Topic 1 - Introduction What is the economic problem? - How society manages its scare resources What are the 2 branches of economics? - Microeconomics: Firms + consumers - Macroeconomics: Countries What is a market-based economy? - Firms determine where resources are allocated towards making goods/services based on demand from consumers What is a centrally-planned economy? - Small group determines where resources are allocated, how much gets made and who makes it What are the 7 lessons from microeconomics? (PCRPTMG) 1. People face trade-offs: To get one thing, we have to give up another - Efficiency: Society gets the most it can from its scarce resources - Equity: Benefits of resources are fairly distributed 2. Cost of something = what you give up to get it - Opportunity cost: Highest-valued alternative that must be given up = are we using this resource in the most efficient way? 3. Rational people think at the margin - We make decisions by comparing costs and benefits at the margin = choose option that maximises benefit - Marginal changes = small incremental adjustments to an existing plan of action 4. People respond to incentives - Incentive: Induces person to act - Respond to incentives because rational people make decisions comparing costs and benefits 5. Trade can make everyone better off - Competition results in gains from trading 6. Markets are usually a good way to organise economic activity - Invisible hand: Buyers/seller act in their own interest but end up taking into account the social costs of their actions = prices guide decision makers to outcomes that maximise welfare of society 7. Governments can sometime improve market outcomes - Sometimes markets fail = require government to intervene to produce socially efficient outcome Topic 2 - How Markets Work Demand What is demand? - Quantities of a good that buyers are willing/able to pay at various prices at a particular point in time - Ceteris paribus: Other things constant - Negative relationship - Price ⬆, quantity demanded ⬇ - Movement along the demand curve = change in the quantity demanded Why is the demand curve downward sloping? - Substitution effect: As price ⬆ consumers substitute away towards a cheaper alternative - Income effect: As price ⬇ the purchasing power of our existing income ⬆ = can buy more What does demand depend on? PCPTNE - Price = movement - Non-price determinants/factors = entire demand curve will shift (shift right = ⬆ demand, shift left = ⬇ demand) - Consumer income - Normal goods = income ⬆, demand ⬆ - Inferior goods = income ⬆, demand ⬇ - Price of related goods - Substitutes = price of apples ⬆, demand for oranges ⬆ - Complements = price of orange juice squeezers ⬆, demand for oranges ⬇ - Tastes - Towards a good/service = demand ⬆ - Away from a good/service = demand ⬇ - Number of buyers - More people = demand ⬆ - Less people = demand ⬇ - Expectations - Expect prices to ⬆ in future, demand ⬆ - Expect prices to ⬇ in future, demand ⬇ Supply What is supply? - Amount of a good/service producers are willing/able to sell at a particular point in time - Ceteris paribus: Other things constant - Positive relationship - Price ⬆, quantity supplied ⬆ - Movement along the demand curve = change in the quantity supplied Why is the supply curve upward sloping? - When the price is high even more expensive production becomes profitable = suppliers supply more output to market What does supply depend on? PITNE - Price = movement - Non-price determinants/factors = entire supply curve will shift (shift right = ⬆ supply, shift left = ⬇ supply) - Input prices - Input price ⬆, supply ⬇ - Technology: Stock of knowledge about how to combine resources efficiently - Improvement in technology = costs ⬇, supply ⬆ - Number of sellers - Market supply: Sum of quantities supplied by all sellers - ⬆ sellers, ⬆ supply - Expectations - Expect prices to ⬆, supply ⬇ Market Equilibrium What is a market? - Mechanism that co-ordinates independent intentions of buyers and sellers What is the market-clearing price? - Equilibrium price + quantity What results in a surplus? - S>D What results in a shortage? - S<D What is market equilibrium? - QD = QS - Changes in determinants of demand/ supply = equilibrium price/quantity will change over time Surplus and Efficiency What is consumer surplus? - Difference between the maximum price a consumer is willing to pay for a good and the price they actually pay for it - That derived from the last unit of a good purchased tends to = 0 What is producer surplus? - Difference between the marginal cost of producing a good and the price they actually get for it What is market consumer surplus? - Summation of all consumer’s surplus What is market producer surplus? - Summation of all producer’s surplus What is total economic surplus? - C.S + P.S = value of total gains/benefits that buyers and sellers receive What is an efficient market? - Want total surplus/gains/benefits to be maximised - Maximised at equilibrium - Marginal benefit (demand curve) = marginal cost (supply curve) - Any deviation from equilibrium = smaller surplus What is DWL? - Deadweight loss - There are mutually beneficial exchanges that could take place but aren’t - Larger the DWL = more inefficient = worse-off firms/consumers are International Trade What does it mean when a country has comparative advantage? - Domestic price < world price = exporter What does it mean when a country hasn’t comparative advantage? - Domestic price > world price = importer If domestic price < world price? - Higher price = domestic consumers worse off + domestic producers better off - DWL = D = increase in total surplus = overall country is better off If domestic price > world price? - Lower price = domestic consumers better off + domestic producers worse off - DWL = D = increase in total surplus = overall country is better off What is a tariff? - Tax on imported goods in attempts to raise the world price for domestic consumers Why are tariffs imposed? PIPUN - Protect local jobs - Infant industry - Protection as a ‘bargaining chip’ - Unfair competition - National security What is the effect of a tariff on trade? - Consumers worse off + producers better off - DWL = D + F = decrease in total surplus = overall country is worse off - Government revenue = E Topic 3 - Elasticity Price Elasticity of Demand What is price elasticity of demand? - The responsiveness of the quantity demanded to a change in price = how responsive customers are to changes in the price of a good/service - = percentage change in quantity demanded/percentage change in price What is elastic, inelastic and unit elastic demand? - Ed > 1 = elastic demand: % change in quantity demanded is greater than the % change in price = consumers are quite responsive - Ed < 1 = inelastic demand: % change in quantity demanded is less than the percentage change in price = consumers are quite unresponsive - Ed = 1 = unit elastic demand: % change in quantity demanded is equal to the percentage change in price = consumers respond proportionately - *use absolute value What makes demand for a good inelastic/elastic? (determinants) - Availability of close substitutes: The more close substitutes, the more people will ‘switch’ if you raise your price - Time: The more time that passes, the greater the opportunity to find suitable alternatives = more elastic - Necessities vs luxuries: Luxuries we can do without, more responsive to changes in price - Definition of the market: Narrower the market defined = more elastic - Share of budget spent on good: Bigger the fraction a good takes up = more elastic Compare perfectly elastic demand and perfectly inelastic demand Perfectly elastic Perfectly inelastic - Ed = ∞ - Ed = 0 - Demand curve = horizontal - Demand curve = vertical What is total revenue? - = price x quantity - Elastic = decrease in price = increase total revenue - Inelastic = decrease in price = decrease total revenue - Unit elastic = no change in total revenue - Reverse is true if prices are rising - *revenue to firms is expenditure by consumers Other Elasticity Measures What is income elasticity of demand? - Responsiveness of demand to a change in income - Same formula as before but replace price with income - Ei > 1 = good is normal + a luxury - 1 > Ei > 0 = good is normal + a necessity - Ei < 0 = good is inferior What is cross-price elasticity of demand? - Responsiveness of demand to a change in the price of one good - Same formula as before but replace price with the other good’s price - Ex > 0 = goods are substitutes e.g. price of butter rises = demand for margarine rises - Ex < 0 = goods are complements e.g. price of cars rises = demand for petrol falls What is price elasticity of supply? - Responsiveness of the quantity supplied to a change in price - Same formulas as before but replace quality demanded with quantity supplied - Es > 1 = elastic - Es < 1 = inelastic - Es = 1 = unit elastic - Es = ∞ = perfectly elastic = horizontal curve - Es = 0 = perfectly inelastic = vertical curve - Because firms often have a maximum capacity for production, the elasticity of supply may be very high at low levels of quantity supplied and very low at high levels What makes supply for a good inelastic/elastic? (determinants) - Time: The more time that passes, the greater the opportunity to adjust the production of good - Cost of inputs: The easier inputs are transferable/substitutable to other types of production, the more elastic supply will be - *if marginal costs rise significantly as supply increases, supply will be less elastic What is price discrimination? - Charging people different price for the same product e.g. movies Topic 4 + 5 - Government Intervention in the Market Price Controls What is a price ceilings? - Price ceilings: The government legally decrees the price of a good can’t rise above a specific level - Set above equilibrium price = no effect - Set below equilibrium price = shortage (QD > QS) - Consumers are better off + producers are worse off but society overall is worse off - Black market can develop = consumers would be willing to pay additional money (under the table) - The better the black market works > closer to equilibrium What is a price floor? - Price floors: The government legally decrees the price of a good can’t falls below a specific level - Set above equilibrium price = surplus (QS > QD) - Set below equilibrium price = no effect - Producers are better off + consumers are worse off but society overall is worse off What is a tax? - In order for the government to pay for various welfare programs it must raise the revenue - Distort the price signal - If producers have to pay the tax = shift supply curve - Higher tax = higher revenue + higher DWL - Supply more inelastic = producer burden greater - Demand more inelastic = consumer burden greater What is a subsidy? - A payment from the government to consumers/producers fo each unit bought/sold - Negative tax - If subsidy paid to producer = shift supply curve - Supply more inelastic = producer benefit greater - Demand more inelastic = consumer benefit greater Externalities What is an externality? - Occur when economic activities affect third parties - Can have additional costs (negative externality) or benefits (positive externality) - Private cost: Cost borne by producer - Social cost: Total cost of producing a good - Private benefit: Benefit received by consumer - Social benefit: Total benefit from consuming a good What causes externalities? - Absence of private property rights: Exclusive right of an owner to use/rent/sell property - Because no one owns the resource, no one can demand restitution for damaging it - These costs/benefits aren’t reflected in the market price What are the types of externalities? Negative consumption e.g. alcohol Negative production e.g. pollution Positive consumption e.g. immunisations Positive production e.g. research - Negative = market output is grater than socially desirable = overproduction - Positive = market output is less than socially desirable = underproduction Solutions to Externalities What is the coase theorem? - Markets self-correct - Assuming transaction costs are low, bargaining can lead to an efficient outcome regardless of the initial allocation of property - Transaction costs: Cost in time/resources parties incur when carrying out an exchange - In reality, transaction costs are seldom low How can the government correct externalities? - Command and control - Regulations that impose quantitative limits on the externality or ban it - E.g. smoking in pubs/restaurants - Blunt approach = doesn’t recognise that different people/firms have different capabilities to reduce the externality - Taxes and subsidies - Tax a negative externality - Equal to the marginal external cost at the socially efficient outcome - Internalising the externality - Problem = tax may be set too low/high - Subsidise a positive externality - To increase quantity - = (P1-Psub) x Q1 - Tradable permits - Find the socially efficient level of production and fix it - Government divides this amount and sells/gives them to firms - Once sold to private firms they trade the permits with each other - Over time demand increases but supply is fixed = price of permits increases - Advantages = internalising the externality, promotes technological progress/ encourages firms to be greener + drives out inefficient producers (need permits>increases costs,>increases price>consumers buy less + efficient producers can sell their permits > earn revenue > charge less for g+s) - Disadvantages = knowing what the socially efficient level of production is Public Goods - Rivalry: One person’s consuming a good = no one else can consume it - Excludability: Don’t pay for a good = can’t consume it What are the types of goods? - Private good = R + E - Public good = - Can cause market failure - Free-rider problem: “If I can consume without paying then I won’t pay", everyone thinks this way = no one will pay for it and the good won’t get produced - E.g. lighthouse + national parks - Solution = need to be produced by the government - Cost-Benefit analysis: Often difficult because there’s no price signal, rely on qualitative info e.g. surveys - Club good/quasi-public = E - Common resource = R - Can cause market failure - It’s in no individual’s interest to withhold from using the resource = tend to be over-exploited, “use resource now and as much as I can because others will” - E.g. fish/whales/wildlife + clean air/global climate - Solution = private property rights (if someone owned the common it would be in their interest to ensure its sustainability), people can bargain and work out a solution themselves + governments can tax/set quotas/issue permits Topic 6 - Consumer Behaviour Utility What is utility? - The enjoyment/satisfaction people receive from consuming g+s - People are rational + seek to maximise their utility - Can’t compare - Total utility: Sum of the satisfaction gained - Marginal utility: Extra satisfaction from getting 1 more - Diminishing marginal utility: Utility ⬆ when consumption ⬆ but at a decreasing rate - Utility is maximised where MU = 0 What constraints do people face? - Budget/income: Can’t consume as much as they’d like - Choice: Have to allocate their scarce resources across many g+s How do you optimise utility? - MUx/Px = MUy/Py - Increasing consumption = MU will fall - Decreasing consumption = MU will rise Behavioural Economics What is predictable irrationality? - Cognitive biases in consumption and investment choices - Preferences for fairness - If people act in self-interest, they would seek to maximise their own welfare no matter what happens to others - People value fairness even if they’re worse off as a result - People should always ignore sunk costs when making decisions but often don’t - Framing effects - People’s preference are influenced bu how alternatives are presented - Money illusion - People care more about nominal values than real values - Signalling - DWL of gift giving = gifts represent complex social exchanges (signalling) rather then simple market ones - Using ‘nudges’ to change behaviour - A policy designed to structure choices so that people make a certain choice - Not supposed to impose any restrictions, just provide a psychological incentive - E.g. advantageous default policy (‘opt-out’ vs ‘opt-in’) + information/ encouragement (information letters on water consumptions in California) - Push policy: Regulatory/tax policy to get firms/individuals to use appropriate nudges usually involving a financial incentive - Criticisms: Few policies meet the criterion of the ‘nudge’, designing helpful policies is complicated, isn’t clear government knows better + government policy may make situation worse Topic 7 - Production and Costs Production theory What is a firm? - Economic units formed by profit-seeking people - Employ resourced to produce g+s for sale - Help reduce transaction costs - Goal is to maximise profit What is the formula for profit? - Profit = total revenue - total costs What are the types of costs? - Explicit costs: Opportunity cost of resources with a corresponding cash payment e.g. equipment - Implicit costs: Opportunity cost of a firm using its own resources without a corresponding cash payment e.g. time What are the types of profit? - Accounting profit = total revenue - explicit costs - Economic profit = total revenue - explicit cots - implicit costs (graphically = [P*-ATC*] x Q*) - Economists also subtract those opportunity costs that don’t have an explicit monetary value - Positive = firms applying resources in optimal manner - Normal/zero = minimum level of profit needed for a company to remain competitive in the market - Negative = firms not applying resources in optimal manner What is production theory? - Relation between output (total product) and the inputs (factors of production) necessary for production of that output - Output varies as we vary the input What are factors of production? - Inputs - Land - Labour - Capital - Entrepreneurship (profit) What is short run production? - At least one input is fixed - Typically capital = takes a long time to increase What is long run production? - No inputs are fixed/all are variable What is the law of diminishing marginal returns? - Short run production - One input fixed (K) + one input variable (L) - How output changes as we add more variable input - Assume labour is homogeneous (have the same skills) - Marginal product = - Q (change in output) / L (1 unit change in labour) (the extra output produced when the variable input is increased by 1) Average product = Q/L 1st = increasing marginal returns = output will increase by increasing amounts 2nd = diminishing marginal returns = output will increase by decreasing amounts 3rd = negative marginal returns It’s a law because as long as one input is fixed, output must eventually increase by decreasing amounts Short run production diagram - x = labour, y = total product - Plot total product curve - x = labour, y = marginal product curve/average product curve - Plot marginal product curve/average product curve What are returns to scale? - Long run production - The long-run relation between a given % change in inputs and the resulting % change in output - Increasing = double inputs > output more than doubles - Constant = double inputs > double outputs - Decreasing = double inputs > output less than doubles Cost theory What are the types of production costs? - Fixed costs = don’t vary with output produced e.g. capital - Variable costs = do vary with output produced e.g. labour Formulas - TC = TFC + TVS - ATC = TC/Q - AFC = TFC/Q - AVC = TVC/Q What is the cost of short run production? - Marginal cost: How much it costs to produce an additional unit of output (increase in TC caused by an extra unit of production) - MC = TVC/ Q - TFC = 0 anyway so just TVC - MC curve first then - MC = increasing marginal returns - MC = diminishing marginal returns Short run production cost diagram - x = quantity, y = total cost - Plot total cost, total variable cost + total fixed cost curves - x = quantity, y = marginal cost - Plot marginal cost curve - x = quantity, y = cost/unit 1. Plot AFC, AVC + ATC curves - AFC over the entire range - AVC + ATC get closer together over the entire range - ATC - AVC = AFC so only need AVC + ATC 2. Plot MC - MC curve first then - MC cuts AVC + ATC at their minimum points = when you add a smaller number to an average, the average falls How do you get MC curve from MP curve? - 1st as each successive worker adds more output ( MP) then their wage (w) is spread over more units of output = MC + increasing marginal returns - 2nd as each successive worker adds less output ( MP) then their wage (w) is spread over less units of output = MC + diminishing marginal returns What is the cost of long run production? - No fixed costs - Firms plan in the long run but produce in the short run Long run production cost diagram - x = quantity, y = cost/unit - Long Run Average Cost (LAC): Indicates the lowest average cost of production at each rate of output when the firm’s size is allowed to vary - Envelope of all short run ATC curves (SATC) - Minimum point on LAC = minimum efficient scale (over entire range of production possibilities, this is the one that minimises average costs) - Economies of scale: Forces that cause a in AC as the scale of operation - Diseconomies of scales : Forces that cause an in AC as the scale of operation - LAC = not necessarily u-shaped = capital isn’t fixed - SATC = u-shaped = eventually diminishing returns set in and average costs rise Topic 8 - Perfect Competition What the mechanisms of competition? - Number of firms in the market, the more firms the more competitive - Similarity of product, the more substitutes the more competitive - Ease of entry/exit in the market, the easier the more competitive The greater the degree of competition - The lower the equilibrium price - The greater the equilibrium quantity - The more efficient What is the key difference between economics and business? - Economists want more competition = lower prices + greater efficiency - Business want less competition = higher prices + greater profits What are the characteristics of a perfectly competitive market? - Many firms, each has a negligible fraction of market share - Firms produce a standardised product - Free entry and exit in the long run Assume firms want to maximise economic profit and consumers want to maximise utility Each individual firm is known as a price taker The overall market demand and supply conditions sets the price, and each firm must accept that price - P = MR = perfectly elastic Revenue - TR>TC = economic profit - Firm will produce at the level where that gap is largest = where the slopes of TR and TC are parallel - Slope of TR = TR/ Q = MR - Slope of TC = TVC/ Q = MC - Therefore, profit maximisation for a firm will occur where MR=MC Profit maximisation in the short run - MR = P (the extra revenue received from selling one more unit of output) - MC = TVC/ Q - Firms will increase output as long as each additional unit sold adds more to total revenue than to total cost - Maximise profit where MR=MC What are the 4 short run profit positions a firm can find itself in? - Positive economic profit (P>ATC) - Economic loss (P<ATC but >AVC) - Normal/zero economic profit (P=ATC) - Shut down (P<AVC) *green area = fixed costs so their loss is *smaller if they shut down Deriving the firm’s supply curve - When price = Pmin firms are indifferent to producing qmin and producing 0 - Loss they’d make whether they produced or shut down is exactly the same - As prices rise, the firm is willing to supply the quantity that corresponds to where P=MC - Therefore, the firm’s supply curve is its MC curve above minimum AVC Profit maximisation in the long run - Normal/zero economic profit - Positive economic profit attracts new entrants - This increases market supply > price decreases > firms cease to enter when normal economic profits are made - Short run losses cause some firms to exit > supply curve shifts left> price increases until normal profits are made Graphically 1. Assume normal profits are made 2. If consumer preferences shift towards this good - Market demand increases (demand curve shifts right) - Increase the price and market output - Firms now earn positive economic profit - Attracts new firms (supply curve shifts right) - Decrease the price until normal profits earned 3. If consumer preferences shift away from this good - Market demand decreases (demand curve shifts left) - Decrease the price and market output - Firms now make a quasi-loss - Repeals new firms (supply curve shifts left) - Raise the price until normal profits earned Efficiency - Equilibrium = P = MC - Firms produce up to where P=MC - = PS maximised - Consumers consumer up to where P=MP - = CS maximised What are the 3 types of efficiency? - Productive efficiency: Output is produced with the least-cost combination of resources (P=MC=LACmin) - Allocative: Firms produced output that is most highly valued by consumers (P=MB=MC) - Dynamic: Ability of firms to continue to lower their cost curves through technological innovation Perfect competitive and efficiency - Productively efficient = firms operate at min ATC in long run - Allocatively efficient = P = MC Topic 9 - Monopoly What are the characteristics of a monopoly? - 1 firm + many buyers - Barriers to entry - Resource mobility and market info may be influent by monopolist - Aims to maximise profits - No close substitutes What are examples of barriers to entry? - Government blocks the entry e.g. patent/copyright incentives, granting a public franchise (exclusive provider) - One firm has control over a key resource to produce a good - Important network externalities in supplying the good/service e.g. facebook - Economies of scales are so large that one firm has a natural monopoly e.g. gas Revenue - Market demand curve is the demand curve faced by the monopolist - A gain in revenue from selling more output - A loss of revenue from selling each unit at a lower price - Maximise profit where MR=MC Profit maximisation in the short run - Positive economic profits - MR = MC then read up to the demand curve to determine price charged to consumers Profit maximisation in the long run - Positive economic profits = because of barriers to entry monopolies can enjoy positive economic profits indefinitely - But are constrained by the demand for their product, as well as their costs Efficiency - Equilibrium = MR = MC - Compare to CS + PS to a perfectly competitive market = CS smaller + PS bigger + DWL Monopoly and efficiency - Isn’t productively efficient = produces to the left of min ATC - Isn’t allocativelly efficient = P>MC - Isn’t generally economically efficient but there are potentially dynamic elements where over time the monopoly can adopt the most efficient productive techniques but - Only extremely large firms can undertake expensive research and development - Major reason patents are given = allows producer to recoup their investment as physical production costs are usually very low so other firms could easily copy them Restraining monopolies - Remove barriers to entry - Restrict mergers and acquisitions - Forms firms to act competitively - Why permit monopolies - Encourage investment - Network benefits - High costs to regulate - Private benefit - Economies of scale Efficient - Natural monopoly: One firm can supply the entire market at a - lower average cost than two or more firms could - Economies of scale may create natural monopoly - Not having more competition could be more efficient Unregulated - Price is higher, quantity supplied is lower than in perfect competition Regulated marginal cost pricing - Price ceiling at the price we’d have under perfect - competition - Set P where P=MC - Efficient - P < LAC so monopoly runs at a loss - Difference is made up by a subsidy Regulated average cost pricing - Set P = AC - Earns normal profits - No subsidy required - Consumer surplus reduced State owned natural monopolies - Replace regulation with direct control - Possible benefits - Control of subsidies - Market power incentives - Government revenue - Equity - Security - Possible costs - Control of costs - Investment incentive - Forgone revenue - Stagnation Regulatory failures - Information = set regulatory price lose information of market price - Costs = tracking and demand - Political incentives - Regulatory capture Topic 10 - Monopolistic Competitive What are the characteristics of monopolistic competition? - Many sellers and buyers - Products differentiated but close substitutes - Relatively free entry and exit - Information is imperfect (advertising) - E.g. restaurants, running shoes Revenue - Products are differentiated = downward sloping demand curve - Quite elastic = depends on number of close substitutes - Maximise profit where MR=MC Profit maximisation in the short run - Positive economic profits - MR = MC then read up to the demand curve to determine price charged to consumers - Same profit possibilities as in perfect competition e.g. positive, normal/zero, quasi-loss and shutdown Profit maximisation in the long run - Normal/zero economic profit = ease of entry/exit Positive economic profit 1. Positive economic profit > firms enter and take market share 2. Demand curve and MR curve shifts left (more elastic as more substitutes) and continues until normal profits earned and no firms enter (where demand curve is tangent to ATC curve) Quasi-Loss 1. Quasi-loss being made > some firms leave, existing firms increase market share 2. Demand curve + MR curve shifts right (less elastic as less substitutes) and continues until normal profits earned and no firms leave (where demand curve is tangent to ATC curve) Efficiency - Isn’t productively efficient = produces to the left of min ATC - Isn’t allocativelly efficient = P>MC - Excess capacity: The difference between output at min ATC and actual profit max level of output (Demand curve tangent to ATC curve) - Monopolistically competitive firms could increase output and decrease average costs but don’t have to because of product differentiation (market power) - Are willing to pay higher price because - Monopolistically competitive markets give us choice, in perfect competition, goods were identical - There is more dynamic efficiency What is price discrimination? - Increasing profit by selling the same good at different prices to different consumers for reason unrelated to cost What are the conditions for price discrimination? - Firm must have some degree of market power - Consumers must have different elasticities of demand - Firm must be able to identity these different elasticities and be able to charge accordingly - Re-sale by consumers isn’t possible What are the types of price discrimination? - First degree (perfect) price discrimination - Second degree (imperfect) price discrimination - Third degree (imperfect) price discrimination What is first degree price discrimination? - Personalised - Demand curve shows the maximum price consumers are willing to pay for each unit of output - Firms would love to charge each consumer this maximum - Convert every dollar of consumer surplus into producer surplus = increase revenue - Allocatively efficient because MC = P What is second degree price discrimination? - Consumers ‘self-select’ themselves as having a particular elasticity - E.g. airline tickets - You decide which group you belong to What is third degree price discrimination? - Different types of consumers are ‘lumped’ together as having the same elasticity - E.g. movie/bus/train tickets Mirror image - Consumers in the inelastic market pay more that those in the elastic segment What are the implications from price discrimination? - Good for firms = firms can earn higher profits - Bad for buyers in total = different price charged that span higher and lower than the one price which would’ve been charged = some are worse off but some (with the highest price elasticity or lowest ability/willingness to pay) are better off, now being able to procure the good/service - Total consumer surplus will always be lower with price discrimination Topic 11 - Oligopoly and Game Theory What are the characteristics of an oligopoly? - Small number of large firms that are interdependent in their decision making e.g. supermarkets - Few large sellers - Either homogenous e.g. oil industry or differentiated products e.g. car industry - Barriers to entry e.g. economies of scale, ownership of key input and government imposed barriers - Demand curve can’t be specified until the behaviour of competing firms is known (unique) What is game theory? - Models that analyse an oligopoly firm’s behaviour as a series of strategic moves which take into account rivals actions What are the elements of game theory? - Rules: The initial conditions governing the conduct of the players in the game e.g. no collusion - Strategies: The options the player has e.g. increase/decrease price - Payoffs: What each player stands to lose/gain when certain strategies are followed e.g. increase in profit/sales/utility What is a payoff matrix? - Summarises players’ strategies and payoffs What is the prisoner’s dilemma? - 2 player game - Players move simultaneously - Addresses = do firms cooperate (collude) with each other or not - Go through what the best option would be for every combination and determine an equilibrium strategy - A one-off game - If the game is repeated, the long-run outcome can differ - Potential strategies - Using signalling as an enforcement mechanism e.g. advertise you will match the lowest price - Tit-for-tat e.g. firm responds with the same action that the rival firm used in the last period e.g. cooperate invites a cooperative response and vice-versa - Prefer to keep a cooperate strategy on critical factors like price and a noncooperative strategy for factors like advertising budgets What is dominant strategy/nash equilibrium? - Where one strategy is always the optimal strategy to pursue - Once other’s strategy is revealed, if you wouldn’t change your strategy then it is - Sub-game perfect Nash equilibrium = no player can make themselves better off by changing their decision at any stage of the game What is the commons dilemma? - What is good for you isn’t what is good for the group What is a sequential game? - One firm will act first, and the other will follow - Use a decision tree *Big W build small store = Kmart definitely enters so therefor it’s not possible to get 30% What is credible threat? - Big W will build a big store, and deter Kmart from entering Efficiency - Price - If firms engage in implicit/explicit collusion = output is lower and price is higher than in perfectly competitive markets - If price wars occur then prices could be temporarily lower than in perfectly competitive markets - Profit - Have ability to make long-run economic profits = barriers of entry e.g. economies of scale - Efficiency loss - Generally efficiency loss - MB often > MC, indicating presence of some DWL - More competitive = smaller DWL
