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Ecoon 1001 ALL Notes Final Revision
Introductory Microeconomics (University of Sydney)
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1. Key concepts and comparative
advantage
What is economics?
Economics is the study of choice under scarcity. Scarcity is faced by consumers, businesses, government,
countries and so on.
o Choice involves consideration of explicit cost (e.g. $3.50 coffee) and implicit cost (value of 2nd
best alternative: giving up staying in bed)
o Opportunity cost = explicit cost + implicit cost
Key issues that need to be addressed in an economy are:
1. What to produce
2. How to produce it; and
3. Who should get what is made
In a modern economy, these questions are typically resolved in the ‘market.’ A market is a place
where buyers and sellers of a particular good or service meet.
Æ Markets can look quite different, from a traditional bazaar to an online trading site.
BUT government still play a critical role in markets, imposing taxes and regulations.
Our focus is on the behaviour of individuals (consumers, firms, government) in markets.
Scarcity and opportunity cost
Resources are limited, so that not all wants can be met – this is scarcity.
o For example, if an individual uses her money to buy one product, she cannot use it to buy
something else
The opportunity cost of any choice is the value of the next best forgone alternative.
o For example, a consumer buys product sandwich. Her next preferred product is sushi. Given this,
the opportunity cost of buying a sandwich is foregoing sushi
o The same concept applies to how an individual spends their time or other resources
Opportunity costs include both explicit costs and implicit costs.
x
x
Explicit costs are costs that involve direct payment (would be considered costs by an
accountant)
Implicit costs are opportunities that are foregone that do not involve explicit cost
Example: Stephen decides to go to university, and his next best option is to work at a construction site
and earn $80K over the year.
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o The explicit costs are those that Stephen must directly pay to go to university, such as student
fees, the cost of textbooks and so on
o The implicit costs are the opportunities that Stephen must forego – that is, working at the
construction site and earning $80K
Opportunity cost does not include unrecoverable or sunk costs.
For example, if a business spent $100m on an advertising campaign last year, it cannot get that money
(or the effort spent) now by making a different decision.
Marginal analysis
x
x
x
Marginal cost: increase in cost caused by producing one additional unit.
Marginal benefit: increase in benefit caused by consuming on additional unit.
Mathematical tools:
o Derivatives, differentials, differential calculus, calculus used to calculate marginal values
o Algebra
Marginal analysis is useful as it allows us to examine the behaviour of individuals in the market.
o If the marginal benefit (MB) of an activity is greater than its marginal cost (MC), an agent is
better off doing that activity; if the MB is less than the MC, they are worse off if they do.
Marginal analysis is a recurring theme in economics.
Ceteris paribus
Ceteris paribus = keeping everything else constant (change things one by one and see the effects).
In the real world, many things change at the same time (prices, income, tastes, taxes etc.) To
isolate the impact of one factor, economists examine the impact of one change at a time, holding
everything else constant – this is called ceteris paribus.
o If we are interested in the impact of the change in the price of a good on the quantity
demanded, we analysis this holding income, and any other relevant variables constant
Correlation and causation
x
x
Correlation – when two or more factors are observed to be moving up, down in the opposite
directions together
Causation – a change in one variable brings about, or causes, a change in another variable
o Economic theory, providing a framework for how the world works, allows us to
distinguish between correlation and causation
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Trade & production possibility frontier (PPF)
The gains from trade
A basic tenant of economics is that trade makes people better off – it is beneficial for the two parties
implied.
x
x
Trade helps allocate goods to those who value them most. This is the gains from exchange.
Example: Baz has a bike he values at $10; Chloe is willing to pay up to $100 for the bike.
o Provided the price is between $10 and $100 both parties can be made better off by
trading the bike
o Note, the price determines how the gains from trade are split; a higher price suits the
seller, a lower price the buyer
Trade also allows people to take advantage of gains from specialisation, reducing overall costs of
producing and increasing output.
ÆTo show this, we first introduce the concept of the PPF.
Production possibility frontier (PPF)
PPF tells us what can be produced and what cannot.
x
x
A PPF graphs the output than an individual (or a country) can produce for a particular set of
resources
Suppose that Australia can use its resources given the state of technology to produce either
good X or good Y, or some combination of both
o This information can be shown on a graph
The PPF traces out combinations of the quantity of two
goods (X and Y) that can be produced if all resources are
used. Point B is attainable, as is A. Point C is
unattainable given current technology and resources.
C
A
B
PPF
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Changes in the PPF
With a shock that boosts the production of both goods,
the PPF will shift outwards from origin along both axes
(technology used in both industries, an increase in the
labour force, and so on).
PPF
PPF'
If there is a shock that boosts the production of X only,
the PPF will shift outwards from origin along the X-axis
only.
PPF
PPF'
Opportunity cost and the slope of the PPF
A
The slope of the PPF measures the opportunity cost of
producing an extra unit of a good (in terms of the
other), for a particular point on the frontier. Here the
opportunity cost of each good is increasing the level of
output of that good
A'
B
B'
PPF
1 unit
1 unit
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Absolute and comparative advantage
x
x
Party A has an absolute advantage over party B in the production of a good if, for a given
amount of resources, A can produce a greater number of that good than B
Party A has a comparative advantage over party B in the production of a good if A’s opportunity
cost of producing that good is lower than B’s opportunity cost
Example: Brokerick takes 1hr to make a pepper mill and 1hr to make a salt shaker. Christopher takes
4hrs to make a pepper mill and 2hrs to make a salt shaker. Both Brokerick and Christopher work for 8hrs
a day.
ÆContinued in book…..
Gains from specialisation
The party with the comparative advantage in the production of a good will specialise in the production
of that good.
To see the gains from trade via specialisation, consider another example: Michelle and Rodney spend
10hrs a day making shoes. It takes Michelle 2hrs to make a left shoe, and 0.5hrs to make a right shoe.
Rodney takes 0.5hrs to make a left shoe and 2hrs to make a right shoe.
ÆContinued in book….
Intuition underlying gains from trade
Total output increases because trade allows parties to specialise in producing the good in which they
have the lower opportunity cost.
o With more output, both trading parties can be potentially made better off
o Trade creates an environment for specialisation to be feasible, increasing the size of the
economic pie
o This increase in output can potentially be shared so as to make everyone better off than without
trade
This concept is very general:
x
x
Trade is beneficial to individuals (and indeed countries) because it allows them to specialise in
industries where they have the comparative advantage, and trade with others for things that
would cost them more to produce personally
Moreover, this principle holds even if one party has the absolute advantage in the production of
both goods; what matters is the comparative advantages or opportunities costs of the parties
2. Market fundamentals: demand
Background
In economics we examine consumer behaviour assuming each consumer tries to maximise their
benefit (or utility) he or she gets from consuming goods and services, subject to their budget constraint.
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First, we consider competitive markets, where the choices of individual consumers do not affect
the price in the market – consumers are price takers.
Benefits and willingness to pay
A consumer derives some benefit from consuming a particular good or service. The benefit a consumer
gets is also their willingness to pay (WTP).
o The maximum price a consumer will pay for a good that is equal to the benefit they anticipate
getting from the item (in money terms)
Total benefit and marginal benefit
x
x
x
x
When a consumer buys multiple units of a good, important to distinguish between total and
marginal benefit
Example: Candice’s willingness to pay for coffee is $4 for the first cup, $3 for the second and $2
for the third
Her total benefit for the three cups is $9
Her marginal benefit (MB) measures how much extra benefit she derives from consuming an
additional cup
o Her marginal benefit is $4 for the first, $3 for the second cup and $2 for the third cup of
coffee
Marginal benefit
Generally, we expect marginal benefit to decline with each additional unit consumed (declining
or diminishing MB).
Æ The extra benefit a consumer gets from a good gets smaller the more of that good the consumer has
already enjoyed.
When the consumer buys many units of a good, typical to have a continuous (smooth) MB curve.
A typical marginal benefit curve.
Individual demand
x
We can use a consumer’s marginal benefit curve to derive his individual demand curve
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x
An individual’s demand is the quantity of a good or service that a consumer is willing and able to
buy at a certain price
o Hence, the individual demand curve traces out all combinations of (a) market price and
(b) individual demand at that price, holding everything else constant
Individual demand and MB
A consumer will purchase units of the good up until the point where P = MB.
x
x
x
If P<MB for a unit of a good the consumer should buy that unit because her willingness to pay
exceeds the price
If P>MB for a unit of the good, the consumer should not buy that unit
Given diminishing MB, consumer should buy the good until P=MB
Consequently, a consumer’s individual demand curve is her MB curve.
Æ Due to diminishing MB, individual demand is downward sloping.
A demand curve represents how much a consumer is willing and able to buy at different prices.
An individual consumer’s demand curve is given by his or
her marginal benefit curve. A movement along the demand
curve is known as a ‘change in the quantity demanded.’
Law of demand
The downward slope of the demand curve means that a consumer consumes fewer units when
the price is higher. This negative relationship between price and quantity demanded is known as the
law of demand.
Movement along a demand curve
x
x
The demand curve is derived by assuming that only price and
quantity change
If there is a change in the price/quantity, there will be a movement
along the demand curve
o If there is a movement downwards along the demand curve,
this is called an ‘increase in the quantity demanded’
o If there is a movement up along the demand curve, this is
called a ‘decrease in the quantity demanded’
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Change in demand
x
x
x
A demand curve is drawn assuming all other relevant factors (other than the price of the good
itself and the resulting quantity demanded) are held constant (ceteris paribus)
o These factors include the income, tastes, expectation and the prices of other related
goods
If any of these factors change, the demand curve itself will shift in or out
A shift of the demand curve is called a change in demand
o If demand shifts rights this is called an ‘increase in demand’
o A shift to the left, this is called a ‘decrease in demand’
A movement of the demand curve itself is called a ‘change in
demand;’ a shift from D1 to D2 is an increase in demand. A
shift from D2 to D1 is a decrease in demand.
Market demand
An individual consumer’s demand curve is given by his MB curve. We can use this to derive the
market demand curve.
The market demand curve traces out combinations of (a) market price and (b) quantities that
all consumers in a market are together willing and able to buy at that price.
We often are interested in demand at the market level (rather than just for one individual). The
market demand curve can be derived by adding together the quantity demanded by each individual
consumer at each price.
Horizontal summation of individual MB curves
Note: The law of demand also
holds for the market demand
curve.
If the law of demand holds for all
individual demand curves, it will
hold for market demand, which is
their horizontal summation.
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A demand curve answers the question ‘if the consumer faces a certain price, what quantity
would they buy?’ for a range of possible prices.
Note: It is only possible to answer this question if the consumer is a price taker – that is the
individual consumer’s choices have no impact on price.
3. Production and costs
Outline
1. We examine the ideas of short and long run for a firm’s production process;
a. In the short run the firm has at least one fixed input of production, whereas in the long
run all inputs can be adjusted if the firm wishes to
2. We analyse the relationship between a firm’s inputs and its outputs – its production function
3. We examine how a firm’s output is related to its costs in the short run and in the long run
The short run and long run
A firm, using the available technology, converts inputs – labour, machines (often called capital)
and natural resources (typically called land) – into output that is sold in the marketplace.
Æ Typically, a firm will require more than one input to produce its final output.
We define the short run and the long run of a firm in relation to whether or not any of the
factors of production are fixed.
Æ An input is ‘fixed’ if it cannot be changed regardless of the output produced.
x
x
x
The short run is the period of time during which at least one of the factors of production is
fixed, for example, the size of a factory might not be able to be changed
In the long run, all factors of production are variable (that is, not fixed). Therefore, when the
firm’s lease of the factory ends, the firm is free to decide whether or not to renew the lease for
that factory
The short run and the long run is not defined in relation to a set period of time, but rather in
relation to how long it takes for all of a firm’s inputs to become variable – this will differ
between industries
Production
A firm requires inputs or factors of production (labour, capital, land etc.) in order to produce its
final output (i.e. goods or services).
A production function shows the relationship between quantity of inputs used and the
(maximum) quantity of output produced, given the state of technology.
The marginal product (MP) is the change in output when one or more input is used. MP is the
slope of the production function.
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x
x
x
x
MP of an input changes as we increase the use of that input
If the MP becomes progressively smaller, this is called diminishing marginal product
Diminishing MP is very common. In the short run there is a fixed input of some kind which
creates a capacity constraint; this will mean that each additional worker will contribute to
output less and less than those first hired.
Crucially, diminishing MP is a short-run concept, relying on the idea that at least one input (like
the factory) is fixed.
Returns to scale – production in the long run
Returns to scale refers to how the quantity of output changes when there is a proportional change in
the quantity of all inputs.
x
x
x
If output increases by the same proportional change, there are constant returns to scale – if we
double the quantity of all the inputs and output also doubles in quantity.
If output increases by more than proportional increase in all inputs, we have increasing returns
to scale.
If output increases by less than the proportional increase in all inputs, there are decreasing
returns to scale.
Note, it is possible that a firm has diminishing MP in the short run, and still has increasing returns to
scale in the long run.
Short-run costs
A cost function is an equation that links the quantity of output with its associated production cost.
For example, TC = f(q), where TC represents total cost and q represents the quantity of output.
A typical short-run total cost function.
x
When output is zero, total cost is positive; this is
because, in the short run, some factors of production are fixed
and must be paid for
x
The total cost curve rises as output increases as costs
increase when more inputs are required
x
The curve rises at an increasing rate; this captures
diminishing MP, as a greater quantity of inputs is needed to
increase output by the same amount as output increases
Fixed and variable costs
In the short run, some inputs will be fixed and some inputs will be variable; as a consequence, a
firm will have some fixed costs and some variable costs.
o Fixed costs (FC) are costs that do not vary with output
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o Variable costs (VC) are costs that vary with output
VC = TC – FC
Example: Consider the cost function TC = 100 + 20q + q2, where q is the level of output produced. When
q = 0, TC = 100. Therefore, in this case fixed costs are FC = 100 (the cost function evaluated at q=0) and
variable costs are VC = 20q + q2.
Marginal cost
Marginal cost (MC) is the increase in total cost from an extra unit of output. Due to diminishing MP, a
typical MC curve will eventually be increasing in output; MC has a positive slope.
Average costs
x
x
x
Average fixed cost (AFC) is fixed cost per unit of output: AFC = FC/q
o Note that the AFC curve is always downward sloping
Average variable cost (AVC) is variable cost per unit of output: that is, AVC = VC/q
o Because of diminishing MP, the AVC curve will eventually be upward sloping
Average total cost (ATC) is total cost per unit of output; ATC = TC/q
o As ATC = AFC + AVC, its shape is affected by both. At very low levels of output, ATC is
usually the decline in AFC dominates, but at higher levels of output, it is usually upward
sloping because the increasing AVC dominates. Together, this will give the ATC curve a
U-shape (i.e. initially decreasing, but eventually increasing with output)
The relationship between MC, AVC and ATC is important. As a rule, MC passes through the minimum of
ATC and AVC.
o Think of a student’s test scores; if the next test score (the marginal score) is higher than the
student’s average, the average rises; if the next test score (the marginal score) is lower than the
average, the average falls.
o The same logic applies to costs: if MC is above ATC, ATC rises; if MC is less than ATC, ATC is
falling; it follows then that MC intersects ATC at the minimum of ATC.
o The same applies to MC and AVC; MC intersects the minimum of AVC (from below).
Costs
MC
ATC
AVC
AFC
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Long run costs
In the long run, all inputs are variable. As all factors are variable:
x
x
If a firm does not want to produce anything, its costs are zero
A firm producing a positive output has more flexibility to adjust all of its inputs, so long run costs
should not be more than short run costs (for a given level of output)
Long run marginal cost
Long run marginal cost (LRMC) is the marginal cost of increasing output by one unit and must
take into account the fact that all inputs can be varied to achieve this increase.
As noted, LRMC will not be more than SRMC.
Costs
Long run average cost
Given a firm’s extra flexibility in the long run, long-run
average cost can be no greater than short-run average cost. As a
result of this, the long-run average cost curve will be the lower
envelope of all of the short run average cost curves.
Economies of scale
x
x
x
Economies of scale is when long-run average costs decrease
with output.
Diseconomies of scale is when long-run average costs increase with output.
Constant returns to scale is when long-run average costs are constant as output expands.
Costs
LRAC
Constant
average costs
Economies
of scale
Diseconomies
of scale
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Stephen’s lecture
The firm
An entity that transforms inputs or resources (x) into outputs or goods and services (y).
Æ Think of it as a production function y = f(x)
The firm’s goal is to maximise profit – recall that this is a constrained maximisation problem.
Economics profits
x
x
x
Economic profits:
o Total revenue less total costs (π = TR – TC)
o Not the same as accounting profits
Revenue:
o Price x quantity
Costs
o Include all opportunity costs
o That is both explicit and implicit costs
Opportunity cost and economics profits
Opportunity cost is the value of the next best alternative that the firm forgoes to produce a good or
service.
x
x
x
x
Explicit costs are money costs
o The amount paid for inputs or factors of production
Implicit costs
o Value of foregone opportunities
o Incurred when firm uses its own capital, the owners uses their own time or financial
resources
Costs of the owners resources:
o The income the owner could have earned in the next best alternative job
Normal or economic profits:
o The expected return for supplying entrepreneurial ability
o Includes all opportunity costs (use of resources, time, money)
o The profits the firm could’ve earned elsewhere
o You can define normal profits as the amount of accounting profit when economic profits
equal zero
For the moment we are only considering the short run. This means some of the firm’s factors of
production (inputs used to produce output) are fixed (FC). Hence, there are some costs that cannot be
avoided or are ‘fixed.’ Other costs are variable (VC).
Æ TC = FC + VC
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Marginal cost and marginal revenue
x
x
Marginal revenue – tells us how much total revenue (TR) changes when output increases by one
unit
Marginal cost – tells us how much total cost (TC) changes when output increases by one unit
Profit maximisation
This is linear because customers are
pricetakers. We can now put in the cost curve
from the above table.
The total cost curve cuts the
TR curve at 50 – this is its
fixed cost.
The slope of the total cost
curve is marginal cost – the
change in total cost due to
an increase in the quantity
produced.
x
Slope of TR curve = marginal revenue
x
Profit maximisation occurs when slope of TR
curve is equal to slope of TC curve
x
Profit max. corresponds with highest point of
profit curve in lower diagram
Profit maximisation occurs at an output level where MR = MC.
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Marginal costs and supply
Marginal costs (MC) represent the extra opportunity costs of producing an extra unit of output.
Hence, MC is also given by the slope of the TC curve. Slope tells us how (total) costs change when we
change output. That is:
Ultimately determine a competitive firm’s supply curve.
Technology and economic efficiency
Recall that we think of a firm as a relationship between inputs and outputs.
o Technological efficiency
o Occurs when it is not possible to increase output without increasing inputs
o Firm uses a give set of inputs efficiently
o Economic efficiency
o Occurs when the cost of producing a given input is as low as possible
o The firm is using a given set of inputs efficiently AND the firm chooses the most efficient
mix of inputs
Consider the following:
Analysis: Clearly method 3 is a technologically inefficient way of constructing TVs. We can ignore Bench
Production because no profit maximising firm would ever use it.
Now consider if the cost of labour is relatively high:
These are all technologically efficient – however not all are economically efficient. We would choose
method 1 – the economically efficient method.
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Now consider if the cost of capital is relatively high:
We would choose method 4. The economically efficient method is the method using more of the least
expensive input. If you are not minimising your cost, you are not maximising your profit.
x
x
x
x
Technological efficiency – depends on what is feasible (the production function)
Economic efficiency – depends on relative cost resources (or inputs)
Economically efficient methods uses:
o Less of a (relatively) more expensive input
o More of a (relatively) less expensive input
A firm that is not economically efficient will not maximise profits
Cost and production functions
The production function relates inputs and outputs. The firm’s cost function relates the total
cost of production and output. There is a one-to-one relationship between the production function and
cost function.
o The production function and cost function ‘tell the same story’
o They mirror each other
Time horizon
x
x
x
x
x
The short run
o Quantities of at least one input is fixed and the quantities of other input(s) can be varied
The long run
o Quantities of all inputs are variable
Variable inputs
o Inputs that can be varied in the SR, e.g. labour
Fixed inputs
o Inputs that cannot be varied in the SR, e.g. capital
For the moment focus on the short-run
Short run technology constraint
x
x
Increasing output in the short run
o Firms must increase labour
Total product (TP) = total output produced
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x
Marginal output (product) is the increase in total product that results from a one-unit increase
in an output (slope of TP curve)
Average output (product) is total product divided by the quantity of input.
Marginal product curve
x
x
x
x
x
Marginal product:
o Increase in total product from a one-unit increase in an input, or
o The slope of the total product curve
o NOTE that this means MP is initially increasing but then decreasing
Shape reflects:
o Gains from specialisation
o Law of diminishing marginal returns
Increasing marginal returns
o The MP of an additional worker exceeds the MP of the previous worker
Diminishing marginal returns
o The MP of an additional worker is less than the MP of the previous worker
Law of diminishing returns
o As a firm uses more of a variable input with a given quantity of a fixed input, the MP of
the variable input eventually diminishes
Relationship between MP and AP
o When the marginal value > average value, than average value is increasing
o When the marginal value < average value, then average value is decreasing
Diminishing MP starts at the maximum
MP.
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Short-run costs
Now consider costs:
x
x
x
Total cost (TC) is the cost of all productive resources used by the firms
Total fixed cost (TFC) is the cost of all the firms fixed inputs
o Cannot be varied in the SR
Total variable cost (TVC) is the cost of all the firms fixed inputs
Average costs
x
x
x
Average fixed cost (AFC) is total fixed costs (TFC) per unit of output
Average variable cost (AVC) is total variable costs (TVC) per unit of output
Average total cost (ATC) is total costs (TC) per unit of output
Marginal cost
x
x
x
Marginal cost:
o The increase in cost that results from a one-unit increase in output
o The slope of the total cost curve:
Decrease initially because of the gains from specialisation
Eventually increase due the law of diminishing returns
Consider the following example:
The MC curve intersects the ATC and AVC curves at their
minimum points:
¾ If MC<AC (ATC or AVC) then AC
must be falling
¾ If MC>AC (ATC or AVC) then AC
must be rising
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Consider the previous example, MC=ATC when:
Long-run costs
Long-run cost: the cost of production when a firm uses the economically efficient quantities of
labour and capital. Just as in the short run, LR costs are affected by the production function.
Recall that the production function describes the relationship between inputs (K,L) and outputs
(y). Æy=f(K,L).
Long-run average cost curve is derived from the SR ATC curves. In the LR, the firm will choose:
o The most efficient production method
o The cheapest combination of all inputs – recall that all inputs are variable in the LR
The LRAC curve comprises the combination of the cheapest SRAC curves.
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Economies and diseconomies of scale
Returns to scale are increases in output that results from increasing all inputs be the same percentage
(a relationship between input and outputs).
o Constant returns to scale – an x percentage increase in all inputs leads to an x percentage
increase in output
o Increasing returns to scale – an x percentage increase in all inputs leads to a more than x
percentage increase in output
o E.g. a 10% increase in inputs leads to a 20% increase in output
o Decreasing returns to scale
Law of diminishing returns: as a firm uses more of a variable input with a given quantity of a fixed
input, the MP of the variable input eventually diminishes. That is, returns to scale are a long run
phenomenon. All inputs are variable. Diminishing returns is a short run phenomenon as one input
(capital) is fixed.
x
x
x
There is a direct relationship between returns to scale and economics of scale
Economies of scale reflect the relationship between output and costs
Recall that the production function (inputs and outputs) is a mirror image of the cost
function (relationship between costs and output)
x
When a firm experiences increasing returns to scale, it also experiences ‘economies of scale’
or falling average cost of production
When a firm experiences decreasing returns to scale, it also experiences ‘diseconomies of
scale’ or increasing average cost of production
When a firm experiences constant returns to scale, it experiences neither ‘economies or
diseconomies of scale’.
That is, average cost of production is constant Typically, we think that a firm has regions
where it exhibits each of these
x
x
x
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Now think about what Rio is doing
x
x
x
They are substituting capital for labour
o That is, they are using more capital goods rather than labour in producing iron ore
Why are they doing this?
o It minimises costs and maximises profit
o Recall that a firm should substitute a relatively cheap input for a relatively expensive
one
What is going on is a long run phenomena
o Rio cannot substitute capital for labour overnight
4.
ƒ
ƒ
ƒ
Supply
Now we use costs to derive an individual firm’s supply function and the market supply function
We focus on competitive markets, in which there are many buyers and sellers, such that no
individual buyer or seller has the power to materially affect the price in the market
As a consequence, both sellers and buyers in the market are price takers
Firm supply
Firm supply is the quantity of output a firm is willing and able to supply at a certain price. The supply
curve traces out all combinations of (a) market price and (b) quantities that a firm is willing and able to
sell at that price.
o Firm supply is drawing the changing price of output, holding everything else that is relevant
constant (ceteris paribus)
x A firm should sell until P = MC
x The marginal revenue (MR) for each unit that the firm sells is the price, P.
o Remember, a competitive firm is a price taker – it cannot affect market price. This
means price is unchanged, regardless as to how much an individual firm sells
x First, if a firm is a quantity where P>MC for the last unit sold (and this is true for at least one
additional unit)
o If that firm increases its output by one unit, it will increase its profit since the additional
revenue from selling that extra unit (P) outweighs the MC
x Second, if a firm is producing where P<MC for the last unit made, the firm can increase profit by
not making that last unit
o The extra revenue (P=MR) is less than the extra costs that are incurred
Consequently, a firm should sell up until P=MC. Now if price changes – from P1 to P2 in the next figure.
As price rises, so does the firm’s MR; it now continues to produce until P=MC for the last unit produced.
As MC is often increasing, the quantity supplied in the market is higher when price is higher. A
movement along the supply curve when output price changes is called a ‘change in the quantity
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demanded’; if output is increasing it is an ‘increase in the quantity demanded’ or for a decrease a
‘decrease in the quantity demanded.’
The law of supply
o The law of supply means that a firm’s supply curve is given by its MC curve.
o As MC curve is upward sloping due to diminishing marginal product
o This gives a positive relationship between the price of a good and the quantity of that good
supplied
o This positive relationship is known as the law of supply
o Note, the law does not always hold, but it often does
Shifts in supply
The firm’s supply curve is derived by assuming that only the price and quantity supplied of the
product can change. We assume that all other relevant factors, other than the own price and quantity of
the good, are held constant (ceteris paribus).
x
x
If any other relevant factors change, the supply curve itself will shift
o These factors include the cost of inputs, technology and expectations about the future
If there is a change in one of these factors there will be a ‘change in supply’, either:
o ‘An increase in supply’ for shifts of the supply curve to the right (S1 to S2); or
o ‘A decrease in supply’ for shifts of supply to the left (S2 to S1).
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Market supply
Given that an individual firm’s supply curve is given by its MC curve, we can use this to derive
the market supply curve.
The market supply curve shows the quantity supplied in a market at different market prices,
holding everything else constant.
o Suppose the market price of carrots is $1. At this price, Jackson is willing to sell five carrots and
Jared is willing to sell eight carrots. This means that, at $1, the total quantity supplied in the
market is 13 carrots. Repeat this for every price to derive the market supply curve.
Graphically, the market supply curve is the horizontal summation of the individual supply curves Æ the
individual MC curves summed horizontally along the q-axis.
The law of supply also holds for the market supply curve. We also use the term ‘change in
quantity supplied’ to refer to movements along the market supply curve, and the term ‘change in
supply’ to refer to a shift of the supply curve itself.
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5. Market equilibrium and welfare
analysis
Together, demand and supply determine the price and quantity traded of a good or service in a market.
These market outcomes are the focus of this lecture.
Market equilibrium
A market is in equilibrium if, at the market price, the quantity demanded by consumers equals
the quantity supplied by firms in the market.
The price at which this occurs is called the market-clearing price (or ‘equilibrium price’).
If a market is not in equilibrium, there will be pressure on price and quantity to move towards
the equilibrium price and equilibrium quantity.
Å A market in equilibrium. The equilibrium price is P*
and the equilibrium quantity traded is q*.
Excess supply
If the market price is above the equilibrium price, the quantity supplied exceeds the quantity demanded.
o This difference is called excess supply
o Sellers cannot find buyers for all units supplied to the market
o There will be downward pressure on prices, as sellers try to bring more consumers into
the market; at the same time, the quantity supplied will fall in response to the decrease
in prices
o This downward pressure on prices will continue until the excess of supply is eliminated, moving
the market towards equilibrium
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Excess supply – price above market clearing price.
excess supply
Excess demand
If the market price is below the equilibrium price, there is excess demand.
o When the quantity demanded exceeds the quantity supplied sellers do not supply enough units
to meet consumer demand
o There will be upward pressure on prices, as buyers compete for limited units in the market; this
increase in prices will increase the quantity supplied and also decrease quantity demanded
o This upward pressure on prices will continue until the excess of demand is eliminated, moving
the market towards equilibrium
Å When the market price is below the equilibrium
price, there is an excess of demand in the market.
excess demand
Comparative static analysis
Markets are affected by a change or event beyond the direct control of buyers or sellers in that
market. In such cases, we may want to analyse how that change or event affects the choices of firms
and/or consumers in the market, and how those choices affect market outcomes.
1. Assume that the market in question is initially in equilibrium
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2. Ascertain whether the change or event will affect the demand curve or the supply curve of the
market (or both)
a. That is, which curve will shift, and which way will it move
3. Use the demand and supply diagram to compare prices and quantities traded in the market
before and after the change
Example
Consider car market when the price of steel increases. The market is initially in equilibrium at
(Q*,P*). Assuming that steel is an input in the production of cars, the MC of making each car will
increase, causing the supply curve to shift upwards (or to the left) to S2. This will cause a decrease in
the quantity demanded, as we move along the demand curve D1 to the new equilibrium. At the new
equilibrium (Q2,P2). Æ Price of cars is higher but quantity traded is lower than before the change in
the price of steel.
Welfare – the benefit to market participants
Markets are one of the main ways that good and services are produced and distributed.
Consumers and firms will only participate in markets if it is beneficial to them (or they are at least as
well off from trading than if they do not).
We can measure and observe changes in these benefits to these participants using welfare analysis.
Consumer surplus
Consumer surplus (CS) is the welfare consumers receive from buying units of a good or service in the
market.
We can measure consumer surplus by evaluating the net value of a good or service to the consumer, as
he or she perceives it. That is, consumer surplus is given by the consumer’s willingness to pay, minus the
price actually paid, for each unit bought.
CS = WTP – P
Example: Hamish buys a chocolate bar. His WTP (or MB) for the chocolate bar is $5.50, but the price is
$2. He receives $5.50 benefits, minus the price paid of $2. Therefore, his surplus from buying the
chocolate bar is $3.50. Repeating this process for every unit purchased calculates the CS Hamish
receives from all the chocolate bars he buys.
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Consumer surplus and the demand curve
Recall that the individual demand curve traces out a consumer’s MB or WTP. An individual’s CS
is calculating the area between the individual demand curve and the price line.
Æ Similarly, we can find the CS of all consumers in the market by calculating the area between the
market demand curve and the price line.
The area of consumer surplus in this market is
denoted by the grey-shaded area – the area under
the demand curve above the price line.
CS
Change in CS with a decrease in price:
If price falls from P1 to P2. CS increases due to reasons: on
all the units previously consumed, the difference between
MB and price is now larger, increasing the net benefit
from consuming each of these units has increased (area
B); and the lower price now means that more units are
purchased, generating an additional benefit to consumers
(area C).
A
B
C
Producer surplus
Producer surplus (PS) is the welfare producers (that is, firms) receive from selling units of a good or
service in the market.
Producer surplus can be measured by considering the net benefit of selling a good or service.
Æ That is, producer surplus is given by the price the producer receives, minus the cost of production, for
each unit of the good or service bought.
Example: Adam sells chocolate bars. The price of chocolate bars is $2. The MC to Adam of producing the
chocolate bar is $0.50. If Adam sells the chocolate bar, his net benefit the $2 received, minus $0.50 in
extra production costs. Therefore, his PS from selling the chocolate bar is $2.50. If Adam sells multiple
units, add up the surplus from each chocolate bar to get his PS from selling chocolate bars.
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Producer surplus and the supply curve
A firm’s supply curve is given by its MC curve.
x
x
A firm’s PS can be found by calculating the area between the price line and the firm’s supply
curve
Similarly, we can find the PS of all producers in the market by calculating the area between the
price line and the market supply curve
The area of producer surplus in this market is
denoted by the grey-shaded area.
PS
PS with an increase in price:
When the market price increases from P1 to P2, PS increases
from $A$ to $A+B+C$. The area $B$ represents the increase
in PS from an increase in the net benefit of selling units that
would have been sold previously. The area $C$ is the
increase in PS from the sale of additional units.
B
C
A
Total surplus
We can also measure the total welfare of all participants in the market. Here, there are only two
types of participants: consumers and producers. In later chapters, we will allow for other participants in
the market (namely, the government).
With only consumers and producers in the market, total surplus (TS) is the sum of consumer surplus and
producer surplus in the market equilibrium:
TS = CS + PS
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Total surplus – sum of CS and PS
In this market, TS is the area between the demand and
supply curves, up to the market equilibrium quantity q*.
TS in this market is denoted by the grey-shaded area.
TS
Pareto efficiency
To analyse welfare further, we introduce the concept of Pareto efficiency.
Pareto efficient is if it is not possible to make someone better off without making someone else
worse off. Conversely, an outcome is not Pareto efficient if it is possible to reallocate resources (or do
things differently in the market) and make someone better off without making someone else worse off.
Another way of thinking about Pareto efficiency in this context is that the Pareto efficient outcomes
maximises total surplus.
Competitive market outcome and efficiency
The competitive market maximises the total gains from trade,
hence it is Pareto efficient. It is not possible to change the level of
output (up or down) and make at least one person better off
without making anyone worse off.
TS
•
The outcome in a competitive market is Pareto efficient.
For all the trades up to the competitive market equilibrium
(Q*), MB ≥ MC. Hence, the consumer is willing to pay more
than the extra cost required to make the item. Trading all
units up until Q* increases total surplus (as it increases CS, PS or both).
•
If fewer than Q* units are traded, this outcome is not Pareto efficient, because it is possible to
increase the number of units traded in order to make the consumer and/or the producer better
off, without making any one worse off.
•
If more than Q* units are traded we know that MC > MB. All units traded beyond Q* make
someone worse off: either the buyer paid more than his MB, the seller received a price less than
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her MC, or both. Therefore, this outcome is not Pareto efficient, because total surplus would if
output were reduced (back to Q*).
In the competitive-market equilibrium, all the potential gains from trade are exhausted.
x There are no consumers left in the market with a willingness to pay higher than any seller’s MC
to provide an additional unit.
x The price mechanism ensures that the people with the highest value for the product (those that
are willing to pay more than the price) end up with the goods, and that those firms with the
lowest cost are the ones who make the goods (the firms who have a MC less than the market
price).
x While these actions are completely decentralized, in the sense that there is no one person
coordinating the actions of the many parties in the market, a competitive market manages to
maximize total surplus (that is, reach a Pareto efficient outcome).
Caveat regarding Pareto efficiency
Pareto efficiency has a very strict and specialised definition. It does not imply either uniqueness or
fairness/equity. It does not imply either uniqueness of fairness/equity.
o It is possible that there are more than one outcomes in an economy that are Pareto efficient
o Further, an outcome that is Pareto efficient is not automatically the most fair or equitable, or
even the most desirable
Concluding comments
x
x
Defined consumer surplus, producer surplus and total surplus
A competitive market has the following characteristics:
o Via the price mechanism, it allocates goods to consumers who value them most highly;
and
o Via the price mechanism, it allocates demand for goods to sellers who can produce at
the least cost
o A competitive market maximises total surplus and, hence, is Pareto efficient. It follows
that a person who can dictate the price and quantity of a good traded in the market (a
‘social planner’) cannot achieve an outcome that is more efficient than the free
(competitive) market
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Elasticity
6.
We are often interested in measuring how a change in one variable affects another. For example,
how does the equilibrium quantity traded respond to a change in the market price, or how demand
responds to changes in consumer income?
One issue with measuring quantitative changes is that different markets use different units of
measurement (litres, kg), each market has its own price level (cents, millions).
Æ Elasticity is a way we can compare quantitative changes across different situations by looking at
proportional (%) changes.
Elasticity measures how responsive one variable (Y) is to changes in another variable (X). That is,
when we increase x by a certain amount, does y change by a small or large amount?
We can calculate elasticity € by dividing the % change in y by the % change in x.
H
% 'y
% 'x
This says for 1% change in x there will be an € change in y. Note the larger the absolute value of € the
more responsive y is to changes in x.
Elasticity – proportional change
Generally, we can calculate the proportional change in a variable by dividing the change in the variable
'y / y
by the variable itself:
H
'x / x
However, it is not always obvious how to determine what the proportional change in a particular
variable is. Two classic methods are:
1. Point method (using the initial values)
2. Midpoint (arc) method – uses the averages of the initial and final points
Point method
At times we are interested in the elasticity around a particular outcome: for example, what is the
elasticity on a demand curve around the point (Q1, P1)?
'q / q dq P
.
Hd
In these cases, we can use the point method of calculating elasticity:
'P / p dP q
Example: Suppose the demand curve for forks is given by Q=100-2P, and the price of forks is P=30. What
is the elasticity at this point? We know that when P=30, Q=40. The slope of the line is -2. Substituting
these values into the point formula gives:
H
2.
30
40
1.5
The interpretation is; at this price, if price of forks increases by 1%, the quantity
demanded of forks falls by 1.5%.
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Midpoint (arc) method
Sometimes we are interested in elasticity when moving from one point to another. For example,
suppose the price of a good changes from P1 to P2, which causes the quantity demanded to change from
Q1 to Q2.
It is unclear in this situation whether we should measure the change in price (resp. quantity) as a
percentage of P1 or of P2 (resp. Q1 or Q2)?
To resolve this ambiguity, sometimes we adopt the midpoint (arc) method: to calculate the proportional
changes use the average (midpoint) of P and Q (or the variables of interest).
The formula for elasticity using the midpoint method is:
Where
ym
y1 y2
and x m
2
x1 x2
2
H
'y / y m 'y x m
.
'x / x m 'x y m
Hd
'q / q m
'P / P m
Example: When the price of spoons is $10, the quantity demanded is 50 units. When the price increases
to $20, the quantity demanded falls to 30 units. To calculate elasticity, we need to find the averages of
price and quantity:
x PM = 15 and QM = 40.
x Also, we need to know: ΔP = 20 - 10 = 10 and ΔQ = 30 - 50 = - 20.
20 15
.
0.75
H
10 40
x Substituting these values into the midpoint formula gives:
x If price of spoons increases by 1%, the quantity demanded of spoons falls by 0.75%.
Interpretation of the elasticity of demand
The price elasticity of demand measures how sensitive the quantity demanded of a good (Qd) is to
changes in price (P).
It is the proportional change in quantity demanded of a good, given a 1% change in its price.
x
x
x
Given the law of demand, the elasticity of demand will normally be negative (or at least nonpositive).
For this reason, some authors find it convenient to drop the minus sign when reporting the
elasticity of demand, treating the negative sign as implicit.
We will not adopt that convention here, but it should be noted that either approach is fine, so
long as it is consistently applied.
Important notes:
x
x
x
x
x
x
x
If єd= 0, demand is perfectly inelastic.
For a 1% change in price, there is no change in the quantity demanded.
Quantity demanded is not at all responsive to changes in price. The demand curve is vertical.
If -1 < єd < 0, demand is inelastic.
For a 1% change in price, the resulting change in quantity demanded is less than 1%.
Quantity demanded is not very responsive to changes in price.
If єd = -1, demand is unit elastic.
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'q P m
.
'P q m
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x
x
x
x
x
x
For a 1% change in price, there is a 1% change in quantity demanded (a proportional change).
єd < -1, demand is elastic.
A 1% change in price results in a change in quantity demanded larger than 1%; quantity
demanded is very responsive to price.
If єd = - ∞, demand is perfectly elastic.
For a small increase in price, quantity demanded will drop to zero.
If a firm raises its price at all, its customers will go elsewhere to buy the product. Demand is
horizontal.
Perfectly inelastic demand
Perfectly elastic demand
When demand is perfectly inelastic, the demand curve is vertical (as seen the left panel). When demand
is perfectly elastic, the demand curve is horizontal (as seen the right panel).
Price elasticity of demand along a straight-line demand curve
The price elasticity of demand depends on the slope of the line, but also the reference point on the
curve used to calculate elasticity.
o The price elasticity of demand changes along a linear (straight-line) demand curve.
o Because the slope of the demand curve is constant, the elasticity varies because the
proportional change in quantity (and price) varies depending on the size of quantity (or price) at
a particular point.
o For every linear demand curve, there is an inelastic section (when quantity is high and price is
low); a point that is unit elastic (in the middle of the demand curve); and an elastic section
(when quantity is relatively low and price relatively high).
o The price elasticity of demand ranges from 0 (when it cuts the Q-axis) to - ∞ (at the Paxis)
elastic
unit elastic
inelastic
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Elasticity and revenue
We can determine from the elasticity of demand how total revenue in the market will change as price
changes.
o As we know from the demand curve, the quantity demanded in the market (q) depends upon
the market price (P). This means that we can write the quantity demanded as a function of
price: q(P).
o Total revenue as a function of P is:
TR(P) = P. q(P)
Total revenue can be calculated by multiplying price and
quantity. In this diagram, the size of total revenue is denoted by
the grey-shaded area.
Total revenue
We can differentiate this equation with respect to P in order to determine how TR changes in response
dTR
dq
to a small increase in price.
q P.
dP
Rearranging gives:
dTR
dP
§ P dq ·
q ¨1 . ¸
q dP ¹
©
dP
q 1 Hd
This equation provides a direct link between the price elasticity of demand and the change in TR.
x
x
In order for TR to increase with a price increase, the right-hand side of the equation must be
positive. This will be true if and only if єd > -1; that is, if demand is inelastic. On the other hand,
if demand is elastic (єd < -1), TR will fall when the market price rises.
On the elastic part of the demand curve (the upper part) the price needs to be lowered in order
to increase total revenue. On the inelastic part of the demand curve (the lower part) the price
needs to be raised to increase revenue. The means that total revenue is maximized when
demand is unit-elastic, in the middle of the demand curve.
The intuition for this result is:
x
x
If demand is elastic, a 1% increase in price will cause a greater than 1% fall in the quantity
demanded. This means that the increase in P is more than offset by the decrease in Q d, causing
TR to fall overall.
If demand is inelastic, a 1% increase in price will cause quantity demanded to fall but by less
than 1%; the increase in P outweighs the decrease in in Qd causing TR to increase overall.
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Elasticity of supply
Elasticity can also be applied to supply. Elasticity of supply єs measures how sensitive the
quantity supplied of a good (qs) is to changes in price (P). That is, what is the proportional change in
quantity supplied of a good, given a 1% change in its price. The midpoint (arc) method and the point
method for calculating elasticity of supply are as follows:
'q / qsm
'P / P m
Hs
x
x
x
x
x
x
'q P m
.
'P qsm
Hs
'qs / qs
'P / p
dqs P
.
dP qs
The elasticity of supply is typically positive, due to the law of supply.
If єs = 0 is perfectly inelastic. For a 1% change in price, there is no change in the quantity
supplied. The supply curve is vertical.
If 0 < єs < 1, supply is inelastic. For a 1% change in price, the change in quantity supplied is less
than 1%. The quantity supplied is not very responsive to changes in price.
If єs = 1 supply is unit elastic} For a 1% change in price, there is a 1% change in quantity supplied
– the quantity supplied changes by the same proportion as price.
If єs > 1 supply is elastic. For a 1% change in price, the change in quantity supplied is more than
1% - the quantity supplied is relatively responsive to changes in price.
If єs = ∞, supply is perfectly elastic. For a small decrease in price, quantity supplied will drop to
zero.
o This means that if the price of a good falls at all below a certain price, firms will stop
supplying the product. The supply curve is horizontal.
Perfectly inelastic supply
Perfectly elastic supply
When supply is perfectly inelastic, the supply curve is vertical (as seen the left panel). When supply is
perfectly elastic, the supply curve is horizontal (as seen the right panel).
Cross-price elasticity
Sometimes we are interested in the relationship between the quantity demanded of one good and the
price of another related good. This relationship can be examined using cross-price elasticity. This
measures how sensitive the quantity demanded of a Good A (QA) is to changes in price of Good B (PB).
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For the point method, the cross price elasticity formula is:
H AB
For the midpoint (arc) method, the formula is:
'QA / QAM
'PB / PBM
H AB
'QA / QA
'PB / PB
dQA PB
.
dPB QA
Where the superscript indicates the midpoint value.
Example:
x
x
x
Suppose that, when the price of teabags is $4 per box, Candice sells 100 litres of milk. If the
price of teabags rises to 8 per box, Candice only sells 60 litres of milk.
Use the midpoint formula to calculate cross-price elasticity. Here, ΔQA = -40 and ΔPB=4. The
average values for price and quantity are QMA=80 and PMB=6.
Therefore, cross-price elasticity is єAB = -40/4 . 6/80= -0.75.
Cross price elasticity – substitutes
Cross price elasticity provides some information about the relationship between the two products. If єAB
> 0, an increase in the price of Good B is associated with a rise in the quantity demanded of Good A.
Goods A and B are substitutes.
Cross price elasticity – complements
If єAB < 0, an increase in the price of Good B is associated with a fall in the quantity demanded of Good A.
This means that the Good A and Good B are complements.
Cross price elasticity – independent goods
If єAB = 0, an increase in the price of Good B is not associated with any change in the quantity demanded
of Good A – they are independent goods. (e.g. ice cream and chainsaws).
Income elasticity
The demand for a good may also depend in part on a consumer’s income. Income elasticity (η)
measures how sensitive the quantity demanded of a good (Q) is to changes in income ($Y$).
•
The midpoint formula is, using the midpoints for quantity (QM) and income (IM):
•
Using the point elasticity formula:
K
'Q / Q
'Y / Y
K
'Q / Q M
'Y / Y M
dQ Y
.
dY Q
Income elasticity – inferior and neutral goods
We can characterise the good, depending upon its income elasticity:
x
If η < 0, demand decreases when income rises. This type of good is called an inferior good.
o E.g. consumers might substitute away from an inferior cut of meat as income rises.
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x
If η = 0, demand is invariant to changes in income; this is a neutral good.
Income elasticity – normal and luxury goods
x
x
When 0 < η ≤ 1, if income rises by 1%, demand for the good increases by less (or, more correctly,
not more) than 1%; this is a normal good.
o Many (if not most) goods are normal goods, for example food.
If η > 1, when income rises by 1%, demand for the good increases by more than 1%; this is a
luxury good.
o For example, caviar, sports cars, skiing holidays.
Concluding comments
x
x
x
x
Elasticity measures the proportional change in one variable, given a proportional change in
another variable.
This unit-free measure of responsiveness can be applied to any two variables of interest.
o Common applications: the elasticity of demand, the elasticity of supply, cross-price
elasticity and income elasticity.
o However, can be used for other uses – like the effectiveness of an advertising campaign
or consumers' response to a government subsidy.
Elasticity will depend on a range of factors, including the timeframe.
Generally expect greater elasticities in the long run than in the short run.
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7.
Perfect Competition
Four different types of markets:
1. Perfectly competitive markets
a. These markets have many buyers and sellers, low barriers to entry and an identical
product
b. Consequently, firms do not have to market power to set prices
2. Monopoly markets
a. A market with one seller and high barriers to entry and the power to choose its price
3. Monopolistically-competitive markets
a. There are many firms selling slightly differentiated products
b. These sellers have scope to set their own prices, but there are low barriers to entry into
these markets
4. Oligopoly markets
a. These markets are characterised by only having a few firms
b. Consequently, the strategic interaction between these firms is critical to the outcome in
these markets. Dictated by the actions of other firms in the market
Characteristics of perfect competition
x
x
x
x
Many buyers and sellers. All buyers and sellers are a very small part of the total market.
Homogeneous products. Consumers are indifferent as to who they purchase from. All firms
have access to the same technology.
Price taker. No individual has sufficient market power to influence market prices – that is, every
participant is a price taker.
Free entry and exit. Firms can freely (that is, costlessly) enter and exit the market in the long run
– there are no barriers to entry in the long run.
Supply in the short run
At least one of a firm’s factors of production is fixed in the short run.
o Firm has a fixed cost of production that will be incurred regardless of its output
o In deciding the level of output to produce in the short run, a firm will ignore its fixed costs
If a firm produces output, its supply curve is given by its marginal cost curve. However, if a firm chooses
not to produce in the SR, we say that the firm shuts down.
The SR supply curve
In the short run, the firm should only take into account its variable costs, as its fixed costs are sunk.
Hence, we can derive the shut-down condition that a firm will shut down in the SR if TR is less than VC:
TR<VC
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We can also divide shutdown by the level of output q to yield.
TR/q < VC/q or that p < AVC
The SR supply curve for a firm
x
x
x
x
If price falls below AVC, a firm will shut down.
If a firm does produce a positive output, it chooses the level of output in accordance with its
supply curve – that is, its MC curve.
$
Remember that the MC curve intersects the AVC curve at
its minimum.
The shut-down rule for a competitive firm is:
P < AVCMIN
The SR supply decision for a firm
On the other hand, a firm will supply a positive quantity provided:
P ≥ AVCMIN. Hence, a firm’s SR supply curve is its MC curve that lies
above AVCMIN.
MC
Market supply in the SR
x
x
x
x
x
In the short run, there is no entry or exit in the competitive market.
A firm is prevented from exiting the market by its fixed costs; if a firm in the market wishes not
to produce anything, it shuts down (but does not exit).
No new firms can enter in the short run.
The number of firms in the market is fixed in the short run.
The short-run market supply by horizontal summation of the individual supply curves
Profits and losses in the SR
x
x
x
x
In a competitive market, it is possible for firms to make profits or incur losses in the short run.
If a firm is making a loss, total revenue must be less than total costs
o In other words, it must be the case that price is greater than average total cost.
Conversely, if a firm is making profits TR > TC, or
o P > ATC
o Note, the difference between P and ATC at the quantity supplied is the average profit
(or loss) a firm is making.
A firm will be willing to continue to sell in the short run when making a loss provided P > ATCMIN.
The firm is better off than shutting down because the extra revenue (in excess of its variable
costs) help it pay for some of its fixed costs.
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ATC
AVC
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Profits in the SR
MARKET
FIRM
A firm in a perfectly competitive
market, making a profit. The greyshaded area represents the size of
that profit.
Losses in the SR
MARKET
FIRM
A firm in a perfectly competitive
market, making a loss. The greyshaded area represents the size of
that loss.
Supply in the LR
x
x
x
x
In the long run, there is free entry and exit in the market.
This means that all costs are opportunity costs.
Hence, a firm deciding its level of output in the long run will take into account the costs of all
inputs.
A firm will enter or exit the market depending on its (anticipated) level profit or loss in the
market. The market will reach its long run equilibrium when there is no longer any entry into or
exit from the market – this occurs when firms are making zero profits.
Firm supply: the exit/entry decision
With free entry and exit in the LR, if a firm chooses to exit it will incur no costs (unlike the SR). Hence, a
firm will choose to exit the market if its TR is less than its TC.
o This means that a firm will exit if P < ATCMIN.
o A firm’s long-run supply curve is the section of its (long-run) MC that lies above ATCMIN.
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A firm’s LR supply curve
The LR supply curve of a firm is traced out by the part of
the MC curve that lies above ATC minimum.
$
MC
ATC
AVC
AFC
Elimination of profits and losses
In the LR, firms can enter or exit depending on whether they are going to make a profit or loss.
When firms in the market are profitable (P > ATCMIN) firms will want to enter the market.
ÆThe entry of more firms into the market will progressively shift the SR supply curve to the right, driving
the equilibrium price downwards.
Potential profits induces entry
MARKET
FIRM
When the market price is
above ATC, profits will
encourage entry into the
market, shifting the supply
curve right from S to S’. This
will put downward pressure
on market prices.
Losses induce exit
When firms in the market are sustaining losses (P < ATCMIN), firms will tend to exit the market.
ÆThis shifts the SR supply curve left, pushing the equilibrium price upwards as firms leave the industry.
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MARKET
FIRM
When the market price is
below ATC, firms in the
market make a loss. This
encourages exit, shifting
the supply curve left from
S to S’, causing price to
rise.
LR equilibrium
x
x
x
x
In summary:
o If price tends to decrease when it is above ATC; and
o Increase when it is below ATC.
Thus price will equal ATC in the long run.
Because the firm supply curve cuts the ATC at its minimum, the long-run price will be p = ATCMIN.
As price equals average total cost, a competitive firm will make zero profits in the long run.
MARKET
FIRM
In the LR, there are zero
profits in a perfectly
competitive market. This
requires p = ATCMIN. Because
there are zero profits, there
is no incentive for any
further exit or entry. The
long-run equilibrium price is
p*, the quantity traded in
the market is Q* and the
output of a firm is q*.
Market supply curve in the LR
x
x
x
x
For the long-run market supply curve, we need to account for the fact that the market responds
to demand via the entry and exit of firms.
As noted above, in the long run price adjusts back to the minimum of average total cost, no
matter what the quantity traded in the market is.
Taking account of exit/entry, the long-run industry supply curve is horizontal at ATCMIN.
An industry with a perfectly elastic long-run industry (or market) supply curve is a constantcost industry.
o Unless otherwise stated, a competitive industry is assumed to be a constant-cost
industry.
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FIRM
MARKET
Dynamics in the LR
FIRM
MARKET
Following an unanticipated increase in demand,
in the short run price rises and firms in the
industry make positive economic profits.
However, in the long run, entry forces prices
back down to the p* = ATCmin. Each firm sells q*
units and economic profits are zero.
Increasing-cost industry
x
x
x
In a constant-cost industry, entry and exit in the long run ensures that all firms earn zero
profits and the price is P* = ATC min.
This assumes that all firms have access to the same technology and have the same cost
structure.
If potential entrants have higher costs than incumbent firms (already in the market), the longrun industry supply curve need not be perfectly elastic.
o In this case the long-run supply curve can be upward sloping; this is known as an
increasing cost industry.
In an increasing-cost industry, the LR industry supply
curve is upwards sloping.
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Decreasing-cost industry
x
x
x
Suppose that as output in an industry expands, costs for all firms fall.
o For example, the computer software industry – as the market has expanded average
costs for all firms could actually fall.
If this is the case, following an increase in demand, as entry will continue until it is no longer
profitable, the new long-run equilibrium price has to be lower than the initial equilibrium price.
In this case, the long-run industry supply curve is downward sloping – this is a decreasing cost
industry.
In a decreasing-cost industry, the LR industry supply curve is
downward sloping.
Concluding comments
x
x
x
If a competitive firm supplies a positive quantity in a market, it sells a quantity where P = MC:
o In the short run if P < AVCmin, a firm shuts down and sells zero output (incurring its fixed
costs); if P > AVCmin it supply where P = MC.
o In the long run a firm exits if P < ATCmin; if P > ATCmin the firm sells where P = MC.
In the short run a competitive firm can make an economic loss or profit (or zero economic
profits).
In the long run, with free entry and exit, price is driven back to ATCmin.
o A competitive firm makes zero economic profits (just covers it opportunity costs so it
has no incentive to exit and no potential entrant has an incentive to enter).
o The long-run industry supply curve is perfectly elastic at P = ATCmin.
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8.
Monopoly
A market with one seller is a monopoly, and that seller is a monopolist. A monopolist will use its market
power to charge higher prices in order to increase its profits.
o As well as increasing profits, this has implications for overall welfare; there is potential for a
market failure
A monopolist might be able to increase profits further by tailoring prices to specific customers based on
their valuations for the product; this is called price discrimination. We also examine several options to
regulate a monopolist.
Characteristics of a monopoly
x
x
One seller (and many buyers)
o Because the monopolist is the only firm in the market, it has the market power to
determine the price in the market – it is a price maker
Barriers to entry to potential entrants
o Control over an essential input not available to other firms
o A patent
o Regulation might prevent entry; or
o The monopolist might simply have a lower cost of production that effectively allows
them to prevent other firms from entering the market
The single-price monopolist
Here we examine a monopolist who charges the same price to all of its customers (also known as a
single-price monopolist).
Because the monopolist is the sole producer, it faces all the demand in the market:
o The monopolist faces the downward-sloping market demand curve.
o A downward sloping demand curve means that the firm has market power (or monopoly power)
– it can raise price and not have the quantity demanded drop to zero
o The monopolist hence has to choose the price (or the quantity it wants to sell).
Marginal revenue
x
x
x
x
Marginal revenue (MR) is the additional revenue that the firm received from selling one extra
unit of a good.
Because the monopolist faces a downward-sloping demand curve, if it increases output by one
unit the price will fall by some amount.
For a monopolist there are two effects at play:
o (i) the increase in output increases total revenue; and
o (ii) the decrease in price decreases total revenue.
Note, there is no price effect for a competitive firm (price is invariant to the quantity it sells).
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Deriving MR
MR is the change in total revenue when the firm sells one more unit Æ can obtain the MR by
differentiating TR with respect to q:
dTR
MR
dq
For example, consider when demand is given by P = a – bq (a and be are constants): TR = P.q = (a – bq).q
From this:
•
MR
dTR
dq
a 2bq
For example, if P = 100 – 2q, MR = 100 – 4q.
Note two things about MR when demand is a straight line:
1. MR has the same vertical intercept as the demand curve (at a); and
2. MR has twice the slope of the demand curve (the MR curve has a slope of -2b whereas the
demand curve has a slope of –b.
Monopolist’s marginal revenue
When the demand curve is linear, the marginal revenue
curve has the same vertical intercept and twice the slope of
the demand curve.
Profit maximization
Profits will be maximized when a monopolist sets MR equal to MC: MR = MC.
o If MR > MC, the monopolist can increase its profit by selling one extra unit.
o If MR < MC, profit falls from selling the last unit, so it would be better off from not selling that
unit.
Hence, profits are maximized when MR = MC.
A profit maximizing monopolist sets MR = MC, and thus produces
quantity Qm. At this quantity, the market price will be Pm
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Profit of the monopolist
The monopolist's profit is given by π= Qm(P -ATC). The area
corresponding the monopolist's profit is shaded grey.
Example of monopolist’s profit maximization
x
x
x
x
Consider a monopolist whose demand curve is given by P = 100-q and a MC = 2q.
As demand is linear we know that MR = 100 – 2q.
Profit is maximized when:
o MR = MC; or
100 – 2q = 2q.
Hence: qm = 25 units; Pm = 100 – q = $75
Welfare with a monopoly
x
x
x
x
x
x
x
x
The monopolist sells a quantity where MR = MC.
This is less than the competitive quantity (or the quantity that would be traded with price-taking
behaviour).
The competitive output level is where MB = MC.
We know that for every level of output (except the every first unit sold) MB > MR.
This means that MR = MC at a lower quantity than when MB = MC.
At the competitive quantity, all the gains from trade are exhausted.
o All the potential trades where MB ≥ MC occur.
However, the monopolist restricts output to Qm < Q*.
o Between Qm and Q* MB > MC, so total surplus would increase if these trade occur.
But the monopolist is interested in its own profit, which is determined by MR, not by MB.
o The surplus lost from the restriction of output is called a Deadweight Loss (DWL).
o Note, the DWL occurs because the monopolist restricts output below the competitive
level, not because it earns profits per se.
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Total surplus and dead weight loss under a
monopoly.
Price discrimination
Price discrimination is when a firm charges a different price to different consumers for the same
product, or when a firm sells different versions (quality or quantity) of the product when the change in
price between the versions does not solely reflect the difference in the cost of production.
ÆThe key intuition behind price discrimination is sell to consumers with a lower valuation for the
product, while still charging a higher price to customers with a higher willingness to pay. If a monopolist
can do this it can increase profits.
In order to engage in price discrimination, a firm needs:
9 Market power (price maker);
9 To be able to prevent arbitrage, which means it can prevent consumers who are charged a
lower price from reselling the product to the customers with high willingness to pay; and
9 Some information about different customers and their willingness to pay for the product.
The ability of a monopolist to engage in certain types of price discrimination depends on the information
it has and the extent to which it can prevent arbitrage. There are three classic types of price
discrimination.
First-degree (perfect) price discrimination
x
x
First-degree price discrimination (or perfect price discrimination) when it charges each consumer
his or her exact willingness to pay (i.e. marginal benefit) for every unit consumed.
Consequently, the monopolist extracts all of the consumer's surplus and receives all the gains
from trade in every transaction.
To highlight the intuition, consider the following example. Suppose it costs the monopolist $1 to
produce an ice cream cone. Bonnie is willing to pay $10 for one ice cream cone; Jen's willingness to pay
is $5.
o If the monopolist were to charge a single price, it would charge $10 and make a profit of $9.
o However, a monopolist employing first-degree price discrimination can charge Bonnie $10 for
an ice cream cone and charge Jen $5 for an ice cream cone, increasing profit to $13.
To engage in first-degree price discrimination:
1. The monopolist will need to have perfect information about each consumer's willingness to pay.
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2. It will also need to be able to prevent arbitrage.
x
x
x
x
First-degree price discrimination can also applies where each consumer buys multiple units of
the good (have downward-sloping demand curves).
The monopolist prices each unit at the consumer's willingness to pay for that unit of the good.
The monopolist will continue to sell provided MB ≥ MC.
The MB curve now becomes the MR curve for the first-degree price discriminating monopolist.
o The monopolist will sell units up to the point where MB ≥ MC; this means that the
efficient quantity is traded. There is no DWL. As the monopolist captures all the surplus
generated, it will continue to sell provided there are potential gains from trade.
When the monopolist engages in first-degree
price discrimination, the efficient quantity is
traded in the market. However, all surplus in the
market is producer surplus.
Two-part tariff
First-degree price discrimination can be implemented using a two-part tariff. With a two-part tariff, a
monopolist charges the consumers two distinct fees:
1. A fixed fee, F, that is invariant to the number of units consumed (like an access or entry fee)
2. A per-unit fee, p, that is paid for each unit of the good consumed, set at the MC of the last unit
purchased.
The fixed fee F is set exactly equal to the consumer’s anticipated CS with access to the market being
charged a per-unit price of p.
ÆF extracts all of the CS, so all the gains from trade go to the monopolist.
When the monopolist uses a two-part tariff, it charges a fixed fee (F) equal to the size of the lighter greyshaded triangle. It then charges a per-unit fee (p) for each unit consumed equal to MC for the last unit
purchased.
Fixed fee
revenue
Per-unit fee
revenue
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Third-degree price discrimination
Third-degree price discrimination is when a monopolist separates consumers into ‘markets’ and
charges a different price in each market.
For example: adult and student prices for movie tickets; different prices for haircuts for men and
women; and different prices for software in different countries.
The information and arbitrage requirements that support third-degree price discrimination are
less stringent than for first-degree price discrimination.
o The monopolist needs to have a way of identifying the market that any particular individual
belongs to.
o The monopolist needs to prevent arbitrage between markets but not within a group or market.
This means that a monopolist can discriminate between groups, but not within groups – hence
they charge a single (different) price to each market.
MARKET A
MARKET B
When a monopolist engages
in third-degree price
discrimination (with
constant MC, it maximizes
profit where MRA = MRB =
MC. The price is higher in
the market where demand
is relatively inelastic; here PB
> PA.
Second-degree price discrimination
Second-degree price discrimination is when a monopolist knows that there are different types of
consumers in terms of their WTP, but it does not know the type of any particular individual consumer.
For example: in a market there might be high-value consumers and low-value consumers but the
monopolist might not be able to ascertain which group any person falls into.
Note the difference between third-degree and second-degree price discrimination:
o With third, the monopolist knows exactly what type of consumer every individual is (a student, a
non-student etc.), but with second-degree the monopolist only knows the possible types that a
consumer could be.
Examples might be business class/economy airline tickets or mobile phone plans.
x
The monopolist cannot identify which type any particular consumer is, so it needs to offer
different versions of the product (at different prices) so that the consumers ‘self-select' and
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reveal their types by the product versions they choose (like a business-class and an economy
ticket sold).
o The monopolist must design the different versions so that the high-value consumer is at
least as well off buying the expensive product than buying the cheaper option (and the
low-value customer must be at least as well off buying the cheaper product than not
buying at all).
o If not, the high-value consumer will opt for the cheaper version, reducing the
monopolist's profit.
An example of a natural monopoly (with declining ATC)
When a firm has a fixed cost and a constant marginal cost,
the average total cost curve will be downward sloping for all
values of Q; this industry will be a natural monopoly.
Regulating a natural monopoly
x
x
x
Given it can create a DWL, governments might try to regulate a natural monopoly.
There are options including:
o Government ownership;
o Marginal-cost price regulation; and
o Average-cost price regulation.
Unfortunately no form of regulation is perfect, however.
Regulation: government ownership
x
x
x
A privately-owned monopoly will maximize profit, disregarding its impact on overall welfare.
In principle, the government take over the ownership and operate the monopoly in a way to
maximize total welfare.
However, this option can be difficult to implement
o The government does not normally have the skills to run such a firm. A professional
manager is most needed, who could pursue their own objectives (perks, empire build,
and so on).
o Without an explicit performance contract (based on profit), the manager will have little
incentive to minimize costs, which itself reduces total surplus.
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o
The DWL with government ownership could be even larger than with a privately-owned
monopoly.
Marginal-cost price regulation
x
x
x
Under marginal-cost price regulation, the government sets the monopoly price at P=MC
(assuming constant MC for simplicity). This means that the DWL = 0.
However, this means that the monopolist makes a loss equal to
the grey-shaded area (that is, its fixed costs), and will exit the
market when it can.
To prevent this, the government will need to subsidize the
monopolist that amount to prevent them from leaving the
market,
o These funds will typically have a DWL associated with
them (from taxation).
o Such a subsidy could also be politically unpopular.
Average-cost price regulation
x
x
x
Under average-cost price regulation, the government sets the monopoly price at P= ATC.
However, the monopolist will produce less than the efficient quantity (the monopolist does not
produce where MB = MC), so there is still some DWL.
However, typically regulation decreases DWL relative to the situation with no regulation at all.
Concluding comments
x
x
x
x
A monopolist can use its market power to raise price and
extract more of the gains from trade.
A monopolist charging the same price to all consumers
restricts the quantity traded below the efficient level, because
its MR < MB for all but the first unit sold – this creates a DWL.
Price discrimination can increase the profits made by the
monopolist. The type of price discrimination depends on what
information the firm has about consumers.
Regulation can improve the welfare outcomes in monopoly
markets, but regulation is by no means perfect and can create
its own problems.
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10.Monopolistic Competition
Characteristics of monopolistic competition
x
x
x
x
Many buyers and sellers
Product differentiation
o Each firm sells a slightly differentiated product. This includes differences in the good or
service itself, as well as differences in location.
o As each firm sells a differentiated product, it has market power (a downward sloping
demand curve), although its market power is limited by the presence of alternative
products.
Free entry and exit
o Firms can freely (that is, costlessly) enter and exit the market in the LR Æ there are no
barriers to entry in the LR
Examples: restaurants, convenience stores, laundromats
The short run
Each monopolistically-competitive firm sells a slightly differentiated product.
o It has some control over the price it charges, facing a downward-sloping demand curve.
o This means that a firm in monopolistic competition is a price maker.
o Consequently, a monopolistically-competitive firm sets a profit-maximizing price (or quantity) in
the same way that a monopolist does.
o In the short run, a firm in a monopolistically-competitive industry can make an economic profit
(or loss).
o Note, the number of firms in the industry in the short run is fixed.
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The long run
In the LR, there is free entry and exit in the market. Like perfect competition, firms will enter
the market if they believe that they can make positive profits by doing so and firms will leave the market
if they are sustaining losses.
If a new firm enters the market, this will affect the demand curves of all incumbent firms in the market.
o There will be a decrease in demand for the products of incumbent firms, as the new firm's
product offers consumers an alternative. This will shift the demand curve to the left.
o The demand curve for each incumbent firm will become more elastic – consumers have closer
substitutes to switch into, making them more price sensitive.
Exit will have the opposite effect.
Elimination of profits and losses
Free entry and exit of firms will eliminate all profits (and losses) in the market.
o The entry of firms in the market decreases demand for other firms, thus lowering the price
those firms can charge and hence lowers their profits.
o The exit of firms from the market increases demand for other firms, thus increasing the price
those firms can charge and hence increases their profits.
In the LR, all firms are still price makers, facing a downward facing demand curve so they maximize
profit setting qM so that MR = MC.
Note that Pm = ATC if profits are going to be zero.
For price-making behaviour and zero profits to hold, the ATC needs to be just tangential to the
demand curve at qm (it cannot cut or lie always above the demand curve).
Elimination of profit and loss in the LR
A firm in a monopolistically competitive market in
the long run. Because of the entry and/or exit of
other firms in the market, this firm's demand curve
(and marginal revenue curve) has shifted such that,
at the quantity associated with MR=MC, the firm is
making zero profits.
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Welfare under monopolistic competition
x
x
x
In the long run, firms in a monopolistically-competitive market trade at the point where Pm =
ATC.
Note that, at this point, ATC > MC, which means that average total cost (that is, production
costs) is not minimized (ATC is minimized when it equals MC).
This implies Pm > MC. Hence, there is a DWL associated with each firm's output, as there are
gains from trade that are not realized.
There are two additional factors that may impact upon welfare:
1. Business stealing. A firm considering entering a market is concerned about its own profits, even
if those profits come at the expense of other firm’s profit. This is called the ‘business stealing’
effect. As firms do not take this effect into account when they decide to enter a market, this
suggests that the number of firms in the market is too high.
2. Product variety. A firm entering the market offers additional differentiation in the market. An
increase in the number of different products offered in a market can increase consumer surplus.
Because firms only consider their own profit, and not the welfare of consumers, this suggest
that the number of firms in the market is not high enough.
It is unclear which of these two effects will dominate, meaning that there may be too many or too few
firms in a monopolistically competitive industry.
10.A game theoretic analysis of
oligopoly markets
An oligopoly is a market that contains a small number of firms.
o Examples of oligopolies: soft drink market, computers, phones, cars, banking, department
stores, supermarkets, and so on.
o This means that the strategic interaction between the firms is critical.
o For example, if one firm drops its price, other firms might be tempted to follow suit.
Game theoretic models are typically used to analyse these markets. Note, strategic interaction was
absent from the other market structures we have studied (competition, monopoly and monopolistic
competition).
Characteristics of an oligopoly
x
x
Few seller and many buyers
o Output in the market is produced by a handful of firms
Price making firms
o Because there are only a small number of firms in the market, each firm retains the
power to set its own prices
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x
x
Barriers to entry
o Entry into the market is difficult, as there are typically significant barriers to entry
Possible product differentiation
o Products may be differentiated or not, depending on the market
As noted, we use ‘game theory’ to study firms’ strategic interaction in these type of markets.
Introduction to game theory
A game has the following elements:
ƒ
ƒ
ƒ
Two (or more) players
A complete description of what actions each player may take; and
A specification of each player’ payoff associated with the actions taken
There are different ways to represent a game; we start by considering a game when players choose their
actions simultaneously.
Simultaneous move games
Simultaneous move games are when players have to choose their actions simultaneously or
without knowledge of what the other player has chosen. It is often convenient to represent a
simultaneous-move game using the normal form of the game, which uses a table or matrix.
Example
Two firms, A and B, are selling an identical product in the same market. At the beginning of the day,
each firm must choose to set their price high (p h) or low (pL) without knowledge of what the other firm
has chosen.
•
If both firms set a price of ph, both firms receive a payoff of $4.
If both firms set a price of pL, each firms will get a payoff of $3.
If firm A sets a price of pH and B prices at pL the payoffs are $1 and $5 to A and B, respectively.
On the other hand, if A chooses pL and B chooses pH the payoffs are $5 and $1 to A and B,
respectively.
Normal form of a game
Player 1
Player 2
Solving simultaneous move games
We can solve (or predict the outcome of) a game by assuming that each player is only interested in
maximizing his own payoff (or at least all the relevant payoff are included in their individual payoff).
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Dominant strategy equilibrium
o A player has a dominant strategy when the action that gives him the highest payoff does not
depend on what the other player chooses.
o If all players have a dominant strategy, the outcome (or equilibrium) will involve each player
choosing their dominant strategy; this is a dominant strategy equilibrium.
Player 2
Example:
Player 1
L
x
x
x
R
T
B
Player 1's dominant strategy is to choose T as this will yield a higher payoff regardless what
Player 2 does.
o If Player 2 chooses L, Player 1 can choose T for a payoff of 4 or B for a payoff of 2.
o If Player 2 chooses R, Player 1 can choose T for a payoff of 3 or B for a payoff of 1.
Player 2's dominant strategy is to choose L.
o If Player 1 chooses T, Player 2 can choose L for a payoff of 8 or R for a payoff of 6.
o If Player 1 chooses B, Player 2 can choose L for a payoff of 7 or R for a payoff of 5.
The dominant strategy equilibrium is (T,L).
o Note, the equilibrium of the game is expressed in terms of the players' strategies (not
the payoffs).
Nash equilibrium
Sometimes a game does not have dominant strategy equilibrium. Given this, we need another
equilibrium concept in order to predict the outcome of the game.
Best response:
o Each player's choice of action is dependent on what she thinks the other player will do. We say
that an action is Player 1's best response if that action gives him the highest possible profit,
given Player 2's choice.
o We use this idea of every player adopting their best response to find the Nash equilibrium.
A Nash equilibrium is when each player’s strategy is their best response to every other player’s strategy.
o In the case of two players, this means that Player 1's choice of action is his best response to
Player 2' choice and that Player 2's choice of action is also her best response to Player 1's choice.
In a Nash equilibrium, no player can unilaterally deviate (that is, switch his choice of action, holding
constant the strategies of all other players) and increase his payoff.
ÆThis is because every player is already choosing their best response and making the maximum payoff
possible, given the other player’s actions.
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Practically, checking each box in the Normal form game and seeing if either player has a unilateral
incentive to deviate is a way of finding all the Nash equilibria.
Example:
Player 2
Player 1
L
R
T
B
Note, this is the game from before: the dominant strategy equilibrium is (T, L). (T, L) is also the Nash
equilibrium. Neither player can make themselves better off by unilaterally deviating – they both have
adopted their best response to the other player’s strategy.
11.Price Regulation and Taxes
We consider two common types of government intervention:
1. Price regulation
2. Taxes and subsidies
Here we assume that the market is efficient in the absence of government intervention (that is, the
market is a competitive market). In this framework, we examine how government intervention affects
market price, the quantity traded and welfare in the market.
Price regulation
Price regulation typically takes the form of a price floor, where the government sets a minimum
price at which a good or service can be traded, or a price ceiling, where the government sets a
maximum traded price.
Price floor
Governments sometimes set a price minimum, or price floor. For example, a price floor in the market
for wool or a minimum wage, which is a price floor in the market for labour.
o A price floor set below the market clearing price P* is non-binding, because the equilibrium
price is already above the minimum price (the price floor).
o A price floor set above P* is binding because the market equilibrium price is less than the
minimum price at which the good or service may be sold;
o Price will need to rise to meet the requirements of the price floor.
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Binding price floor
Raising the price above P* affects the quantity demanded and the quantity supplied in the market. At
the price floor:
The quantity demanded by consumers is QD
The quantity supplied by producers is denoted $QS
This results in an excess of supply of ($QS – QD).
Efficiency of a binding price floor
x
x
A binding price floor creates excess supply.
o This takes the form of a product stockpile (as in the
case of a binding price floor in agricultural markets or unemployment in labour
markets).
A binding price floor creates a welfare loss (a reduction in total surplus).
o Raising price means that some gains from trade are realized.
o Moreover, there is no guarantee that it is the lowest-cost firms that supply the quantity
demanded with the artificially high price.
Price ceiling
x
x
x
x
When a government puts in place a price ceiling, it sets a maximum price at which a good or
service may be traded.
In the absence of any government intervention, the equilibrium price and quantity will prevail in
the market – that is, (Q*, P*).
A non-binding price ceiling is set above the equilibrium price, P*.
A price ceiling set below P* binding because the equilibrium price is greater than the maximum
price at which the good or service may be sold.
o The price in the market will need to fall down to the price ceiling.
Binding price ceiling
At the price ceiling price, the quantity demanded by consumers is denoted by QD, whereas the quantity
supplied by producers is denoted QS. This results in an excess of demand of (QD – QS).
ÆAt that price there are not enough units supplied to meet the
quantity demanded.
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Price ceiling
With excess demand, there is an issue about how the limited number of goods available should be
allocated to consumers. Some options include:
x
x
x
Queuing.
o For example, there could be a first-come, first-served rule, which often results in
queues. Consumers who are willing to wait receive the good.
Discrimination.
o A government official might pick which consumers get the good. This can be
problematic if the good is distributed on the basis of nepotism rather than who values
the good the most.
Side payments.
o Consumers might make side payments (that is, payments in addition to the price) to the
firm or the government official to guarantee access to the product.
o This is can be illegal. It also tends to favour ‘insiders’ against ‘outsiders’, who may
actually value the good more highly.
Efficiency with a price ceiling
x
x
x
The implementation of the price ceiling restricts the use of price to allocate the good.
o The advantage of a using the market to allocate the goods and services produced is that
consumers who value the product most highly get the goods.
With all alternative allocation methods, it is possible that the good is allocated to consumers
who do not value the good most highly.
This can reduce total surplus generated in the market.
Price controls in the long run
x
x
x
Supply and demand change over time. This means that a price ceiling or price floor that was
non-binding may become binding.
Supply and demand will be more elastic in the long run.
This can mean that shortages or excess of a product may be worsened in the long run.
o For example, the excess-demand issues of rent-control laws tend to worsen in the long
run as both renters and landlord respond to the incentives generated by the lower price.
Taxes
x
x
x
A tax is a compulsory payment made to the government.
Per-unit taxes or ‘specific taxes‘ are taxes of a fixed amount be unit of the good trade – that is,
for every unit, a tax of t must be paid to the government.
This can be distinguished from an ad valorum tax, where the amount of the tax is a fixed
percentage of the price.
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Tax on consumption
x
x
x
x
Consider a tax of t per unit that has to be paid for by consumers.
For every unit purchased, consumers must pay the market price P to the producer as well as a
tax of t to the government. Hence, the total amount paid by consumers is P+t.
Once a tax of t is introduced, consumers must factor the tax into their purchasing decisions.
Now, consumers will only buy an additional unit of the good if the total amount paid (P+t) does
not exceed their marginal benefit (MB).
o The maximum price P that a consumer is willing to pay for any unit is P=MB-t, so that
P+t = MB.
o This means that the demand curve shifts downwards by the size of the tax.
This creates a new equilibrium at the intersection of S0 and D1. At the
new equilibrium:
o
The quantity traded in the market is Qt.
o
The price received by producers is Pt.
o
The total amount paid by consumers is Pt +t; they must pay the
market price, plus the tax of t to the government.
Tax on producers
x
x
x
x
Let us now turn to taxes paid by producers. For every unit sold, producers must pay a tax of t to
the government.
The total amount that a producer receives for selling a unit of the good is (P-t), which represents
the price received minus the payment of the tax.
Now, producers will only sell an additional unit of the good if the amount they receive covers
their marginal cost.
o The minimum price that producers should be willing to accept is P=MC+t.
The minimum price that producers are willing to accept is increased by the size of the tax; the
supply curve shifts vertically upwards by the size of the tax.
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o This create a new equilibrium at the intersection of S1 and
D0 .
o At this new equilibrium, the quantity traded in the market is
Qt, and the price in the market (paid by consumers) is Pt.
o The net amount received by producers is the market price
minus the tax of t, that is, Pt .
Economic impact of a tax
x
x
x
x
The effect of a tax is to drive a wedge between the price
paid by consumers (PC) and the amount received by producers (PP).
This will have implications for welfare (see the following figure.
Both consumer surplus and producer surplus will decrease as a result of the tax:
o Fewer units are traded in the market;
o On each unit, consumers pay a higher price and producers receive a lower price relative
to a market without a tax.
The government now receives some surplus in
the form of tax revenue. The total revenue
received by the government is denoted by the
size of the tax (t), multiplied by the number of
units taxed (Qt).
Economic incidence of tax
x
x
x
x
x
x
The surplus to the government must also be
factored into total surplus;
o Total surplus is given by the sum of consumers surplus, producer surplus and
government revenue.
The deadweight loss from taxation is caused by reduction in the quantity traded in the market
(from Q* to Qt).
The larger this reduction, the greater the DWL.
o The size of the DWL depends on how elastic the demand and supply curves are.
o The more elastic the demand and/or supply curves, the greater the effect of the tax on
the quantity traded in the market, hence the larger the DWL.
As a rule, the legal incidence of the tax has no bearing on the economic incidence of the tax.
Rather, the economic incidence of the tax is determined solely by the relative elasticities of the
demand and supply curves.
Hence, a tax (of the same size) on consumers and producers has identical welfare effects.
o The tax places a wedge between the price suppliers receive and the price consumers
pay – this is the same wedge regardless as to which party legally pays.
o That is, the same leftward shift from the market equilibrium quantity is required to have
the satisfy the required height difference between the supply and demand curves.
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x If the demand curve is elastic relative to the supply curve,
producers will bear a greater share of the tax burden.
x Conversely, if the supply curve is elastic relative to the demand
curve, consumers will bear a greater share of the tax burden.
x Usually, the economic incidence of the tax is shared between
both parties, but there may be exceptional cases if either curve is
perfectly elastic or perfectly inelastic.
Incidence with perfectly elastic supply
Incidence with perfectly inelastic demand
Incidence and DWL when the laws of demand and supply hold
x
x
x
x
When the laws of demand and supply hold both sides pay for some of the tax, the precise
incidence depending on the relative elasticity of supply and demand.
o The relatively inelastic side of the market pays for more of the tax.
The DWL generated by a tax depends on the elasticity of supply and demand.
A DWL is caused by a reduction in the quantity traded (from q* to q t). The larger this reduction,
the bigger the DWL.
For a given tax t, the reduction in quantity is going to be larger the more elastic market
participants are, because the wedge between the D and S curves must equal to the size of the
tax.
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Relatively elastic supply
Relatively inelastic supply
DWL and the size of the tax
x
x
x
x
x
With a zero tax there is no DWL or tax revenue.
If a small tax is levied, it causes a wedge between D and S, reducing the quantity trade. This
creates a DWL.
As the tax is increased, the wedge becomes larger and the DWL increases.
This is true up to when the tax is equal to the difference between the MB and the MC for the
first unit – the difference between the height of the D and S curves at q = 0.
Once a tax is this large, there is no trade and all the potential gains from trade are lost (the DWL
is equal to the area between the D and S between 0 and q*.
Tax revenue and the size of the tax
x
x
x
As the tax increases, tax revenue first rises, then falls. The logic is very similar to why total
expenditure in a market can rise or fall with a price increase.
Start with a tax of t = 0. With no tax, tax revenue is zero. If a small tax is implemented, tax
revenue is equal to the tax the quantity traded.
o This is true for further small tax increases; the tax revenue rectangle increases as the
proportional increase in the height of the rectangle outweighs the reduction in the
length.
But as the tax gets larger, the proportional decrease in quantity beings to outweigh the
proportional increase in the tax, and total tax revenue starts to fall.
o This continues up until the tax totally crowds out the market, there is zero quantity
traded and there is no tax revenue.
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12.Externalities and public goods
Competitive markets are usually Pareto efficient. This is because all mutually beneficial trades
occur, maximising the gains from trade and hence total surplus.
There are some situations where the market outcome will not be efficient; these are called market
failures. One type of a potential market failure is an externality.
An externality is a cost or benefit that accrues to a person who is not directly involved in an
economic activity or transaction.
The presence of an externality means that the market outcome may not be efficient, because the
market does not take into account these external costs and benefits of producing or consuming a
product.
Æ The competitive market produces too much (with negative externality) or too little (with a positive
externality).
External costs and benefits
x
x
x
x
An externality is a cost or benefit of an economic activity that accrues to a person not directly
involved in that activity.
These costs or benefits are also known as ‘external costs’ or ‘external benefits’.
A positive externality occurs when the economic activity results in external benefits for a third
party. For example, education can benefit society generally as well as the individual themselves.
A negative externality occurs when the economic activity results in external costs for a third
party. For example, pollution from a factory could be endured by people not involved in the
market transaction.
Positive consumption externalities
In the presence of a positive externality, the marginal benefit to society of an additional unit of
the good – the marginal social benefit (MSB) – is made up of two components: the marginal private
benefit (MPB) that is enjoyed by the individual consumer and the marginal external benefit or
externality (MEB) that accrues to a third party:
MSB = MPB + MEB
The difference between the individual’s private MB and
the MSB is the size of the externality.
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Negative production externality
With a negative production externality, the marginal cost to society of an additional unit of the
good – the marginal social cost (MSC) – is: the marginal private cost (MPC) that is incurred by the
producer and the marginal external cost (MEC) that is incurred by a third party:
MSC = MPC + MEC.
The size of the negative externality is the difference between
the MSB and the MPB for a given level of output.
The problem with externalities
x
x
x
Externalities are a source of market failure because they represent external costs or benefits
that are not accounted for by the market.
As market participants on consider their own benefits and costs, the market equilibrium is
determined by demand (MPB) and supply (MPC):
MPB = MPC
For efficiency, all costs and benefits. The socially optimal equilibrium is determined by the
marginal social benefit and marginal social cost curves:
MSB = MSC
Positive consumption externalities
The market equilibrium and the socially optimal outcome in
the presence of a positive externality. The area representing
DWL is shaded grey.
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Negative production externalities
The market equilibrium and the socially optimal outcome in the
presence of a negative externality. The area representing DWL is
shaded in grey.
Positive production externality
With the positive production externality the MSC is lower than the
MPC by the size of the positive externality. The market output Q M
(where MPB = MPC) is less than the surplus-maximizing quantity Q*.
The DWL is shaded in the figure – for every unit between QM and Q*
the MPB > MSC, indicating there is forgone surplus in the market
equilibrium relative to the efficient outcome.
Negative consumption externality
The MSB is less than the MPB by the size of the externality; MSB
= MPB - MEC, where MEC is the size of the external cost. The
area representing deadweight loss is shaded in grey.
Private market solutions: the Coase
Theorem
One way that an externality may be corrected is via private bargaining between the involved
parties. In this way, the market participants and the third parties affected by the externality can
‘renegotiate’ the market outcome, such that the socially optimal outcome is implemented and the
DWL is eliminated.
o Provided property rights have been clearly assigned and there are no transaction costs,
bargaining will lead to an efficient (i.e. socially optimal) outcome, regardless of the initial
allocation of property rights.
Coase Theorem: intuition
x
The Coase Theorem depends crucially on property rights.
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In this context, the ‘property right’ referred to is the right to decide whether and to
what extent the economic activity causing the externality goes ahead.
It is an application of the gains from trade principle, where the parties try to find all mutually
beneficial trading opportunities.
The socially optimal outcome is attained regardless of which party is allocated the property
rights.
o Nevertheless, the allocation of property rights will have implications for how the gains
from trade are distributed between the parties.
o
x
x
Why might Coase Theorem fail?
u
u
u
Property rights not defined
o If initial property rights are not properly defined, the parties will not have a ‘starting
position’ from which to begin their negotiations.
Transaction costs
o If these costs are too high, it can prevent the parties from negotiating or trading at all.
Identity of parties unknown
o If the parties are unable to identify each other, it will not be possible for them to engage
in negotiations. This could prevent the efficient outcome being achieved.
Government solutions to externalities
x
x
x
A tax or subsidy can be used to ‘correct’ the market failure caused by an externality, by reducing
or increasing the quantity traded in the market to the socially optimal level.
o These taxes or subsidies are also caused ‘Pigovian taxes’ or ‘Pigovian subsidies’.
A tax or a subsidy makes it as if the individuals internalize the external cost or benefit; this
provides them with the same incentives as the incentives required to choose the efficient level
of output.
The tax or subsidy should be set at the size of the externality at the efficient level of output.
Pigovian subsidy for positive externality
x
x
x
x
The quantity traded in the market (QM) is less than the socially optimal quantity (Q*).
To raise the quantity traded in the market to Q*:
o Governments can grant a subsidy to either consumers or producers, creating an
incentive for the market participants to increase the quantity traded.
A subsidy to consumers shifts the demand curve (MPB curve) up by the size of the subsidy per
unit, increasing the equilibrium quantity traded.
A subsidy to producers, shifts the supply curve (the MPC curve) down by the size of the per-unit
subsidy, increasing the equilibrium quantity traded.
The subsidy should be equal to the size of the externality (the difference between MPB and MSB) at
the socially optimal quantity. Because the size of the subsidy is equal to the size of the externality, the
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subsidy causes market participants to ‘internalize’ the externality.
Æ This implements the socially optimal outcome and eliminates the DWL.
SUBSIDY TO CONSUMERS
SUBSIDY TO PRODUCERS
Pigovian tax for a negative externality
x
x
x
x
Governments can impose a tax on either consumers or producers, creating an incentive for the
market participants to decrease the quantity traded.
A tax on consumers shifts the MPB curve down by the size of the tax, decreasing the quantity
traded.
A tax is imposed on producers shifts the MPC curve up by the size of the tax, decreasing the
quantity traded.
The tax should be equal to the externality (the difference between MPC and MSC) at the socially
optimal quantity.
o The tax causes market participants to ‘internalize’ the externality.
TAX ON CONSUMERS
TAX ON PRODUCERS
Quantity regulation
x
x
The government could regulate the quantity traded in the market directly by mandating that a
certain quantity (specifically, the efficient quantity) be produced.
A quality regulation could be implemented by requiring a licence to produce (or consume) a
unit of output and by limiting the number of licences issued.
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o
It is like a licence to create the externality.
Taxes and subsidies versus regulation controls
One advantage of regulation is that it creates certainty about the level of output and pollution. This is
valuable when the government is unsure about how market participants will react to a tax or subsidy.
Two advantages of a Pigovian tax or subsidy over a regulation:
1. As a tax is a price to pollute, firms will have an incentive to keep reducing their level of
pollution, even if they have already met the regulation.
2. Some firms can reduce emissions more cheaply than other firms. A tax can help the total
reduction in pollution be achieved more cheaply, as firms that can reduce emission relatively
cheaply will reduce more in response to the Pigovian tax than firm for which reducing emissions
is more costly.
Tradeable permits
x
x
x
x
x
x
x
A tradeable market is an attempt to capture both the advantages of a regulation and a tax.
Tradeable permits are licences that may be transferred between parties; thus, consumers (resp.
producers) may trade with each other for the right to consume (resp. produce) units of output.
Tradeable permits create a market for pollution.
o If a firm holds a permit, the opportunity cost of using it is that it cannot sell it. If it sells
it, on the hand, the opportunity cost is that it cannot use it.
What the tradeable permits market creates is an incentive for a firm with a relatively low value
for the permit to trade it with another firm that values it more.
A permit is a licence to pollute, so with a low value of polluting (maybe they make a low-value
product) will sell their rights to pollute (their permits) to others who value the right to pollute
more highly (such as a firm that makes a high-value product).
Similarly, a firm that can reduce its emissions relatively cheaply will sell its permit to a firm that
has a higher cost of reducing emissions.
This market for permits means that, regardless as to the initial distribution of permit, the firms
will trade the permits so that the efficient outcome is achieved.
Public goods
x
x
x
x
A public good is a good or service that is non-excludable and non-rival.
Non-excludable. A good is non-excludable if the owner or provider of the good cannot stop
people from consuming it (and receiving the benefit from doing so).
o For example, national defence, clean air.
Non-rivalrous. A good is non-rivalrous if one person's consumption does not prevent another
person from also consuming and benefiting from the good.
o For example, street lighting.
In contrast, a private good is excludable and rivalrous.
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The MB curve for a public good
x
x
x
For a private good, the market demand curve is obtained by the horizontal summation of all the
individual marginal benefit (MB) curves along the Q-axis.
o This is because private goods are rivalrous.
Society's total MB curve for a public good is obtained by the vertical summation of all the
individual MB curves along the P-axis.
This is because public goods are non-rivalrous, so if several individuals wish to consume a good,
they can share units of that good.
o For example, suppose Aliya values a lighthouse at $30 and Victoria values the
construction of a lighthouse at $50. But they can both `share' the same lighthouse –
they do not need a lighthouse each.
o Together, Aliya and Victoria would be willing to pay $80 for the lighthouse. Therefore,
society's total willingness to pay is the sum of each individual's valuation of the good.
Society’s MB for a public good
Two individuals have marginal benefits for the public good of
MBW=10-q and MBG=20 - 2q. q is the number of public good
provided. The total MB curve is the vertical summation of the
individual MB curves, and is given by the equation MBT =30 3q.
$
30
20
10
10
The problem with public goods
x
x
x
x
The efficient quantity of a good is the quantity at which MC = MB. In the case of a public good,
this means the quantity where the marginal cost of provision is equal to society's total MB for
the public good.
Because the good is non-excludable, consumers cannot be excluded from enjoying the public
good even if they have not paid for it (this is called ‘the free-rider effect’).
This makes it difficult for private firms to enforce payment and hence make profits from the sale
of a public good; as a result, there is little to no provision of public goods by the private sector.
As a result, public goods are often provided by the government, who can enforce payment for
the public good through the taxation system.
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Common resources and the Tragedy of the Commons
x
x
x
Common resources are often thought of as ‘partial’ public goods because they are nonexcludable, but rivalrous.
o Examples of common resource goods might be: fishing stocks on the high seas; mineral
deposits where there is no effective government oversight.
The market failure arising from common resources is over-exploitation. This problem is
frequently referred to as the Tragedy of the Commons.
o Each individual considers their own benefits and costs of using the common resource,
but ignores the negative impact their use has on others.
One way to address the over-exploitation of common resources is to create enforceable
property rights over the good.
13.International Trade
Introduction
x
x
x
x
Trade between individuals can be mutually beneficial for all parties involved.
This is also true at an international level: there can be gains from trade if countries produce
goods in which they have a comparative advantage, and then trade those goods with other
countries.
Here we analyse what determines whether a country is an exporter or importer of a particular
product.
We also examine the welfare effects of international trade, as well as the effects of government
policies with respect to trade, including tariffs and quotas on imports.
Welfare under autarky
The market equilibrium in autarky is given by the
intersection of domestic demand (Dd) and
domestic supply (Sd). The equilibrium in autarky is
(Qd, Pd).
Welfare under international trade
x
We will assume that the country is a small country, meaning that the domestic consumers and
producers cannot affect world price because they make up such a small part of the world
market.
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x
x
x
o That is, the world price Pw is independent of actions in the domestic market.
This means that the world price Pw is either a perfectly elastic demand or supply curve for the
small country.
The relationship between the domestic equilibrium price (Pd) and the world price determines
whether the country is an exporter or an importer of the good.
The relationship between Pd and Pw is an indicator of comparative advantage:
o If Pd < Pw the country has a comparative advantage in producing that good;
o If Pd > Pw the country has a comparative disadvantage in producing that good.
An exporting country
x
x
x
x
x
x
Assume that Pd < Pw, the country has a comparative advantage in producing that good – the
country will be an exporter.
With international trade, price will immediate jump to the world price P w.
The world price Pw is effectively a perfectly elastic demand curve for domestic producers.
o Foreign consumers are will to buy as many units as domestic producers are willing to sell
at Pw.
As the price moves from the domestic equilibrium price (Pd) to the world price (Pw), the
domestic quantity supplied will increase to QS and the domestic quantity demanded will
decrease to QD.
The quantity supplied by domestic producers now
exceeds the quantity demanded by domestic
exports
consumers.
The difference in these quantities is sold to the world
market; thus the country is an exporter of the good.
Welfare for an exporting country
x
x
x
Because the price rises to Pw, domestic consumers are worse off for and domestic producers are
made better off.
On the whole, total welfare increases. The loss of consumer surplus is less that the increase in
producer surplus.
As total surplus is higher with international trade, autarky cannot be Pareto efficient.
o A change from autarky to international trade generates sufficient extra surplus for
producers such that they can (at least theoretically) compensate consumers fully for
their loss in surplus and still be better off.
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exports
Importing country
x
x
x
Now suppose Pd < Pw, the country has a comparative disadvantage in producing the good.
The price will fall in the domestic market to P w – it is a perfectly elastic supply curve for this
small country.
o Domestic consumers can buy as much they want at that price – so it is not possible to
induce them to pay a higher price.
As the price moves from the domestic equilibrium price (Pd) to the world price (Pw).
o The domestic quantity supplied will decrease to QS and the domestic quantity
demanded will increase to QD.
o Quantity demanded by domestic consumers
exceeds the quantity supplied by domestic
producers – this difference is filled by imports.
Welfare for an importer country
x
x
x
x
Because trade causes price to fall, consumers are
imports
better off and producers are worse off.
On the whole, total welfare increases. The loss of
producer surplus is more than offset by the increase in consumer surplus.
Given total surplus is larger with international trade, autarky cannot be a Pareto efficient
outcome.
It is (theoretically) possible for consumers to compensate producers for all of their loss of
surplus given a move from autarky to international trade, and still be better off.
imports
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Barriers to trade – tariffs
A tariff is a tax for importing a good into a country, which increases the cost of importing the
good. For example, a tariff might require a foreign firm to pay $10 to the government for every item of a
product it imports.
Impact of a tariff
x
x
x
x
x
With a tariff of t, this tariff raises the price of imports in the domestic market by the size of the
tariff from Pw to (Pw+ t).
Because domestic producers are now ‘competing’ with the higher price, there will be an
increase in the domestic quantity supplied from QS to QS1.
There will be a decrease in domestic quantity demanded from Q D to QD1.
This is because the tariff makes foreign producers less competitive in the domestic market,
giving domestic firms a greater share of sales.
The quantity of imports decreases from to QD1 - QS1.
Welfare effects of a tariff
x
x
x
As a result of the tariff and hence the increase in price, domestic consumers are made worse off
– CS falls by area abcd .
On the other hand, domestic producers are made better off for two reasons – PS increases by
area ahgd.
The tariff creates government surplus as the government now receives revenue from foreign
producers who import the good – the tariff revenue is hbef.
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DWL from a tariff
x
x
x
x
x
x
x
The increase in producer surplus and government surplus (tariff revenue) does not fully offset
the decrease in consumer surplus.
The resulting DWL of the tariff is A+B.
Triangle B arises from the decrease in the quantity demanded from Q D to QD1 – this is the
deadweight loss from under consumption.
o For each unit between The DWL from arises because for each unit between Q D1 and QD
consumers have a higher MB than the MC of acquiring the good (the world price Pw),
but the tariff puts a wedge between this price and the price consumers have to pay.
o The tariff reduces total surplus by reducing consumption from Q D to QD1.
The triangle A is the DWL of from overproduction.
This DWL from overproduction arises because between QS and QS1, the economy could have the
good at a marginal cost of Pw – the country can have as much of the good as it wants at the
going world price.
The tariff raises the price enjoyed by domestic producers, increasing domestic output from QS to
QS1, even though the domestic MC of production is higher for domestic firms than P w over this
range of output.
This means that the economy is not minimizing the cost of obtaining the good. These costs are
captured by the DWL from overproduction
Quotas
A quota is a legally-enforced limit on the number of goods that may be imported into the country.
Suppose the government imposes a quota, after the total number of goods allowed by the quota (Q)
have been imported if more of the good is wanted, consumers will need to turn to domestic producers.
o There is an additional kink in the effective supply curve (first relying on the low-cost domestic
suppliers who have a MC below Pw then imports under no more are allowed due to the quota,
then higher cost domestic suppliers).
The new equilibrium is where the new effective supply curve intersects the domestic demand curve.
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Welfare impacts of quotas
x
x
x
x
The effect of a quota on the welfare of domestic consumers and domestic producers echoes the
effects of a tariff.
Domestic consumers are made worse off for two reasons and domestic producers are better off.
As with a tariff, the import quota creates a DWL because it puts a wedge between P w and the
price the good is traded for in the domestic market.
Because domestic price is higher, there is a DWL from under-consumption and from
overproduction. The intuition is the same as with a tariff
Profits to
foreign
firms
The left and right
panels are
equivalent ways
of showing the
welfare effects of
a quota. This
holds because the
domestic supply
curve is parallel
to the last section
of the effective
supply curve
Tariffs vs quotas
For a given tariff, there is an equivalent quota that will yield the same price, quantities and level of
imports traded in the domestic market.
Conversely, for every given quota, there is an equivalent tariff that gives rise to the outcomes in the
domestic market.
The key difference between tariffs and quotas is who receives the benefit from the increase in the price
of imports:
x
x
x
The tax revenue from a tariff accrues to the government.
With a quota, the benefit accrues to the importer, who can buy a good on the international
market for Pw and sell it on the domestic market for the higher price.
However, the government can capture this extra surplus by requiring foreign firms to purchase
an import licence at a price of equal to difference between the new domestic price and the
world price Pw per unit imported, or if it auctions the licences off in a competitive process.
Importantly, however, the two DWL triangles remain.
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Arguments against free trade
Argument
Infant industries. Short-term protection can
allow an industry to develop, after with the
barriers to trade can be removed
Strategic trade policy. This suggests that a
country to manipulate the international trading
environment in its own interest
Anti-dumping measures. Dumping occurs when
foreign firms sell their goods in a country at a
price below cost, with the intent of forcing local
producers out of business
Environmental standards. Protection is needed
as domestic firms face higher costs of production
because they have to comply with higher
environmental standards than do foreign firms
Employment protection. An argument is often
made for trade protection to promote
employment in the protected industries
Counter
However, protection typically remains in place for
a long time, and these industries often have little
international success
Most countries are not large enough. But this
strategy also requires governments perfectly
understand the behaviour of firms and other
governments around the world, which is near
impossible
But it is difficult to distinguish competition from
dumping, and a restriction on trade can hurt
domestic consumers by increasing prices in the
short run
It is not clear that imposing trade barriers is the
best way to deal with this issue, particularly when
it is possible to address environmental
externalities more directly
While trade barriers will typically increase
employment in the protected segment of the
economy, it will also divert employment away
from other sectors in the economy, particularly
those where the country might genuinely have a
comparative advantage
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