The Big Picture: Demand (Preference, Budget Constraint) + Supply
→ Market Equilibrium
Firm’s decisions
1. What industry to enter?
2. How to produce at minimum cost: (How much labor and
capital to use)
3. How much to produce? (Maximize Profit)
4. How do firms make these decisions?
Product Curves
How the firm’s total product, marginal product, and average
product change as the firm varies the quantity of labor
Total Product Curve for ECON Cheeseman
KEY IDEAS FOR LECTURE 4
The seller’s problem has three parts: production, costs, and
revenues
• Almost all production processes have increasing marginal
returns initially and diminishing marginal returns eventually
• When marginal product exceeds average product, average
product increases. While when marginal product is below
average product, average product decreases
• In short run, we distinguish between variable cost and fixed
cost
• Firm will choose the level of quantity at which MR=MC
Marginal Product Curve for ECON Cheeseman
• Almost all production processes have:
• Increasing marginal product initially + Diminishing
marginal product eventually
•
Increasing and Decreasing Marginal Product
•
•
•
Increasing marginal product: Specialization
Diminishing marginal product: Each additional worker
has less access to capital and less space to work in
Law of diminishing returns
• As a firm uses more of a variable input with a
given quantity of fixed inputs, the marginal
product of the variable input eventually
diminishes
Average and Marginal Product
Curves
TC=TVC+TFC
- Total fixed cost is the same at each
output level
- Total variable cost increases as
output increases
- Total cost also increases as output
increases
Marginal Product > Average Product
Average Product increases
Marginal Product < Average Product,
Average Product decreases
Marginal Product = Average Product,
Average Product is at its maximum
More Concepts of Costs
• Average fixed cost (AFC) =TFC/Q
• Average variable cost (AVC)=TVC/Q
• Average total cost (ATC)=TC/Q
• TC =TVC+TFC----------ATC =AVC+AFC
• Marginal cost: The increase in total cost that
results from a one-unit increase in total product
Short-Run Cost
MC<AVC, AVC is falling
MC >AVC, AVC is rising
MC = AVC (Minimum
AVC)
Profit and Revenue
• Profit=total revenue-total cost
• Total revenue (P☓Q)
• The amount of money the firm brings in
from the sale of its outputs
• Marginal revenue
• Change in total revenue results from a
one-unit increase in the quantity sold
Marginal Analysis and Supply Decision
•
•
•
If MR > MC: Profit increases if output increases
If MR < MC: Profit decreases if output increases
If MR = MC: Profit is maximized
• Profit decreases if output changes in either direction
PERFECT COMPETITION (PART 2)
Step 1: Profit maximising output
- Firms choose the quantity
o MR = MC = P
Step 3: Market supply curve
Step 2: MC = Supply
- Is it true for all prices?
- Only when P > min (AVC)
- When P < AVC, quantity supplied
=0
Temporary Shutdown Decision
- TR < TVC
- P < AVC
Shut Down Decision – cut off price being
minimum price = min AVC
Step 4: Short-run equilibrium
-
Total quantity supplied by all
firms at each price
- Each firm’s capital and the
number of firms remain the
same
From individual supply to market supply
- 10000 Firms
Quantity
Supplied By
Individual Firm
Total Quantity
supplied
0.5
0
0
0.79
854
8540000
1.13
1225
12250000
1.41
1500
15000000
Short run profit
- Profit = TR – TC
- (P-ATC)/Q
From Short Run to Long Run
• Profit>0, <0, or =0
• If Profit>0
• The number of firms increases
• New firms enter the industry
• If Profit<0
• The number of firms decreases
• Existing firms exit an industry
Profits and Losses in the Short Run - P =1.13, P=0.8, P=min (ATC)
FIRM ENTRY IN THE LONG RUN (FOR PRICE = 1.13)
FIRM EXIT IN THE LONG RUN (FOR PRICE = 0.8)
Summary
• Profit
• Entry
• Market supply curve shifts rightward
• Price falls
• No more incentive for entry (Eliminate the profit)
• Entry stops (long-run equilibrium)
Summary
• Loss
• Exit
• Market supply curve shifts leftward
• Price rises
• No more incentive to exit (Eliminate the loss)
• Exit stops (long-run equilibrium)
Implications of Long Run – Equilibrium
- Long run equilibrium price = min (ATC)
- Long run equilibrium profit = 0
Short Run
Long Run
Equilibrium
Price
Determined by market supply
and demand
min ATC
Profit
>,<,or =0
0
Quantity
P=MC
P=MC
WHAT HAPPENS IN THE SHORT RUN?
•
Market demand curve shifts rightward, price rises, and
each firm increases the quantity it produces
•
Profit>0=Firms enter the market
WHAT HAPPENS IN THE LONG RUN ?
Enough firms have entered, and firms make zero profit. Entry
stops
More firms and higher market quantity
MONOPOLY
-
Extreme market structure
Only one seller provides a good or service that has
no close substitutes
2 conditions
- No close substitute
o With a close substitute, the monopoly firm faces
competition from the producers of the substitute
- Barriers to entry
o Constraint that protects a firm from potential competitors
o Eg govt licence, copyright, and patent.
TWO MORE MARKET STRUCTURES (THAT LIES BETWEEN PERFECT
COMPETITION AND MONOPOLY)
IS MONOPOLY LEGAL ?
Being a dominant business is fine, but in every country has
laws or institutions to promote competition and regulate
anti-competitive activities.
Singapore – CCCS oversees anti-competitive activities.
- Merger – Uber and Grab – uber fined for this.
- Anti-competitive agreements
o CCCS case 2018, penalised 13 fresh chicken
distributors for 1) coordinated amount and
timing of price increases, 2) agreeing not to
compete for each other’s customers in the
market.
- Abuse of dominance.
o Protecting or enhancing the dominant position
is illegal
o Deter competitors from entering the market
o Drive competitors out of the market
o SISTIC Monopoly Case – largest ticketing
agency in Singapore
▪ Fined 769K
▪ Exclusive dealing: Agreement with
Esplanade
▪ All events must use SISTIC as the only
ticketing
provider
→deters
competitors
Many competing firms – Products are differentiated → MONOPOLISTIC
COMPETITION (no barriers to entry, any number of firms can enter at any
time. They do have some degree of market power because they produce
different products.
Few firms competing → OLIGARCHY.
TWO MORE MARKET STRUCTURES (THAT LIES BETWEEN PERFECT
COMPETITION AND MONOPOLY)
Many competing firms – Products are differentiated → MONOPOLISTIC
COMPETITION (no barriers to entry, any number of firms can enter at any
time. They do have some degree of market power because they produce
different products.
Few firms competing → OLIGARCHY.
CHARACTERISTICS OF MARKET STRUCTURES
The number of firms is the key to determine the market structure.
Oligopoly
An oligopoly is a market structure characterized by a small number of firms that dominate the industry. These firms hold significant
market power, allowing them to influence prices and output levels. In an oligopoly, firms are interdependent, meaning the actions of
one firm can directly impact the others. This often leads to strategic behaviour, such as price-fixing, collusion, or non-price competition
(like advertising and product differentiation). Examples of oligopolistic industries include the automotive, airline, and
telecommunications sectors. The presence of few competitors makes the market less competitive than perfect competition but more
so than a monopoly.
Can be divided into TWO CATEGORIES
DIFFERENTIATED PRODUCTS
HOMOGENEOUS PRODUCTS
o
Cereal
o Steel
o Automobiles
o Gasoline
o Laundry detergent
o Computer hard drives
o Cigarettes
Oligopolies’ Problem
2 characteristics
- Significant barriers to entry (very similar to monopoly)
- High degree of interdependence between the few firms (quite unique)
o Only few firms are operating
o Each firm’s profits and maybe the profit maximising choices really depends on other firms’ actions/ There exists a high
degree of interdependence between the few firms.
One of the easiest cases of oligopoly is an industry with two competing firms – duopoly.
DUOPOLY WITH HOMOGENEOUS PRODUCTS
OLIGOPOLY WITH DIFFERENTIATED PRODUCTS
Industry with two firms that compete against one another by
setting prices
- Betrand competition
Assumption: The firms are producing H OMOGENEOUS PRODUCTS
A more realistic industry is a set of firms that make similar but not
homogenous/different products
Boeing VS Airbus, Coke VS Pepsi, Apple VS Samsung
Three important points
- These differentiated products are substitutes.
o Consumers have incentive to substitute among those
products.
- As a result, no company will be able to capture the entire
market
- When consumers view the products as less substitutable,
economic profits will be higher.
o Consumers view the products as being somewhat
unique. This differentiation helps the seller a lot,
because the market structure is actually closer to a
monopoly. So, economic profits will be higher as well.
Apple Versus Samsung
• Innovation and Differentiation
• Quality
• Global Expansion and Localized Approach:
• Affordable Pricing
• Marketing and Promotion
• Customer Service and Support
• Partnerships and Collaborations
Example: Bottled Water
• A and B
• Total demand=1000 bottles of water
• If your price is less than B’s price, demand = 1000
• If you price is equal to B’s price, demand = 0 - 1000
• If your price is more than B’s price, demand = 0
• What does the demand curve look like?
Residual demand
It depends on the prices
charged by A and B
COLLUSION
• Firms conspiring to set the
market price
• P=$5, each company will
get half of the demand
• Profit=(5-1)500=2000
Equilibrium
Both have a MC of $1
A is charging $5
B is charging $4
Is this an equilibrium?
What should A do in response?
Then, what should B do in
response?
Where does it end?
•
•
•
P=MC=$1
Profit=0
How could A and B avoid a
price war?
PROBLEMS OF COLLUSION
• Illegal
• Strong incentive to cheat
• (4.9-1)1000=3900
• Detection and punishment
of cheaters
KEY IDEAS FOR LECTURE 5
• Firms will shut down when price is lower than minimum AVC
• Long-run equilibrium price equals min(ATC) and equilibrium
profit is zero
• Monopoly represents an extreme market structure with a
single seller
• Two market structures that lie between perfect competition
and monopoly are oligopoly and monopolistic competition
• The residual demand curve depends on the prices of all firms
in the industry
Consumer Surplus
-
-
Difference between the consumer’s willingness to pay for a product and the cost of purchasing the product.
o Willingness to pay 1 mil for a house.
o Only paid 0.8 million
o CS is then 0.2 million.
CS is the area below the demand curve and above the price. (downward sloping demand curve)
Example: Willingness to Pay for Candy.
-
$0.9 for the first candy
$0.7 for the second candy
$0.5 for the third candy
$0.1 for the fourth candy
Can we construct the demand curve for candy? Yes, we can!
Looks a bit weird. It is because candy is not divisible. So,
suppose the price of candy is 30 cents.
How can we quantity the lower satisfaction? Calculate the change
in consumer surplus. The blue shaded area represents the
decrease in consumer surplus, which is $750.
Producer Surplus
-
Difference between the amount producers actually receive by producing and selling a certain unit and the
amount producers have to receive to produce a certain unit. (price minus cost essentially)
PS is the area below the price and above the supply curve.
Example: PS in the market for houses.
3 construction firms
Each firm can only build 1 house in a year.
Firm 1 cost = 0.4 million
Firm 2 cost = 0.5 million
Firm 3 cost = 0.6 million.
Suppose the market price is 0.7 million. Then, all three firms will build a
house.
Total Surplus (CS+PS)
-
Efficient market outcome
o Total surplus is maximised.
-
Not efficient market outcome
o Total surplus is not maximised.
o Suffer from deadweight loss (net loss in total
surplus).
Price Discrimination
Price discrimination is a pricing strategy where a seller charges different prices for the same product or service
to different consumers or groups. The goal is to maximize profits by tailoring prices based on consumers'
willingness to pay. There are various forms of price discrimination, such as first -degree (individualized pricing),
second-degree (tiered pricing based on quantity or features), and third-degree (charging different prices to
different demographic groups).
Charging different prices to different consumers for the same good, 1st, 2nd, and 3rd degree.
1st degree price discrimination
- Charge each consumer at his-her willingness to pay
(hypo situation)
o Closest example would be at the auction.
Consumer surplus here is ZERO, CS=0
2nd degree price discrimination
- Quantity discount
- Buy two get 15% discount, for example.
Example of 3rd degree price discrimination
- Age
o Senior discount, student discount
- Gender
o Ladies’ night in bars and clubs
- Geographical location
o Staples charges different prices based on where
the online shoppers live (by postal code).
▪ E.g., MacDonalds in Orchard would
charge higher prices.
- Mac users vs. PC users in the future?
o Orbitz (online travel agency) recommends
pricier hotels to Mac users.
3rd degree price discrimination
- Firm offers different prices for different groups/segments
of consumers.
Progressive Tax System
A progressive tax system is a structure in which the rate of taxation increases as the taxable income of an individual rises .
In other words, higher-income earners face a higher percentage of taxation on their income, while those with lower incomes
are taxed at lower rates. The objective of a progressive tax system is to distribute the tax burden more equitably, placing a
relatively heavier burden on those with greater financial means. This approach is often designed to promote income equality
and address socioeconomic disparities within a society.
Redistribute Income to Address Fairness Issues
Average tax rate = total taxes divided by total income
- On average, for one dollar, how much you need to pay
for tax.
Marginal tax rate = the rate paid on the last dollar of income
Average and marginal tax rates are higher for households with
higher income.
- Takes higher share from higher income earning
individuals in order to decrease inequality.
-
Suppose your taxable income is $60K, which falls in the third
category.
For each dollar, 14.98 cents for tax.
Marginal tax rate – last dollar, 22%
Suppose your income has doubled to 120k.
(9875 x 0.1) + ((40125 - 9875) x 0.12) + ((85525 -40125) x 0.22) +
((120000-85525) x 0.24) = 22879.50 (total tax payable, which is
more than doubled).
Average tax rate = 19.07 %, Marginal rate, 24%
WELFARE ANALYSIS
TAX INCIDENCE
-
-
-
No government intervention
o TS = CS +PS
With government intervention (tax)
o TS = CS + PS + tax revenue collected
With government intervention (subsidy) 𝐷𝐷 ↑ 𝑆𝑆 ↓
o TS = CS + PS – subsidy payment
Who bears the burden of a tax
o How the burden of taxation is distributed.
TAX ON PRODUCERS
WITHOUT TAX,
$3 TAX ON SELLERS , CS, PS, $3 TAX PER HAT
DWL. WHAT FRACTION OF THE SUPPLY: 𝑷 = 𝟎. 𝟏𝑸𝒔 (RECALL CHANGE IN 𝟎. 𝟏𝑸𝒔 = 𝟔 − 𝟎. 𝟎𝟓𝑸𝒅,
$3 TAX IS PAID BY THE BUYERS ? Y/ CHANGE IN X ), DEMAND: 𝑷 = 𝟔 − 𝑃𝑆 = 40 𝑥 4 𝑥 0.5,
𝐶𝑆 = 2 𝑥 40 𝑥 0.5,
𝑇𝑆 = 120
𝟎. 𝟎𝟓𝑸𝒅
Price
$0
$1
$2
$3
Supply
0
10
20
30
Demand
120
100
80
60
$4
$5
$6
40
50
60
40
20
0
WITH TAX, EQ IS,
Demand
$0
$1
$2
$3
$4
$5
$6
0
10
20
30
40
50
60
120
100
80
60
40
20
0
AFTER
TAX
P CONSUMER PAY
$4 PER
$5
UNIT
PER
UNIT
P PRODUCERS
$4 PER
$2
UNIT
PER
DWL=30
GOVERNMENT
RECEIVE
UNIT
RECEIVES
Incidence on Consumers
= $1 per unit
Incidence on Producers
= $2 per unit
𝑇𝑆 = 120
Supply
TAX
𝟑 + 𝟎. 𝟏𝑸𝒔 = 𝟔 − 𝟎. 𝟎𝟓𝑸𝒅,
𝑃𝑆 = 2 𝑥 20 𝑥 0.5,
𝐶𝑆 = 1 𝑥 0.5 𝑋 20 = 10,
𝑇𝑆 = 10 + 20 + 60 (𝑡𝑎𝑥) = 90
TAX ON CONSUMERS
$3 TAX ON BUYERS , CS, PS, $3 TAX PER HAT
WITHOUT TAX,
DWL. WHAT FRACTION OF THE SUPPLY: 𝑷 = 𝟎. 𝟏𝑸𝒔 (RECALL CHANGE IN 𝟎. 𝟏𝑸𝒔 = 𝟔 − 𝟎. 𝟎𝟓𝑸𝒅,
$3 TAX IS PAID BY THE BUYERS ? Y/ CHANGE IN X), DEMAND: 𝑷 = 𝟔 − 𝑃𝑆 = 40 𝑥 4 𝑥 0.5,
𝐶𝑆 = 2 𝑥 40 𝑥 0.5,
𝟎. 𝟎𝟓𝑸𝒅
*AFFECTS DD CURVE
Price
BEFORE
WITH TAX, EQ IS,
$0 PER
$3
UNIT
PER
UNIT
BEFORE
TAX
AFTER
TAX
P CONSUMER PAY
$4 PER
$5
UNIT
PER
UNIT
P PRODUCERS
𝟎. 𝟏𝑸𝒔 = 𝟑 − 𝟎. 𝟎𝟓𝑸𝒅,
𝑃𝑆 = 2 𝑥 20 𝑥 0.5,
𝐶𝑆 = 1 𝑥 0.5 𝑋 20 = 10,
𝑇𝑆 = 10 + 20 + 60 (𝑡𝑎𝑥) = 90
$4 PER
$2
UNIT
PER
DWL=30
GOVERNMENT
Incidence on Consumers
= $1 per unit
Incidence on Producers
= $2 per unit
$0 PER
$3
UNIT
PER
RECEIVE
UNIT
RECEIVES
$10 Subsidy on Producers
WITHOUT SUBSIDY, Q = 9, P = 15
CS = A + B, PS = D + F, TS = A + B + D + F
WITH SUBSIDY. Q = 12, P = 10
CS = A + B + D + E, PS = B +C +D + F
SUBSIDY = B + D + C + E + G
TS = A + B + D + F – G
DWL = G
UNIT