King Fahd University of Petroleum & Minerals
College of Industrial Management
Department of Finance & Economics
Class Notes of
ECON.101
MICROECONOMICS
Dr. Usamah A. Uthman
Associate Professor of Economics
http://faculty.kfupm.edu.sa/finec/osama/
1
CHAPTER 1: INTRODUCTION TO MICROECONOMICS
Why study Economics? Because it helps us to understand the world better.
Almost every problem under the sun must have some economic dimension
either in terms of cause, effect, or both. (Examples found in p. 4 in Book, (1)
wars, (2) population growth, (3) environment, (4) marriage traditions….etc.
What is Economics? It is the study of the allocation of scarce resources to
satisfy unlimited wants or needs.
What are the resources of the economy?
1.
Labor (most important) – physical + mental.
2.
Land – it includes under land (petrol + minerals)
3.
Capital (man made) – buildings + machines  last for long time not like
food. (things not for immediate consumption)  used for further production.
Scarcity: there is no unlimited amount of resources in nature. This implies that
we have to be rational in resource utilization.
Rationality + Efficiency+ fairness in distribution makes scarcity less acute.
Opportunity cost is the value of the next best foregone alternative. It is the
value of other goods and services that could have been obtained but were not.
The scarcity of resources forces us to make a choice about the use of these
resources  implies the existence of (opportunity) costs.
Scarcity implies that
choices must be made, and
making them implies the
existence of cost.
Scarcity  Choice  Cost
Example
Choices
A
B
C
D
E
Rewards
2,500
2,300
2,100
90
80

F
Go to
school
The opportunity cost of “ to go to school, F ", is "A", the second best.
2
Example
Butter
"Straight line,
because ratio of
prices constant"
50
- ve slope "because
more of one means
less of the other
100
Bread
Income
=
SR 100
PBread
=
SR 1.0
PBt
=
SR 2.0
Opportunity cost stays constant no matter how much is produced, because
relative prices are constant.
Figure 1-1
A Choice Between Bubble Gum and Chocolates
©1999 Addison Wesley Longman
3
Slide 1.2
Figure 1-2
A Production Possibility Boundary
Slide 1.3
©1999 Addison Wesley Longman
4
military
goods
unattainable
Points on line when
all resources are
used (efficient)
Scarcity : points
beyond PPF"
(PPF) Production
Possibility
Frontier
B
Attainable
Here is the max "on curve"
Opp. Cost measured by by
taking the slope of the curve
tangent.
A
civilian goods
inefficient
(2) choice: society cannot be at
more than one point
(3) cost: to move from one
point to the other, some
sacrifice has to be made
opportunity cost: grows larger
as we increase what is produced
of one good ,at the expense of
the other.
Four key problems (The Economic problem):
1.What to produce and how much?
-What things can be produces in the economy?
-How much production should we make?
-What method (or technology) should be used?
2.Who gets what, Or what is consumed by whom? is determined by levels of
incomes.
work
inheritance subsidies
(or taxes)
5
luck
(or political Power)
3.
Why
resources
may
be
idle
(not
used)?
-what causes unemployment of labor?
-what causes idle business capacity?
4.
What causes economic growth?
Figure 1-3
The Effect of Economic Growth on the Production Possibility Boundary
Slide 1.4
©1999 Addison Wesley Longman
To answer these questions, the study of economics is divided into two broad
areas of study:
*microeconomics: is the study of the behavior of individual economic units
such as the consumer, producer, individual markets as they may be affected by
the price system and government behavior.
Macroeconomics: Is the study of the behavior of aggregate (total) economic
variable such as
total consumer total investment, unemployment, inflation, interest rate,
economic growth.
6
Four types of economic systems ( or how society responds to the 4 econ.
Questions?): Example: feudal system in medieval Europe.
A.
Traditional economy: economic outcome is a result of history, tradition,
habits, and social norms.
B.
Command economy: there is a central authority (usually
government)that makes decisions about major economic variables. This
requires huge amount of information. (command economy = centrally
planned economy like the former Soviet Union).
C.
Market system: the extreme type is called laissez faire (do not interfere).
The decision process is affected by price signals as determined by market
(market system = price systems)
D. Mixed economy: most countries lie here where one could see different
degrees of market and command elements.
These economies differ in the way in which economic decisions are
coordinated.
x
x
x
command economy
x
market economy
7
Ownership-coordination (decision) mix:
1
4
Private
Ownership
+
private
coordination
Market
principle
3
Public
ownership
+
central
coordination
economy
Private
Ownership
+
public
coordination
2
Public
Ownership
+
private
coordination
Command
Coordinating
economy
Nazi
Germany
Market
coordination
1
+
4
=
Main Mixes
SABIC + SAUDIA AIRLINES
Government intervention: is not purely good, nor purely bad. There are good
government interventions, and bad ones. It depends on direction + magnitude,
timing, and mix (example – should health care be public or private).
A market system is necessary but not sufficient for the well being of
societies
The essence of a market economy is the existence of
(1) The right of private ownership
(2)
The freedom of contracting, however, this did not originate in Europe,
ISLAM respects and enforces these rights.
8
Coordinating decision making
Economies differ in :
ownership
Public ownership
Private ownership
Soviet Union (to some extent)
United States (to some extent)
Living standards: For a better living standard, we must increase the productive
capacity of society. Labor productivity is most important factor of production.
SEE FIG. 1-4 below.
9
Figure 1-4
A Century of Growth in Labor Productivity
Slide 1.5
©1999 Addison Wesley Longman
The rule of 72: To estimate the no. of years it takes to double the standard
of living, assuming a certain rate of econ. Growth:
72
Number of years for output to double = ----------------------Rate of growth
Distribution of Income: the increase in total income in recent years slowed
down and shifted the income distribution from poorer to the better educated
workers due to change in production processes which needs higher skills. SE
FIG 1-5 below
10
Figure 1-5
Real Earnings of Young Men and Women, 1972-1992
Slide 1.6
©1999 Addison Wesley Longman
Technology changes are constantly changing the nature of our economy. Job
structure decreases in industrial employment sector.
The increase in services employment is because (1) services that used to be
produced within manufacturing firms have become separate specialist firms (2)
the rapid growth of international trade .
(3) more products highly technological, so increased amounts are spent on
product design.
Households spend a rising proportion of their incomes on services rather than
goods.
When we mention that each generation has more real income we must
remember that new products have been introduced, so more money will be
spent (dishwashers, T.V., stereos, etc.)
SEE FIG. 1-6 below.
11
Figure 1-6
The Changing Composition of Nonagricultural Employment
Slide 1.7
©1999 Addison Wesley Longman
Globalization: is due to rapid reduction in transportation rates and the
revolution of information technology.
-Transnational corporations: are firms with physical presence in many
countries and have decentralized management
-
Product markets are globalizing: a single product may have parts from
different countries.
-
As a result of globalization we can produce cheaper products in lowwage countries.
12
ECONOMIC POLICY
Policy ends are the goals we want to achieve.
The Policy mean are
ways to achieve ends
All policies have costs and benefits
(1) A laissez faire policy
(free market)
Government policy
(2) Strict control policy
Six questions that can be asked about any economic
policy:
1.
What are the policy goals?
2.
Does the proposed policy achieve its goals?
3.
Does it have side effects?
4.
Are there alternative means to achieve the goals?
5. What are the costs and what are the benefits?
6. What should be done in the short run? What should be done
in the long run? Some short run measures may have to be phased
out in the long run, otherwise, they may complicate the problem
over time. Such as what?
These questions must always be in your mind when
addressing any problem
13
Chapter3: The Anatomy of The Market Economy
The specialization of labor is the allocation of different tasks or jobs to different
people. This results in more efficiency in work and higher output for two reasons
a) It allows each person to do the job he can do best , while leaving other jobs for
other people. b) concentration on one particular job leads to what is called “’
learning by doing”.
Division of labor is a further specialization in doing repetitive job for producing
a single (particular) final product.
Specialization and division of labor  more efficiency  higher output  more
and more trade (more economic growth + higher standard of living). The
innovation of money helps this process.
Innovation of money: eliminated the inconvenience of barter (exchange goods
for other goods) and gave people more time to specialize in production and be
more efficient and produce more and increase room for trade.( how many prices
for each good or service one needs to know if money was not used?)
READ EXTENTIONS 3-1 & 3-2
Decision makers in market economy
1.
Households (Family, all people living under one roof) – known as
consumers. Assumptions about HH:
a)
b)
c)
2.
a)
b)
c)
consistent in decision making
try to maximize utility (satisfaction)
they own the factors of production (labor, capital, and land)
Firms (businesses) – known as producers
consistent in decision making
try to maximize profits
they employ factors of production
14
3.
Government: no particular assumption about government behavior
except maximization of public welfare. Consistency may not be there
because:
a)
b)
multiple government organization with different regulations (rules)
some government officials may have personal goals.
The market: the modern concept is not limited to a physical location but refers
to the activity of exchange of goods and services.
Technological improvements in production, communication
transportation have led to major developments in today’s markets.
and
The sectors of the economy: Two ways of looking at economic organization in
the economy:
1)
The
economic
(profit)
criteria
(:market-non-market
sectors)
MARKET
PROFIT- MAKING
NON-MARKET
NON- PROFIT MAKING
Buying and selling costs are
covered by charging a fee
(selling) for output.
(a) government: most services
for no fees, cost is covered by tax
or borrowing (b) charities: costs
are covered by donations.
Example:
Microeconomics (looks to demand and supply): Asks about prices of goods.
Macroeconomics: Asks about average level of all prices.
15
2)
Public – private ( the legal criteria) one makes laws and the other obeys
laws or ownership.
Public Government
Sector
(production provided by
Government)
Private
(production provided by
private agents
Example:
General Motors is in the private and market sectors.
SABIC is a public but market sector.
Institutions are social structures that regulate the behavior of society such as
laws (formal institutions)), customs (informal institutions), values (religion).
laws (formal institutions) designed by government to: 1 ) protect the right of
ownership and 2) enforcement of contracts
Institutions affect the allocation of resources (economy) and distribution of
income.
The Market is one of the social institutions but not the only one
Adam Smith (a famous Scotch economist, and founder of modern
microeconomics) called the price mechanism as “The Invisible Hand”. The
price system allows the decentralized coordination of the decision making of
millions of individual consumers and producers. The coordination comes through
prices, wages and profits.
16
An Over view of The Macroeconomy : see Fig’s 3-1 & 3-2
Figure 3-1
Real and Money Flows
©1999 Addison Wesley Longman
Slide 3.2
Flows of goods and services (real Flows)
Real flows of money incomes (monetary Flows)
For every purchase there is a sale.
For every buyer there is a seller.
Goods markets: services + goods that are produced and sold in market.
Factor markets: Markets of factors of production.
In The two markets – producers and consumers interact.
17
Figure 3-2
The Circular Flow Elaborated
©1999 Addison Wesley Longman
Slide 3.3
Leakages = Taxes + Savings + Imports
T
+
S
+ IM
Injections = government purchases + Investment + Exports
G
+
I
+
X
For Macroeconomic Equilibrium: Sum of injections = sum of leakages
Macroeconomic disequilibrium generates microeconomic disequilibrium.
READ APPLICATION 3-1
Failure of central planning and success of market planning due to:
1.failure of coordination: did not use prices to signal scarcity and abundance.
2.failure of quality control: dependence on quantity, not quality.
3.absence of work-oriented incentive system.
4.failure to protect environment (because of fulfilling production plans).
18
Market economy is characterized by constant change in structural job, technology
used, types of products produced.
The collapse of the Soviet Union in 1991 was painful because of the transition to
market economy. Need them to change the institution which is very hard.
Transition of economy: is the fourth type of economy, where there is a transit
from centrally planned economy to free market economy. Transitions in former
communist economies: has been painful and time consuming because:
1.
The credibility of reforms: most problem is the general disbelief that the
government will allow bankrupt firms to shutdown.
2.
The rule of law: command economy had different laws; to make new
laws takes time.
3.Sectoral adjustments. a) change from public to private ownership and b)
expanding the consumers' goods sector and reducing the military sector.
END OF CHAPTER 3
19
End-of – Chapter Discussion Questions:
Chapter 1.
Q1.a the policy goals are stop seal hunt, but the conflict is that is has a cost of
hunters losing jobs.
Q2.
scarcity is due to shortage of supply in nature (resources) or the degree of
development (is not great), but poverty is due to scarcity or income distribution.
No, but we can say less scarce, because enough does not mean unlimited
amounts.
Q6.
LM/KM > LUSA/KUSA  Mexico has relatively more labor than USA
1.
Private market  Saudi Airlines
Yes. Could (privatization)  increase competition which can increase
efficiency.
Privatization
efficiency
Competition
Flow concept: related to time
Stock
:
variable with no time dimension
20
Ch. 4: Demand, Supply & Price
THE DEMAND SIDE OF THE MARKET
Quantity demanded: total quantity desired by consumers of some product or
service during a period of time.
1.
Total: refers to total market, not individual
2.
Desired: actually demanded (not imaginary demand)
taking into consideration the current economic factors.
does not imply the quantity actually purchased (bought or sold)
3.
It has a time dimension. This is a flow concept.
Factors affecting demand:
1.
The product own price
2.
per capita (per person) income
3.
prices of related products (substitutes, or complements)
4.
market size (population)
5.
taste (example, change in fashion, from fountain pen to ball point pens.
6.
distribution of income
7.
expectations (future) example: We know that we are going to have cold
winter. Demand for winter clothing will increase.
8.
demographic structure of population.: EX: male vs. female ; old vs.
young
9.
Seasonal factors.
Prices of related goods
Substitutes :
other products that satisfy same needs
Complements:
products tend to be used together
Example: Orlando airplane ticket  demand of Disney tickets
21
The law of demand: quantity demanded is negatively related to price, ceteris
paribus ( holding other things constant). This is so because there are usually
other substitutes.
Demand schedule (Curve): the relationship between price and quantity
demand, holding other factors constant (ceteris paribus).
Figure 4-1
A Demand Curve for Carrots
©1999 Addison Wesley Longman
Slide 4.2
Figure 4-2
Two Demand Curves for Carrots
©1999 Addison Wesley Longman
22
Slide 4.3
Figure 4-3
Shifts in the Demand Curve
©1999 Addison Wesley Longman
Slide 4.4
Result: An increase in demand shifts the D- curve to the right & causes an
increase in quantity demanded too. A decrease in demand causes the opposite.
Very, very, important:
Distinguish between quantity demanded and demand.
Many students make a mistake here.
Change in quantity demanded: could be due to change in own price, a change
or shift in demand or both. (if both change we take net effect (see figure 4-4 in
book).
A movement along a demand curve is a result of change in price alone. A shift
of the demand curve is the result of a change in factors other than price  change
in entire demand.
Change in demand: refers to shift of the entire curve and is due to change in
one or more factors other than own -price .A shift in demand implies a change in
quantity demanded at each price P, or that for each quantity there will be a
different price..
Example: change in mobile phone prices 10,000  3,500  500 is a change in
quantity demand (along the curve not a shift).
23
Figure 4-4
Shifts of and Movements Along the Demand Curve
©1999 Addison Wesley Longman
Slide 4.5
THE SUUPLY SIDE OF THE MARKET:
Quantity supplied: total quantity producers are willing to produce and sell during
a period of time.
1.
Willing: not imaginary, but what they could do, but not necessary what
they actually succeed in selling.
2.
It is a flow concept (time related). The amount they succeeded in selling
is called quantity exchanged.
Factors affecting quantity supplied:
1.
product own price
2.
prices of inputs (cost)
3.
number of suppliers (degree of competition)
4.
technology (Example, improvement in transportation)
5.
government regulations ( taxes, quality standards, licenses, tariffs ….etc.)
6.
prices of related goods.
7
Seasonal factors, especially for agricultural products and oil.
Inputs: all things a firm uses to produce its output (Ex. Labor, materials,
electricity, fuel, machines, land…..etc.)
24
The Law of Supply: The quantity supplied is positively related to own-price,
ceteris paribus.
Figure 4-5
A Supply Curve for Carrots
©1999 Addison Wesley Longman
Slide 4.6
The Supply Curve represents the relationship between quantity supplied and
price; other things being constant. It refers to the entire relationship between
quantity supplied and price.
Quantity supplied: is a single point on supply curve.
Distinguish between movement along the curve and shift of the
entire curve
Shift of supply curve can take place due to a change in any factor affecting QS ,
other than the product's own price. It means that at each price, a quantity
different from the previous one will be supplied. The right shift in a supply curve
indicates an increase in the quantity supplied at each price.
When the Number of suppliers goes up; market supply curve shifts to the right
(downward). However, individual supplier S-curve shifts to the left (upward.)
The quantity supplied may change due to movement from one point to other on
the supply curve due to change in price alone, shift in supply ,or both.
SEE FIG.4-6 below.
25
Figure 4-6
Two Supply Curves for Carrots
©1999 Addison Wesley Longman
The determination of equilibrium Price:
26
Slide 4.7
Figure 4-7
Determination of the Equilibrium Price
Slide 4.8
©1999 Addison Wesley Longman
(1)
a)
b)
 excess supply
at P> 60 : qs > qD
producers cut down production qs and P
producers lower price
Consumers: as they see price goes down, quantity demanded goes up.
Until
(2)
qs = qd  q= qe
at P< 60
:
&
qd
P = Pe
>
qs 
Consumers compete for limited supply
excess demand
P 
Producers see P 
produce more  qs
Eventually qs = qd  q= qe & P = Pe
Read highlighted numbers pp.82-83 (explanation)
27
qd
Conclusion:
Below equilibrium price, there is excess demand  pressures on price to go
upward
Above equilibrium price, there is excess supply  pressures on price to go
downward
Four laws of supply and demand:
(1)
First law: A rise in demand causes an increase in both equilibrium price
and equilibrium quantity.
An upward shift in demand curve  Pe, qe, qd, qs
(2)
Second law: A fall in demand causes equilibrium price and equilibrium
quantity to decrease
Figure 4-8
The Four “Laws” of Demand and Supply
©1999 Addison Wesley Longman
Slide 4.9
A down shift of demand curve  Pe , qe, qd, qs
(3)
Third law: A fall in supply causes increase in equilibrium price and
decrease in equilibrium quantity.
A supply decrease (shift upward)  Pe , qe , qd  , qs
Prices rise in response to excess demand and fall in response to excess supply.
28
(4)
Fourth law: A rise in supply causes decrease in equilibrium price and
increase in equilibrium quantity. Supply increase (downward move).
Upward shift  qe , Pe , qd  , qs

absolute price: amount of money needed to acquire one unit of product.

relative price: ratio of two absolute prices. Expresses the price of one
good in terms of another.
Example:
apple's price
orange's price


50%
30%

orange is relatively cheaper.
Under inflationary situations what matters is relative, not absolute or money
prices.
A product's price is relatively constant if its price rises as fast as the general
levels of prices.
If price level is constant to raise relative price of product is by raising its money
price.
If price level is increasing, to raise relative price must raise product's money price
faster than price level increase.
29
Chapter 5 ELASTICITY
Suppose the gov't. wants o increase the output of some product. Which situation ,
in the figure below will make it easier?
Figure 5-1
The Effect of the Shape of the Demand Curve
©1999 Addison Wesley Longman
Slide 5.2
If government wants to increase commodity produced for consumer it will
be more successful if it operates on the demand curve.
Price elasticity: the degree of change in quantity demanded due to a change in
price.
Measurement of price elasticity
Percentage change in Qd
Price elasticity
=
-----------------------------Percentage change in P

=
(q2 – q1)/q1 (q2 – q1) P1
-------------- = ----------- x ---(P2 – P1)/P1 (P2 – P1) q1
30
Orange Market
P1 = SR7/K
Quantity Demanded
q1 =
100,000K
30%
43%
P2 = SR 4/K
q2 =
PC Market
130,000K
Quantity Demanded
PPC
= 5,000SR
q1= 500 PC
40%
50%
PPC
= 2,500SR
In the orange market =
In the PC Market
q2= 700 PC
(13 – 10)/10
--------------(4 – 7)/7
=
-0.30
---- = -.75
0.43
(700 – 500)/500
-0.4
=------------------------ = --- = -0.8
(2,500-5,000)/5000 0.5
The demand for PC's is more elastic than the demand for oranges.
Why? Because in price elasticity we always take the absolute value of the
elasticity number.
IF
 >1 demand is elastic  change in quantity demanded is greater than change
in price
=1
demand is unitary elastic
 <1
demand is inelastic
In the two cases above demand is inelastic in both markets in the range of prices
given.
Demand ( Price) elasticity can vary from 0 to 
31
Figure 5-2
Elasticity Along a Straight-Line Demand Curve
©1999 Addison Wesley Longman
Slide 5.3
Special cases of elasticity:
Figure 5-3
Three Demand Curves with Constant Elasticity
©1999 Addison Wesley Longman
Use of average price and quantity in elasticity:
32
Slide 5.4
Assume prices went up instead of going down.
By computing average price and quantity, makes it independent of whether
movement is from A to B or B to A (whether price increases or decreases).
0
PC
=
(10 – 13)/13
--------------- =
(7 – 4)/4
0.23
----- = 0.31
0.75
=
(5 - 7)/7
-------------- =
(50 - 25)/25
0.29
----- = 0.29
1.0
In both markets the elasticity measure became different. What is elasticity? To
go around this problem we use:
(q2 – q1) / (q2 + q1) / 2
Average elasticity= ---------------------------(P2 – P1) / (P1 +P2) / 2
(q2 – q1) (P1 +P2)
------------- x--------(P2 – P1) (q2 + q1)
=
Note: In this definition and in the one before Elasticity is not the slope of Dcurve.
>1
=
(
q 2  q1
P 2  P1
=1
)( )
P1
q1
<1
Unitary elastic
inelastic
Slope is
constant
(Any demand curve)
Conclusion: Demand
curveasdoes
changes
we gonot have same elasticity over every part of curve
although it has same
slope.
However:→
along
the curve
33
Steeper D- Curve → more elastic
Less steep D- Curve → less elastic
Factors affecting elasticity
1.
Availability of substitutes  products with more substitutes are more
elastic.
2.
The broader the definition of a commodity the lower is the elasticity.
(may not have substitute). Cloth, or food as a whole is less elastic than
individual clothing or food.
3.
Short run vs. long: in the long run elasticity tends to be higher.
People will have more time to adjust.
The long run curve tends to be more elastic than the short run, as shown in graph
below
Figure 5-4
Short-Run and Long-Run Demand Curves
©1999 Addison Wesley Longman
Slide 5.5
Example: The
rise of price of petrol in 1970s in short term should change a little in quantity
demand, but in long run more fuel efficient methods were made and so steep
decrease in quantity demanded.
Necessities vs. luxuries:  > 1
<1
luxuries
necessities
elastic
inelastic
The Relationship between Price Elasticity and Total Revenue( Very, very
imp.)
4.
34
Total Revenue
=
(price x quantity)
Case 1) Suppose  > 1  % change in quantity demanded > % change in price.
Now suppose price increases:
P.Q
 TR =

Total revenue decrease
Case 2) Suppose  = 1 ( unitary elastic demand ). This implies that the %
change in P &q are equal
TR = P. Q

TR = constant
Case 3)
Suppose  < 1 (inelastic demand)
 TR = P. Q 
Thus TR increases
As price falls along a linear demand curve, total expenditure rises first, reaches a
peak, then falls.
P
 = 1,
TR
max
TR
>1
=1
<1
>1
<1
Q
Q
35
Figure 5-5
Total Expenditure and Quantity Demanded
Slide 5.6
©1999 Addison Wesley Longman
Income Elasticity
is the responsiveness of Q.D to change in income
Increase in income shifts the demand curve to right for normal goods and to the
left for inferior goods.
Here we do not use absolute value.
Income Elasticity of demand:
y < 0

0 < y <1
1 < y
(y =
% Q
)
%Y
inferior goods. What does it mean?
normal goods
normal – luxurious goods
SEE TABLE 5-6 FOR INCOME ELASTICITIES OF SOME GOODS
The income – consumption curve
36
Figure 5-6
Various Income-Consumption Curves
©1999 Addison Wesley Longman
Normal inelastic):
quantity increases
at a decreasing rate
(normal -
luxurious
elastic): quantity
increases at an
increasing rate
Slide 5.7
Normal/ inferior:
quantity rises
first, decreases as
income rises
further
Normal goods: an increase in income leads to an increase in Q.D and vice versa.
Most goods are normal goods.
Inferior goods: an increase in income leads to a decrease in Q.D
Luxuries food: + ve. and greater than 1 (they are elastic normal goods)
Example from table 5-6 : restaurant eating  = 2.4  luxuries
Starchy food
 = -.2  inferior goods
What Determines Income Elasticity?
37
1)The more basic (necessity) an item is, the lower is income elasticity.
2) The level of household income: for poor people as income rises , some
normal goods become inferior.
3) The level of per capita income ( or degree of economic development).Compare
Sri Lanka to USA in the consumption of poultry.
4) Social habits. In France an increase in income shows less increase in demand
for wine than in United States. What does it mean?
Importance of Income Elasticity: It give an idea about how consumers are
going to spend their incomes as incomes rises or decreases. Producers of goods
that are highly income elastic are going to enjoy higher increases in their
incomes.
Cross Price Elasticity of demand:
Cross price elasticity = xy = (
%  Qx
)
%  Py
If xy < 0 P ( cars) , Q (gasoline) cars & gasoline are complements.
If xy > 0
P ( air travel), Q( land travel)   substitutes
Cross price elasticity could vary from -  to + 
Importance of Cross – Price Elasticity:
are in competition with each other.
xy shows to what degree products
High xy  higher competition
This is important for Anti-trust ( anti- monopoly) cases to give an idea about
degree of monopoly exercised by some products.
Elasticity of supply: Measures the responsiveness of quantity supplied to change
in price.
38
s =(
%  Qs
)
%  Ps
it is usually positive because S- curve has +ve. slope
Special cases:
P
P
S
S
Q
s = 0
=
a small drop in price makes the quantity producers willing to supply from drops
to 0.
Determinants of supply elasticity:
(1) The Ease of substitution in production (how easy it is to convert production
from one product to another).
Example:
If machines producing cars can be easily modified to produce trucks, then supply
of trucks and cars will be more elastic
(2)
The degree of change in cost. If change in cost is small as production
increases, supply will be elastic.
(3)
Example: If cost of producing a unit of output rises slowly as production
increases, then the stimulus to expand production in response to a rise in price
(profit) will cause a large increase in quantity supplied.
39
(3)
Short-run vs. long-run (in the long run supply is more elastic).
Example:
It is hard to change quantities supplied in response to price in a matter of weeks.
For example, it takes a long time to build pipeline to an oil field and even it takes
longer time to discover this field.
Two cases where elasticity matters ( See Fig’s 5-7 & 5-8)
Case #1:
Shift in Supply
Figure 5-7
Short-Run and Long-Run Equilibrium Following an Increase in Supply
©1999 Addison Wesley Longman
Slide 5.8
In the short run there is overshooting in price, meaning that the change in price is
larger in the short run than the final equilibrium price .Also, there is an
undershooting in quantity, meaning change in short run equilibrium quantity is
less than final long run equilibrium quantity.
A.
In short run, causes large fall in price, but small increase in quantity.
B.
In long run, demand more elastic, thus, long run equilibrium price is
higher; and quantity is higher than short run.
Case #2: Shift in Demand:
40
Figure 5-8
Short-Run and Long-Run Equilibrium
Following an Increase in Demand
©1999 Addison Wesley Longman
Slide 5.9
A.
In short run supply is inelastic, cause big change in price equilibrium, and
small change in equilibrium quantity.
B.
In long run, supply is elastic, cause small change in price and bigger in
quantity equilibrium.
Short run – overshooting of price
Short run – undershooting of quantity
Applications To Elasticity
41
The Incidence of A Sales Tax:
Figure 5-9
The Effects of a Gasoline Excise Tax
©1999 Addison Wesley Longman
Slide 5.10
Tax =t (Riyals per unit): The vertical distance between the two S- curves.
P0: equilib. Price before tax.
P0 + t : original equilib. Price plus the per unit tax.
Pc : Consumer price : price paid by consumer after tax.
Ps :
Seller price is price received by seller after tax.
Results of tax:
1)
Decrease in Q.S by amount Q0 – Q1
2)
At price (P0 +t) there is an excess supply.
3)
P0 < Pc <( P0 + t)
4)
Ps= (Pc – t) < P0
Hence the consumer pays a price greater than the pre- tax price, but he does not
pay for the full tax. The seller suffers a reduction in his realized price by an
amount less than the full tax. Thus the burden of the tax is shred by both sides of
the market. But who pays more?
Why shift supply curve, but not demand curve?
As far as consumer is concerned nothing has changed that would shift the
demand curve ( a rise in price implies a movement along in demand curve).
As far as the producer is concerned supply will shift because of higher cost due to
tax.
42
Figure 5-10
Elasticity and the Incidence of a Sales Tax
©1999 Addison Wesley Longman
Slide 5.11
The incidence (burden) of the Sales Tax – depends on the relative elasticities
of supply and demand .The less elastic side stands to bear a grater burden of
the tax.
Employer –Paid Health Insurance
43
Figure 5-11
The Incidence of Mandated Employee Health Insurance
©1999 Addison Wesley Longman
Slide 5.12
The fig. above is essentially similar to fig.5-9
1)the Supply of labor is relatively inelastic. Thus it is relatively less responsive
to change in wages.
2)Regardless of who pays for health insurance ( employers or workers) , the SCurve of labor shifts to the left by the amount of the required premium (t).
3) wages paid by the employers rise to We ( > W0), while wages received by
workers fall to Ws (< < W0)
4)
The overall level of employment to falls from E0 to E1.
3)
Also, the rise in wages paid by employers is less than the fall in wages
received by employees
Conclusion: there is no difference between letting employees pay health
insurance or employers pay for it, since the burden of insurance will be shared by
both sides of the labor market. However, The health insurance is mostly paid
by employees ( the workers) because of the supply of labor is relatively less
elastic than the demand for labor. So it is the shape of the S - & D- curves
that matters , not who pays for the health insurance.
END OF CHAPTER 5
44
Review on Ch 4 and 5
Demand curve shifts to the right if Average income, ↑, pp.↑ price of sub 6 price
of comp↓ taste in favor of product.
Absolute price in terms of or relation to other products in inflationary period in
relative price means its absolute price rises more than price level and vice versa (
relatives rise less than price level)
The main determinant of price elasticity of demand is availability of substitutes.
n>1 total expenditures the related to price
n<1 total expenditure the related to price
Read p. 106 summary “D”
Chapter 6. Demand & Supply in Action ( MORE APPLICATIONS)
45
I.) PRICE CONTROLS
Price controls are imposed by governments and hold the price at some
disequilibrium level.
Controlled price above equilibrium value causes a surplus.
Controlled price under equilibrium value causes a shortage.
At disequilibrium prices, the quantity actually exchanged will be determined by
the lesser of the quantity demanded or supplied. SEE FIG. 6-1 BELOW
Figure 6-1
The Determination of Quantity Exchanged in Disequilibrium
©1999 Addison Wesley Longman
Slide 6.2
A Price floor: is the minimum permissible price that can be charged for a
particular good.
A Price floor above equilib. price is not effective (or binding) ,because the
equilibrium price is attainable.
46
Figure 6-2
A Binding Price Floor
©1999 Addison Wesley Longman
Slide 6.3
Effective price floor lead to excess supply. Either surplus will exist, or
someone will buy this excess supply (Ex. The government)
Excess supply due to price floors of wage ( minimum wage), causes
unemployment. This is a controversial issue. See Chap.16 on labor markets.
The consequences of price floors depend on the nature of product
controlled.
excess wheat cause wheat to accumulate at (Government ) warehouses.
Why governments would like to put price floor? To help certain groups
(sectors) in the economy. Ex. Minimum wage legislation.
A Price Ceiling: is the max. permissible price that can be charged for a
particular good or service.
If set above equilib., it is ineffective ( unbinding)
Effective price ceiling leads to excess demand
Ways of Allocating A product in Excess Demand:
1) Seller’s preference. Sales may take place "under the counter"
2) first-come-first-served bases. People may rush to stores & long waiting cues
may develop)
3) Gov't. may impose the use of ration coupons. People need to pay both money
& coupons to buy a product.
Black markets may develop as a result of price ceilings.
Black Markets:
47
* Black Markets: markets of goods which are sold illegally at prices that violate
price controls
* Effective price ceiling gives a potential for a black market, because profit
can be made by buying at controlled price (P1)and selling at black market
price (P2). See Fig. 6-3 below. Profits realized are the dark shaded area.
Figure 6-3
A Price Ceiling and Black-Market Pricing
©1999 Addison Wesley Longman
Slide 6.4
A) in communist countries: essentials were subject to effective price ceilings
which caused unsatisfied consumers
B) in Market Econs: Tickets of concerts & sporting events are subject to price
ceilings.
*Government goals in price ceilings:
1)to restrict production of some unnecessary goods ( during war time) to
divert resources for other uses
2)to keep prices down during inflationary periods.
3)to satisfy notions of fairness in consumption of products that are in short
supply. (with black markets only first goal achieved)
II) RENT CONTROLS: A case of Price Ceilings:
48
*The first generation of rent controls concentrated on controlling rents only
* second generation controls were concerned about “ regulating “
housing rental market , rather than controlling the rental price. The specifics of
controls may vary greatly from one country to another or from time to time.
Saudi Arabia had some sort of rent controls in the 1974-1983 period, in the
aftermath of rising inflation due to increase in oil prices & Gov't expenditures.
The Predicted Effects of Rent Controls ( see Fig.6-4)
Figure 6-4
The Effects of Rent Control in the Short Run and the Long Run
©1999 Addison Wesley Longman
Slide 6.5
1. House shortage: in the SR ( q2-q1)
2. Land Lords may allocate houses via sellers’ preferences
3. Black Markets may appear .landlords may charge large entrance fees from
new tenants, and may then kick them only to take entrance fees from new tenants.
* The short run effects of rent controls differ from those of long run. In the
short run some buildings may be converted into residential units. The conversions
may be limited , however.
* The limited response to rent controls in short run implies that short run
supply is inelastic. See fig. above.
* If expected return from investing in new rental housing is below what can
be earned from other investments, funds will go else where. So the long run
supply curve is more elastic ,which causes a large decrease in supply ( increase
excess demand.) The shortage becomes ( q2-q3). Indeed most of the shortage in
the LR comes from the increase in Q- demanded
Other Effects of Rent Controls
49
The shortage will cause existing tenants not to give up their places, even
though their family size may be growing. They may take lower income jobs , or
even stay unemployed , to take benefit from low rents that may not be available
in other areas.
For policy issues distinguish between short run and long run solutions.
Policy measures should usually be imposed gradually & phased out
gradually.
B) Temporary VS. Permanent increases in demand: See Fig.6-5
Figure 6-5
Rent Controls in Response to Increasing Demand
©1999 Addison Wesley Longman
Slide 6.6
1) When Rent Control can work? When shortages are temporary
If there were no rent controls the temporary change in demand will cause rents to
rise from r0 to r1 and then back to r0.
But if rent controls are imposed, existing owners are prevented from making
large profits, but the harmful supply effects are limited, because a LR supply
response is not expected. The shortage in the SR will be q1- q0. QS. will not be
affected.
2) When Rent Control Fail? When shortages are permanent
1) Permanent rise in demand from D0 to D1 will cause rents to increase from ro
to r1.
2) it will then fall to r2, if there were no rent controls, as the quantity of
accommodation increases.( SL is more elastic than Ss).
3) if rent controls are applied, in long run The LR S- curve, SL applies. A
permanent shortage of q1-q0 develops
50
C) Who gains and who loses
* Gainers: existing tenants
*Losers 1) Landlords who do not get the return expected on their investments
2) Future Tenants: the rental housing they require will not be there in
the future as demand increases.
D) Policy Alternatives:
1) Market Solution : let rents rise to cover rising cost. This may be very painful
to tenants in the SR.
2) If government does not like it. It may:
a) Build public houses or subsidies the building of private houses. Saudi Arabia
did both of these options.
b) Provide income assistance to the people who need it.
Whatever option is adopted, there are always costs that have to be paid by
someone.
READ APPLICATION 6-1
Note : Material on Agriculture & Farm Problem is not included, and thus not
edited. The material in the book discusses the nature of the problem in Western
economies, especially in the United States, which is different from that in Saudi
Arabia. You may read it , however if interested, especially if you want o compare
the problem over different economies.
However , the FOUR LESSONS about resource allocation, at the end of the
chapter, are included
III) Agriculture and the Farm Problem
There are two separate problems
1)
First problem: There is a long-run tendency for farm incomes to fall
below urban incomes.
2) Second problem: Agricultural prices fluctuates substantially from year to year
causing a great deal of variability in farmers incomes.
*Agriculture long term problem arises from both demand and supply:
1) Increasing domestic supply due to tremendous productivity improvements.
2) Lagging domestic demand: Most foodstuff have low income elasticities,
because people are already well fed. so as income grows, demand for agriculture
grows but less rapidly.
51
3) Export demand: in spite of explosive world population growth & rising
world demand, many developing countries succeeded in raising their
productivities . In addition to that large agricultural subsidies in Europe turned
these countries into exporters. Subsidies is a major issue in the WTO
negotiations between developing and developed countries.
4) Excess supply: Both demand and supply curves in Agriculture markets are
increasing, but demand is slower than supply
5) Resource Reallocation: Depressed prices, wages, makes resource to move
out of Agriculture in the other sector. This has proven to be painful and takes
time.
* short term fluctuation occur mainly because of factor beyond farmer control (
pests, flood, drought…) These could cause large supply fluctuations. With the
presence of inelastic demand, this causes large fluctuations in incomes and
prices.
1) Fluctuating Supply with inelastic demand
More crop sends price down (less income)
Less crop send price up (better income)
Figure 6-6
The Effect on Price of Unplanned Variations in Output
©1999 Addison Wesley Longman
Slide 6.7
2) Fluctuating Demand with inelastic supply
Giving an inelastic supply curve for agriculture products will be sensitive to
demand shifts because factors of production in Agriculture is not easy to
transform them to non agriculture rise.
52
Figure 6-7
The Effects on Receipts of a Decrease in Demand
©1999 Addison Wesley Longman
Slide 6.8
in this graph shift cause sharp drop in price because small proportion of world
supply.
THE THEORY OF AGRICULTURAL POLICY
A) Exports at world market prices: at world markets domestic producers face a
perfect elastic demand curve, indicating they can sell all they want at world price
because world price not affected by their own sales.
1) Output fluctuations at given world price – income fluctuate in same direction
of fluctuation in output to stabilized incomes of farmers the government can
allows farmers to store output at bumper crops, then sell them in years of poor
crops.
53
Figure 6-8
Exports at a Given World Price
©1999 Addison Wesley Longman
Slide 6.9
2) Fluctuation in World price
Government can stabilize farmers income by creating a scheme that guarantees
farmers a price = to average fluctuations world price. Farmers in low prices
years=payments paid in high payment years. Only problem is that ---price set too
high.
B) Sales on the Domestic Market Only.
Demand curve in domestic market is negatively sloped and (inelastic)
1) Price stabilization if the governments policy imposes a demand curve which is
perfectly elastic at support price it can only stabilize price, but revenue (income)
will make income same direction of output (supply). This policy can be made for
example by buying when there is a surplus and setting when there is shortage.
2)
Revenue Stabilization:
Too much price stability causes income to vary directly with production too
little price stability cause income to vary inversely to production it must make
demand curve until elastic to stabilize income . this is done by buying in periods
of low input and selling in low input, put only enough to let prices change in
inverse proportions to output.
* An in-kind tax as “Zakat” helps to reduce both the excess supply and the
pressure on the farmers cash flow.
*For lessons about Resource Allocation:
54
1)
Cost can be shifted but not avoided:
- production uses resources , thus invites costs to members of society
- Nothing can be for free
- standard of living depends on availability and efficiency of resources, thus
cost are real.
- rent control can changes share of costs lowering the share for some and rising
the shares for other, but cannot be avoided.
2) Market prices encourage Economical use of resources
- on demand side: high prices make consumer economize or use substitutes
lower prices makes consumer buy more.
- on supply side, rising price increase profits, so suppliers tend to real--resources to industries with profits until profits fall to levels that can be earned
elsewhere
- price sys. Responds to the need for a change in the allocation of resources.
3)
Government intervention affects Resources Allocation:
- Intervention inhibits free market resources allocation mechanism
- Exp. In Rent control if price held down, consumers will not economize by
purchasing more, and suppliers will not realbate resources to that industry. So
shortage continues and equilibrium never reached. If government provided that
supply for the shortage resource will be allocated to it and therefore fewer
resources will be devoted for other goods.
* long run changes in demand and cost do not induce resource allocation
through private decisions
4)
Intervention require other Alternative Mechanism:
- During shortages allocation by means of sellers preference or Gov. rating
- During surplus government must buy extra supply
- The other mechanism are: 1) Force resources out of industries were prices
held too high (Agriculture)
2) Force resources into industries were price
too low (housing)
*Gov. intervention brings with it costs, to enforce law. Also in longrun supply
curve more elastic and shortage may became larger.
.
END OF CHAP. 6
CHAPTER 7: CONSUMER BEHAVIOR
55
* Discusses how people go about spending their income over a variety of goods.
* The general organizing principle of consumer behavior is utility
maximization.
* utility ca not be measured but is real.
* consumer choice is imp. To market econ – consumer try to max their utility
No. of Units
Consumed
0
Total Utility
Marginal Utility
0
100
1
100
50
2
150
25
3
175
20
4
5
190
200
10
Ex. First glass of water is essential (necessity) to sustain life  a high marginal
utility. However, successive glasses of water have less marginal utility.
* Water going down the drain while brushing teeth has low marginal utility
* Marginal utility of the last of all units consumed is very low although total
utility is increase.
* Total Utility: is the full total satisfaction from total amount consumed
*Marginal Utility: is the change in total utility as consumption is changed by one
unit (A little more of that product).
* The law of diminishing M.U.: (utility theory)
Successive units consumed of a good (or service) bring about decreasing
marginal utility, holding consumption of all other goods constant (ceteris
paribus).
56
Figure 7-1
Total and Marginal Utility
©1999 Addison Wesley Longman
Slide 7.2
Total utility increases at a decreasing rate. How do we know?
Maximizing Utility:
*households try to maximize utility given their available income and time.
How to maximize total utility ? *Consumer will allocate, expenditures so that
utility gained from last riyal spent on any good is equal to that obtained from
ant other good.
Assume:
MU Apple = 15
PA = SR 3/ kilo
15/3 = 5 utiles/SR
MU Banana = 15
PB= SR 5
15
 3utiles / SR
5
Is the consumer max. his utility?
Which good should he increase his consumption of, and which one he should
decrease? Obviously the consumption of banana should be increased, and apple
decreased. As that happens, the MU of banana decreases and MU of apple
increases, until we have
57
Mux Muy

Px
Py
So we are not equalizing marginal utilities. Rather , we are
equalizing MU per riyal spent .
Or
MUx Px

MUy Ry
The RHS: is the relative price determined by market conditions and beyond
control of consumer.
The LHS: is decided by the consumer subject to his income , taste and
relative prices
*All consumers face the same set of market prices. When all consumers are
fully adjusted to market prices, each will have identical ratios of MU for each
pair of goods.
.
Derivation of The Consumer’s Demand Curve:
A rise in a product price (ceteris Paribus) will decrease the MU per riyal spent
on that product and decreases the quantity demanded by each consumer.
Assume price of x↑ and
.condition
price of y constant .This disturbs the Utl. Max
One unit less of X→ increase in MUx
One unit more of Y→ decrease in MUy
Until
Mux Px

MUy Py
Thus: prices affect Mu / riyal  affect Q.D.  The indivisual D- curve is –
ve slopped
58
The market demand curve
curves
is the horizontal sum of individual demand
The Market Demand is the horizontal sum of individual demand curves because
we want add quantity demanded at each given price. See EXTENTION 7-1
THE DISTINCTION BETWEEN TOTAL & MARGINAL UTILITY
Consumer Surplus
Figure 7-2
Consumer Surplus for an Individual
Q
Slide 7.3
©1999 Addison Wesley Longman
No.
of
Shawerma
1st
2nd
3rd
4th
5th
Total
Price Willing
to pay
50SR
30Sr
20SR
5SR
3SR
108
Mkt Price
3SR
3SR
3SR
3SR
3SR
15
59
Consumer
Surplus
47
27
17
2
0
93
Figure 7-3
Consumer Surplus for the Market
©1999 Addison Wesley Longman
Slide 7.4
Consumer Surplus is difference between consumer valuation and Mkt Value,
measured as area under D-curve and above Mkt Price
*surplus arises because we usually purchase every unit at a price equal to the
value (MU) we associate with the last unit consumed. In other words , while the
MU associated with different units are different , we pay the same price for each
unit
THE PARADOX OF VALUE:
 Water is necessary to life, but commands a much less price than diamond. The
source of the paradox is the confusion between total utility with marginal
utility.
 The Solution of the paradox
. Water supply is far more plentiful in nature than Diamond.
* Since marginal Utility is determined by the last unit consumed, and , the
MU. of water is far less than that of diamond. Since price is determined by
the marginal unit, the price of a unit of water is far less than the price of a
unit of diamond. However, the total utility of water is far higher than that of
Diamonds, because the first unit consumed has a very, very high MU
*Consumer Valuation is estimated in two ways = total are under demand curve.
60
1) sum of each successive valuation, or
2) consumer may be asked how much he is willing to pay to consume amount in
question if alternative was to have non-of that product.
FREE & SCARCE GOODS
* A free good: one which if: P=0 Qs> Qd
A scarce good: if P=0, Qs < Qd there will be excess demand (most goods are
scarce goods)
The market value of some product bears no necessary relation to the total
that consumers place on that mount
- Most views of people about prices is a reaction to total values not marginal
values.
- When consumer is deciding between zero price and low price he must ask: Are
the marginal uses of water so imp. that we are willing to use scarce resources to
provide quantities wanted.
Figure 7-4
Total Value Versus Market Value
©1999 Addison Wesley Longman
Slide 7.5
-The minimum quantity of water can be provided free. But providing all water
free will have negative effects.
- if we want to know what consumers gain or lose from consuming a little bit
more, we need to know the Marginal Value not total value.
61
- consumers will consume a good until the marginal value they place on further
consumption is zero (when price zero)
- many necessities have low marginal value uses that will be encouraged if given
at zero price. This could imply a lot of waste
*A minimum fee for consumption of some necessities may be necessary to help
reduce waste and relocate resources into other more important uses. This is
specially true if the marginal utility of extra consumption units is very small.
Even a very low price can help economize a lot
INCOME AND SUBSTITUTION EFFECTS OF PRICE CHANGES
A fall in the price of a good (say ice cream) affects the consumer in two ways.
First, it changes relative prices and provides an incentive to buy more ice cream.
Second, the consumer has more purchasing power to spend on all products. This
implies there is a change in real income, which motivates the consumer to buy
more of all normal goods. To isolate the effect of a change in relative prices from
the change in real income, economists distinguish between the substitution
effect and the income effect
*The substitution effect measures the change in quantity demand as the result of
change in relative prices holding real income constant. This effect is always
negative. Meaning if relative prices change in one direction quantity demanded
change in other direction .
* The income effect measures the change in the quantity demanded when the
purchasing power ( real income ) changes , holding relative prices constant at
their new value
. The income effect is positive for normal goods, but negative for inferior
goods.
When the price of a good changes, the change in Q. D is the sum of the two
effects
If
(-) (-)
P↑ = SE+IE
(for normal goods)
62
This means when the price of a good rises, real income decreases, and Q.D
decreases. So for a normal good the income effect reinforces the substitution
effect.
(-) (+)
P↑ = SE +IE (for inferior goods)
This means that when the price of a good rises, real income decreases, and Q.D
increases. So for an inferior good the income effect weakens the substitution
effect
.
*Real income is the quantity of goods that can be purchased with a given amount
of nominal (money) income. It is measured as
*Real Income = nominal income
price level
How to measure the price level? This topic is discussed in the next course on
Macroeconomics
Measuring the Income Effect (V. IMP)
*The extent of the income effect depends on the change in real income which in
turn depends on the share (fraction) of income spent on that good and the extent
of the change in the price of the good.
Ex.1 The consumer spends 30% of his income on housing. Let rent go up by 5%
what is the change in his real income?
(0.3)(0.05) = .015=1.5% is the reduction in his real income
Ex.2 Expenditures on salt is 0.01% of income, price of salt ↑ by 50%
The size of real income change is = (.0001) (.5) = 00005=.005%
Small change in real income
NOTE: your textbook ( Pp151-152) is not accurate. What we are measuring
here is not strictly speaking the income effect, but actually the change in real
income which in turn affects the extent of the income effect.
Extension 7-2 CAN DEMAND CURVES HAVE A POSITIVE SLOP?
1) Giffin goods – A Giffen good must be an inferior good and income effect
must be negative and large than substitution effect ( every Giffin good is an
63
inferior good but not every inferior good is a Giffen good). most inferior goods
have a positive slope
P↑→ (Real income) ↓ → Q.D↑ (inferior goods) and income effect bigger than
substitution effect. (this the with stable goods for which a large fraction of
income spent on)
D
Giffen good
2) Conspicuous consumption good: Because of the “snob effect” the
consumption of some individuals is the related to the prices of luxuries. EX
demand for diamond (For individual /not true for market demand curve)
3) Goods with perfectly inelastic demand
*the assumption that gasoline is perfectly inelastic was proved wrong. Higher
gasoline prices in the mid 1970’s led to the production of smaller cars, to more
car pools, to more economic driving speeds, and less pleasure driving. Falling
gasoline process in the mid 1980’s led to a reversal of these trends
Summary
1) Surplus arises because consumer can purchase every unit of a product at a
price equal to the value on the last unit purchased.
*Demand has – slope because consumer valuation on all other units exceeds the
value of last unit purchased.
* Choices concerning a bit more or bit less can be predicted only by Marginal
value (utility)
* Price is related to marginal value.
*Change in price implies an income effect + substitution effect.
64
*Income effect is the reaction of consumer to change in Real income caused by
change in price, holding relative prices constant.
* The combined effect of the two ensure that demand curve is –vely. sloped.
Appendix TO Chapter 7: Indifference Curves
* If different bundles of goods give the consumer the same level of satisfaction,
the consumer is said to be indifferent between these bundles. These bundles can
be represented by what is called an indifference curve.
1) The indifference curve is – vely sloped. Meaning if the consumer wants to
consume more of one good ,he has to consume less of the other.
2)Any point above the I.C is preferred to any point on it
Any point below the I.C is inferior to any point on it
Figure 7A-1
An Indifference Curve
©1999 Addison Wesley Longman
Slide 7.7
* The slop of the I.C at any point measures the Marginal Rate of Substitution
(MRS ) one good in terms of the other. i.e is amount of one good that a
consumer is prepared to give up to get one more unit of the other good.
*MRS is always negative, but we take the absolute value.
65
Ex. Moving from point a to point b requires the sacrifice of 12 units of clothing
to get 5 units of food . Thus
MRS 
 12
5
The (MRS) decreases as more is obtained of one and less is left for him of the
other The slope becomes less and less when moving downward along curve.
This means that he is welling to sacrifice less and less of clothing as he gets
more of food
The indifference map
The consumer taste (preference) can be described by a set of indifference curves
called the indifference map. Higher curves  has higher level of satisfaction.
Figure 7A-2
An Indifference Map
©1999 Addison Wesley Longman
THE BUDGET LINE
*Indifference curves illustrated consumer taste
66
Slide 7.8
*Budget line illustrates the possible alternatives available to the consumer.
Figure 7A-3
A Budget Line
©1999 Addison Wesley Longman
Slide 7.9
Pts. above BL. are unattainable
Pts. below BL. are attainable , but do not exhaust all income. In our theory here ,
we assume all income is spent . So the consumer is always on some point of his
BL
If all income is spent
Income = (Pf x Qf) + (Pc x Qc) (Consumer Alternate equation)
Budget Line : also called isocost line reflects available combinations of
consumption to the consumer given his income and relative prices and assuming
consumer spends all his budget (income)
The slop of the budget line measures relative prices and represent the opportunity
cost of getting one good in terms of the other.
If all income spent on food Y=Pf x Qf (Consumer is on pt. b on the above
figure)
If all income spent on clash Y=Pc x Qc
(Consumer is on pt. a on the above
figure)
67
The relative prices of food to clothing is (This concept is V.V. IMP. You shall
need it for some future courses)
Pf Qc

= 60/30 = 2/1
Pc Qf
Note that the ratio of quantities is the reciprocal of the ratio of prices
Both represent slope of budget line. Also, both reflect opportunity cost.
This means that to consume one more unit of food 2 units of clothing have to
be sacrificed. In other words the opportunity cost of consuming 1 more unit
of food is two units of clothing.
THE CONSUMER’S UTILITY MAXIMIZATION
For utility Max., the consumer tries to reach the highest possible indifference
curve. His UTIL. is max. when the B.L. is tangent to some I.C. At that pt. his
MRS is equal to the relative prices of the two goods
Figure 7A-4
The Consumer’s Choice
©1999 Addison Wesley Longman
The utility max. condition is when :
68
Slide 7.10
MRS = Slope of budget line =
Qc = Pf = opportunity cost
Qf
Pc
At the tangency pt. the rate at which the consumer is welling to substitute on
good for the other is equal to what the market requires
Qc
 MRS 
Qf
If
2 3

1 1
Explanation : This means the consumer is willing to pay a price for more food
,more than what the market requires. So he moves downward on the I.C
* Change in consumer’s Income:
Let Money Income rise, but relative prices do not constant change. (ceteris
Paribas).
Figure 7A-5
The Income-Consumption Line
©1999 Addison Wesley Longman
If his money income doubles
budget lines will shift out
69
Slide 7.11
- the shift will be parallel because slope depends only on relative prices of two
products (here constants).
- will be able to buy twice as much
* Each level income will have a utility max point (meaning consumer is doing as
well as possible at every level of income).
- if we connect the utility max pts. we get the income-consumptions line.
* Consumer reaction to a change in Price:
- change in relative prices changes slope of budget line, holding money income
constant
Ex. Price of clothing  with money income & price of food constant. The
budget line changes slope
Figure 7A-6
The Price-Consumption Line
©1999 Addison Wesley Longman
Slide 7.12
- by joining the tangency pts. we get the price- consumption line
The slope of budget line determined by relative prices, but its position
determined by price, and income.
* Derivation of the Demand Curve:
70
is
Figure 7A-7 (i)
Derivation of a Consumer’s Demand Curve
©1999 Addison Wesley Longman
Slide 7.13
Figure 7A-7 (ii)
Derivation of a Consumer’s Demand Curve
©1999 Addison Wesley Longman
Slide 7.14
Every pt on price - consumption line gives a price of the product and quantity
demanded (=info. needed for demand curve).
*INCOME AND SUBSTITUTION EFFECTS: (V. V. IMP. Especially for
upper courses in microeconomic theory)
71
Figure 7A-8
The Income Effect and the Substitution Effect of a Price Change
©1999 Addison Wesley Longman
Slide 7.15
The consumer is originally at pt.E0, and B.L a-b
Assume the price of gasoline decreases. The B.L becomes a- j and he is on E2.
Remember that a decrease in price means a rise in real income ( he can consume
more of all goods , including gasoline)
To examine the Sub. Effect, we must eliminate the income effect by reducing
the consumer’s money income. So that the consumer can be on his the original
I.C. This is done by shifting the a-j line parallel to itself to a-j1This brings the
consumer to pt. E1.
Note we are maintaining the new relative prices
q0-q1 is the Substitution effect.
To examine the Income Effect
We restore his money income back to what it was , but maintaining the new
relative prices. He will be back to pt. E2.
q1 -q2 is the income effect
Note that using I.C’s , to measure the SE, we are holding the consumer’s
utility ( not purchasing power ) constant. This is slightly different from what
is explained earlier ( Pp149-150 in the textbook . see also the footnote on p.
150).
The income effect, however, is still the same. i.e , holding relative prices
constant.
END OF CHAPTER 7
72
Chapter 8- Production and Cost in the short run
In this chapter and the next we build a theory of how producers behave. To
understand supply , we must understand , among other things, what
determines cost of goods and services
PROFITS AND COSTS
A basic assumption of the theory of the firm is that firms try to Maximize profit,
which implies the minimization of cost.
Profit may not be the only objective of firms, but they are so imp. that they can be
considered as good enough to explain behavior.
Other objectives may include Max. of market share, promoting some social
objective
Factors of production
1) land: not only its surface, but anything that can come from land (water, oil,
minerals…) : Provided by nature.
2) Labor is physical and mental effort exerted by humans.
3) Capital: Man -made means of production (machines, Road buildings,
instruments etc.) that are used for further production. Extensive use of physical
capital is one distinguishing feature of today’s economies.
The meaning of cast:
Def. Cost to the producing firm, is the value of all inputs used to produce its
output.
Measuring Cost. Measurement of cost is governed by the concept of opportunity
cost. To do that , the firm must assign a monetary value to its inputs equal to
what it has sacrificed to use the input. This may not be an easy job.
Ways to Measure Opportunity Cost:
1)
Purchased and hired inputs that are intended for use in the current
period. The opportunity cost is measured by direct MKT price paid.
Ex. Interest on borrowed money measures the cost of funds.
Price paid for intermediate goods purchased from other firms.
Wages paid to labor
These are called explicit costs
73
2)
Imputed ( implicit) costs .These are not directly recognizable, because
they do not involve direct out- of- pocket costs. They are neither purchased
nor hired. No payment to anyone outside the firm is made.
Sources (types) of Implicit Costs
2-A) The use of one’s own financial capital: The forgone profit of another
activity.
Exp. If firm uses SR1000 to finance production, the opp. Cost would be the
forgone interest from lending the funds to someone else.
2- B) Durable Assets: they last for a long period of time .
- Accountants look at historical costs and use conventional methods to show
depreciation in value. One method is the straight- line depreciation method,
where the value of the asset is reduced by a fixed amount every year.
Accounting depreciation methods may differ substantially from actual
depreciation required by opp. cost principle:
- Econ. cost for owning an asset for a year is the loss in its value during that
year (they look at market value).
B-1) Assets that can be resold: A person buys a for, intends to use it for
6 years , and sell it for SR 6000
- According to straight -line depreciation method, the car will cost
him SR 1500 a year.
- However, if the market value of the car after a year is only SR 12000 , it has
cost him SR 3000 to use.
 The change in mkt. value  a change in econ. Cost.
B-2) Assets that can not be resold.
- The cost of an asset with no alternative use is called “sunk cost”.
Assume a firm buys a machine for SR100000, and is expected to serve for 10
years.
- Acct. depreciation for machine is 10000 a year.
- Assume costs of other factors is 25000$.
- And output is sold for SR 29000 and
Total Acct. Cost = 10000+25000= SR 35000
Acct .Profits( loss) = 29000- 35000 = - SR 6000
74
Economically speaking this is wrong. For the machine has no other alternative
use , and thus its cost is a sunk cost. Thus its opp. Cost is zero. The only
relevant cost is the operating cost of SR25000. Thus there is profit of SR 4000,
not a loss of SR 6000.
An Important Principle:” Let bygones be bygones”. In other words, because
sunk costs involve neither current nor future costs, they should have no influence
on current or future decisions.
Costs that can not be recovered by changing the current course of action (
Production), should have no influence on our actions. These are called
SUNK COSTS.
To see this:
Assume the firm decides to stop production.
Total Rev = 0, Its operating cost is zero, but it will not recover any of its Fixed (
machine) cost
But if it continues prod. , it will have SR29000 in Revenue, pay for its
operating cost of SR 25000, and be left with SR4000, which is a partial recovery
of its fixed cost
.
C) Risk taking: When a firm bears risk , it will not carry on production
unless it is compensated for risk. If the firm does not generate enough retun
to compensate for risk it will not be able to convince investors to invest in it.
Ex. Suppose you invest SR100000 in some risky business, and expect that in case
of failure will lose SR10000
If an alternative riskless investment could bring SR100000
To earn a SR 10000 profit, and be compensated for risk, you need to earn 20000
profit on the successful SR90000. This is a rate of return of 22.2 %. You should
generate 10% to cover for the opportunity. Cost of the forgone riskless
investment, and 12.2% to cover for risk.
d) Patents and special advantages:
Copyrights, locations, special types of process, brand names all have value
because they could be sold or leased to others. If not then there is an opp. Cost to
using them.
Total Costs = explicit costs + implicit costs
75
THE MEANING OF ECONOMIC PROFITS
SEE Table 8-1
ACCT.PROFITS = TR- EXPLICIT COSTS
NORMAL PROFITS are profits just sufficient to cover for the opp. Cost of
capital and risk. This means that for the firm to make normal profits it must
also cover its explicit costs.
ECONOMIC PROFITS are profits in excess of all explicit and implicit costs.
 ECONOMIC PROFITS
= TR – OPP.COSTS

(EXPLICIT COSTS + IMPLICIT COSTS)

NORMAL PROFITS
If TR= OPP.COSTS
normal profits

Econ. Profits are zero. The firm is only making
What does this mean? It means that the firm has covered its explicit cost plus a
return to capital and risk
firm has no incentive to move out of business, because all factors hidden as
well as visible are being rewarded at least as well as they would be in their
next best alternative use
In ECONOMICS WHEN WE TALK ABOUT PROFITS, WE MEAN
ECONOMIC PROFITS.
TIME Horizon for decision making:
- decisions are organized into three classes:
1) short run. How to best to employ existing plants + equipments
2) long run : what new equipment and plants to select given known technology
3) very long run : how to encourage or adopt new technology
A) The short run: is the period during which at least one input is fixed. Fixed
factors are factors that are sometimes physically impossible to change or
prohibitively expensive. This could include large plants, management services,
76
or highly skilled labor. Variable factors are factors than can be changed in short
run.
* it does not correspond to a specific period. It could be weeks or years
B) long run: The time when all inputs are variable , while the basic
technology is fixed
.
- The firm planning decision are long run decisions, because they are made from
given tech, but with freedom to choose from variety of protection processes.
C) very long: When technology changes.
The production function: a representation of the physical relationship b/w total
output and different combination of inputs.
*Production Function in the Short Run
1) Total product (TP): total output produced during a period of time. It may
change as the scale of variable inputs is changed.
2) Average product (AP) = (TP) : total output per unit of input.
L
3) Marginal Product (MP) =

L
See Table 8-2
77
Figure 8-1
Total Product, Average Product, and Marginal Product Curves
©1999 Addison Wesley Longman
Slide 8.2
AP is rising as long as MP>AP
It does not matter if (MP) is rising or decreasing
When MP =AP, Ap is at its Max
When MP is below AP, AP is decreasing
Diminishing Marginal Product:
Law of diminishing returns: if successive units of a variable input are applied
to a fixed input, eventually each additional unit of the variable input will add less
to total product than the previous unit did
Marginal product may increase first , because of division of labor then, but then
Marginal product will decrease, because each additional worker will have less
and less capital to work with.
The law of diminishing return describes a short run phenomenon because at
least on input is fixed.
: *Read Application 8-1 from book p. 178
SHORT – RUN VARIATIONS IN COST
78
.
Total cost is the full cost any given level of output,
Note. The def. of cost in this chapter and next relate cost to the level of
output not input. i.e it is the cost of output we are discussing not the cost of
inputs
TC=TFC+TVC
changes with the change in scale of output.

Does not change with scale of output (overhead costs)
ATC= TC
Q
(cost per unit of output)
AFC= TFC
Q
AVC= TVC
Q
ATC=AFC+AVC
MC ( marginal or incremental cost) =
C
is the change in total cost as level of
Q
output increase by one unit.
NOTE: 1)we assume that input prices are constant in the SR. So the source of
change in SR costs is the change in the scale of output.
2) Because TFC do not vary with output, marginal cost is actually equal to the
change in variable costs
SEE EXTENSION 8-2 FOR A SUMMARY OF THESE RELATIONS
SHORT - RUN COST CURVES:
SEE TABLE 8-3
79
Figure 8-2
Total Cost, Average Cost, and Marginal Cost Curves
©1999 Addison Wesley Longman
Slide 8.3
Figure 8-1
Total Product, Average Product, and Marginal Product Curves
©1999 Addison Wesley Longman
Slide 8.2
ATC= AFC+AVC
ATC is obtained by vertically adding AFG+AVC Curves. The distance between
TC and TVC is constant and equal to TFC
MC cuts ATC and AVC at their lowest pts. As long as MC<ATC and
MC<AVC, ATC and AVC will be declining. When MC is > AVC & ATC, these
two will be rising. It doesn’t matter if MC itself is decreasing or rising
The decline of AFC shows the spreading of fixed costs over more units of output.
80
Capacity of firm (q c in Fig.8-2) is level of output for which ATC is minimum
(meaning this is the biggest output that can be produced, before average cost
rises.
. If firm production output less than capacity (minimum total average cost) is said
to have excess capacity.
The Relationship between Cost & Productivity
When MP and AP are rising, MC, AVC, and ATC are decreasing.
When MP is at max. , MC is at min.
*When Average product is Max the average variable cost is Min.
This is because each worker adds same wage cost, but adds more output. Thus
cost per unit of out must falls. Productivity and cost concepts are mirror
images. Meaning, when productivity is rising, cost is declining, and vice versa.
What does a “U”- shaped Cost curves mean? This is a manifestation of the
Law OF Diminishing Marginal Returns
When average productivity decreases fast enough and average variable cost
increases faster than the decline in average fixed cost .when this happen AVC
and ATC increases.
SHIFTS IN SHORT - RUN COST CURVES
Cost curves shift if the price of any variable input changes. This will shift the
firm MC and AC curves
81
Figure 8-3
The Effect of a Change in Input Prices
©1999 Addison Wesley Longman
Slide 8.4
A family of short run cost curves:
There is different short run cost curve for each quantity of fixed factor.
EXTENSION 8-1: WHY ARE THERE FIRMS?
The decision to produce internally or to buy from the market depends upon the
transaction costs involved in dealing in the market.
What are transaction costs? Cost that are associated with concluding a transaction
in the market in addition to the direct price paid for the good or the service, such
as the costs searching, negotiating, contracting, transportation , risk cost,
complicated contracts. The higher the transaction cost the less will be the
reliance on market and the more reliance on institutions within the firm.
END OF CHAPTER 8
82
CHAPTER 9: PRODUCTION AND COST IN THE LONG RUN
THE LONG RUN: NO FIXED FACTORS:
In the SR: To change output  change level of variable factor (input).
In the LR: When all inputs are variable, but not tech, the firm must decide on the
level of output and the method of production. (changing the input ratios).
The firm needs to be both technically and economically efficient. See Extension
9-1
EXTENTION 9-1
Engineering efficiency: using no more than necessary of a single KEY input to
produce a certain level of output.
Technical Efficiency: not using more than necessary of all inputs.
Technical EFF. is not sufficient, however.
Econ. efficiency. : To choose the method of production that produces a given
level of output at the lowest cost possible.
Econ efficiency: refers to value rather than physical amount.
to decide weather it is worth doing what is considered Engineering efficient
depends on comparing cost of input saved to inputs used.
Technical efficiency is a precondition to producing any output at the least cost
Choice of Factor mix: In order to minimize cost, the firm should use a
combination of inputs such that the marginal product per riyal spent on labor=
marginal product per riyal spent on capital.
This means that
*Cost minimization:
MPL MPk

PL
Pk
marginal Product is the productivity of the last unit of the input
Ex.
PL= SR10 & MPL = 40 units of output.
PK= SR50 & MPK = 300 units of output
MPL MPk

PL
Pk
40 300


10
50
4≠6  Substitute capital for labor
83
Another way to express cost minimization
MPL PL

MPk Pk
RHS: determined by technology chosen by the firm
LHS: relative prices of inputs determined by the MKT.
The substitution principle: if factor prices change, firms must substitute the
relatively cheaper factor for the other. This changes the labor- capital ratio.
This implies that the method of production will change . Furthermore, the
allocation of resources in the economy will change in response to changes in
inputs relative prices and changes in demand. This is also affects distribution of
income.
Relative prices changes due to change in relative scarcities of the factors of
production in the Econ.
What we mentioned before show us why methods of production differ across
countries.
EX. US farmers, use more machines, but Chinese farmers use more workers.
EX. Pakistan , a relatively poor country builds nuclear power plants to substitute
for rising prices of imported oil.
84
Long RUN COST CURVES
When all inputs are variable there is a least cost combination of inputs to produce
every level of output.
Figure 9-1
A Long-Run Average Cost Curve
©1999 Addison Wesley Longman
Slide 9.2
1)The LRC curve is determined by technology (which is fixed in the LR) and
input prices
2)Moving from any pt. or LRATC curve implies firm must change all factor
inputs.
3)Since all inputs are variable) in the long run, there is no difference between
AVC,AFC and ATC. In the LR There is only LRATC.
In the fig. above, in the SR, q1 can c2 produced at cost level c1,but in the LR ,
when all inputs are variable, the ATC for the same output level can go down to
c1
The Shape of the LRATC curve
The U-shaped curve is evidenced by many empirical studies
1) Decreasing LRATC: the range of output fro zero to q m . If all inputs are
changed by the same proportion, output increases more than proportionately. This
is called increasing returns to scale). In other words as cost decreases faster
than the increase in output , the are economies of scale.
85
Sources of economies of scale:
a) Change in method of production & tech. makes more room for the
specialization and division of labor.
b) The nature of geometry especially when it comes to storage areas.
Exp. Volume Storage 1mx1mx1m=1m3
Cost of surface Area= (1mx1m)x6=6m2
Assume increased storage 2mx2mx2m =8m2
Cost of surface area (2mx2m)x6 = 24 m2
%∆ in storage capacity (output) = 8-1 =700%
1
%∆ in surface area (cost) = 24-6 = 300%
6
While cost and surface area increased by 300 %. The storage capacity increased
by 700 %.
c) Inputs that do not have to be increased as output increases and for a long
period of time. Such as R &D. They cause ATC to decrease
2) Constant Costs: A flat LRATC implies constant returns to scale (constant
economies to scale) .Output and input change in same proportion.
3) Increasing Costs: Rising LRATC  diseconomies to scale (Decreasing
returns to scale.) As the firm gets larger, coordination and management becomes
more difficult. Output rises less as inputs increase.
** LR decreasing returns differ from SR diminishing returns. In the SR at least
one input is fixed. In the LR all inputs are variable
- The short run diminishing return must happen
- The long run decreasing returns may not happen (not a must)
86
Relationship between SR and LR cost curves:
Figure 9-2
Long-Run Average Cost and Short-Run Average Cost Curves
©1999 Addison Wesley Longman
Slide 9.3
1)The SR & LR cost curves are both derived from the same production function.
.
2)SRAC at all levels of output is above LRAC, except at q o ( When fixed factor
quantity is optimal
3) Two curves are tangent at the level of about for which the amount for the fixed
factor (input) is optimal at that particular output. . For all other levels there is
either too little ( if output >q0) or too much( if output<q0) of the fixed factor
87
Figure 9-3
The Envelope Relationship Between the Long-Run Average Cost Curve
and All of the Short-Run Average Total Cost Curves
©1999 Addison Wesley Longman
Slide 9.4
The long run average total cost is an envelope of many SRATC Curves. For
every point on the LRATC curve there is an associated SRATC curve tangent to
that point.
Shifts in the cost curves:
1) Technological improvements usually shift costs curves downward.
2) Changes in factor prices
. Although factor prices change gradually, it can change rapidly. Ex. 1980’s
price of oil fell dramatically. In 2004 oil prices rose dramatically.
THE VERY LONG RUN:
Tech. change refers to all improvements through invention and innovation in the
available techniques of production. → increase productivity → econ. growth →
high standard of living.
What is productivity? The level of output produced by a unit of resource input.
A widely used measure: output per hour of labor.
Other measures: output per worker & output per person.
What determines tech. change? IT was thought mainly a random process.
BUT,
as a result of economic research we know better: It is no longer a sudden event.
Research became an endogenous process, directed and affected by market and
88
social needs. Firms and governments respond to signals in the environment and
the market. They direct resources into research to solve particular problems.
EX. The quadrupling of oil prices in the 1970’s led to the design of smaller and
more fuel efficient cars
Invention is the creation of new techniques and products.
Innovation: The introduction (application) of an invention
Invention is thus a precondition to innovation..
Invention is cumulative in effect: lots of invention and innovation are the result
of previous achievements
Innovation is costly and risky. Costs may not be recovered and profits may not
be realized.
Kinds of Technological changes
1) New Techniques: changes in the techniques available for producing existing
products are called process innovation. Ex. The different processes to produce
Electricity: oil, gas , nuclear, solar…..
2)
New product: The new goods and services that are being invented and
marketed are called product innovation Ex. Computers, jet engines, mobile
telephones, vacuum cleaners
3)
Improved Inputs: improvements in health, education, banking raise the
quality of services. Improvements in material inputs. Ex. Steel today is lighter &
stronger that 20 years ago.
*FIRM’S CHOICES IN THE VERY LONG RUN: if the price of an
important input rises, Options open to the firm:
1) Substituting away from that input by changing the production technique
within the limits of existing technology .
2) Invest in research to develop new prod. tech. that innovate away from that
input.
The two responses are substitutes. Both involve costly resources. The first,
however has better predictable results
EX. Assume there is a high and permanent increase in labor cost. The
options include:
1)
Relocate production to some place where labor is cheaper.
2)
Replace existing machines with less labor intensive ones.
3)
Develop a new prod. Tech.
SEE APPLICATION 9-1
END OF CHAPTER 9
89
CHAPTER 10: Competitive Markets
The degree of competition in the market and its impact on output and prices
depends on the market structure of the industry.
- What is an Industry? Firms that produce a particular product or closely- related
products.
- What is A Market Structure? characteristics of an industry that effect behavior
and performance of firms in that industry. There are four structures:
1) perfect competition
2) monopoly
3) monopolistic competition
4) oligopoly
The Theory of Perfect Competition:
The less power a firm has in the MKT, the greater the degree of competition.
Perfect Competition  zero power
A perfectly competitive market is a market where no firm can influence the
MKT.
Assumptions of Perfect Competition:
1) All firms produce the same homogenous product.
2) A large no. of small producers.  The long run output of each firm is very
small relatives to total industry output.
3) information is available to all producers & consumers.
4) Resources are perfectly mobile and entry into, and exist from industry is easy.
The first three ass. implies that every firm is a price taker  No firm can
influence mkt. price.
90
Demand
Curve
for
A
perfect.
Compet.
Firm.
Figure 10-1
The Demand Curve for a Competitive Industry and for One Firm in the Industry
©1999 Addison Wesley Longman
Slide 10.2
An infinitely elastic demand curve for the competition firm →firm can sell all of
its output at MKT Price. Firm cannot influence price. Does not mean it can sell
infinite amount. If it dares to raise the price, it may lose all sales.
Note : the industry as a whole has the regular downward –sloping D-curve
TR, AR, & MR:
TR=P.Q “Total amount of Riyals received by seller”
TR PQ

P
Q
Q
TR ( P )Q
MR 

P
Q
Q
AR 
Thus: For a Competitive firm
P= AR=MR
Every additional unit sold will bring the same additional revenue.
See Table10-1
91
Figure 10-2
Revenue Curves for a Price-Taking Firm
©1999 Addison Wesley Longman
Slide 10.3
Rules for All Profit- Max. Firms ( even if not perfectly competitive)
1)
Should the firm produce at all?
Option 1) not to produce →T.R.=Ø,TVC=0,TFC>O,
Rule #1: As long as TR>TVC (AR=P>AVC) firm should produce or.
However, if TR < TVC , the firm should stop production.
The point of Q where TR= TVC ( P= AVC) , the firm is indifferent. The firm can
just cover its variable cost. This point is called The Shut down Point, if TR<
TVC it should stop operating.
Firms in perfect composition will produce output equals its marginal cost with
MR (or price), this is true as long as price (AR) is greater than AVC.
How much should the firm produce ?
Rule # 2: Optimal output is where MR = MC
This is the profit max. condition.
For the competitive firm P=MR=MC
92
Figure 10-3
The Short-Run Profit-Maximizing Output Choice of a Competitive Firm
©1999 Addison Wesley Longman
Slide 10.4
Figure 10-4
The Short-Run Profit-Maximizing Output Choice
of a Firm Using Total Cost and Revenue Curves
©1999 Addison Wesley Longman
Slide 10.5
Conclusion: A perfectly competitive firm is a price taker but a quantity- adjuster.
i.e the firm has no control of market price, but can decide about quantity
produced.
93
Short –Run Supply Curve For The Firm:
Figure 10-5
The Derivation of the Supply Curve of a Price-Taking Firm
©1999 Addison Wesley Longman
Slide 10.6
The SR supply curve of the competitive firm is MC curve above min. AVC.
Supply curve, where MC exceeds AVE called Short run supply curve because it
is based on short run profit maximization.
The S- Curve For The Industry: is the horizontal sum of MC curves above Min.
Figure 10-6
The Derivation of the Supply Curve of a Competitive Industry
AVC curves
©1999 Addison Wesley Longman
94
Slide 10.7
SR Equilib. In A Compt. MKT:
When industry is in short run equilibrium, every, and each firm is maximizing
profits. This means each firm is producing and selling a quantity, for which
MC=P
Three possible positions in the SR. See Fig. 10-7 below
Figure 10-7
Alternative Short-Run Profits of a Competitive Firm
©1999 Addison Wesley Longman
Slide 10.8
LONG RUN DECESIONS: from Fig. 10-7 above
Key difference between a perfectly competitive industry in the short run and in
the long run is the entry or exit of firms.
Entry into and exit from an industry is determined by the existence of profits and
loses.
Long run equilib. happens when earning zero ( econ.) profits
In Fig. 10-7-i
P <ATC, but > min. AVC  The firm is minimizing losses. It shall exit the
industry at the earliest possible chance, unless things improve. Exit will happen
win losses occur → shifting mkt. supply curve to the left, until market price
covers ATC
In Fig. 10-7-ii
P=Min. ATC
95
Firm is breaking even meaning Econ. Profit =0. It is only covering its opportunity
cost of capital & risk  firm making normal profits. It is doing just as well it
could do else where.  No incentive to exit, or for other firms to enter.
In Fig.10-7-iii
P>ATC
Firm makes SR (Econ.) Profits.  There is an incentive for other firms to enter
the industry. As supply increases, price and profits decrease. Firms must adjust
output to
New price.
Figure 10-8
The Effect of New Entrants
©1999 Addison Wesley Longman
Slide 10.9
Long Run Equilibrium For a competitive Industry occurs when all
firms are earning zero profits.
Profits provide a signal for resource allocation among the
economy’s industries.
Conditions for LR Equilibrium:
1) Every firm must be optimizing (i.e. producing were SRMC = P = min.
SRATC)
2) No firm is making loses
3) No firm is making profit
4) Every firm must be producing at Min LRATC. (Meaning: it can not increase
profit by changing level of production). See Fig. below
96
Figure 10-9
Short-Run Versus Long-Run Profit
Maximization for a Competitive Firm
©1999 Addison Wesley Longman
Slide 10.10
Producing q0 at P0 → firm not minimizing LR cost because it could have
produced q0 at Co by a larger plant, to take advantage of econ. of scale. Profits
would rise, because ATC < P
But as long as LRATC is decreasing →there are unexploited economies of scale.
LR profits are max. only at q m . This is called the minimum efficient scale (
MES).
When each firm is producing at min. LRATC, it looks like fig.10-10 below:
97
Figure 10-10
A Typical Firm When the Industry Is in Long-Run Equilibriom
©1999 Addison Wesley Longman
Slide 10.11
P = MC = min. SRATC= min. LRATC 
Zero Econ. Profits →normal econ profits →all input are paid their opp.cost.
The LR Industry Supply Curve: Suppose mkt. demand increases  demand
curve shifts upward →firms attracted to industry. Will new LR price be >,< or =
initial LR price?
This depends on what happens to the industry Long Run Supply Curve
98
Figure 10-11
Long-Run Industry Supply Curves
©1999 Addison Wesley Longman
Slide 10.12
In part i: When the expansion of the industry does not put upward pressures on
input prices  LR cost curves of existing firms unaffected. Because new firms
face same tech + factor prices  New and old firms have the same cost curves.
The LRS curve is horizontal. This is called a Constant cost industry.
In part ii: Increasing cost industry means new firm joining the industry cause
upward pressure on input prices.
1) For more output supply →input prices increase
2) the SRATC increase (shift upward)
3) supply stops increasing when price equal min long run average cost (total costcovered) P=ATC because cost has risen →equilibrium at a higher prices
In part iii: Decreasing cost industry  A downward sloping supply curve.
Could it happen? No it cannot happen for a competitive industry, because in the
LR equilib. each firm must be at min. LRATC. For if the firm can reduce cost by
building a larger plant it will be so with out waiting the demand curve to shifts.
i.e ,the competitive firm is assumed o have exhausted all internal econ. of scale
However a competitive industry can have a downward sloping S- curve if
another non-competitive Industry that supplies inputs to the competitive industry
can exploit its own economies of scale and reduce input prices , this can be a
99
source of external economies of scale and cost curves
industry will be shifting down.
of the competitive
Ex. Automobile and tire industry: The tire industry building larger plants,
exploiting large econ. Of scale, tires prices decrease, automobile cost decreased
Internal econ. Scale of sale are scale economies within control of firm.
External econ of scale economies outside control of competitive firm.
Note: long run industry supply curve shows relation b/w the Mkt price and
quantity produced when firm is in long-run equilib.
Please read App. 10-2 p.227
Changes in Technology:
Technology lowers cost curve → firms using the new tech. make econ profits on
the new plant→ new firms join the industry →supply shift rightward →price
goes down. Industry continues to expand until price equal min. short run ATC of
new plants →econ profits=0 →old plants will not be covering their long run costs
→ they continue to be used as long as p >AVC. Eventually, outmoded plants will
be discarded and a new LR equilib. established where all plants using new tech.
See Fig.10-12 below
100
Figure 10-12
Plants of Different Vintages in an Industry with Continuous Technological Progress
©1999 Addison Wesley Longman
Slide 10.13
Plant 1: oldest plant, p=min. AVC, making losses. If price falls further, it will be
closed down.
Plant 2: intermediate age, AVC < p < ATC  making losses, but covering its
variable cost, and some of its fixed cost.
Plant3: newest tech. Due to entry of other firms, p= min. ATC, covering normal
profits only.
In an industry were there is continuous tech. change we observe:
1)plants of different ages and efficiencies coexist side by side. EX ; Farm
equipment in the agricultural sector. Critics of using old tech. must remember
that efficiency requires using a plant as long as revenues cover AVC.
2) Mkt. price is governed “determined” by min. ATC of at he most efficient
plant. New firms will stop joining the industry when econ. Profits are zero → P=
min. ATC.
3) old plants are discarded when they are economically obsolete, When p< AVC
even though they may be physically good.
*Declining Industries:
What if  in demand (change in taste) ? → Mkt. price  →firms covering AVC
previously are not able to do so → firms suffer looses.
101
→ The Response of Firms”
1) continue to operate with existing equipment as long as its VC can be covered
.
2) When old equipment becomes obsolete and can not cover VC, it will not be
replaced unless new equipment covers its total cost.
3) As demand decreases, industry capacity keeps shrinking
Conclusion:
Antiqued equipment in a declining industry is the results not the cause of the
industry’s decline.
The Response of Government: Gov’ts often try to rescue declining industries
for the fear of losses of jobs. Experience tells , that supporting genuinely
declining industries only delay their demise at a significant social cost. When
gov’t eventually withdraws its support, the decline is usually more abrupt,
and hence the required adjustment more difficult than if the decline was
more gradual.
A more effective response would be to provide retraining and income
support to disadvantaged workers.
*The Appeal of Perfect Competition.( Why should economy try to reach a
perfectly competitive Structure?)
1) No single firm or consumer has any power over the mkt. power. If tastes
change, for example , prices change and the allocation of resources change. The
Mkt mechanism “invisible hand” determines the allocation of resource among
competing uses.
2) Mkt. forces, not gov’t policies eliminate shortages and surpluses. No need for
regulatory agencies nor for bureaucrats to make arbitrary decisions
END OF CHAPTER 10
102
CHAPTER 11: Monopoly
Monopoly: one single firm produces and sells all output of some product or
service
A Single Price Monopolist:
Cost & Revenue curves in short run:
1)U-shaped cost curves are a result of diminishing returns. This is the case under
perfect compt. and monopoly alike.
2)Monopolist demand curve= MKT Demand Curve.
3)Because monopolist charges same price for all units sold
AR=P
4)Demand Curve is the same as AR Curve : AR 
TR PQ

P
Q
Q
5)Monopolist firm faces a downward sloping demand curve. Marginal revenue is
less than price b/c in order to sell more, price must be reduced for the entire
sales, not just additional sales
103
Loss in Rev= (P1-P2) (q1) ←old unit sold “already sold”
Gain in Rev= (P2) (q 2 - q1)_← new units
Net change in T.R. is the difference
See Fig.11-1 below
Figure 11-1
A Monopolist’s Average and Marginal Revenue Curves
©1999 Addison Wesley Longman
SEE TABLE 11-1
Marginal Revenue and elasticity
104
Slide 11.2
Figure 11-2
The Relationship Between Total, Average, and
Marginal Revenue and Elasticity of Demand
©1999 Addison Wesley Longman
Slide 11.3
Short –Run Profit Max.:
The two rules developed in Chap.10 should be applied:
1) Decision to produce: P>AVC
2) How much to produce? Level of Q where (MR=MC)  <P=(AR)
Monopoly profits: Monopoly is no guarantee of making profits. See Fig.11-3
below
105
Figure 11-3
Short-Run Profit Maximization for a Monopolist
Slide 11.4
©1999 Addison Wesley Longman
If the monopolist suffers persistent losses, it will eventually exit.
No Supply curve for monopolist: We cannot locate a supply curve for
monopolist, because for the same optimal quantity a multiple of demand and MR
curves can be drawn, such that several MR curves intersect the same MC curve at
the same quantity. Thus multiple prices can be found for same output.
See THE HANDOUT DRAWING PROVIDED BY PROFESSOR UTHMAN
Comparison between perfect comp. and monopoly:
Perfect Comp.
1). Firm is a Price taker but quantity
adjuster
2). Price=MR=AR (demand curve
perfectly elastic)
3) optimal output P=MC
4) Supply curve along MC curve
above min. AVC
106
Monopoly
1). Price setter
2) Price=AR>MR (demand curve
downward sloped)
3) Optimal output MR=MC, & P>
MC
4) supply curve cannot be located
Perfect competitive industry →equilibrium determined by intersecting industry
supply curve with mkt. demand curve.
Monopoly: because output determined at (MC=MR)<P
Produces less output than perfect comp. industry.
1) Perfect comp. industry achieves allocative efficiency ( discussed in Chap.13)
2) Monopolist produces where P>MC society gains as more output increase. If
monopolist suffers losses  continue producing as long p>AVC. However in
long run it will exit if it cannot cover opp. Cost.
Monopoly in LR:
The persistence of monopoly profits in long run is subject to the ability of other
firms to enter the industry.
Barriers to entry: Either natural or created
1) Natural barriers
a)l large econ. of scale, , where LRATC is negatively sloped for a very large
size of output. One firm’s MES point can satisfy the total market demand. This is
called natural monopoly. Usually, the higher fixed costs are, the larger econ of
scale. It is a matter of technology.
b) High setup costs: costs of developing products, establishing brand names
and dealers network.
2)
Created barriers
a) created by Government action such as patents, copyright laws to protect R
&
D and enable companies to recover expenses of Research.
b) Franchises by big firms
c) licenses by govt. and professional organizations to practice some
professions , such as dentists, accountants, lawyers….etc.
d) Sabotage and threat of force by organized crime, or use of political
influence.
Protection of patents rights is a major area of disagreement between developing
& developed nations, especially in the area of medicine.
The very long run and The Process of Creative Destruction
107
The very famous Austrian- American economist Joseph Schumpeter (1883-1950)
argued entry barriers were not a serious problem in the very LR. Monopoly
profits are the driving force behind invention and innovation that leads to the
replacement of one monopoly with another. He called this process, the process of
creative destruction, where one product destroys another. He argued further that
perfect comp., is inferior to
monopoly because monopoly profits are the main
driving force for invention and innovation, which in turn is the major source of
econ. growth.
SEE APPLICATION
DESTRUCTION
11-1
FOR
EXAMPLES
OF
CREATIVE
Dr. Uthman’s Remark: Schumpeter’s argument is applicable to a dynamic
economy where monopoly is the result of scientific research. This is very imp.
As it has to do with how should governments regulate monopolies? In other
words, we could have monopolies that are not creative at all. EX: Monopolistic
car dealerships, & domestic air travel in Saudi Arabia
Cartels as Monopolies:
Competitive firms may agree to cooperate and act as one seller, restricting total
output , so as to max. joint profits. This is called a cartel. Total output will be at
the point where industry’s MC=industry’s MR. A quota will be assigned to
every firm.
See FIG.11-4 below
108
Figure 11-4
The Effect of Cartelizing a Perfectly Competitive Industry
©1999 Addison Wesley Longman
Slide 11.5
Under perfect comp., output is where p (measured along the D- curve ) =MC→P
=P c and q=q c . If industry behaves like one firm →output will be where
MC=MR→P=P m . Thus cartelization leads to a higher mkt. price and lower
industry output ( P m >P c , & q m <q c .)
Two problems face cartels:
1) How to enforce an agreement on output quotas and prevent cheating .This is
the main dilemma of a cartel. Cartels tend to be unstable because of the
incentive to cheat.
SEE FIG.11-5
EX: IATA (The International Air Travel Association) is a good example of cartel
failure.
2) How to restrict entry of other firms. Barriers must be created, such as licenses,
govt. concessions. …. .etc.
SEE APPLICATION 11-2 FOR EASE of ENTRY & TECHNICAL
CHANGE
109
Figure 11-5
A Cartel Member’s Incentive to Cheat
©1999 Addison Wesley Longman
Slide 11.6
Why The Incentive to Cheat? In the Fig. above:
At the monopoly price, p 1 , a firm can increase ,and maximize its profits by
increasing its output from its quota ,q 1 , to q 2 . At this point P= MC for the firm,
and profits increase by the light shaded area.
When every firm cheats, price is depressed to the competitive level, p 0 , at min.
ATC, & q= q 0 . No more monopoly profits exist.
A
MULTIPRICE MONOPOLIST: PRICE DISCRININATION: When a
producer charges different prices for different units for reasons not be
related to cost differences
Ex. Of price differentials that are not price discrimination:
1) quantity discounts
2) wholesale price and retail price.
3) price that vary with time and place. Ex. Electricity
Different Forms of Price Discrimination: Persistent profitable P.D is either
because different buyers are welling to pay different prices, or the same buyer is
welling to pay different prices for different units. In both cases the producer is
trying to capture some of the consumer’s surplus (Remember from Chap.7)
Price discrimination has to do with different valuations of different units or
different customers. Different valuations imply different elasticities of
demand.
110
1) Discrimination among units of output. The monopolist can whip out consumer
surplus increase profits if he can charge a different price for every different unit.
This called perfect price discrimination.
2) Discrimination among buyers: If the producer can detect the max. price each
buyer is welling to pay for every single unit. Suppose there are four buyers
Assume:
MC =1
P1 = 4
P2 = 3
P3 = 2
P4 = 1
For a single, non- discriminatory monopolist, Profit max.
When MR=MC
TR 4
 4
Q
1
(2 x3)  (1x 4)
2
MR2=
1
(3 x 2)  (2 x3)
0
MR3=
1
MR1=
Thus Q*=2, P*= 3 & Profit = 4
However with perfect discriminate among buyers, it could change first buyer $4
and second 3 and so on. So profit= (4+3+2+1)-(4) =6 It would be indifferent from
selling 4th unit.
3)
Discrimination among markets: In a tariff- protected home market set
MR=MC  P> MC.
In foreign & more competitive mkts., set
P=MC
EX: Saudi medicine is cheaper in Bahrain than in Saudi Arabia, in some cases by
one third!
4) Price Discrimination in General
The larger the no, of different prices a firm can change, the greater the firms
ability to increase revenue + profits.
SEE FIG.11-6 BELOW
111
Figure 11-6
Price Discrimination
©1999 Addison Wesley Longman
Slide 11.7
When Price Discrimination is Possible?
P0
1) Price discrimination among units of output is possible if only the seller is able
to keep track of each consumer’s purchases.
EX:
a) electric companies & gas stations use meters
b) magazines → new subscription vs. renewals
c) coffee shops →by coffee cards. For each cup purchased a hole is punched in
the card. After 10 cups the consumer gets one free cup.
d) Airlines discriminate between children & adults.
2) price discrimination among buyers is possible only if those who face low price
cannot re- sell to people who face high price.
The ability to prevent resale depends or nature of product +ability to classify
buyers into different groups.
Services are less easy resold than goods
Transportation costs, import quotas, traffic barriers are factors that make
discrimination possible
Also, firms must control supply that reaches consumer from other firms.
The Consequences of P.D:
112
1)
higher rev. & Profits for the discriminating firm as compared to nondiscriminating.
2)
Output under P.D will be larger than under single – price monopolist
Normative Aspects of Price Discrimination
Two aspects are involved in evaluating cases of price discrimination:
1) effect of it on level of output: P.D  higher output
2) effect it on income distribution: P.D  transfers income if from buyers to
sellers.
QUESTION: is every case of P.D necessarily bad?
END OF CHAPTER 11
CHAPTER 12: Imperfect Competition
113
When competition is imperfect  that each firm has some degree of market
(monopoly) power.
Q: How to measure that? Industrial Concentration
The concentration ratio measures the percentage of total sales controlled by the
largest four (or eight) companies
Problems with concentration ratio
1) Definition of MKT size : national market may be divided into isolated regional
markets due to high transportations cost. So measures of concentration ratio
should be conducted regionally .
2) Degree of international competition through imports & exports, also, effects
measures of concentration ratio.
General characteristics of imperfect competition:
1) Firms select their products → products in industry are not identical, not
homogenous→ there is product differentiation among firms . differentiated
products: are products that are similar enough to be called the same product,
but dissimilar enough that they can be sold at different prices.
Ex. Different brands of soap, PC’s, cars, tameez, foool& maaa’soub.
Are you laughing?
2) Firms choose their prices: because products are differentiated →firms face a
downward sloping demand curve. A firm can choose to change its price without
the fear of loosing all of its sales. Prices are called administered prices and set by
firm Firms are price setters.
One contrast: under perfect comp. price change continuously with changes in
supply and demand. Under imperfect compt., prices change less frequently, and
transitory changes in demand are met by changes in quantity, with prices
constant. Rising costs due to inflation are passed to consumers by rising prices.
3) Non-Price competition: in perfect comp , a firm does not advertise because ,
product is standardized. It faces a perfectly elastic demand
-monopolist: does not advertise because no comp.
-product diff in imperfect comp. leads to a degree of monopoly power which is
enhanced by
a) heavy advertising to shift demand curve upward.
114
. (b) quality and guarantees, brand name distinction., packaging, color smell
.location, ….. etc.
(c) practices to prevent entry .
MONOPOLISTIC COMPETITION: Firms sell differentiated products,
establish brand names and advertise.  firms have some degree of mkt. power .
This is the monopolistic part of the industry.
However, each firms monopoly power is severely restricted in the SR & LR. In
the SR, there are lots of similar,( substitute) products sold by other firms D- curve
is very elastic. In the LR, there is free entry into the industry.
Assumptions 1) Each firm produces one specific variety or brand . There are
many substitutes  The firm faces a very elastic demand curve.
2) A large no. of firms →they ignore each other practices → there is no
dependency in behavior among firms. Similar to perfect compt.
3) Freedom for entry into and exit from industry.
Predictions of the Theory
Product differentiation is the only thing that makes monop. Compt.
Different from perfect compt.
SR Decisions of the Firm : out puts is set were MR=MC some econ profit may
be made in SR. See Fig. 12-1 below, part i
115
Figure 12-1
Profit Maximization for a Firm in Monopolistic Competition
©1999 Addison Wesley Longman
Slide 12.2
The LR: existence of profits→ other firms enter industry → demand curve
facing industry shifts downward until D- curve is tangent to ATC . Since
P=ATC→ Econ profits =0
Q. Why tangency is only Solution for long run equilib.?
1) if demand curve did not touch ( remained above) ATC curve, then firms will
lose and exit occurs, shifting each firms demand curve to the right until tangency
occurs.
2) if demand curve cuts D- curve curve, then firm will make profits and entry
occurs until tangency occur at P=ATC.
Long run equilib. →zero econ profit even though each firm faces sloped demand
curve. Each firm has excess capacity as LR equilib. is not at min. LRATC.
Evaluation of the theory: excess capacity Theorem generated heated debate
among economists about firms producing differentiated products, for it meant
these firms produce at higher cost, compared to perfect copmt. This suggests
that modern market economies are systematically inefficient.
Another view:
Excess capacity does not necessarily mean there is a waste of resources because
consumers benefit from the variety of choices.
From society point of view, there is a trade off b/w producing more brands to
satisfy diverse tastes and producing fewer brands at a lower cost per unit. The
socially optimal no. of brands means that marginal benefits of variety is equal to
the extra cost that one more variety.
116
Empirical Relevance: many economists argued that monopolistic compet. never
existed. Distinguish between products & firms. Single – product firms are
extremely rare in manufacturing industries.
Many competing (differentiated) products are produced by a few large firms
(high concentration). EX: soap, cigarettes, chemicals, breakfast cereals.
These firms make large profits without attracting new entry, violating the 3rd
assumption of monopolistic compt. There are a very high concentration ratios
that they should be called oligopoly mkt. structures.
However, the theory remains useful where concentration ratios are low &
products are differentiated , as in the cases of gas stations, & restaurants.
OLIGOPOLY:
Industry contains two or more firms, at least one which
produces a significant portion of industry output. Whenever there is a high
concentration ratio the MKT is oligopolistic .
Characteristics:
1). Firms face negatively sloped demand curve.
2) The no. of firms is small. Every firm takes into account that other firms may
respond to its actions. There is, thus interdependence in behavior among firms.
This is the KEY difference between oligoppoy & other mkt structures
3) As result of interdependence, firms exhibit is strategic behavior in the sense
that behavior is based on calculations, and may try to impose costs on others.
4) there are many types of oligopoly. A large No. of small firms , but a big few
firms is called “ the competitive fringe.
5) products are differentiated and prices are administered.
117
B)
A)
B)
C)
Price
leader
D)
Douply (two
firms)
Competitiv
e fring
Big no; of small sellers
Causes of Bigness:
1) Economics of scale: a) due to division & specialization of labor. Such division
of labor, as Adam Smith observed long time ago, depends on the mkt. size. (See
Extension 3-2, Chap.3)
. b) Very large fixed costs that come with product development and marketing
networks that can be spread over a very large size of output.
2) Created reasons (factors) of Bigness: mergers, acquisitions or forcing
competitors into bankruptcy. Anti rust laws promote competition, and sees large
firms are undesirable.
STRATEGIC BEHAVIOR & THE BASIC DILEMMA OF OLIGOPOLY:
In deciding strategic behavior oligopolistic firms face the basic dilemma of
competing or cooperating.
Cooperative & Non- Cooperative Outcomes. Firms cooperate overtly or
tacitly.  the cooperative outcome is to try to reach a monopoly solution.
However, there is always the incentive to cheat.
An example from game theory: Game theory is an active area of economic
research
118
Figure 12-2
The Oligopolist’s Dilemma:
To Cooperate or to Compete?
©1999 Addison Wesley Longman
Slide 12.3
if the two firms do not cooperate, total industry output =1 1/3 of market demand
(excess supply)
Cooperative outcome: Max joint profits, which is position a single monopolies
would reach.
Non- coop. Outcome , is outcome reached when firms when firms act to satisfy
their own interests, taking as given ( assuming constant) the behavior of other
firms. Both firms are cheating or do not cooperate. This is called “Nash
equilibrium” In the Fig. above , there is only one Nash Equilib.
The basis of Nash equilib. is rational behavior in the absence of cooperation.
John Nash developed Game Theory in 1950’s & received Noble Prize in 1994.
SEE EXTENSION 12-1 FOR THE PRISONERS DILEMMA
Types of competitive Behavior:
119
a)
compt. For mkt shares through advertising, variations in quality, secret
discounts, and rebates.
b)
Very LR Competition: When technology & product characteristics
change constantly , the firm that behaves competitively is expected to earn a
larger share of profits & mkt. share than under cooperation. This comes
through invention & innovation. Such behavior contributes to econ. Growth
& raises the standard of living
Factors influencing firms’ cooperation:
1) The smaller the no, of firms.
2) The more standardized or homogenous the product is, the more the incentive
to cooperate.
3) The more growing the market is
4) the existence of a dominant firm. A dominant firm could become a price leader
even without agreement.
5) If non- price rivalry is absent, or limited.
6) When barriers to entry of new firms are greater.
THE IMPORTANCE OF ENTRY BARIERS: Natural barriers, discussed in
Chap.11 are important in explaining persistent profits. However firms’ created
barriers are also imp.
a )Brand Proliferation: multiple brands are partly in response to customer
taste, but could discourage new entrants.
The larger no of brands, the smaller expected sales of new entrants.
b) Advertising : Advertising costs could increase the cost of entry. SEE FIG.
12-3 below
120
Figure 12-3
Advertising Cost as a Barrier to Entry
©1999 Addison Wesley Longman
Slide 12.4
In the fig above:
ATC 0 is Cost with no advertising, MES at q 0
AAC is av. cost of advertising. It decreases as output rises.
ATC 1 is new ATC after advertising. It is higher than before, but MES is larger at
q 1 . This will support larger market demand
COTESTABLE MARKETS: Markets do not have to have many firms or actual
entry for profits to be held near competitive level.
Thus Potential entry can do the job in generating a competitive outcome if:
1) entry is easily accomplished 2) firms take potential entry into account.
Sunk costs of entry: are initial costs that a firm must incur to enter a mkt that
can not be recovered if the firm exists.
EX.: advertising, a plant which does not have other use.
A perfectly Contestants market: A mkt in which firms can enter and exist
without any sunk costs.
The lower sunk costs are, the more contestable the mkt. is. Contestability where it
is possible is a force to limit oligopolistic profits, even if actual entry doe not
occur.
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Empirical Relevance: Most economists believe although the theory is an elegant
extension of perfect compt., there are at least some barriers to entry in all
markets. Contestability is a matter of degree
Oligopoly: An Overview
Three questions for evaluating oligopolistic mkt structures:
1)
Do oligopoly firm allocate re3sources differently from compt. Firms?
2)
Where do oligopolies settle in the SR & LR between monopoly &
perfect compt. in terms of profits?
3)
How much do they contribute to econ. Growth in terms of invention
&innovation?
4)
Market Mechanism under oligopoly:
The market system reallocates resources, in response to changes in demand
roughly the same way under oligopoly as under perfect compt.
Very long run comp. Oligopoly is a very imp. Mkt struct. For in many
industries the MES is simply too large to support the existence of many
firms.. The challenge to policy makers is to keep oligopolistic firms
competing, rather than colluding, and use their competitive powers to
improve products and to reduce costs, rather than to erect entry barriers
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