Key Diagrams for Year 2 Microeconomics
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A selection of important microeconomic diagrams for parts of the Year 2 Microeconomics (A-Level) course.
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Key Diagrams for Year 2 Microeconomics
- 1. Key Diagrams for Year 2 Microeconomics Tutor2u, June 2018
- 2. THEME 3.2 - BUSINESS OBJECTIVES SALES REVENUE MAXIMISATION MC Price and Cost Output AC MR AR Profit Max: MC=MR Revenue Max: MR=0 P1 C1 Total Revenue
- 3. THEME 3.2 - BUSINESS OBJECTIVES SALES MAXIMISATION MC Price and Cost Output AC MR AR Profit Max: MC=MR Sales Max is at an output where AR=AC At this output, normal profits are made P1 Q1
- 4. SATISFICING THEME 3.2 - BUSINESS OBJECTIVES MC Price and Cost Output AC MR AR Possible satisficing price P1 Q1 Q2 P2 C2
- 5. MAXIMISING REVENUE THEME 3.3 – REVENUES, COSTS & PROFITS Price Output MR AR Revenue Max: MR=0 • Total revenue is maximised when marginal revenue = zero • This is at the mid-point of the demand (AR) curve for a business with a downward-sloping AR P1
- 6. THEME 3.3 – REVENUES, COSTS & PROFITS PRICE TAKERS AND PRICE MAKERS Price Output Price Output AR = MR AR MR Price takers accept the ruling market price and sell each unit at the same price. (AR=MR) Price makers have some pricing power and will face a downward sloping AR curve; MR will be below AR
- 7. AVERAGE AND MARGINAL COST CURVES THEME 3.3 – REVENUES, COSTS & PROFITS MCCost AC AVC AFC AFC will fall as the level of output expands MC also cuts AVC curve at min of AVC
- 8. AVERAGE AND MARGINAL COST CURVES THEME 3.3 – REVENUES, COSTS & PROFITS MCCost AC AVC AFC AFC will fall as the level of output expands MC also cuts AVC curve at min of AVC
- 9. THEME 3.3 – REVENUES, COSTS & PROFITS LONG RUN AVERAGE COST CURVE (LRAC) Q1 Average Cost (Unit Cost) Output LRAC Q2 Q3 Economies of scale cause AC to fall Lowest point on LRAC is output of productive efficiency Rising LRAC – means diseconomies of scale
- 10. THEME 3.3 – REVENUES, COSTS & PROFITS DISECONOMIES OF SCALE – IMPACT ON FIRMS Q1 Price and Cost Output AR P2 C1 Q2 P1 LRAC C2 Producing an output beyond the minimum efficient scale e.g. at Q2 leads to lower total profits. Diseconomies of scale cause unit costs to be higher than at output Q1.
- 11. THEME 3.4 – MARKET STRUCTURES ALLOCATIVE EFFICIENCY Price Quantity Demand Supply P Q R S T O Producer surplus Consumer surplus Allocative efficiency is at an output which maximizes total consumer welfare At the market equilibrium price, consumer and producer surplus is maximized – at this output, economic welfare is maximized.
- 12. THEME 3.4 – MARKET STRUCTURES PERFECT COMPETITION – SHORT RUN Price, Cost Output Price, Cost Output Market Supply and Demand Revenues, Costs and Profits for a Competitive Firm D S AC MC P1 AR=MR Q1 C1 Supernormal profits
- 13. THEME 3.4 – MARKET STRUCTURES PERFECT COMPETITION – LONG RUN ADJUSTMENT Price, Cost Output Price, Cost Output Market Supply and Demand Revenues, Costs and Profits for a Competitive Firm D S1 AC MC P1 AR1=MR1 S2 P2 AR2=MR2 Q2
- 14. THEME 3.4 – MARKET STRUCTURES SHUT-DOWN PRICE AC AVC P1: Price = average cost, normal profits made P2: Price = average variable cost P=Min AVC is the shut down price for a competitive firm in short run Price MC P1 P2
- 15. THEME 3.4 – MARKET STRUCTURES MONOPOLISTIC COMPETITION – SHORT RUN MC Price and Cost Output AC MR AR P1 Q1 C1 Supernormal Profit
- 16. THEME 3.4 – MARKET STRUCTURES MONOPOLISTIC COMPETITION – LONG RUN MC Price and Cost Output AC MR2 AR2 P2 Q2 In the long run equilibrium, average revenue is tangential to AC – meaning normal profits are being made because P=AC
- 17. THEME 3.4 – MARKET STRUCTURES MONOPOLY PRICE AND OUTPUT MC Price and Cost Output AC MRProfit Max: MC=MR P1 Q1 C1 Supernormal Profit AR The average revenue is much higher than the unit cost at output Q1 The monopoly is a price-maker although it is also constrained by their demand curve
- 18. NATURAL MONOPOLY THEME 3.4 – MARKET STRUCTURES Price and Cost Output LRAC LRMC MR AR P1 C1 A natural monopoly there there are high fixed costs involved in supplying a good or service such that the long run average cost curve may fall continuously as output increases in the long run. Marginal cost is less than average cost. This helps to drive down average cost as output increases. Q1
- 19. THEME 3.4 – MARKET STRUCTURES 3RD DEGREE PRICE DISCRIMINATION Price Output Price Output AR AR MRMR MC MC Elastic demand – consumers responsive to small price changes Inelastic demand – high willingness/ ability to pay P1 Q1 P2 Q2 C1
- 20. THEME 3.4 – MARKET STRUCTURES PEAK AND OFF-PEAK PRICING Price Output MR off peak AR off peak MC P off-peak Q1 Q2 P peak MR peak AR peak At off-peak times, market demand is low and firms will have spare capacity
- 21. PRICES AND PROFITS IN CONTESTABLE MARKETS THEME 3.4 – MARKET STRUCTURES MC Price and Cost Output AC MR P1 Q1 C1 AR Q2 P2 Profit maximising price Price where normal profits are made Threat of competition likely to cause firms to price at P2 rather than P1
- 22. CONTROLLING MARKET POWER – PRICE CAPPING THEME 3.6 – GOVERNMENT INTERVENTION MC Price and Cost Output AC MR AR P1 Q1 C1 Supernormal Profit Capped Price Q2 C2 At a capped price, the monopolist can make a profit, but supernormal profit will be lower.
- 23. KINKED DEMAND CURVE MODEL 4.1.5.5 OLIGOPOLY Price and Cost Output AR1 P1 AR2 Cutting price below P1: Likely reaction of other firms is to follow the price reduction. Demand likely to be relatively inelastic – little benefit in terms of extra sales and total revenue Q1 P2 Q2 P3 Q3 Raising price above P1: Likely reaction of other firms is to hold their prices. This will cause an elastic demand response and results in lost sales and falling total revenue
- 24. KINKED DEMAND CURVE MODEL – OUTCOME 4.1.5.5 OLIGOPOLY Price and Cost Output AR1 Is there a profit maximising equilibrium in this market? In the diagram here MC1 cuts through the gap in the marginal revenue curve MR1 MC1 Kinked demand curve model assumes: Other firms will follow if prices are cut Firms will not follow if prices rise MC2 One of the key predictions of the kinked demand curve model is that prices will be rigid or “sticky” even when there is a change in the marginal costs of supply (this is assuming that firms in the market are profit seeking)
- 25. ELASTICITY OF LABOUR DEMAND 4.1.6.1 DEMAND FOR LABOUR Wage Rate Employment LD1 W1 W2 W3 E1E2 LD1 is elastic – i.e. employment is sensitive to a changing wages Wage Rate Employment LD2 W1 W3 E1E3 LD2 is inelastic – i.e. a large rise in wages causes only a small fall in employment
- 26. ELASTICITY OF LABOUR SUPPLY 4.1.6.2 INFLUENCES ON SUPPLY OF LABOUR Wage Rate Employment LS1 W1 W2 E1 E2 Wage Rate Employment LS2 W1 W2 E1 E2 In relatively lower-skilled jobs, the labour supply is elastic because a pool of labour is available to be employed at a fairly constant market wage rate. Where jobs require specific skills and training, the labour supply will be more inelastic.
- 27. EQUILIBRIUM WAGES 4.1.6.2 INFLUENCES ON SUPPLY OF LABOUR Wage Rate Employment LS1 W1 E1 Wage Rate LS1 W1 W2 E1 E2 LD1 LD1 An outward shift of labour demand LD2 Employment
- 28. LOW PAY AND THE UK MINIMUM WAGE 4.1.6.6 THE NATIONAL MINIMUM WAGE Wage Rate Employment LS1 W1 E1 Wage Rate EmploymentE2 E3 LD1 LD1 W1 LS1 W2 Min Wage The free market wage is W1 with employment level of E1. If a minimum wage of W2 is introduced, then employment contracts to E2 and the supply of labour expands to E3
- 29. MONOPSONY EMPLOYER – WAGE ANALYSIS 4.1.6.4 IMPERFECTLY COMPETITIVE LABOUR MARKET Wage Rate Employment Labour Supply (= ACL) W1 E1 • Profit maximising employment level is where MCL=MRPL i.e. E2 number of people are employed • Their marginal revenue product is valued at W2 • Monopsony power of the employer allows them to pay a wage rate W3 Labour Demand = MRPL Marginal cost of labour (MCL) E2 W2 W3
- 30. MONOPSONY EMPLOYER – WAGE ANALYSIS 4.1.6.4 IMPERFECTLY COMPETITIVE LABOUR MARKET Wage Rate Employment Labour Supply (= ACL) W1 E1 • Monopsony employer can use their buying power to pay a wage lower than the value of the marginal revenue product of workers employed at E2 • Monopsony power can lead to exploitation of employed workers Labour Demand = MRPL Marginal cost of labour (MCL) E2 W2 W3 Total wages Lost wages from under-payment
- 31. MONOPSONY POWER WITH MINIMUM WAGE 4.1.6.4 IMPERFECTLY COMPETITIVE LABOUR MARKET • A minimum wage is enforced in the labour market. • This means that the marginal cost of employing labour is constant up to employment level E4 • Thereafter the MC and AC of employing workers diverges Wage Rate Employment Labour Supply (= ACL) Labour Demand = MRPL E2 W3 Total wages E4 MCL MCL with min wage Wmin
- 32. MONOPSONY POWER WITH MINIMUM WAGE 4.1.6.4 IMPERFECTLY COMPETITIVE LABOUR MARKET • The new profit maximising level of employment with the minimum wage is now at E3 – which is a higher employment level and a higher wage than with the previous wage paid by the monopsony employer. Wage Rate Employment Labour Supply (= ACL)Wmin Labour Demand = MRPL E2 W3 Total wages E4 MCL MCL with min wage E3
- 33. TRADE UNIONS – WAGE AND JOBS ANALYSIS 4.1.6.5 INFLUENCE OF TRADE UNIONS Wage Rate Employment Labour Supply W1 E1 Labour Demand Union negotiated wage W2 E2 Higher wage income from union collective bargaining Lost wage income from contraction in employment • Unions will have more success in raising wages for their members if the demand for labour is relatively wage inelastic • Unions also more influential when they represent a high % of all workers in a given industry/occupation • Pay might also rise if unions and employers agree a pay deal based on better productivity
- 34. THE LORENZ CURVE 4.1.7.1 DISTRIBUTION OF INCOME AND WEALTH Cumulative % of Income100% 50% 0% Line of Equality Lorenz Curve (High Inequality) Lorenz Curve (Low Inequality) Households by Income – Quintile DistributionPoorest Richest The Lorenz Curve gives a visual interpretation of income or wealth inequality. The diagonal line shows a situation of perfect equality of income i.e. 50% of population has 50% of income
- 35. Key Diagrams for Year 2 Microeconomics Tutor2u, June 2018