPF refers to an economy (not a firm), which has (is endowed with) a fixed amount of resources, is characterized by a given level of technology, produces only two goods (or two classes of goods) and fully utilizes all available resources. Because resources are not equally well suited for the production of all goods (in other words, because resources tend to be specialized) the PPF is bowed towards the origin (concave to the origin). If resources were perfectly substitutable (i.e. if they were equally well suited for the production of both goods) then the PPF would be linear (constant opportunity costs, constant marginal costs) A PPF shows the maximum amount of good Y that an economy CAN produce for each and every amount of good X it produces, if it fully utilizes all available resources with its given level of technology. Alternatively, a PPF is the locus of points which show the productive limits of an economy. A PPF is a technological relationship; it provides us no information about choices. It shows what an economy CAN do, not what it chooses to do. c.h. ziogas (ziogas11@yahoo.com) The IB @ The Moraitis School (This is a DRAFT copy)
  4. 4. 4 Typically, a PPF is concave (bowed in) towards the origin; the slope becomes steeper and steeper i.e. the opportunity cost of producing more and more of good x (the one on the horizontal axis) is increasing: law of increasing (marginal) cost. Points outside a PPF denote output combinations of the two goods that are unattainable given the resources available and the present level of technology. Points inside PPF: denote attainable but inefficient output combinations in the sense that resources are not fully utilized e.g. unemployment is present2. Points on the PPF: denote attainable and efficient combinations (i.e. no waste of scarce resources is present; also, it is not possible to achieve more of one good without sacrificing some of the other). Growth of an economy can be illustrated through an outward shift of the PPF. We can distinguish between: 1) Actual growth: an increase in the amounts of goods and services actually produced (a movement from a point inside the PPF to another one with more of at least one good). Real GDP (related concept) has increased. 2) Potential growth: the rate at which a country’s economy could grow, if all its resources were fully employed (an outward shift of the PPF) / (see Smith & Rees: Economic Development) (related concepts: trade cycle; potential output; trend output) (Note: the idea of ‘development’ is often illustrated within the IB with an outward shift of a production possibilities curve where on the axes, merit3 goods and luxury goods are denoted; development is said to have taken place if the outward shift is greater for the so called ‘merit’ goods. Strictly speaking, this is incorrect, since even if the economy CAN produce more ‘merit’ goods –compared to luxury goods- it is NOT a priori known whether it will indeed choose to produce more merit goods! It could very well be the case that despite the potential for more merit goods, it is more fur coats that are indeed produced! Remember, the PPF does not provide us information about the choices a society makes; it provides us information only about the production possibilities it possesses) In general growth can occur either if the amount of available resources increases, or, if technology improves. More specifically, it occurs if there is an increase in: • Land: e.g. if new metal deposits/minerals are discovered. 2 So, if an economy suffers from unemployment, it is located somewhere inside its PPF (its production possibilities); if unemployment decreases, it will move to a point further towards the PPF; the PPF will not shift, since the amount of labor (resources more generally) available has not increased. It is only that the existing resources are utilized more efficiently. 3 Later in this set of notes a precise definition of ‘merit’ goods is provided. For the time being, typical examples ‘merit’ goods include basic education and basic health care. c.h. ziogas (ziogas11@yahoo.com) The IB @ The Moraitis School (This is a DRAFT copy)
  5. 5. 5 • • Labor: if population increases (through a natural increase and /or if net inmigration occurs), if there is an increase in the number of people in the working age, if there is an increase in the participation rate of some population subset (e.g. more women decide to join labor force or, more teenagers), and if skills / level of education embodied in the labor force improves (in other words, if human capital increases). Capital: if the stock4 of capital (i.e. of machines, tools, equipment, buildings etc) increases. The stock of capital can increase by investment. (Related concept: the Harrod–Domar growth model; see later my development notes) Investment Definition: the change in the stock of capital (of a firm or of an economy) over the change in time. When a firm spends to acquire more machines, more tools, more factories, we say that it is investing. (see my macro notes for the three types of investment spending) Do not confuse with financial investment. Also note that it is only firms that invest. Households (people) may undertake ‘financial’ investments (but not ‘economic’ investments since households do not produce goods / services)5 More formally: I = ΔK/Δt If a firm (or an economy) had at the beginning of a time period 22 machines and at the end it had 28 machines then investment equal to 6 machines took place in that period of time6. The opportunity cost of increasing the stock of capital of an economy (in other words the opportunity cost of investment) is sacrificing present consumption, presumably in order to be able to enjoy increased consumption opportunities in the future (this can be shown can be shown through a PPF with consumption goods in one axis and capital goods in the other axis) š Focusing now on a market economy: A market economy is one where market forces alone, without Government or God intervening, provide answers to the three fundamental questions, and in which private property rights are well defined and enforced. The participants in a market economy are consumers and producers. The interaction of consumers and producers (firms) in markets determine the market price of each 4 note the distinction in Economics between so called ‘stock variables’ which are defined at a point in time and ‘flow variables’ which require a time dimension. 5 Households may also undertake investment in human capital: by acquiring more education, more skills, more training. 6 Check the idea of depreciation (capital consumption) in my macro notes. c.h. ziogas (ziogas11@yahoo.com) The IB @ The Moraitis School (This is a DRAFT copy)
  6. 6. 6 product. Changes in market conditions thus result in market price changes which set off a chain of events leading to more or less of the good being produced and thus to a change in the allocation of scarce resources. Definition of a ‘market’: A market can be defined as a ‘process’ (or, an institution) in which producers and consumers interact in order to sell and buy a good or a service. To analyze the functioning of markets we thus need to somehow analytically summarize the behavior of consumers and the behavior of producers (firms). Consumer Demand: The concept is an analytical way of summarizing the behavior of buyers. Specifically, we define demand as the relationship between various possible prices of a good and the corresponding quantities that consumers are willing and able to purchase per time period, ceteris paribus (i.e. all other factors affecting demand remaining constant) Demand Curve: A graph showing the relationship between the price of a good and the quantity of the good demanded over a given time period. Price per unit is measured on the vertical axis; quantity demanded per time period is measured on the horizontal axis. A demand curve can be for an individual consumer or for the whole market. The market demand curve is diagrammatically derived by the horizontal summation of the individual demand curves. Law of Demand: The inverse relationship between price and quantity demanded; when the price of a good rises, quantity demanded will fall, ceteris paribus7. Exceptions to the law (demand being positively sloped) include Giffen goods and Veblen (also known as status symbols or snob goods; ostentatious consumption). All Giffen goods are inferior goods (but all inferior goods are not Giffen goods). Veblen goods though are of course not inferior. The typical example in the literature of Giffen goods is the one provided by Sir R. Giffen himself: potato demand by the poor Irish farmers during the Irish famine of the 19th century. The Law of Demand holds because of: the substitution effect: if the price of good X rises, all other goods automatically become relatively cheaper; thus, people will tend to substitute other goods for X. The size of the substitution effect depends primarily on the number and closeness of available substitute goods. the income effect: if the price of X rises, consumers real income8 drops; thus, people will tend to buy less. The size of the income effect depends primarily on the proportion of income spent on the good. 7 A most common mistakes students make is to loosely employ the terms ‘demand’ and ‘quantity demanded’: a change in the price of a product leads to a change of ‘quantity demanded’ NOT ‘demand’! More on this difference can be found later in these notes. c.h. ziogas (ziogas11@yahoo.com) The IB @ The Moraitis School (This is a DRAFT copy)
  7. 7. 7 Note: Be careful about the meaning of the term ‘quantity demanded’. It refers to the amount that consumers are willing and able to purchase at a given price over a given time period. It does not refer to what people would simply want to consume. Note that ‘willingness’ reflects preferences whereas ‘ability’ reflects the income constraint one faces.9 Statement of the problem that the typical consumer faces: He/she has a fixed amount of income (Y) and he/she faces a fixed set of prices. We assume that consumers seek to allocate their expenditures among all the goods and services that they might buy so as to gain the greatest possible utility (satisfaction). Definition of Utility: Utility is the satisfaction one gains by consuming a good or a service. Goal of (rational10) Consumer: To maximize his/her utility, subject to his/her budget (i.e. income) constraint. The logical rule for maximizing utility: MU of the last euro spent on A should equal the MU of the last euro spent on B (1) In general, the marginal utility derived from the last unit acquired of some commodity divided by its price per unit should be the same across goods. So, MU of A / price of A = MU of B / price of B (2) Rearranging (2) produces the following result: MU of A / MU of B = price of A / price of B This means that in equilibrium the consumer will adjust purchases of any two goods until their marginal utilities are proportional to their prices. For example if a unit of A costs twice as a unit of B, the marginal utility from the last unit of A must provide double that from the last unit of B. We will now examine the relationship between utility and the quantity consumed for an individual: as more of a good is consumed, the extra satisfaction decreases (and after a point it might even become negative). This is the Law of Diminishing Marginal Utility. 8 Income is not the same as ‘money’ or ‘wealth’! Income is the sum of wages, interest, rents and profits: the rewards to the factors of production one owns and offers to the production process. It is a ‘flow’ variable in the sense that it requires a time dimension to make sense: if I claim that my income is 500 euros you can not be sure I am making a lot of a little if I do not specify a time dimension: is it 500 an hour, or a week, or a month? 9 See later in these notes the discussion about the desirability of allocative efficiency that rests on this point. 10 A consumer is ‘rational’ if his preferences are consistent; for example if a consumer prefers some basket (set) of goods A to some basket of goods B and prefers basket B to some other basket of goods C, than the rational consumer must prefer basket A to basket C. For our purposes though, it suffices to say that a ‘rational’ consumer behaves in such a way to achieve his goal i.e. to maximize his utility. c.h. ziogas (ziogas11@yahoo.com) The IB @ The Moraitis School (This is a DRAFT copy)
  8. 8. 8 A demand curve is negatively sloped due to the income effect and the substitution effect11 (and it follows from the Law of Diminishing Marginal Utility). Other factors affecting Demand (so called ‘shift’ factors): 1) Changes in consumers’ income (Y). As income rises, demand for most goods will rise (demand will shift to the right). Such goods are called normal goods. There are exceptions to this general rule, however. As people get richer, they spend less on inferior goods, such as low quality food or lower quality clothing, and switch to better quality goods. The demand for inferior goods decreases when incomes increase (demand for inferior goods will shift to the left). They are characterized by a negative income elasticity of demand (more on this later). Thus if incomes in an economy rise through time, the pattern of demand will change. This has important implications on production, unemployment etc (related concept in my macro notes: trade cycle) 2) Changes in preferences (tastes). The more desirable people find a good, the more they will demand it. Tastes are affected by advertising, by fashion, by observing other consumers, by considerations of health etc. Note that the concept of consumer sovereignty rests on the idea that firms in competitive markets are forced to respond to changes in consumer preferences in order to survive. The consumer dictates (through his ‘euro’ votes) which goods and in what amounts will be produced. In the real world, consumer sovereignty is far from complete as firms, through advertising, manipulate these preferences. 3) Changes in the price of other goods. Two cases are distinguished: Case of Complements: Defined as goods that are consumed together (‘jointly consumed’), such as peanut butter and jelly, shoes and shoe polish etc. When the price of a complement of good X rises, demand for X will drop (shift left). Case of substitutes: Defined as goods in competitive consumption, such as pizza and burgers: When the price of a substitute of good X rises, demand for X will rise (will shift right; e.g. if Pepsi’s price rises, demand from Coke will increase) 4) Size of the market i.e. number of consumers. As the size of a market (the number of consumers) increases, demand for most products will tend to rise. 7) Age distribution of the population: A change in the age distribution would affect the pattern of demand. Classic example refers to an ageing population where demand for fake teeth will rise and for chewing gum will drop. 7) Changes in the distribution of income 11 For most purposes it does not matter how you draw a demand curve: whether it is linear or not, whether it intersects the axes or not, as long as it reflects the law of demand, i.e. as long as it is negatively sloped! c.h. ziogas (ziogas11@yahoo.com) The IB @ The Moraitis School (This is a DRAFT copy)
  9. 9. 9 If the income distribution becomes less skewed and more equal, demand for certain luxuries may drop and for certain basic goods and services to rise. 6) Changes in the distribution of sex in the population A change in the proportion of males to females may also affect the pattern of demand. 7) Expectations (of changes in market prices, in income etc.) For example, if people think that the price of a good is going to rise in the future, they are likely to buy more now before prices go up. Shifts of Demand versus Movements Along a Demand (source of a typical student mistake) curve, there must have been a shift of the supply curve. Given such an increase in price, the decrease in quantity demanded is also known as a ‘contraction’ in demand whereas the rise in quantity demanded that follows a price decrease is also known as an ‘extension’ of demand. A shift in the demand curve occurs when a determinant other than the price changes; we then say that a change in demand has occurred. A movement along the demand curve occurs when there is a change in price; we then say there is a change in quantity demanded. Note that for a change in price to occur along a demand Consumer surplus Definition: The difference between what a consumer is prepared to pay and what she actually pays for a given amount of a good. Represented by the area under the demand and above the price line. This is a very significant concept that will aid our analyses of welfare changes. š Supply: The concept of supply is merely a way to analytically summarize the behavior and goals of firms. It is defined as the relationship between various possible prices and the corresponding quantities that firms are willing to offer per time period, ceteris paribus. Supply curve: A graph showing the relationship between the price of a good and the quantity that a firm (or, firms) is (are) willing to offer over a given period of time. It may be upwards sloping, vertical, horizontal or even negatively sloped. In the short run it will be upward sloping as firms will be prepared to offer greater quantities per period only if market price is higher, given that (marginal) costs rise (as a result of the law of diminishing marginal returns- later in notes) In the long run, when producers have more time to adjust fully to changes such as rising demand, costs need not rise. A supply c.h. ziogas (ziogas11@yahoo.com) The IB @ The Moraitis School (This is a DRAFT copy)
  10. 10. 10 curve may therefore even be downwards sloping. (see increasing returns to scale later in these notes) c.h. ziogas (ziogas11@yahoo.com) The IB @ The Moraitis School (This is a DRAFT copy)
  11. 11. 11 Note: Three time periods are conventionally recognized for supply: a. Momentary period (or, Market period): situations when there is insufficient time to alter quantities offered for sale / all factors of production are considered fixed b. Short-run: refers to a period over which production can be varied within the confines of the producer’s existing productive facilities / some factor (the size of the firm, its capacity) is considered fixed c. Long-run: refers to a period long enough to alter everything that producers wish to alter in response to a change in price. / all factors are considered variable Supply and Price: The relationship (at least in the short run) between price and quantity supplied is a direct (positive) relationship. Why? A simplistic answer: at higher prices, a firm’s profit margin is greater, thus it will be willing to offer more of the good. More correctly: whereas the consumer is assumed to seek to maximize utility, the producer is assumed to seek to maximize profits. Assuming fixed productive capacity, producing ever increasing quantities of a good, becomes more and more difficult i.e. more and more costly (law of diminishing marginal returns – of increasing marginal costs). If this holds, then a firm will be willing to offer more units of the good only if the market price is higher. Also, if the price remains high, new producers will be encouraged to set up in production. Total market supply thus rises. So, if price rises, quantity supplied is expected to increase. Factors affecting supply (‘shift’ factors) 1) Costs of production. The higher the costs of production, the less profit will be made at any price. As costs rise, firms will cut back on production, probably switching to alternative products whose costs have not risen so much. The main reasons for a change in costs are as follows: a. Changes in input prices: costs of production will rise if wages, raw material prices, rents, interest rates or any other input prices change. b. Change in technology: technological advances can fundamentally al- ter the costs of production i.e. supply will increase (shift to the right). c. Change in productivity (output per unit of input). d. Changes in Government policy: costs will be lowered by government subsidies and raised by the imposition of indirect taxes (with an indirect tax it’s as if production costs rise so, supply decreases, i.e. shifts left: the vertical shift is equal to the tax per unit; symmetrically, in the case of a subsidy) 2) Size of the market i.e. number of firms in the market. 3) Expectations of future price changes. 4) Other factors, such as weather conditions as is the case for farm products c.h. ziogas (ziogas11@yahoo.com) The IB @ The Moraitis School (This is a DRAFT copy)
  12. 12. 12 Producer Surplus: … defined as the difference between what a producer earns and the minimum required to offer that amount. Diagrammatically, it is the area below the price and above the supply curve. Price And Output Determination in Competitive Markets The interaction of market demand and market supply determines the equilibrium price and output. If, at some price, excess supply exists, then the price will tend to drop. If excess demand is the case then the price will tend to rise. It follows that there will be no tendency for the price to change (= equilibrium) if there is neither excess supply nor excess demand in the market. In other words, if Qd = Qs. Diagrammatically: At P = P1: Qd=Q1 and Qs=Q0 : Qs>Qd i.e. there is excess supply (ES) in the market. If ES exists, then the price will tend to drop. At P=P2: Qd=Q3 and Qs=Q4: Qd>Qs i.e. there is excess demand (shortage). If ED exists then the price will tend to rise. Equilibrium condition: A price will be an equilibrium price, if neither ED nor ES exists or equivalently, if ED=ES=0 or equivalently, if Qd = Qs. In this case P is the market price (the equilibrium price) since at P, Qd = Qs = Q. The Allocation Of Scarce Resources Problem: Determine the optimal amount (from society’s point of view) to be produced of each good (and, as a result, the optimal resource allocation) Assume two goods: apples and oranges, and one resource, land (e.g. the island of Crete). Determine some allocation of land, which, in turn, determines some amount of apples and some amount of oranges being produced. The question that arises is: Should one more unit (a kilogram, a ton, whatever) of apples be produced? Consequently, should more land go to the production of apples? The answer will be ‘yes’, if that one more unit of apples is valued more by society (measured by how much society would c.h. ziogas (ziogas11@yahoo.com) The IB @ The Moraitis School (This is a DRAFT copy)
  13. 13. 13 be willing to pay, the vertical distance up from that Q towards the demand curve) than what it costs society to produce it, i.e. more than the value of sacrificed oranges (measured by the vertical distance up from that Q towards the supply curve). Thus, more should be produced as long as the extra benefit to society from the increased production exceeds the extra cost it entails that reflects the value of the alternatives sacrificed. Output is optimal from society’s point of view when for the last unit, Price (= MB) is equal to Marginal Cost i.e. when all the net benefits have been exhausted (alternatively, when the marginal valuation of the last unit equals its marginal cost – i.e. the marginal valuation of what has to be sacrificed). Note that in a free competitive market (i.e. where no monopoly power exists), where decision making units (i.e. households/consumers and firms/producers take into consideration the full true benefits and costs of their actions (i.e. where externalities are not present – see notes further down) and where consumers can not conceal their true preferences (i.e. where no free-riders exist thus ruling out the case of public goods – see notes further down), then the market forces themselves will lead to the optimal amount of each good being produced and consumed and thus to an optimal from society’s point of view resource allocation. Social surplus (the sum of the consumer and producer surplus) is maximized. Allocative efficiency has been achieved. (more on this important concept later). What if only OQ’ units are produced? (as is the case under monopoly) Consumer surplus (C.S)= area (P’HF) Producer surplus (P.S)= area (AKHP’) Social surplus: AKHF There is a welfare loss involved equal to the area (KLH) that reflects the allocative inefficiency resulting from the fact that less than the socially optimal amount of the good is produced (under monopoly). The market forces (consumers & producers) have failed to reach the socially efficient outcome (more on this issue later). c.h. ziogas (ziogas11@yahoo.com) The IB @ The Moraitis School (This is a DRAFT copy)
  14. 14. 14 ELASTICITY Definition: In general, elasticity is defined as the responsiveness of something (an economic variable), when something else (another economic variable) changes. We will examine: Ø Price elasticity of demand. Ø Income elasticity of demand. Ø Cross Price elasticity of demand. Ø Price elasticity of supply. Price Elasticity Of Demand (PED) definition: symbol: measure: the responsiveness of quantity demanded to a change in price. PED or, ep, or, Ep The percentage change in quantity demanded divided by the percentage change in price: Ep = %ΔQd /% ΔP i.e. Ep = (ΔQ/Q1) / (ΔP/P1) PED is thus the ratio of the changes of two variables (P & Qd) that change (move) in opposite direction: if P rises, then Qd decreases and vice versa. As a result PED is always a negative number. Often the minus sign is ignored. BUT, in PED computational questions, never forget to use the minus sign, even if it is not provided! Ranges of Price Elasticity of Demand (ignoring the minus sign) I. Demand is elastic (for small changes around the initial price): if Ep>1 i.e. the percentage change in quantity demanded is larger than the percentage change in price. Demand in this range is relatively responsive to price changes (demand is elastic for small changes around the current price if a change in price leads to a proportionately greater change in quantity demanded) II. Demand is inelastic (for small changes around the initial price): if 0<Ep<1 i.e. the percentage change in quantity demanded is smaller than the percentage change in price (if the change in price leads to a proportionately smaller change in quantity demanded). Demand in this range is relatively unresponsive to price changes. III. Demand is unit elastic: Ep=1 i.e. the percentage change in quantity demanded is equal to the percentage change in price. IV. Demand is perfectly elastic: Ep à ∞. Infinite elasticity arises when a small decrease in price raises quantity demanded from zero to an infinitely large amount. In other words, if price rises even slightly, nothing will be bought from the consumers. A demand curve of infinite elasticity as a straight horizontal line. V. Demand is perfectly inelastic: Ep=0. A change in price has no effect on quantity demanded. A demand curve of zero elasticity is a straight vertical line. NOTE: Even along a linear (i.e. constant slope), demand curve, PED is NOT constant, but continuously changes (from infinity to zero). There are however the following exceptions, where PED is constant throughout the length of the curve: 1. The case of a perfectly inelastic demand curve. c.h. ziogas (ziogas11@yahoo.com) The IB @ The Moraitis School (This is a DRAFT copy)
  15. 15. 15 2. The case of a perfectly elastic demand curve. 3. The case of a unitary elastic demand curve (rectangular hyperbola: Q = a/P). Note: all areas below represent total revenues / total consumer expenditures and are equal Relationship between PED and Total firm Revenues (TR) Total Revenue (TR) is the product of price times quantity bought. It is not the same as profits12. TR(Q) = P*Q What will happen to firm’s revenues (and hence consumer expenditures) if there is a change in price? The answer depends on the price elasticity of demand: Ø If price changes and Ep>1 As price rises, quantity demanded falls, and vice versa. When demand is elastic, quantity demanded changes proportionately more than price. Thus the change in quantity has a bigger effect on total consumer expenditure than does the change in price. Since demand is elastic, total expenditure changes in the same direction as quantity: if P rises, Q falls proportionately more; thus TR / TE falls. if P falls, Q rises proportionately more; thus TR / TE rises. 12 Profits are the difference between total revenues and total production costs. c.h. ziogas (ziogas11@yahoo.com) The IB @ The Moraitis School (This is a DRAFT copy)
  16. 16. 16 When demand is elastic, then, a rise in price will cause a fall in total consumer expenditure and thus a fall in the total revenues. A reduction in price however, will result in consumers spending more, and hence firms earning more. Ø If price changes and 0<Ep<1 (i.e. inelastic). Price rises proportionately more than quantity. Thus, the change in price has a bigger effect on total consumer expenditure than does the change in quantity. Total consumer expenditure changes in the same direction as price: if P rises, Q falls proportionately less, thus TE rises. if P falls, Q rises proportionately less, thus TE falls. Ø If price changes and Ep=1: In this case, price and quantity change in exactly the same proportion. Its demand curve is a rectangular hyperbola. A change in price will have no effect on TE (hence TR). If one graphs total revenues against P or Q, the function will be a straight line parallel to the horizontal axis. Knowing the PED for a product permits a firm to predict the effect that a price change will have on its revenues. Determinants of PED: (Note: some students confuse these factors with factors affecting demand!) 1. The number and closeness of available substitutes: The more substitutes there are for a defined – Pepsi vs. soft drinks - : the good, and the closer they are, the more broader the definition, the fewer the easily will people switch to these altersubstitutes available to the consumer natives when the price of the good and thus the more price inelastic derises; the greater therefore will be the mand is expected to be for small price price elasticity of demand. (related: changes around the current price) how broadly or narrowly the good is 2. The proportion of income spent on the good: The higher the proportion of our insmall proportion of our income on a come that is spent on a good, the more good (if it is ‘insignificant’) then a we will be forced to cut consumption change in price will not affect our when its price rises: the bigger will be spending behavior, it will be price inethe income effect and the more elastic lastic. will be the demand. If we spend a 3. The time period involved: When price rises people may take a time to adjust their consumption patterns and find alternatives. The longer 4. the time period after a price change, then, the more elastic is the demand likely to be. The nature of the good, i.e. whether or not it is addictive: if addictive, then it’s demand curve is relatively inelastic e.g. cigarettes, alcohol etc. This has profound implications on the decision of governments to tax such products. c.h. ziogas (ziogas11@yahoo.com) The IB @ The Moraitis School (This is a DRAFT copy)
  17. 17. 17 5. Whether it is jointly consumed. For example electricity is used for a number of uses: oven, fridge, light etc. its demand is therefore more inelastic. Uses of PED. It allows comparison of quantity changes with monetary changes. It helps a firm predict the direction of change of total revenues given a price change. It helps a price discriminating firm determine its pricing policy. It helps determine the size of the ‘mark-up’ in pricing decisions of oligopolistic firms. (Mark-up pricing later) It helps a firm determine what proportion of an indirect tax it can pass on to consumers in the form of a higher price. Knowledge of PED is necessary in order for the government to calculate the size of the necessary tax if it wishes to decrease the consumption of a (‘demerit’) good. It permits the government determine the incidence of an indirect tax. It helps predict the effect of currency devaluation on the trade balance (see the Marshall-Lerner condition in my trade notes). Income Elasticity of Demand Definition: Symbol: Measure: the responsiveness of demand for a good when consumer’s income changes ηy, Ey, ey, IED ηy = %ΔQd / %ΔΥ Ø If ηy>0: normal good i.e. a good whose demand increases as consumer incomes increase. They have a positive income elasticity of demand. . Ø If ηy<0: inferior good i.e. a good whose demand decreases as consumer incomes increase. Such goods have a negative income elasticity of demand. Ø If ηy>1 i.e. %ΔQd>%ΔΥ then the good is income elastic i.e. a rise in income leads to a faster rise (proportionately greater) in demand. Luxury goods (as well as most services) usually are income elastic Ø If 0 <ηy<1 i.e. %ΔQd<%ΔΥ then the good is income inelastic (as income rises, demand rises but at a slower rate). Basic (every day consumption, staple goods) goods are usually income inelastic (food as a broad category) Ø If ηy=0 then the demand of the good is not affected by income changes. Note: some industries are considered ‘cyclical’ and some ‘acyclical’ as a result of their income elasticity of demand: as overall economic activity fluctuates in the short run (the ‘trade’ or ‘business’ cycle – see macro notes), the construction (auto, furniture, etc) industry also fluctuates in the sense that demand for housing rises and falls also, whereas the food industry does not (as much at least): it is ‘acyclical’. c.h. ziogas (ziogas11@yahoo.com) The IB @ The Moraitis School (This is a DRAFT copy)
  18. 18. 18 Factors affecting Income Elasticity of demand: 1) Degree of ‘necessity’ of the good. In a developed country, the demand for luxury goods expands rapidly as people’s incomes rise, whereas the demand for basic goods, such as bread, rises slowly. Engel’s Law states that as incomes increase, a declining proportion of income is spent on food. This, it is often said, is because of the ‘fixed capacity’ of the human stomach. Food is therefore income inelastic. Furthermore, certain basic foodstuffs may behave as inferior goods meaning that their income elasticities are negative. Thus, as incomes increase people to some extent switch away from such basic items as rice, bread and potatoes and substitutes them with higher protein foodstuffs; and as their incomes rise still further total expenditure on food increases, but food takes a declining proportion of household income (see Smith & Rees, p.96). 2) The living standards of the economy (Fisher-Clark theory, Smith & Rees, p.95) 3) The rate at which the desire for a good is satisfied as consumption increases. Question:Why is the concept of IED useful to economists studying the economic development of countries? Cross Price Elasticity Of Demand. Definition: Symbol: Measure: The responsiveness of demand for one good (x) to a change in the price of another good (y) Exy, CPE, XPE Exy= %ΔQx / %ΔPy = (ΔQx/ΔPy) * (Py1/Qx1) Here, the sign matters as to how we interpret CPE: Ø If Exy>0, then x and y substitutes (competitive demand) Ø If Exy<0, then x and y are complements (jointly demanded). Ø If Exy=0, then x and y unrelated. The further away from zero, the stronger the relationship between the goods; the closer to zero, the weaker the relationship. Usefulness of CPE Useful to delineate markets. Whether muffins and eggs are in the same market or not as Kellogg’s cereal (the ‘breakfast’ market / re: The US. vs. Kellogg’s) can be determined by examining the size of their CPE of demand. c.h. ziogas (ziogas11@yahoo.com) The IB @ The Moraitis School (This is a DRAFT copy)
  19. 19. 19 Price Elasticity Of Supply Definition: Symbol: Measure: the responsiveness of supply when the price of the good changes PES PES = %ΔQS / %ΔQP Sign of PES is positive since supply curves typically have a positive slope Ø If PES > 1 : supply is elastic, for small changes around the initial price: a change in price leads to a proportionately greater change in quantity supplied) Ø If PES < 1 : supply is inelastic for small changes around the initial price: a change in price leads to a proportionately smaller change in quantity supplied Ø If PES = 1 : supply is unitary elastic for small changes around the initial price. Ø If PES = 0 : supply is perfectly inelastic for small changes around the initial price. Ø If PESà∞ : supply is perfectly elastic for small changes around the initial price. Note (useful for multiple choice questions): all linear supply functions that cut the P - axis are price elastic, and all linear supply functions that cut the Q axis are price inelastic. If supply is linear and goes through the origin then it has unitary (and constant) elasticity of supply throughout its length. In all other cases, PES varies along the length of the curve. 1. Perfectly price inelastic supply (PES = 0) 2. Perfectly price elastic supply (PES à ∝ 3. Unitary elastic throughout length (PES = 1) c.h. ziogas (ziogas11@yahoo.com) The IB @ The Moraitis School (This is a DRAFT copy)
  20. 20. 20 4. Price elastic but not constant (PES > 1) 5. Price inelastic but not constant (0< PES < 1) c.h. ziogas (ziogas11@yahoo.com) The IB @ The Moraitis School (This is a DRAFT copy)
  21. 21. 21 Factors affecting PES the quantity offered remains the same while prices rise. In the short run, some inputs can be increased while other remain fixed. Supply can increase somewhat, within the constraints that the firm’s existing capacity impose. In the long run all adjustments are possible i.e. all factors of production are considered variable. I. The time period: As mentioned in the section of PED, time is distinguished into the immediate (market period), the short run and the long run. In the immediate time period, NO adjustments are possible i.e. for the firm, all factors of production are considered fixed. In this case, demand shifts but supply is not responsive; thus, II. The extent to which excess capacity exists. If it does, supply is expected to be more elastic. III. Whether skilled or unskilled labor predominantly employed/used. IV. Whether long or short time lags characterize the production process. The longer the time lags, the longer it takes for sup- ply to adjust to new demand conditions. (Agricultural products are characterized by long time lags.) V. The speed by which costs rise as output rises: The less the additional (= marginal) costs of producing additional output, the more firms will be encouraged to produce for a given price rise: the more elastic supply will be. Importance of PES It determines the extent to which an increase in demand will affect the price, and/or quantity of the good in a market. The more inelastic supply is, the greater the increase in price given an increase in demand; the more elastic supply is, the greater the impact of an increase in demand on quantity. c.h. ziogas (ziogas11@yahoo.com) The IB @ The Moraitis School (This is a DRAFT copy)
  22. 22. 22 Price Controls Often, governments consider the market determined price of a product unsatisfactory i.e. either too high or too low. In such cases, the government in- I. tervenes and sets the price of a god, either below the market price or above the market price. Setting a Maximum price (or, “price ceilings”): This is done to prevent prices from rising above a certain level often for reasons of fairness. In wartime, or times of famine, the government may set maximum prices for basic goods so that the poor can afford them. Thus the government in this case aims at pro- Effects: A shortage is created. This means that the price mechanism, fails to perform its rationing function, i.e. to allocate the good: since a shortage exists, some consumers will end up not enjoying the tecting consumers. This policy may also be seen in the housing market (rent controls). For a maximum price to be effective it must lie below the free market equilibrium price. good, even though they are both willing and able to pay the price. Therefore, an alternative rationing device is required: a) Allocation on a ‘first come, first served’ basis. This is likely to lead to queues developing, or firms adopting waiting lists. b) Seller’s preferences i.e. firms deciding which consumers should be allowed to buy: for example, giving preference to regular customers. c) Randomly e.g. by ballot. d) Rationing using coupons. This alternative has been used in times of war, e.g. in the UK during the Second World War. A major problem with maximum prices is likely to be the emergence of black (parallel) markets, where cus- tomers, unable to buy enough in legal markets, may well be prepared to pay much higher prices. In the long run additional costs may emerge:: e) Quality may worsen. f) If other non-controlled goods may be produced with the same inputs, then supply may further shrink making shortages more severe. To minimize these types of problem the government may attempt to reduce the shortage by encouraging supply (i.e. attempting to shift supply to the right), for example: drawing on stocks, by direct government production or by granting subsidies or tax relief to firms. Alternatively, it may attempt to reduce demand: by the production of more substitute goods, or by controlling people’s incomes. c.h. ziogas (ziogas11@yahoo.com) The IB @ The Moraitis School (This is a DRAFT copy)
  23. 23. 23 Minimum price (or, price floor): The government sets minimum prices to prevent them from falling below a certain level. This may be done to protect producers’ incomes, usually farmers’. Another example may be found in the labor market: minimum Effects: A surplus is created. The government might even aim at creating a surplus (e.g. of grains) which can be stored in preparation for possible future shortages. In order for the price to be main- Overall: Farmers are better off since their income rises. Part of their earned income is by consumers and another by the government. Consumers are worse off since they enjoy less of the good at a higher price. Overproduction occurs. wage legislation can be used to prevent workers’ incomes from falling below a certain level. For a minimum price to be effective it must lie above the equilibrium price level. tained at the promised level, the government must buy the surplus at the promised price. It must thus spend the product of the promised minimum price times the amount of the surplus. This means that society is worse off since there is misallocation of scarce resources. Also, government expenditures rise, or alternatively, spending in other areas has to decrease. Indirect Taxation Indirect taxes are taxes on goods / expenditures. They can be either per unit taxes (e.g. €2.00 drs. per pack of cigarettes), or sales taxes (e.g. a percentage of the price: Value Added Tax, e.g. 18% of price). Effects of a per unit indirect tax. Analytically, it’s as if production costs rose by the amount of the tax: supply (which is marginal cost), as a result, will shift leftwards (vertically upwards) by the amount of the tax. Ø Ø Ø Ø Ø Market price is expected to rise. Equilibrium quantity is expected to decrease. Producers’ net of tax price is expected to decrease. Producers net of tax revenues decrease. Tax revenues collected by government = (tax per unit)*(number of units sold). Question: Do consumers spend now more? Not necessarily, since it depends on the PED. The incidence of indirect taxes depends on the elasticity of demand and supply of the commodity in question. The size of the increase in price and decrease in quantity differs in each case, depending on the price elasticity of demand and supply. The total tax revenue is given by the amount of tax per unit, multiplied by the new amount sold and is shared between the consumer and the producer. c.h. ziogas (ziogas11@yahoo.com) The IB @ The Moraitis School (This is a DRAFT copy)
  24. 24. 24 The following formula holds (very useful for related MCh questions): (% incidence on consumers) / (%incidence on producers) = (PES) / (PED) Ø Quantity will fall less, and hence tax revenue for the government will be greater, the less elastic are demand and supply. Ø Price will rise more, and hence the consumers’ share of the tax will be larger, the less elastic is demand and the more elastic is supply. Ø Price will rise less, and hence the producers’ share will be larger, the more elastic is demand and the less elastic is supply. Note: A sales tax is analyzed in the same way as a per unit tax except for that the shift of supply is not parallel but the ‘wedge’ (= vertical distance) widens at higher prices. Subsidies Definition: A payment (usually per unit of output produced) made by the government to producers in order to lower the market price, increase output and consumption of the product and raise producers’ income / revenues. Analysis of subsidies is symmetric to that of indirect taxation. The effect of the subsidy is to shift the effective supply curve vertically downward13 (to the right) by the amount of the subsidy. Effects: Ø Market price drops.(i.e. consumers are better off) Ø Equilibrium quantity rises (quantity produced and consumed of the good increases) Ø Producers’ price (inclusive of the subsidy) rises. Ø Government expenditures (= subsidy per unit times the # of units produced) rise Ø Producers’ income increases The following also holds: % of benefit from subsidy for consumers / % of benefit for producers = PES / PED Agriculture and Agricultural Policy (Excellent analysis found in Sloman, paragraph 3.3, a must) Governments often intervene in agricultural markets. This is because: I. There has been a long-run downward trend of relative prices and of farmers’ share of (national) income. II. There are short run fluctuations of prices and incomes (prices and incomes exhibit short-run volatility). 13 It will later become clear that supply is nothing else but the ‘marginal’ cost curve: MC shows the extra cost incurred of producing an extra unit of output. Consequently, a subsidy will shift the MC curve down by the amount of the subsidy since it will lower production costs. c.h. ziogas (ziogas11@yahoo.com) The IB @ The Moraitis School (This is a DRAFT copy)
  25. 25. 25 Why? Ø the long-run downward trend is explained as follows: Supply has increased dramatically due to the mechanization of production, the use of fertilizers, the advances in biotechnology, disease control etc. which have raised productivity of the sector. However, demand has not kept pace because of low income elasticity of demand: per capita incomes rose but demand for food and farm products rose by proportionately much less Ø the short-run downward trend is explained as follows: Short run supply is perfectly inelastic (due to the long production lags associated with agricultural products), and subject to random shocks (weather). On the other hand, demand for agricultural goods is relatively price inelastic - since spending on such products is a small proportion of consumer spending and on the whole these goods have few substitutes - leading to sharp price fluctuations. Note: Farm income varies inversely with supply conditions i.e. poor crop, higher income! Export revenues of developing countries: These characteristics affect also the export revenues of developing countries that export predominantly primary commodities (farm and non-farm products; not oil): their export revenues fluctuate in the short run and in the long run their ‘terms of trade’ worsen. See my trade and development notes on these issues. Policies: There are various forms of government intervention; one of them is granting a subsidy which we have already examined. The government may also use buffer stocks, deficiency payments, set aside policies etc Buffer stocks (and Commodity Agreements) If the government (or an agency) merely wants to stabilize prices, it can simply fix a price which balances demand and supply over the long term. If there is a good harvest the government (or, the manager) buys up the surplus and puts it into store. If there is a bad harvest it releases appropriate quantities stored onto the market. c.h. ziogas (ziogas11@yahoo.com) The IB @ The Moraitis School (This is a DRAFT copy)
  26. 26. 26 Problems / Effects Ø Price may stabilize but farmers’ incomes do not: they vary directly with output Ø There is an incentive to overproduce since government in essence guarantees that whatever is produced and not bought by consumers is bought by the government. Ø It is costly since storage costs and financing costs exist which though may be recouped if good and bad harvests alternate. Note: Buffer stocks can only be used with food that can be stored: i.e. non-perishable foods like grain, wine or milk powder etc Commodity agreements are used, usually unsuccessfully, by groups of developing countries for commodities (primary products traded in world markets) such as coffee and cocoa (many data response questions on these issues). Deficiency payments. Definition: … are variable subsidies, where the amount paid per unit is that which is necessary to make up the deficiency between the market price and the previously agreed guaranteed price. An advantage of the system is that the deficiency payment was based on the average market price. There was therefore an incentive for farmers to improve quality and get a better than average price without thereby sacrificing any subsidy. Note: So it’s the same thing as the government granting a subsidy, but we don’t know the subsidy from the beginning! (Check out ‘set aside’ policy, in Sloman, section 3.3) c.h. ziogas (ziogas11@yahoo.com) The IB @ The Moraitis School (This is a DRAFT copy)
  27. 27. 27 The Theory Of Production And Costs Production Definition: the transformation of inputs into output. A production function relates inputs and output. It assigns the maximum output (Q) obtainable from each combination of inputs, given the level of technology (note: the latter relates to the idea of ‘X-inefficiency’ – later) Q = f(x1, x2, x3,…xn) or, simplifying: Q = f(K, L) where K = capital, L = labor Note that technology is reflected in the functional form ‘f’ Short run analysis: Q= f(K, L): Output can change by varying the level of labor, given the level of capital (K is constant) (i.e. given the ‘scale’, capacity, size of the firm) Marginal product (of labor): Definition: the extra (or additional or increment in) output obtained because extra labor is employed; thus, the change in output because of a change in labor. Measure: MPL = ΔQ/ΔL This is the slope of the total product (TP) curve, i.e. MP is nothing but the rate of change of TP (the 1st derivative of Q with respect to L) In order to observe the behavior of MPL as L rises, all we have to do is to observe the behavior of the slope of TP. v v v v v From 0 to L2 we climb a mountain: slope is positive, so is MP. Beyond L2 we go down a mountain : slope is negative, so is MP. At L2, neither going up nor going down the mountain, slope is ZERO, so is MP. Between 0 and L1, slope is positive AND INCREASING! Between L1 and L2, slope is positive BUT DECREASING! Average Product (of labor). Definition: output per worker Measure: total product over units of labor: APL = Q/L ,or, TP/L c.h. ziogas (ziogas11@yahoo.com) The IB @ The Moraitis School (This is a DRAFT copy)
  28. 28. 28 APL is a measure of labor productivity. Diagrammatically, the slope of the ‘ray’ from the origin to the point of interest on the TP curve is the AP of L at that level of L. To determine thus the behavior of APL as L increases (moving to the right on the horizontal axis) one needs to observe the behavior of the slope (NOT the length) of this ‘ray’. Short run analysis How does APL behave as L rises? AP(L’)= OQ’/OL’= AL’/OL’ APL is the slope of the ray from the origin. To determine the behavior of APL, you just need (as mentioned previously) to observe the behavior of the slope of the ray from the origin to various successive points on TPL . The Law of Diminishing Marginal Returns: v It is a short run law: it assumes the existence of at least one fixed factor (usually K i.e. the size/ scale of the firm) v The variable factor, usually labor, is assumed homogeneous. v Thus, any difference in returns is solely due to the capital/labor ratio employed. v That’s why it’s also known as the Law of Variable Proportions. v Technology is assumed constant/given. v If K and L were perfect substitutes, then the law would not hold. v It can be shown that as MPL decreases, MC rises (useful for MCH questions) Statement of the Law: As more and more units of a variable factor (labor) are used with a fixed factor (capital), there is a point beyond which total product will continue to rise, but at a decreasing rate, or equivalently, that marginal product, will start to decline. v Note that past L2 units of labor we encounter NEGATIVE returns. v The L of DMR’s is a purely technological law v The firm will not hire more than L2 workers since MPL <0 (too many workers for available capital), nor less than L1 since MPK<0 (too much capital for the available labor) c.h. ziogas (ziogas11@yahoo.com) The IB @ The Moraitis School (This is a DRAFT copy)
  29. 29. 29 v The economic region of production is thus between L1 and L2. Short run costs of production The short run is a period of time over which at least one factor of production is fixed, the calendar time will vary from firm to firm. All firms are subject to costs which can be split up into fixed and variable costs as follows: 1. Fixed Costs are costs that do not vary when the level of production varies and exist even if output is zero e.g. rent, interest on loans, insurance costs, fixed contract costs etc. 2. Variable costs vary with the level of output e.g. raw materials, components, labour. Definitions Total cost (TC) = Total fixed cost (TFC) + Total variable cost(TVC) Average total cost (ATC) total cost TC TFC + TVC = = = output Q Q Average fixed cost (AFC) total fixed cost TFC = = output Q Average variable cost (AVC) total variable cost TVC = = output Q Marginal cost is the extra (additional, increment in) cost resulting from an increase in output; it is thus the change in costs because of a change in output or the slope of the total cost curve (and of the total variable cost curve, since the two vary by fixed costs which do not affect marginal cost): change in TC (or VC) Δ(VC) Marginal cost (MC) = change in output ΔQ Due to diminishing returns, these short run cost curves will be U - shaped. The cost may fall initially as there are increasing marginal returns, but eventually when diminishing returns set in the costs will start to rise. More formally, since MC = ΔVC/ΔQ = Δ(wL)/ΔQ = wΔL/ΔQ = w/MP, so if MP rises then MC drops and if MP decreases (L of DMR’s) then MC rises. Equivalently, AVC = VC/Q = wL/Q = w/AP The only curve this is not true for is the average fixed cost curve. This will decline continually as the same level of cost is spread over more and more output. These changes can be seen on the cost curves below. c.h. ziogas (ziogas11@yahoo.com) The IB @ The Moraitis School (This is a DRAFT copy)
  30. 30. 30 Note that MC cuts through the minima of ATC and AVC; this is the result of the laws governing the behavior of marginal and average magnitudes: if marginal less than average then average will decrease and if marginal greater than average then average will rise. (think of the example with your grades to remember the logic behind the above) Production in the long run In the long run there are three possible effects on output from an increase in the scale of operation, in the level of use of all factors. These are: • Constant returns to scale - the % increase in output is equal to the % increase in all inputs. For example, doubling all factors (size), doubles output Q. As a result, average (unit) costs of production remain constant. • Increasing returns to scale - the % increase in output is greater the % increase in inputs. For example, doubling all factors (size), more than doubles output Q. As a result, average (unit) costs of production decrease. The firm enjoys economies of scale. • Decreasing returns to scale - the % increase in output is less than the % increase in inputs. For example, doubling all factors (size), less than doubles output Q. As a result, average (unit) costs of production rise. The firm suffers from diseconomies of scale. These possibilities are shown on the diagram below where the long run average cost curve initially slopes down with the increasing returns to scale, then is flat with constant returns and then slopes up with decreasing returns. c.h. ziogas (ziogas11@yahoo.com) The IB @ The Moraitis School (This is a DRAFT copy)
  31. 31. 31 The long run average variable cost curve (LRAC) describes the average cost of producing each output level when the firm is able to adjust all inputs optimally, when the firm is able to optimally adjust its size, its scale of operation. Economies of Scale (EOS): A firm enjoys economies of scale if unit (average) costs decrease as firm size increases. EOS are cost savings due to increased scale of production. They can be distinguished into internal EOS and external EOS. Internal EOS cost savings that are a result of actions of the firm itself. External EOS are cost savings for a firm that originate from developments outside the firm, for example from the industry in which it operates. This implies that a firm can create conditions that lead to internal EOS but can only hope for external EOS. Internal EOS can result from technical, marketing, management, financial or riskrelated reasons. More specifically: • Technical EOS (or, Plant Economies of Scale: 1. 2. 3. 4. a larger in size firm bay be able to adopt technologies of production not available for smaller sized firms: capital equipment (which embodies technology) is often indivisible (indivisibilities of K) Larger firms offer more room for specialization of workers and managers “Law of dimensions” (also known as the “container” principle): these cost savings arise because of the fact that volumes rise faster than surfaces (a³, a²) e.g. a tanker of double length can carry more than double the amount of oil etc. or a storage tank that can store double the volume of anything, costs less than double to manufacture (also blast furnaces, pipes, vats, lorries). The “law of multiples” [A] 40units/ hour 3A à [B] 30units/ hour 4B à [C] 20 units/ hour 6C c.h. ziogas (ziogas11@yahoo.com) The IB @ The Moraitis School (This is a DRAFT copy)
  32. 32. 32 Many production processes require sequential use of a number of machines. A larger size firm can buy such a combination of machines that idling time is minimized. • Marketing nature (Marketing economies of scale) 1. On the input side, a larger firm buys inputs in bulk and thus secures better prices from its suppliers. 2. On the output side, distribution costs are usually lower for larger firms (eg it may own its own truck fleet). 3. Advertisement on TV requires a certain minimum threshold level of messages to be effective. A large firm can divide this cost over a large volume of output. 4. Research and development - as firms grow they may be able to put in place R&D that benefits them across a number of areas of their activity • Financial nature (financial EOS) a large firm is able to borrow from banks at lower interest rates (i.e. faces smaller borrowing costs) compared to a small firm (both because of size of loans and because of reputation/credit risk). Also, as firms grow they may get access to more efficient and cheaper methods for raising finance (e.g. equity markets) • Management EOS Large firms can employ specialists in each department (eg a large supermarket hires financial experts to manage its cash on a daily bases, a large department store hires specialist “buyers” for each type of product it sells. • Risk-related EOS a large firm can diversify by selling not one but many products in not one but many markets (or, even countries) thus spreading and minimizing risks External economies of scale There has been a revival of interest in idea of Marshallian industrial districts. It is argued by some economists and economic geographers that there are substantial benefits to be gained from firms in the same area of production clustering together. Areas frequently quoted as examples are the Emilia Romagna area of Italy, Baaden Wurtemburg in Germany (engineering), Prato for textiles and clothing and Silicon Valley in California (more recently, Slovakia is heralded as the new Detroit for the car industry). c.h. ziogas (ziogas11@yahoo.com) The IB @ The Moraitis School (This is a DRAFT copy)
  33. 33. 33 External Economies of Scale originate outside the firm; as the industry grows, firms’ unit costs decrease; as a result of similar firms locating together in one area à economies of agglomeration. Why? They may benefit from the presence of suppliers, distributors, a skilled labor market, and specialist research and development institutions. More specifically: 1) A specialized labor force may develop (e.g. technical schools catering to their needs may also be established. 2) Complementary firms may also be established 3) Better transportation and telecommunications, networks may develop 4) Marketing of by-products may become an option. Diseconomies of scale Internal When firms get beyond a certain size, costs per unit of output may start to increase. There are several possible reasons for these diseconomies of scale. • Management problems of coordination. • Workers' motivation may decrease and industrial relations may deteriorate. • Complex interdependencies of mass production may lead to disruption if there are any hold ups in any particular part of the firm. Put succinctly, after a point, size may become a problem à since, problems of control, communication, co-operation may emerge & workers’ incentives may deteriorate; diseconomies of scale are a major reason for firms to divest. External After a point, congestion costs may develop. Also, as an industry grows, after a point, input prices (raw materials, specialized labor etc) may start to rise. (Question: Can a firm be characterized by Diminishing Marginal returns and increasing returns to scale at the same time? Answer: Yes, if, given its scale, it produces with increasing MC (i.e. decreasing MP, Dim. Marginal Returns) but, if it increases its scale of operations, unit (average) costs drop (= Economies of Scale, thus IRS)) c.h. ziogas (ziogas11@yahoo.com) The IB @ The Moraitis School (This is a DRAFT copy)
  34. 34. 34 Goals of firms • • • • profit maximization π(Q) = TR(Q) – TC(Q) sales / revenue maximization sales = TR(Q) satisficing theories: the firm tries to achieve at least a certain level profit / sales. long-run profit maximization (which may entail suffering short run losses) (Read on the “principal-agent” problem, Sloman p.217”) Role of economic profits in a market economy Profits are the reward of entrepreneurship. They differ from the other factor incomes in that profits are not contracted (as wages are) but are a residual and may thus even be negative (losses). • • • • Supernormal profits attract resources into an industry whereas losses free up resources permitting their use in other industries Striving to achieve profits results in greater efficiency Supernormal profits provide the incentive and funding for firms to finance expansion (i.e. investment) Supernormal profits can be used to finance R&D programs and may thus lead to product and process innovations Economic Profits Economic profits are found if from total revenues we subtract economic costs of production. The key to understanding the term “economic profits” is to realize that from an economist’s point of view the term economic costs refers to the value of ALL resources that are sacrificed during the production process! (Remember that the fundamental economic problem is that of scarcity…). This means that economic costs include not only the so-called explicit costs of a firm (also known as ‘out-of-pocket costs), i.e. the explicit payments it makes for the use of factors) but also implicit costs which include the value of firm–owned resources (for which it is not forced to make any payment but, for the economist, are still sacrificed resources) AND the minimal reward that the factor ‘entrepreneurship’ requires to remain in that line of business. This last item is known as ‘normal’ profit and is formally defined as the minimum the firm requires to remain in business. Normal profits are thus included in economic costs! The idea is that to secure the scarce factor entrepreneurship in a business some minimum reward is necessary for the risk that the person(s) is undertaking. If this reweard does not materialize, then the firm will close down. Remember, for a firm to secure labor, wages have to be paid which, of course, is an element of cost. To secure ‘entrepreneurship’ a minimum would also be required which, symmetrically, should also be included in costs (remember, entrepreneurship is a –very- scarce resource!) Consequently, if total revenues are equal to economic costs thus defined, then economic profits are zero à this means that the firm is just making normal profits! Zero economic profits thus imply normal profits: there is no reason c.h. ziogas (ziogas11@yahoo.com) The IB @ The Moraitis School (This is a DRAFT copy)
  35. 35. 35 MARKET STRUCTURES We distinguish four (4) market structures: * Perfect Competition * Monopoly * Monopolistic Competition * Oligopoly Perfect Competition Assumptions - Characteristics • Very many (theoretically, infinite many ) small firms • Homogeneous product (i.e. identical across sellers; examples of such products are few, mostly in primary sector: farm products, metals, etc. Note that the foreign exchange market is also a good example of such a market) • Free entry and exit (i.e. No barriers to entry / or to exit) • Perfect information • Perfect mobility of factors e.g. no geographical or, occupational immobility of labor These assumptions are not realistic nevertheless the model is useful: Economies of scale (IRS in production) exist and firms exploit them in most production processes. In the production of most goods larger in size firms can produce at a lower unit cost than smaller firms can. Firms thus have an incentive to grow either internally (through investment in physical capital) or through mergers and acquisitions. Thus large firms are very common in most industries. The number of firms in a market can be explained by the relationship between the minimum efficient scale (MES) (or minimum optimal scale – MOS) and the size of the market. The MES is defined as the smallest scale with which a firm can attain the lowest long run average costs. It should be understood that, given market size, the larger the MES the smaller the number of firms that can profitably coexist in a market. Firms also have the incentive to differentiate their product either in real ways (by improving quality, changing characteristics etc) or in imaginary ways so that they acquire some degree of monopoly power. Monopoly power is defined as the ability to raise price above marginal production costs. The Lerner Index of monopoly power is defined as the difference between price and marginal cost as a proportion of price (a perfectly competitive firm thus has zero monopoly power since as it will become clear, price is equal to MC). A firm selling a even a slightly differentiated product faces a negatively sloped demand curve for its product and thus has the ability to increase price without losing all of its customers. Firms also have the incentive to create entry barriers so that they can maintain supernormal profits in the long run. Exit barriers in the form of sunk costs also are common. Sunk costs are costs that a firm can not recoup (recover) upon exit. Sunk costs are low if a firm can sell or in other ways dispose of its capital equipment without a loss. Information is in the real world costly. Uncertainty and risks surround all business and consumption decisions. Search costs also exist and may be significant. Lastly, both capital and labor may suffer from immobility. Labor, for example, suffers both c.h. ziogas (ziogas11@yahoo.com) The IB @ The Moraitis School (This is a DRAFT copy)
  36. 36. 36 from occupational and from geographical immobility (which lead to structural unemployment) Short Run Equilibrium in Perfect Competition Typical firm Market • A perfectly competitive (pc) firm considers the market determined price as a parameter. It is thus known as a “price taker”. It can not increase the market determined price (no one would buy from it and it has no incentive to lower it since being by definition so small compared to the market it can sell all it wants at the current market price: it thus faces a perfectly elastic demand curve for its product; consumers face infinite perfect substitutes to choose from) • The demand curve a firm (any firm) faces always shows the Average Revenue TR pxq (AR) it collects at each level of output: AR (q) = = =p q q Thus, the AR for each q is the market price (P). à AR = P, in ALL market structures • Since only in PC is a firm able to sell any quantity it wants at the same (current) market price, it is only in PC that MR = P for all q’s To maximize profits it chooses q* for which MR=MC (and MC is rising) Visual / Geometric determination of the level of profits at q* π>0: positive economic profits i.e. firm is making more than normal profits: it is making supernormal profits! (it is making more than the minimum profit it requires to remain in this line of business) à i.e. resources in this market are being rewarded more than what they would have earned in their next best alternative! This by itself is an incentive for other entrepreneurs to organize the necessary factors and enter this industry. {note the role of profits and losses in allocating and re-allocating scarce resources in a market economy: profits attract more resources – assuming no barriers -- while losses free-up and channel resources into more productive uses; note that whether freed up resources may or may not be channeled into more productive uses depending upon their mobility} c.h. ziogas (ziogas11@yahoo.com) The IB @ The Moraitis School (This is a DRAFT copy)
  37. 37. 37 As a result resources will be attracted from other less remunerative activities into this market. à entry will take place π>0 à (= supernormal economic profits) Entry à Market supply ↑ à Market price ↓ à AR (=P) will drop until economic profits become zero i.e. until typical firm earns only normal profits (π=0). (Note that a firm earning normal profits is making money à just enough money to induce it to remain in the market) Shut down rule – Short run and long run • • if price is at P1 or P2 firm is profitable and will thus offer q1 and q2 respectively if P=P3, then firm is making losses! (Since ATC (q3) = q3C > AR = q3B) Should it perhaps shut down? à if it produces, its losses = area (P3BCF) à if it shuts down, it will be losing the fixed costs = area (HACF) but area(HACF) > area(P3BCF) Thus it will not shut down; it pays to operate until fixed costs do not exist, until all contracted obligations expire. • if P=P4 firm is once again making losses à if it continues to operate producing q4 its losses = area (P4B΄C΄F΄) à if it instead shuts down it will face its FC = area (H΄ A΄C΄F΄) Area (P4B΄C΄F΄) > area (H΄A΄C΄F΄) thus, in this case it will shut down! c.h. ziogas (ziogas11@yahoo.com) The IB @ The Moraitis School (This is a DRAFT copy)
  38. 38. 38 A loss making firm, in the short-run, will shut down only if P < AVC or, equivalently, if TR < VC Example: Assume a pizza parlor can sell a pizza at $10.00 each14. Assume that it costs him $9.00 to make each pizza in terms of the cheese, ham, sauce, labor and electricity required (his variable cots). He is making $1.00 on each and say, he sells 1000 pizzas a month. If his rent (fixed cost) is $2,500.00/month, he is making losses $1,500.00 per month. If he shuts down though he would have to pay his rent until his contract expires losing $2,500.00 a month. Clearly, it pays NOT to shut down until contracts expire (or, loans repaid). If though it cost him $10.50 to make each pizza in terms of ham and cheese then he would be losing the rent and $0.50 on each pizza! Clearly, it would pay to shut down immediately. Long Run Shut Down Rule …. while In the long run (i.e. when all adjustments have been made) it will shut down if P < AC i.e. if Π < 0 Thus the short run supply curve of a PC firm is that portion of MC above (min)average variable costs. (note that only perfectly competitive firms have ‘supply’ curves; for reasons explained in class, firms facing negatively sloped demand curves for their product do NOT have supply curves; there is no one-toone correspondence between Q chosen and market price) Long-Run Equilibrium Condition In the long run, the price and thus the market demand curve each perfectly competitive firm faces will be forced to touch (to be tangent to) its average cost curve at its lowest point. Zero economic profits (AR = AC) and with profit maximization (MR = MC) together with the fact that in perfect competition P=AR=MR combine to give the following long run equilibrium condition: q* : P (=AR) = MR = MC = min AC . Efficiency in Perfect Competition Allocative efficiency is achieved if markets are perfectly competitive since, for the last unit produced, P =MC (1) Technical (or, Productive) efficiency is also achieved if markets are perfectly competitive, since firms are forced to produce with minimum Average Costs (2) Interpretation: (1) “Just the right” amount from society’s point of view is produced, not more, not less à scarce resources are allocated in an optimal way à the impersonal, decentralized market (price) mechanism (i.e. the “invisible hand”) leads to the best (from so14 I am assuming the pizza is a price taker. c.h. ziogas (ziogas11@yahoo.com) The IB @ The Moraitis School (This is a DRAFT copy)
  39. 39. 39 ciety’s point of view) allocation of scarce resources; it solves the fundamental question that all societies face (which goods to produce and in what amounts) in the best possible way, a way that maximizes social welfare. (2) This socially optimal amount is also produced with minimum Average Costs i.e. with minimal waste of scarce resources If one realizes that the fundamental problem of economics, namely scarcity, forces all societies to answer the 3 fundamental questions (what, how and for whom) it is realized that achieving allocative efficiency is most desirable. Perfect competition answers the ‘what’ question in the best possible way and thus it leads to a socially optimal allocation of resources (allocative efficiency). In addition, given the scarcity of resources, the how question is answered in the best possible way since perfect competition guarantees that there is least waste in the use of resources (productive efficiency) But: • • • There is no guarantee that the goods produced will be distributed to the members of society in the fairest proportions. There may be considerable inequality of income. Thus, there is no guarantee that PC will lead to the optimum combination of goods being produced. Don’t forget that allocative efficiency is achieved in perfect competition given market demand; but market demand is defined as the willingness and ability to buy a good at each price, and ability reflects the income constraint that each one of us faces. A very poor person may thus not be ‘counted’ in the market demand for a ‘basic’ product! • Even though firms under PC may seem to have an incentive to develop new technology, they may not be able to afford the funds necessary to invest in research & development. (note the Schumpeterian argument concerning the desirability of ‘temporary’ monopoly power – see these notes further down) Also they may be afraid that if they did develop new more efficient methods of production, their rivals would merely copy them à investment would be a waste of money. • Perfectly competitive industries produce undifferentiated products. This lack of variety might be seen as a disadvantage to the consumer • Price in competitive markets change given any change in demand or cost (supply) conditions. These fluctuations may deter long term investment. In contrast, the price stability often found in oligopolistic markets may seem desirable for planning considerations. Monopoly • Industry coincides with the firm i.e. one firm producing a good without close substitutes c.h. ziogas (ziogas11@yahoo.com) The IB @ The Moraitis School (This is a DRAFT copy)
  40. 40. 40 • • Unique product High barriers to entry The concept of monopoly is relative since it depends crucially on how narrowly / broadly the product / market is defined. Note also the importance of the geographical factor i.e. location in relation to transportation costs. Some interesting points: 1) A monopolist can choose either the level of output or the price but not both, since the monopoly firm is still constrained (still faces) by a negatively sloped demand curve. 2) A monopoly firm does not necessarily make huge profits. It may even make losses [function of relative position of demand (AR curve) and average costs]. It can be shown that if demand (AR) is linear, MR is also linear, has the same vertical intercept and double the slope (1) Linear demand can be written as P = a – bQ (2) Total revenues equal by definition P x Q à Combining (1) and (2) à TR = (a – bQ)*Q à TR = aQ – bQ² Marginal Revenue = ∆TR dTR → = a − 2bQ à MR = a-2bQ MR = ∆Q dQ {Same vertical intercept but slope is double (–2b)} • A monopolist can set the price (not a price taker); the degree of monopoly power is given by the difference between the price charged and marginal cost expressed as a proportion of price (Lerner Index of monopoly power) • A profit maximizing monopoly will never choose a rate of output that corresponds to the inelastic section of the demand it faces à it will always choose elastic section (since for profit maximization MR = MC and since MC is necessarily non-negative, it follows that MR must be at the profit maximizing Q non-negative. MR is non-negative only for the set of Q’s corresponding to the elastic region of the demand curve) • Assuming that MC > 0 the profit maximizing output level is necessarily less than the revenue maximizing level of output (where MR = 0) and thus the corresponding price charged is higher. In other words, revenue maximization leads to more being produced at a lower price. Natural monopoly: A situation where long-run average costs would be lower if an industry were under monopoly than if it were shared between two or more competitors. The MES is so large compared to the market size that only one firm can profitac.h. ziogas (ziogas11@yahoo.com) The IB @ The Moraitis School (This is a DRAFT copy)
  41. 41. 41 bly exist in the market. Obviously, a natural monopoly is a result of massive scale economies. Natural monopoly examples are sometimes found in utility companies. Pricing policies in public regulated utilities include average cost pricing and marginal cost pricing (the latter being unacceptable by the private natural monopolist since it would imply a loss making situation; if adopted it necessitates subsidization by the government) (Study Sloman and Mankiw on Regulation of monopolies) Barriers to Entry / Exit definition: Anything that deters entry into an industry or, that prevents exit from an industry (exit barriers; examples of exit barriers: contracts that necessitate compensation of factors, single use machinery that can not easily be sold etc.. See the sunk cost discussion later in these notes) Alternatively, a barrier is anything that raises the unit cost of a potential entrant above the level enjoyed by the incumbent firm. Types of Entry Barriers: I. Natural Barriers (a) Natural Monopoly Often, production technology is such that massive economies of scale are present. As a result, the minimum efficient scale (MES) is such that, given market size, only a few, (or, sometimes only one) firms can profitably (co)-exist: when only one firm can profitably exist in a market it is the case of natural monopoly described above. A diagram can illustrate why only one firm can profitably exist (if 2 firms coexisted, each facing half the market demand, both would have been loss making firms) Examples à “utilities” à distribution of electricity, water company, post office These firms are either nationalized, or, if privatized, then regulated. If regulated, then efficient pricing would require setting P=MC (Marginal Cost Pricing) BUT, no private firm would accept this regulation since it would have been making losses (since AC are decreasing for the relevant output range, MC will lie below it) The maximum output that a private monopoly would accept to produce is Q (i.e. government may demand average cost pricing, i.e. setting P=AC). This is the next best solution (2nt best solution). c.h. ziogas (ziogas11@yahoo.com) The IB @ The Moraitis School (This is a DRAFT copy)
  42. 42. 42 b. Exclusive ownership of some vital input For example, ALCOA (Aluminum Company of America) owned or controlled virtually all known bauxite reserves of the US à thus, no other firm could produce aluminum. II. State Created a) patents à exclusive right to produce granted by the state to protect innovations (question on optimal patent time) b) licenses for example, for cell phone services, taxis, doctors, lawyers, etc. c) tariffs, etc. (tariff: a tax on imports à trade protectionism) State created barriers are the only type of barriers that may create “entrenched” monopoly positions – see later the section on the Schumpeterian critique. III. Firm Created Firms have every incentive to try to erect barriers in order to enjoy monopoly power and long run supernormal profits. a) heavy advertising and brand name image creation (but firms in other industries may have an equally significant brand name permitting them to enter a different market (case of Branson’s Virgin brand name and others) b) excessive product differentiation / proliferation c) maintaining excess productive capacity because potential entrant know that incumbent (existing) firm can easily increase output thus depressing price to unprofitable levels (e.g. cement firms do this). d) limit pricing à setting price NOT at the profit maximizing level but only slightly above unit costs: the extra output from entrant will depress price to unprofitable levels. Comparison of PERFECT COMPETITION & MONOPOLY (insert diagram; make the competitive market supply (which is also the MC curve) linear and close to the vertical axis so that you can easily illustrate the case where the monopoly firm being larger enjoys EOS by drawing a 2nd MC curve to the right –and below- of the initial one that will lead to lower price than PC and a higher output level) Assume a competitive industry and note the long run market determined equilibrium price and output. Assume now that this perfectly competitive industry is now monopolized. Further assume that cost conditions remain the same (i.e. that production technology is the same) c.h. ziogas (ziogas11@yahoo.com) The IB @ The Moraitis School (This is a DRAFT copy)
  43. 43. 43 à Monopoly restricts output and charges a higher price: Qm < Qc and Pm > Pc For the last unit produced by the monopoly firm, P>MC i.e. fewer units than socially optimal are produced à allocative inefficiency results (misallocation of scarce resources). In addition the monopoly firm is not forced (in the sense that perfectly competitive firms are) to produce at minimum AC. Thus, typically the monopoly suffers also from technical / productive inefficiency. Lastly, monopoly situations are characterized by a 3rd type of inefficiency known as “X-inefficiency”, a term coined by H. Leibenstein that refers to the internal slackness, typical of monopoly practices. It is the result of the protected position! (i.e. of barriers). i.e. that a monopoly may NOT be operating at the lowest set of cost curves possible (since, in production, for each combination of inputs, it is not forced to produce the highest output present technology permits) but, Monopoly firms may lead to Dynamic Efficiency If the monopoly firm enjoys Economies of Scale then it may be the case that output is even greater than that under PC and the price charged even lower. In addition, the monopoly firm, because of the fact that it may maintain supernormal profits in the long-run, may end up financing R&D (=research and development) programs and thus it may be characterized by a faster rate of innovation (= new methods of production (= process innovation) and new products (= product innovation)). The Schumpeterian argument presented below argues that temporary (non-entrenched) monopoly positions are the necessary result of successful innovations. And temporarily advantaged entrepreneurs would be constantly challenged and eventually displaced by other innovations (‘the perennial gale of creative destruction’). Note the importance of potential competition and of the threat of (‘hit and run’) entry (see Baumol’s theory of Contestable Markets presented below where even a monopoly structure may be forced because of the threat of competition to produce with a socially efficient cost structure) (Remember that a monopolist – or any firm facing a negatively sloped demand for its product - does not have a supply curve as explained earlier) Price Discrimination (PD) A pricing policy that certain firms adopt to further increase their profits. definition: Price discrimination exists when a firm sells the same product at two or more different prices in two or more markets (provided that the price differences do NOT reflect production or provision cost differences; (if they do reflect cost differences certain examiners within the IB call it ‘price differentiation’; in my opinion an error; google search the term restricting results to university sites i.e. .edu sites or .ac.uk or consult major textbooks) c.h. ziogas (ziogas11@yahoo.com) The IB @ The Moraitis School (This is a DRAFT copy)
  44. 44. 44 Examples: Airline tickets / train and bus fares / clubs / theatres, cinemas / phone services / lawyers - doctors – consultants / “dumping” à when a firm sells abroad at a lower price than in its protected domestic market (a form of international pd). Question: Answer: 1. 2. 3. Can all firms practice price discrimination? No, certain conditions have to be met for price discrimination to be feasible: The firm must enjoy some degree of monopoly power à i.e. it must face a negatively sloped demand curve (a perfectly competitive firm cannot thus practice price discrimination). No resale of the good (“seepage”) should be possible; the two markets must be separable (otherwise, “arbitrage” – buying low and selling high – will guarantee that one price will eventually dominate) The price elasticities of demand between markets must differ à some consumers must be willing to pay more (usually because less substitutes are available to them). Types of price discrimination 1) 1st degree price discrimination (or, perfect price discrimination; a highly theoretical case) Here, it is assumed that the seller is fully aware of the consumer’s willingness to pay and charges her the maximum price she is willing to pay for each unit consumed. Note: In perfect PD, • all of the consumer surplus is appropriated (taken) by the producer • Allocative efficiency is achieved! (since all units for which P > MC are produced and sold up until that unit for which P=MC) The closest real world approximation of this highly theoretical construct may be open air markets where ‘haggling’ is common, typically found in the Middle East. 2) 2nd degree price discrimination (or, block price discrimination) Here “blocks” of units of output are sold at different prices to the same consumer e.g. if you buy the first 10 units you pay €100.00 but for the next 10 you pay €90.00 3) 3rd degree price discrimination (the commonest type) Here markets are segmented to the extent that conditions 2 and 3 are met. e.g. hotels in high is low season and most other cases Price is higher in the market characterized by the more inelastic demand curve. Equilibrium Condition (useful for multiple choice questions) since MR1 = MC in market 1 and MR2 = MC in market 2 c.h. ziogas (ziogas11@yahoo.com) The IB @ The Moraitis School (This is a DRAFT copy)
  45. 45. 45 it follows that MR1 = MR2 = MC Do consumers ever benefit in the presence of price discrimination? Yes, there are situations where certain groups do benefit: 1. The group that pays the lower price if it is lower than that in the single price case If it permits the firm to sell more output and as a result it enjoys economies of scale (that are at least to an extent passed along to the consumers in the form of overall lower prices) If a good was unprofitable to offer without pd (in other words if pd makes the provision of a good profitable to a group that otherwise would have to do without it) 2. 3. Monopolistic Competition Two economists who worked separately developed the theory of monopolistic competition: Edward Chamberlin (The Theory of Monopolistic Competition) in Cambridge, Massachusetts and Joan Robinson (Imperfect Competition) in Cambridge, UK. The assumptions on which the theory of monopolistic competition is based are three. The assumptions are: • A very large number of firms just like in perfect competition. This implies that each firm has a very small share of the market. Each monopolistic competitor is not aware about what the other firms are doing. • Freedom of entry and exit. There should not be excessively specialized assets (sunk costs) to make exit from the market difficult when a normal profit is no longer made. • The product is differentiated: Each firm sells a product, which is somewhat different to that sold by its competitors. This assumption is the one that makes the model ‘monopolistic’. If each firm sells a good or service that no other firm sells then it enjoys some (a very small) degree of monopoly power. It is the second assumption that distinguishes monopolistic from perfect competition. Examples: retail businesses such as hair salons, gas stations, restaurants, textbook markets, VHS and DVD rentals etc. Predictions of the monopolistically competitive model: • Allocative and technical inefficiency result • The monopolistically competitive model predicts that there will be excess capacity. This means that the firm will produce less output than the one corresponding to minimum average costs. Too many firms enter so that each individual firm is unable to use all the capacity at its disposal. The many empty c.h. ziogas (ziogas11@yahoo.com) The IB @ The Moraitis School (This is a DRAFT copy)

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