Microeconomics

Perfect competition is defined by the following five conditions: Large number of producers (so that no one producer can affect price). Homogeneous products. Free entry and exit from the market. Perfect information. Perfect mobility of factors of production. All five are required for a market to be perfectly competitive.

5 Factors of Perfect Competition?

"Economics is the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses" (L. Robbins)

Definition of Economics

The intensity of advertising can be measured by the advertising / sales ratio. From high (39% for personal stereos) to very low (0.02% for petrol or flour). What explains the differences in advertising intensity between sectors? Differences in market structure. Oligopolies vs. monopolistic competition. Differences in product characteristics. Consumer durables, new products, etc.

Advertising?

Shifting the demand curve outwards. Increasing the demand for the product. Making the demand curve less elastic. Increasing brand loyalty vs. substitutes. This explains why certain types of products have low advertising /sales ratios. Petrol, flour, etc. They already have an inelastic demand.

Aims of Advertising?

Is the cost per unit of output: AC = Total Cost / Quantity = Average Fixed Cost + Average Variable Cost Example: If it costs a firm £2000 to produce 100 units of a product, the AC would be £20 for each unit (2,000/100).

Average Cost (AC)

Falls with the level of output.

Average Fixed Cost (AFC)

Average Product Labour = Total Product Labour / Labour

Average Product of Labour (APL)

Total Variable Cost per unit of output

Average Variable Cost (AVC)

Monopolistic competition integrates the idea of brands and brand loyalty into competitive markets. A product may have a multitude of features that allow product differentiation.

Brands?

The consumer has a limited income (I) to purchase goods Each type of good has a defined price (p) per unit We assume that the consumer spends all his income Savings are treated as another type of good. Example: Imagine the following "student budget" Total income is £50 The price of a meal is £10 The price of a cinema ticket is £5 The budget constraint is: I = p1 x1 + p2 x2 50 = 5 x Tickets + 10 x Meals

Budget Constraint Line?

Any bundle within the budget constraint is affordable, but not all the budget is spent (C,D). Any bundle beyond the budget constraint you cannot afford (H,G). Any bundle on the budget constraint is affordable and ensures all the budget is spent (E,F). If the person has a fall in income, the budget constraint line will decrease. If there is an increase in the price of cinema tickets, the budget constraint line will decrease. If price of meals decreases from 10-5 the budget constraint line decreases also.

Budget Constraints and Choice?

PESTLEE

Businesses are affected by which factors?

It is generally stable. Every game has at least one Nash equilibrium (in mixed strategies): The proof of this result is the main contribution of John Nash (Nash equilibrium). He received the Nobel Prize for it in 1994.

Central Properties of Game Theory?

All other things being equal. No other factors can affect the demand = not realistic.

Ceteris Paribus

Finding the choice of the consumer requires bringing in the two elements: The indifference curves, which show how agents rank the different bundles. The budget constraint, which shows which bundles are affordable, and which are not. Both of these are defined over the same "consumption space", so they can be superposed easily.

Choice

If the price decreases, the individual demands more of the good. Demand curve is sloping downward.

Demand Curve

If demand is price elastic, total revenue will rise if prices fall, because quantity demanded rises more than in proportion to fall in price. If demand is price inelastic, total revenue will fall if prices fall, because quantity demanded rises less than in proportion to fall in price. Total revenue is therefore maximized when the price elasticity is unity (i.e. -1)

Demand Elasticity?

1. Public goods. 2. Taxes (Positive and Negative Externalities). 3. Subsidies (Positive and Negative Externalities). 4. Regulation (Positive and Negative Externalities). 5. Merit goods. 6. Missing markets.

Compensate for Market Failure?

The concept of an elasticity is central to understanding consumer behaviour and business decision-making How sensitive is demand to changes in price or income ? Is this the same for all goods ?

Concept of Elasticity?

The firm must be able to set its price. There must be several types of buyers with different price elasticities of demand. The firm must be able to prevent resale of the goods (i.e. to separate markets).

Conditions required for a firm to successfully use price discrimination:

The difference between the maximum amount a consumer would have been prepared to pay for a product and what the consumer actually paid.

Consumer Surplus?

When the price of a good rises, the quantity demanded (Qd) will fall, ceteris paribus, and when the price falls the quantity demanded will rise. Underlying the demand curves is the law of diminishing marginal utility.

Demand and Supply Curves

The demand for labour depends on the marginal revenue product of labour (MRPL) which is: Marginal Physical Product (MPP) x Price of the good Labour demand curve slopes downwards because of diminishing returns to labour (i.e. declining MPP).

Demand for Labour?

Quantity of a good or service that consumers are willing to and able to buy at a given price in a given time. Effective Demand: Consumers must be willing and able to. Law of Demand: Inverse relationship between price and quantity, when price goes up-, we want less of something. When price goes down, we want more of something.

Demand?

The analysis of investment is similar to labour markets. The big difference is that the firm can buy capital outright by investment as well as hire capital (capital services). If hiring capital services, analysis is the same as for labour markets. When considering buying capital, this is an investment decision, and the firm compares: The present value of all future returns from the investment compared with the cost of investment (supply price of capital) . This is called the Present Value method of investment appraisal.

Determination of Investment?

Micro-Economic: Those factors that influence businesses at the firm level or within the market or industry the firm operates in. Macro-Economic: Those factors that influence the firm or business through their impact on the aggregate economy at the national or world level.

Difference between Micro-Economics and Macro-economic influences?

Shows that as more is consumed, the utility (satisfaction) of each extra cup decreases.

Downward Slope of Law of Diminishing Utility?

Poor information about the optimal rates. Bureaucracy and inefficiency. Shifts in government policy. Lack of market incentives. Lack of freedom of choice for the individual.

Drawbacks of Government Intervention?

We are all part of the economy (local, national, international) The world economy has been major news Imposition of trade tariffs by China and the USA "Uncertainty" Etc. Many important and current world issues have economic roots: Global warming, migration flows, trade imbalances, the rise of China as a world power, the question of development in Africa, etc.

Economic Concepts

The net benefit to the consumers of purchasing the good on the market. the net benefit to the producer of selling the good on the market.

Economic Surplus Measures?

A rise in demand (shift right) The price rises this causes an increase in the quantity supplied. A rise in supply (shift right) The price decreases this causes an increase in the quantity demanded. An increase in demand through an increase in income. An increase in supply as a result of more producers in the market.

Effects of Changes in Demand and Supply?

Another explanation of the determination of wages is efficiency wage hypothesis. The theory of efficiency wages attempts to explain why: Some wages can be higher than the market equilibrium causing 'equilibrium' unemployment.

Efficiency Wage Hypothesis?

An elasticity is a measure of responsiveness It gives the % change in one variable following a % change in another variable.

Elasticity?

When Qd = Qs, When the Supply and Demand cross.

Equilibrium?

The essence of imperfect competition is that it cannot sell any amount that it wants at the going market price. If it wants to produce and sell more, it has to reduce price (and if it raises price it loses demand). This means that MR < AR.

Essence of Imperfect Competition?

The strategy of choosing the policy which has the best possible outcome (maximising the maximal outcome) for risk loving subjects.

Examples of Other Strategies / Games: Maximax

Choosing the policy whose worst possible outcome is the least bad (maximising the minimal outcome) - for risk averse subjects.

Examples of Other Strategies / Games: Maxmin

One player chooses his action before the others choose theirs (first mover advantage). Best depicted with a decision tree showing the sequence of possible moves.

Examples of Other Strategies / Games: Sequential Games

Where a subject will make an aggressive move, only if the rival does it first (repeated game).

Examples of Other Strategies / Games: Tit for Tat

What policies can be used to remove negative externalities ? Regulation (permits, emission standards, smoking bans). Taxation problem: what is the optimal level of taxes, i.e. what is the size of the externality? Importantly, in terms of policy there is an optimal level of pollution! It is not socially desirable to reduce it to zero.

Externalities?

1 - Scarcity Resources are finite: there is a limited quantity of natural resources, a limited production capacity, and so a finite number of goods that can be produced On the other hand, human wants are potentially unlimited The overall demand for the resources available within a society cannot be met So we have prices to ration demand Prices are determined in different ways

Key Concepts: 1. Scarcity

Game theory studies strategic behaviour. The prisoner's dilemma is the "historical" game that founded game theory: The solution is sub-optimal from the point of view of the players. There is a solution that makes both players better off, but the rationality of the agents does not lead to it. The prisoner's dilemma shows how difficult it is to get agents to cooperate, even when cooperation is beneficial to all agents. Example: The prisoner's dilemma applied to a duopoly: Two firms competing in a market can: Collude and share monopoly profits (cartel). Compete as a duopoly. Profit in a cartel > profit in a duopoly . If collusion is not illegal, then it is clearly the optimal situation from the point of view of these two firms. 2 players: 2 firms (X and Y) producing the same good (e.g. Airbus/Boeing) 2 strategies: Price £2 Price £1.80 Given 2 players and 2 strategies, there are 4 possible market configurations. These are listed in the payoff matrix.

Game Theory?

Products are not perceived by consumers to be different in terms of quality, but in terms of tastes. Similar products with similar components/costs of productions. Price of different varieties often the same. Examples: Cars: Colour options of a range of cars. Clothes: Sizes/colours of clothes, shoes, etc.

Horizontal Product Differentiation

There are different ways of regulating a monopoly. The typical instrument is the price ceiling. Firms are told to reduce prices if they are making supernormal profits (i.e. rate of return on capital above the average). Firms are told to reduce barriers to entry.

How are a Monopoly regulated?

We use surplus as a measure of welfare.

How can we measure the overall inefficiency of the monopoly compared to perfect competition?

Several aspects of the imperfect competition model are relevant to business: Welfare implications of imperfect competition. Public regulation of monopolies. The ability to put in place different pricing strategies.

How is Imperfect Competition relevant to business?

Unsurprisingly, imperfect competition is inefficient compared to perfect competition: P > mC: there is a mark-up on marginal cost. Consumers with a willingness to pay above the MC will not be satisfied since the quantity produced is too low. Marginal utility > Marginal cost, so welfare could be increased by producing more. Not producing at minimum AC Excess capacity.

Imperfect Competition in regards to efficiency?

This means that there is the possibility of increasing returns to scale, which means that output rises more than in proportion to the increases in inputs, leading to decreases in the average cost of production

In the long-run all factors of production are variable?

Indifference curves represent preferences in "consumption space". They are built from the consumer's utility function over bundles of goods. A given indifference curve represents all the combinations of goods that provide the same utility to a consumer. The consumer is therefore indifferent to all these combinations. Indifference curves further from the origin correspond to higher levels of utility. Indifference curves are normally convex to the origin because of the law of diminishing marginal utility. The slope of the curve is called the marginal rate of substitution, which is the ratio of marginal utilities.

Indifference Curves

The existence of market power. The existence of barriers to entry. Lower quantity and higher price than under perfect competition.

Inefficiency under Imperfect Competition?

The second method of investment appraisal is the internal rate of return (IRR). If the IRR > i then the investment should go ahead. Supply price £2000=£1000/((1+𝑟))+£1000/(1+𝑟)^2 +£1000/(1+𝑟)^3 +£2000/(1+𝑟)^4 Solve for r If r > market interest rate (i) → investment is profitable.

Internal Rate of Return?

In economics, these resources are usually referred to as factors of production These are usually classified into: Land: usually refers to all natural resources. Its amount is assumed fixed for non-renewable in contrast with renewable Labour: the workers available to the economy. Its amount increases with population growth Capital: machinery/buildings available. Its amount increases with investment and technology Human Capital: more recent, refers to the available skills/knowledge/education/health Entrepreneurship: setting up businesses/willingness to take risks

Key Concepts: 2. Factors of Production

The scarcity problem means that demand has to be rationed and choices have to be made Microeconomics in particular focuses on understanding how choices are made

Key Concepts: 3. Choice

The overall problem for economies is to decide: what to produce how much to produce what combination of factors to use for whom to produce

Key Concepts: 4. Resource Allocation

This concept arises from having to make choices in a situation of scarcity It is the cost of giving up alternative goods when we decide to consume or produce something Example: What is the cost of a year at university ? Actual costs: fees, books, laptop, food, rent, etc. Opportunity cost: The year's worth of (minimum) wages you are forgoing whilst you are at university. For your information, that's around £10,000 !

Key Concepts: 5. Opportunity Cost

Given that: Choices have to be made There is an opportunity cost (produce or consume more of A ⇒ give up some of B) Agents are assumed to make rational choices (challenged by some behavioural economists) Agents will choose the best outcome possible. i.e. They choose the outcome with the lowest opportunity cost Example: A year at university costs at least £10,000 in lost wages But NOT going to university has a bigger opportunity cost in lost lifetime earnings!

Key Concepts: 6. Rational Choices

1. Specialisation of Production. 2. Division of labour between individuals. 3. Reaching economies of scale. (Adam Smith, 1776)

Key factors of Firms?

Like most product markets, the labour market is far from competitive because: Labour is not homogenous: variations in skill and ability. Entry / exit can be costly/complicated for both employees and employers. Imperfect information on skill/ability. Imperfect mobility of labour. 'Sticky Wages' (wages are not fully flexible).

Labour Market?

Consumers get 'bored' of always consuming the same good: the law of diminishing marginal utility. They have a preference for variety (convex preferences). For example, the marginal utility of a good like cake for example gets smaller as more cake is eaten as the satisfaction is met and therefore the satisfaction with each added quantity of the good decreases. As quantity consumed increases, the marginal utility derived from each extra unit decreases.

Law of Diminishing Marginal Utility

There are many types of imperfect competition. A monopoly is where there is only one firm in the industry with no substitutes. Imperfect competition has welfare implications for society: The ability to push prices above the marginal cost so that prices are higher, and output is lower, than under perfect competition. To practice price discrimination. Barriers to entry stifle competition and may slow technical progress.

Lecture 6 Summary?

Monopolistic competition is characterised by having many firms with differentiated products. Firms also use non-price competition to distinguish their product. Advertising is an effective tool to gain market power. In the long-run, profits competed away but welfare is lower than under perfect competition because p>MC.

Lecture 8 Summary?

The issue of low pay: It is important to identify low paid workers because low pay is a cause of poverty. Why is there a growth in low pay? Unemployment due to recession. Greater flexibility of labour market. The growth in part-time employment. A possible solution: minimum wages Effects in competitive markets. Effects in monopsonistic markets.

Low Pay and Discrimination?

The extra cost of producing one more unit. It follows directly from the law of diminishing returns. The marginal cost of labour (MCL) per unit of output is the inverse of the MPL i.e. if there are diminishing returns to labour, the marginal cost of labour will rise.

Marginal Cost (MC)

If the marginal cost is lower than the average cost, the average cost is decreasing. If the marginal cost is higher than the average cost, the average cost is increasing. If the marginal cost is equal to the average cost, the average cost does not change. If the market price is less than the average variable cost, the firm will prefer to produce nothing (shutdown condition).

Marginal Cost Curve Cuts the Average Costs Curve at its minimum point?

Marginal Product of Labour = Δ Total Product Labour / Δ Labour

Marginal Product of Labour (MPL)

The marginal utility (Carl Menger) of a good (mU ) measures the increase (or decrease) in total utility (∆U) following a unit variation in the quantity consumed (∆ q). mU = ∆U/ ∆ q Marginal utility is assumed to decrease because if it did not consumers would spend all income on the good with the highest mU. Extra utility gained when one more cup of Coca Cola is drunk. Utility = Satisfaction Average Utility = Total Utility / Quantity.

Marginal Utility?

The aggregate quantity demanded at a given price level. It is not the demand of a single individual, but that of all the agents in the economy. It can be built by adding up the individual demand curves.

Market Demand

Up until now we have made several implicit assumptions when analysing markets. For example, the welfare of agents depends only on their own consumption / production decisions. BUT Maybe people's satisfaction/welfare depends indirectly on what other people decide? How can these effects be taken into account? Private firms cannot capture all the returns: cannot exclude free-riders. Existence of positive externalities in production and consumption. 1. SC< PC 2. SB >PB Production: Education, Roads. Consumption: Vaccination. Existence of negative externalities in production and consumption. 1. SC > PC 2. SB < PB Production: Pollution. Consumption: Smoking.

Market Failure?

Market power refers to the ability of a firm (e.g. monopoly) to influence the price. How can one measure this power? In perfect competition we have p=mC. One could expect a firm with market power to try and push the price above the marginal cost so that p>mC. This divergence is known as a mark-up and can be measured (as we will see later).

Market Power?

Products are targeted to specific segments of a given market. Products can be horizontally/vertically differentiated within that segment. The aim is often to capture the niche in the market, i.e. a specific target population. Examples: Cars: Family cars, sports cars, 4x4, etc. Clothes: Sports wear, formal wear, casual, urban, etc. Location.

Market Segmentation?

Product: quality, reliability, branding and packaging. Pricing: price discrimination, discounts, price of competitors. Place: distribution network, location of retail outlets, warehouse facilities, transportation issues. Promotion: amount and type of advertising, selling techniques, other gimmicks.

Marketing Mix?

Merit goods are those which the government expects that people will under-consume and which therefore ought to be subsidised or provided free. Examples: education museums vaccinations.

Merit Goods?

Has a few number of firms. Has restricted barriers to entry. Nature of product is undifferentiated or differentiates. Examples are cement, cars or electrical appliances. Demand curve is kinked as it depends on rivals reactions.

Oligopoly

Microeconomics analyses the decisions taken by individual economic agents in individual markets: product market; factor market. Agents are consumers, producers and the government.

Microeconomics?

Missing markets is the lack of existence of markets. Examples: Defence. Street lighting, where demand exists, but supply is absent. Insurance for crop failure in poor countries.

Missing Market?

Has many/ several number of firms. Entry to barriers are unrestricted. Nature of products are differentiated. Examples are plumbers, restaurants. Demand curve is downward sloping, relatively elastic, some control over price.

Monopolistic Competition

Because each firm produces a slightly different good, consumers can have preferences over these different varieties. There will be an element of "brand loyalty" in consumer behaviour, where one variety of a good will be preferred over another one. Differentiation by 'space' (geography) Examples: hotels, restaurants, hair dressers, travel agents, newsagents, etc. Each firm has a small amount of market power. Because of "brand loyalty", it can increase its price a bit without losing all its customers. The price elasticity of demand is not infinite. The demand curve facing the firm is downward-sloping (not flat as in perfect competition). There will be a mark-up: Price is above mC. As firms can enter the market freely, economic profits are equal to zero in the long-run. At the firm level, the short-run equilibrium diagram is distinctive to imperfect competition. Short-run profits. The adjustment to the long-run behaves like perfect competition: Extra firms enter the market, attracted by the profits (entry is free). The demand facing each firm decreases until profits are competed away BUT price > MC.

Monopolistic Competition in Detail?

Has a single producer without substitutes. Has restricted or completely blocked entry and exit barriers. Nature of products are unique. Examples are local water companies. Demand curve is downward sloping, inelastic, considerable control over price (market demand curve is the same as the firm's demand curve).

Monopoly

Monopoly.

Most imperfect form of competition?

The position resulting from everyone making their optimal decision based on their assumptions about their rivals' decisions.

Nash Equilibrium?

Net Present Value (NPV) of an investment refers to the discounted benefits of an investment minus the cost of the investment.

Net Present Value?

Technical standards: technical specifications of the product. Quality standards: quality of components, of manufacturing process. Design standards: Design, colour, etc. Service characteristics: Products are often sold packaged with a service.

Non-Price Competition Features?

Oligopoly means competition amongst the few. A common situation in many industries: Car industry, aeronautical industry Agribusiness (Nestlé, Kraft foods, DelMonte Foods) Electronics, computing. Compared to the monopoly case, each firm has an extra element to consider: the behaviour of its competitors . As one firm's output influences market prices, competitors will react . This will lead to strategic behaviour. A simple solution for determining the market price and quantity is possible if the firms decide to cooperate or collude. This cooperative equilibrium is called a cartel. OPEC was a good example: an organisation of independent producers, producing the same good, who decide to coordinate their production. When firms do this (i.e. maximise collective profit), they practice monopoly pricing and get monopoly profits. This practice is illegal in most countries! Also, there is an incentive to cheat. Often, firms will not cooperate, and a more complex model is needed. When firms in an oligopoly do not cooperate, there is a non-cooperative equilibrium Compared to the monopoly and the cooperative cartel case, it becomes difficult to characterise the market equilibrium (price and quantity). If a firm changes its output, this changes the market price, and the profits of competitors. They will react to this change in profits by changing their output (price). Simple assumptions about the reaction of competitors can give a basic model for explaining oligopolistic behaviour: the kinked demand curve model.

Oligopoly in Detail?

The best option is the one on the budget constraint line where its crosses with the indifference curve. The optimal bundle is on the tangency between the budget constraint and the indifference curve. At this point the ratio of prices is equal to the marginal rate of substitution between the two goods or the ratio of marginal utilities. This means that the optimal bundle is on the highest indifference curve achievable The one that gives the most satisfaction.

Optimal Bundle

Agents are free to enter and exit markets in response to changing market conditions. There are no barriers to entry or exit: no costs involved, no new information required.

Perfect Competition: Free Entry and Exit from the Market?

The good is exactly the same regardless of who produces it. Consumers cannot tell which firm produced a specific item: Example: a bag of popcorn. Consumers have no preferences with respect to producers. There are no brands: No "Brand Loyalty"!

Perfect Competition: Homogenous Products?

There are many producers and consumers. None is large enough to individually influence the market outcome (either price or quantity). All agents in the market (firms and consumers) are price takers (as opposed to monopoly where firms can set prices).

Perfect Competition: Large Number of Agents?

Agents are constantly informed of the changing market conditions. Agents also know all the characteristics of the goods.

Perfect Competition: Perfect Information?

Inputs to production can change markets freely. Labour allocated to a given production can costlessly switch to any other production. The same applies to capital. This is a corollary of free entry and exit from the market.

Perfect Competition: Perfect Mobility of Factors of Production?

£1,000 today is not worth £1,000 next year because it could have been invested in the present and yielded a return. The present value (PV) approach: 𝑃𝑉= ∑_1^𝑛▒𝑋_𝑡/((〖1+𝑖)〗^𝑡 ) Where: PV is the present value of investment. Xt is the earnings from the investment in year t (t=1...n; where n is the life of the investment). i is the market rate of interest (expressed as a decimal: i.e. 10% = 0.1). ∑ is the sum of the years' discounted earnings. Example: Buy a machine that will produce revenue of £1000 each year for four years and then wear out and sell for £1000 as scrap. Is the investment worthwhile? PV = £1000/1.1+£1000/(1.1)^2 +£1000/(1.1)^3 +£2000/(1.1)^4 =£909 + £826 + £751 +£1,366 = £3,852 If the machine cost less than £3,852 it is worth buying it.

Present Value?

A firm with market power can also use price discrimination. This is when the same good is sold to different customers at different prices.

Price Discrimination?

The price elasticity of demand: 𝜀_𝑝^𝐷= (% (∆𝑄_𝑑))/(% (∆𝑝)) In general it is negative An increase in price reduces the quantity demanded. Demand is price-elastic if the price elasticity is greater than 1 in absolute value (magnitude) 10 % increase in price ⇒ >10% fall in demand. Demand is price-inelastic if the price elasticity is smaller than 1 in absolute value (magnitude) 10 % increase in price ⇒ <10% fall in demand.

Price Elasticity of Demand?

The fact that a firm possesses market power means that it is a price-setter.

Price-Setter?

Specialisation means information about production is asymmetric. The inherent difficulties involved in motivating one party (the agent) to act in the best interests of another party (the principal) rather than in their own interest. The assumption is that the agent has more knowledge than the principal about the effort action being carried (division of labour) The agent can use this to reduce his effort (self interest) without the principal noticing. Example: Managing a firm The principals are the shareholders of a firm, who invest through their shares They hire an agent: the CEO to run the firm for the shareholders' benefit BUT there is a large information asymmetry! To ensure agents are doing their job properly, shareholders (principal) can use: Monitoring of the CEO: Principals can hire audit cabinets to certify accounts (they have to by law) Motivate the CEO: bonuses and stock options But there are two possible problems The CEO can simply rent-seek, i.e. run the company in a way that simply 'ticks the boxes' The hiring of audit cabinets is in itself an agency problem.

Principal-Agent Problem

The difference between the minimum price required for a firm to supply a good and the price that is actually paid.

Producer Surplus?

The production function is the relation between factors of production as inputs and the amount of output produced for a given technology: Inputs: land, labour, capital, entrepreneurship, etc. Let us assume that there is a single factor of production, labour, holding other factors of production constant. A firm using labour to produce paper clips with a fixed amount of other factors of production

Production Function?

It is assumed that firms try to maximise profit. The profit of a firm is given by: Profit = Total Revenue - Total Cost Firms try to generate as much revenue as possible. The quantity that maximises profits will not necessarily be the same as the one that maximises revenue!

Profit Motive?

Profit = TOTAL REVENUE - TOTAL COST The profit maximisation condition finds output q where: mR = mC This is valid for any firm, with or without market power.

Profit of the Firm?

For public goods, the coordination of agents cannot happen in the market. Everybody is a consumer of the good whether they want it or not. A supplier of the public good cannot exclude people who refuse to pay for the good (free riders). This supplier has no way of recuperating his costs. There is a market failure in public goods: they will not be provided in a free market.

Public Goods?

Regulation: the government or some independent agency regulates the behaviour of firms that may have large degrees of monopoly power or may create negative externalities. Examples: Pollution permits (carbon trading schemes). The Office for Gas and Electricity markets (Ofgem).

Regulation?

APL is maximised when it is equal to mPL. If mPL>APL , then the average product must be increasing. If mPL<APL , then the average product must be decreasing.

Relation between the average and marginal products?

Economics allows us to understand the factors which influence a firm in their decision-making process This can be broken down into three areas: Internal decision-making in the firm External effects of business decisions External influences on the firm

Role of Economics in Business

Slope (gradient) of the demand curve indicates the elasticity (responsiveness of quantity demanded to change in price).

Shape of the Demand Curve

It is called the marginal rate of substitution, which is the ratio of marginal utilities.

Slope of Indifference Curve?

There are two main inputs into production: labour and capital. In orthodox neoclassical theory, wages are determined in the labour market, where the supply equals the demand for labour. Monopsony arises when a firm or group of firms is the main employer of one type of labour. A statutory minimum wage is one way of addressing the problem of low pay. Firms apply various methods to decide which type of capital they will invest in and whether their investment is worth doing.

Summary of Lecture 10?

There are economic arguments for State intervention in the functioning of markets for the maximisation of social welfare to compensate for market failure. Types of market failure: Public goods, positive and negative externalities in both consumption and production, merit goods, missing markets. Different methods of government intervention: Taxes - subsidies - regulation frameworks. According to the Coase Theorem there are co-operative solutions.

Summary of Lecture 11?

In a free market prices are determined by the interaction of demand and supply. Demand depends mainly on price and income. Supply depends on costs and number of producers. The slope of the demand curve measures the price elasticity of demand which affects the total revenue of a firm.

Summary of Lecture 4

Perfect competition is the benchmark against which other market structures are judged e.g. monopolies, oligopolies. Under perfect competition resources are allocated efficiently because P = mU = mC. This is what is meant by economic efficiency. The market gets back to equilibrium after a disturbance through the free entry and exit of firms. The concepts of consumer and producer surplus are important for understanding welfare.

Summary of Lecture 5?

Oligopoly is a common market structure. The kinked demand curve is a distinctive characteristic of oligopolies -leading to sticky prices. Game theory provides an insight into the strategic behaviour of firms. Firms always take into consideration what competitors are doing to make strategic decisions.

Summary of Lecture 9?

Utility can be used as a measure of consumer satisfaction. Marginal utility diminishes as consumption increases. Consumers will choose the affordable bundle that brings them the highest satisfaction. Observing consumer choices when changing prices allows us to build demand curves. The relevance of this is that producers need to know how consumers will respond to price changes. They do surveys to estimate demand curves.

Summary of Utility Lecture

The market price of the good. The price of inputs. Technology. Through the production function. N˚ of producers in the market. Expectations.

Supply depends on:

The supply of labour. The supply of labour (hours) by an individual worker. There should be an increase in the wage to offset increasing marginal disutility of work. Upward sloping supply curve. Profit - maximising firms will hire labour up to the point where wage = MRPL. In a free market, the hourly wage will equal wm.

Supply of Labour?

The quantity of a good or service that suppliers are willing and able to supply at a given price at a given time period. When the price of a good rises, the quantity supplied (Qs) will also rise, ceteris paribus Law of Supply: When price is higher/ up, suppliers are more willing to supply. When price is lower, quantity supply goes down.

Supply?

Taxes and subsidies are useful (C. Pigou) to correct for externalities. Advantages of taxes and subsidies: The rate can vary according to the size of the market distortion . Disadvantages of taxes and subsidies: Subsidies have to be paid for. They introduce distortions themselves. Lack of precise knowledge.

Taxes?

1. A plan 2. A ploy (idea, trick) 3. A pattern of behaviour 4. A position with respect to others 5. A perspective.

The 5 'Ps' of Strategy?

Named after Ronald Coase (Nobel Prize for Economics in1991) No state intervention is required to correct externalities if: There are defined property rights. There are no transaction costs between agents. In this ideal case, all the state has to do is define property rights, and the market will internalise the externality. In real life, however, transaction costs exist. Asymmetric/imperfect information about the externality. Proving the existence of an externality can take a lot of time and effort. Asymmetric relations between agents. Imagine a pollution litigation between a big chemical consortium and a local association. What is the likelihood of the association making its case with no external help? In that case, a 2nd role appears for the State: reduce transactions costs between agents. Encourage the creation of consumers' rights associations (increase coordination between agents). Create environmental watchdogs with a monitoring mission (reduces the information asymmetries). Reinforce legal / mediation /dispute resolution institutions (reduces the transaction costs). This decentralised approach to reducing externalities is becoming increasingly popular: In theory it is cheaper: taxes on pollution do provide an income, but monitoring costs are usually higher. In theory it is also more efficient: the state doesn't need to figure out what the size of the externality is, which is a problem with taxation or regulation.

The Coase Theorem?

Measures the variation of the quantity demanded following an increase in income of agents Positive for normal goods An increase in income increases the quantity demanded. Greater than one for luxury goods. An increase in income increases the quantity demanded more than proportionately. Negative for inferior goods An increase in income reduces the quantity demanded.

The Income Elasticity of Demand?

Measures the variation of the quantity demanded following an increase in the price of another good. Example : what is the effect of the increase in the price of petrol on the demand for 4x4's in % change? This gives information on whether the goods are substitutes or complements. The cross price elasticity of demand Is negative for complement goods Example : ↑ price of fuel ⇒ ↓ demand for 4x4's Is positive for substitute goods Example : ↑ price of iPhones⇒ ↑ demand for Samsung. The magnitude of the elasticity gives information on the strength of the link between goods A large magnitude (>1) means a strong complement / substitute link A small magnitude (<1) means a weak link A magnitude close to 0 means no link

The cross price elasticity of demand?

The market price of the good. The income of consumers. The preferences of consumers. The number of potential consumers. The price of other goods: Substitutes or complements. Expectations: Future incomes, prices, etc.

The position and slope of the demand curve depends on?

The price mechanism in a free market: In the case of a shortage: the price rises In the case of excess supply: the price falls

The price mechanism in a free market:

The sum of the total fixed costs and the total variable costs: TC = TFC + TVC

Total Cost (TC)

The costs that the firm incurs regardless of the level of production.

Total Fixed Costs (TFC)

Is the total output produced by a given number of workers.

Total Product of Labour (TPL)

There is a link between the price elasticity of demand and how changes in price affect the total revenue of a firm. Total Revenue = Price x Quantity The elasticity provides information on: How sales will react to changes in price. The point where revenue from sales is maximum.

Total Revenue

TOTAL UTILITY = QUANTITY X AVERAGE UTILITY Total utility is maximised when marginal utility = 0.

Total Utility Equation

Total utility increases but at a slower rate as more of the good is consumed. If consumer is paying more than the marginal utility, then it doesn't make sense to consume that unit at all. They will keep consuming as long as utility derived is more than the price paid for the good. mU = Price Marginal Utility = Marginal Price Benefit = Demand Curve When price increases, quantity decreases, when price decreases, the quantity increases.

Total Utility?

Any other production costs - the largest is labour, they increased with the level of production.

Total Variable Costs (TVC)

Static economies of scale: Specialisation and division of labour. Greater efficiency of large machines. Indivisibilities. Organisational and administrative economies. Financial economies

Two Types of Increasing Returns: 1. Static Economies of Scale.

Dynamic economies of scale: Output increases lead to capital accumulation. Capital accumulation embodies technical progress. Learning by doing.

Two Types of Increasing Returns: 2. Dynamic Economies of Scale.

The change in the price of the good Own price elasticity of demand The change in the price of other goods Cross price elasticity of demand. The change in the income of the agent Income elasticity of demand.

Types of Elasticities

First degree: Each customer is charged exactly his willingness to pay. Example: Stall holders in a bazaar, car dealers, lawyers, architects, accountants.

Types of Price Discrimination: First Degree

Second degree: Prices depend directly on the quantity purchased by customers (very common in real life). Examples: Three for two offers.

Types of Price Discrimination: Second Degree

Third degree: Customers are grouped into separate markets with different prices according to the elasticity of demand. Examples: traditional airlines, cinemas, banks.

Types of Price Discrimination: Third Degree

Starting from 0, a firm will increase its output until an increase in output no longer increases profits. or mR = mC Profits are maximum when the revenue of selling an extra unit just covers the extra cost of producing that unit. In perfect competition mR = price = mC.

Until what point does a firm increase its output?

Historically, utility as a measure of satisfaction is grounded in utilitarianism The utility function assigns a value to the level of satisfaction associated with the consumption of a basket of goods Examples: Tea and biscuits; cinema tickets and meals.

Utility?

Products are perceived by consumers to be different in terms of quality. Superior/inferior quality of components. Differences in the costs of production. Essential for positioning in terms of price. Examples: Cars: Standard vs. luxury cars. Clothes: Supermarket range vs. designer label.

Vertical Product Differentiation?

What if there is market power? i.e. a small number of firms buying labour. This is known as a monopsony. Similar to the monopoly in terms of market power and welfare. The buyer's market power pushes the wage below the marginal cost of labour (mCL).

Wages under Monopsony?

Zero profits doesn't mean no profit. It means the firm makes enough just to stay in business and not to do something else. Resources are allocated efficiently and welfare is maximised because p = mR = mC, which means that marginal cost of production equals marginal utility of production. This is the condition for an optimal allocation of resources. This is what is called in microeconomics economic efficiency.

What are zero profits?

If one of these conditions fails to hold, then we have imperfect competition. This set of conditions is never met in reality! We have markets with few firms, distinct brands, products are not homogenous, information is never perfect, and mobility between markets is often a problem. But the concept of perfect competition is important as a benchmark for assessing the different kinds of imperfect competition.

What happens if Perfect Competition is not met?

Surplus is maximised under perfect competition. It serves as the benchmark for models of competition. Surplus is key to measuring welfare. It is an important policy tool for understanding why certain market structures need to be regulated or deregulated. Surplus is also important for understanding how interventions into the market such as price ceilings/floors and taxes influence the welfare of consumers and producers.

What is Surplus?

If firms have to reduce price to sell more, or lose sales if they increase price, the marginal revenue (mR) < price -in contrast to perfect competition.

What is mR (Marginal Revenue) equal to when a firm has market power?

The Monopolistic competition model can help here! Shifting the curve outwards. Making the curve steeper.

What is the effect of advertising on the demand curve ?

Subsidies for merit goods: free school meals; vaccination; prescriptions. Intellectual property rights (IPR). Praise/Compliment (Blood donations).

What policies can be used to promote Positive Externalities?

To save transaction costs Coordinating production A smaller number of contracts Within a firm, allocation of resources and coordination of production: Is not done via market interaction of supply and demand It relies on management issuing orders and workers carrying them out

Why are there firms

This is why competition policy often regulates existing market structures with few producers and attempts to prevent the emergence of new ones. In the UK, it is the Competition and Markets Authority.

Why does Competition Policy / Regulation exist?

Worker health argument (only really valid for low wages): a higher wage increases the ability to work productively (calories needed, etc.) Motivation argument: workers feel rewarded, and more motivated. Opportunity cost argument: workers will not want to lose the job, and hence shirk less. Smaller turnover of workers (replacing workers is costly). Signal to market argument: Paying higher wages allows the producer to attract the more productive workers.

Why would wages above market equilibrium benefit firms?