Economics ss4

Lecturer:

ECONOMICSIntroduction to Economics

Linh TranFebruary 2011

1

2

What is Economics? Why do we need to study this?

What are the links between Economics & other subjects?

What topics will we learn for CFA L1? Schedule?

Introduction: Overview of Economics

3

CONTENT OF LEVEL 1


4

LINKS BETWEEN ECONOMICS AND OTHER SUBJECTS


5

SCHEDULE


Saturday 28‐Jan Saturday 4‐FebSS4 Introduction to Microeconomics LOS16 The Firm and Market StructuresLOS13

LOS14 SS5 Introduction to MacroeconomicsLOS17

LOS15 Demand & Supply Analysis: The Firm

Saturday 11‐Feb Saturday 18‐FebLOS18 Understanding Business Cycles SS6 Economics in a Global Context

LOS20 International Trade & Capital Flows

LOS19 Monetary & Fiscal Policy LOS21 Currency Exchange RatesRevision

Break Break

PM

Demand & Supply Economics: Introduction

Demand & Supply Economics: Consumer Demand Aggregate Output, Price and Economic

GrowthPM

Week 3 Week 4

AM

Week 1 Week 2

AM

Break Break

Lecturer:

ECONOMICSSS4: Microeconomics Analysis

LOS13: Demand & Supply Analysis: Introduction

Linh TranJanuary 2012

7

OVERVIEW THE PURPOSE OF MICROECONOMICS

Overview of Microeconomics

8

MIND MAP

Reading 13: Demand & Supply Analysis: Introduction

9

TYPES OF MARKETS


Sell labor services, land, entrepreneurial risk-taking ability

Save money => capital to “sell” to firms (i.e. lend/invest)

Factor Market Goods Market• For factors of production: land, labor,

physical capital, materials,

intermediate goods

• For finished goods & services

Capital Market• For long-term financial capital

(equity, bond)

FIRMS HOUSEHOLDSSell finished goods & services

Raise funds (debt/equity) to invest in productive assets

10

DEMAND FUNCTION


• Demand: the willingness & ability of consumers to purchase a given

amount of a good/service at given values of variables

Example:

Exercise: Interpret the sign & magnitude for each coefficient:

Own-price (Px)

Income (I)

Price of other goods (Py)

• Demand Function: represents buyers behavior

Variables/Factors influenced: ________________________________

11

DEMAND CURVE


e.g.WhenI=50,Py =20

• Holding other factors constant (ceteris paribus)

• Inverse demand function:Price as a function of quantity demanded

Demand Curve: shows both the HIGHEST PRICE willing to pay for each

quantity, or the HIGHEST QUANTITY willing to purchase at each price

“Law of Demand”

Curve is downward sloping

i.e.

Source: CFA Curriculum 2012

e.g.10

3

12

SHIFTS & MOVEMENTS ALONG THE DEMAND CURVE



Qx

Px

e.g.11.2

28

10

38

8 Qx

Px

28

11.2

• Other factors change (e.g. Income, Price of other goods…)

11.8

29.5

Movement Along the Curve Shift of the Curve

Change in quantity demandedas price changes

Change in demand as other variables change

• Slope does not change

13

SUPPLY FUNCTION


• Supply: the willingness & ability of firms to sell a good/service at

given values of variables

Exercise: Interpret the sign & magnitude for each coefficient:

o Own-price (Px)

o Wage (W)

• Supply Function: represents sellers behavior

Variables/Factors influenced: _________________________________Output price, costs of input, technology level

Example:

14

SUPPLY CURVE



• Inverse supply function:Price as a function of quantity supplied

Supply Curve: shows both the HIGHEST PRICE willingly accepted for each

quantity, or the HIGHEST QUANTITY willingly supplied at each price

e.g. Wage = 15, then

Curve is upward sloping i.e.

“Law of Supply”


500

3

15

SHIFTS & MOVEMENTS ALONG THE SUPPLY CURVE



Qx

Px

1

‐250 500

3

4

750 Qx

Px

1

‐250

• Other factors change (e.g. Wage, Price of other goods…)

Movement Along the Curve Shift of the CurveChanges in quantity supplied as price changes

Changes in supply as other variables change

e.g. e.g.

11.8

1.1

‐275 475

3.1

• Slope does not change

16

AGGREGATING THE DEMAND & SUPPLY FUNCTIONS


• Aggregating rule: Sum up Demand/Supply Functions of each

individual/firm

=> Sum horizontally (quantity), not vertically (price)

Example: 1000 identical buyers, each has demand function:

Derive the market aggregate demand function?

Derive the inverse market demand function, hold I = 50, Py = 20

Determine the slope of the market demand curve

17

AGGREGATING THE DEMAND & SUPPLY FUNCTIONS


Graphic Illustration

Qx

Px

11.2

28

8

8 Qx

Px

11.2

28

8

8

2 identical buyers

e.g.

24 33.6

e.g.

• Sum up horizontally (quantity), not vertically (price)

• Market curve is less steep than individual curve

MARKET EQUILIBRIUM & MECHANISM

18


• Equilibrium: Is where Supply meets Demand

Question: Find equilibrium point?

o Solve for Px, Qx such that:

o Pe = ________, Qe = _________

• Mechanism to move towards equilibrium:

o If P < Pe: Demand exceeds supply => increase P

o If P > Pe: Supply exceeds demand => reduce P

Qx

Px

sx

dx QQ

Demand: curve:

Supply curve:

dxx 2.5Q28P sxx .004Q01P

Excess supply

Excess demand1

‐250

S

11.2

28

D

• Exercise: Market Mechanism: Excess Demand/Supply

In the local market for e-books, the aggregate demand & supply are given by:

1. Determine the amount of excess demand or supply if price = $12

2. Determine the amount of excess demand or supply if price = $18

19


xsx

xdx

P003116,1Q

P0043606,Q

20

STABILITY OF EQUILIBRIUM


• Stable Equilibrium: o Market can automatically return to

equilibrium after shocks

o Normal condition

• Unstable Equilibrium: o Once pushed away, market will not

return to its old equilibrium

o Bubble condition

Excess supply or

demand?

Price or ?

Excess supply or demand?

Price or ?

Source: CFA Curriculum 2012Source: CFA Curriculum 2012

21

STABILITY OF EQUILIBRIUM: MULTIBLE EQUILIBRIA


• Non-linear supply curve

o Example: Labor supply

• 2 equilibria points:

o Stable: Where Demand

intersects Supply from above

o Unstable: Where Supply

intersects Demand from above


22

AUCTION

• One of the most traditional methods to determine equilibrium price

• Types

o Common Value Auction

Auctioned item has an actual value that is the same for every bidders

Bidders have to estimate that true value.

Example: oil lease contract

o Private Value Auction

Each bidder have a subjective value of the item that is unique

Example: unique price of art


23

AUCTION MECHANISMS

• Ascending price (or English) auction:

o Begin at low price & raise it incrementally

o Open outcry => can learn about the true value by observing other bids

• First price sealed bid auction

o Submit bidding price in envelop => Cannot observe bid

o Tend to submit conservative bid to avoid Winner’s curse

• Second price sealed bid (or Vickery) auction

o To induce bidders to reveal their reservation prices

o Winner pays the price equal to the second-highest bid

o If bidding increments are small => Same result as English auction


24

AUCTION MECHANISMS

• Descending price (or Dutch) auction:

o Start with a very high price => lower until there is a willing buyer

o Demand curve is negative-slope

o Multiple-unit format:

Quoted price is per-unit

Transactions could occurs at different prices for different buyer

o Modified Dutch Auctions: common practice in securities markets

Establish a single price for all purchasers which clears the market

Example: Auction of U.S. T-bill


25

• Example: Auction of U.S. Treasury bill

Auction of $90 billion T-bill with both competitive & non-competitive

Non-competitive bids: willing to purchase at whatever the price

What is the winning price?

Bidders at that price will have their orders partially filled. How much is filled?


$99.9095

(30%)


26

CONSUMER SURPLUS = VALUE – EXPENDITURE


Is the difference between the amount a consumer is willing to pay (Value)

and the amount he must pay for it (Price)

Demand curve is also marginal value curve

Source: Schweser 2012

27

PRODUCER SURPLUS = REVENUE – VARIABLE COST


Is the excess of market price (Price) over the variable cost of

production (Cost)Supply curve is also marginal cost curve

PSCS TS


28

• Example: Calculating Consumer & Producer Surplus

o A market demand function is given by the equation:

Determine the value of consumer surplus if price = $65.

o A market supply function is given by the equation:

Determine the value of producer surplus if price = $65.

o Calculate total surplus at price = $65


2P180Q d

P15-Qs


29

UNDER/OVERPRODUCTION & DEADWEIGHT LOSS


Inefficient resource allocation occurs when the sum of producer & consumer surplus is not maximized => Create deadweight loss(decrease in total surplus) to the society

UnderproductionTo the Left of the equilibrium

OverproductionTo the Right of the equilibrium

Source: Schweser 2012 Source: Schweser 2012

30

CAUSES OF DEMAND/SUPPLY IMBALANCE

• Imposition by governments: as quantity consumed/produced is not

the efficient quantity that maximizes total benefit => deadweight loss

o Price regulation (price floors/ceilings)

o Taxes, subsidies & quotas

• Free markets do not lead to maximization of total surplus:

o Public goods

o External costs

o External benefits

o Public goods & common resources => “free-rider” problem


31

GOVERNMENT REGULATION & INTERVENTION

• Why intervene?

o To correct for negative/positive externalities: market does not reflect the true

social benefit/costs (e.g. public goods)

o Social consideration: child labor law, human-trafficking

• Means:

o Price regulation: Price ceiling & price floor

o Per-unit tax: On Consumers (Excise tax) & On Producers

o Other means:

Volume control: Tariffs on imported goods, quotas on import/exports

Trade banning


32

MARKET INTERFERENCE: PRICE FLOOR


Long-run Effects

-Excess supply

-Substitution away

from the price-

controlled goods

Example: Minimum Wage in the Labor Market:

2. Producers substitute Labor for Capital

1. Excess Supply of Labor -> Unemployment

3. Non-monetary benefits, working conditions, on-the-job training


33

• Example: Price floor

A market has demand & supply function

o Qd = 180 – 2P Qs = -15 + P

Calculate the amount of deadweight loss that would result from a price floor

imposed at a level of 72

Solution:

- Solve for equilibrium price & quantity

- Draw the demand & supply curve

- Find the quantity demanded at price floor 72: QF

- Find the price that would lead to supplier supply at QF

- Calculate deadweight loss (area of shaded triangle)


Q

P

15

‐15

S

130

90

D

72

51

65

5036

34

MARKET INTERFERENCE: PRICE CEILING


Long run Impacts

- Long waiting time to

purchase (Opportunity

cost)

- Sellers discriminate

- Sellers take bribe

- Sellers reduce quantity

Example: Rent ceilings in the Housing Market

a

Price ceiling transfer surplus (area a) from

sellers to buyers, but create deadweight loss

to society


35

MARKET INTERFERENCE: TAX


Tax Imposition: Tax Incidence: Statutory vs. Actual Incidence

Conclusion: Actual incidence is Independent on Who would pay

Equilibrium Price Equilibrium Quantity

OR ? OR ?

E

QE

PE

Price

Quantity

DSTax

Stax

Ptax

Qtax

PS

Revenue from buyers

Revenue from sellers

DWL

Tax on producers

E

QE

PE

Price

Quantity

DS

Tax

DtaxPtax

Qtax

PS

Tax on consumers

DWL

Revenue from buyers

Revenue from sellers

36

• Exercise: Calculate Effect of per-unit tax on SellersMarket demand curve:

Market supply curve:

Where price is measured in $ per unit. A tax of $2 per unit is imposed on sellers.

1. Calculate the effect on the price paid by buyers & price received by sellers

2. Demonstrate that the effect would be unchanged if the tax has been imposed on the

buyers instead of sellers.

Hint:

1. Calculate pre-tax equilibrium price & quantity

2. Find the inverted supply & demand functions

3. Find the new equilibrium price & quantity

4. Find the tax burden bear by each party in each case & compare


2P180Q d

P15-Qs

37

TAX AND ELASTICITY OF SUPPLY & DEMAND


• Supply Curve is more

steep => Sellers bear a

higher burden

• Demand Curve is more

steep => Buyers bear a

higher burden


38

SUBSIDIES LEADS TO OVERPRODUCTION


• Subsidy is payment made

by governments to

producers (farmers)

• With Subsidy:

o Equilibrium price

o Supply Curve shifts

o Quantity


39

QUOTAS LEADS TO UNDERPRODUCTION


• Quota is an upper limit imposed

on the quantity of a good that

may be produced over a specific

period by the governments

• With Quota:

o Supply Curve shifts

o Quantity

o Equilibrium price


40

ELASTICITY: PRICE ELASTICITY OF DEMAND (PED)


• As the price of a normal good increases, quantity demanded

decreases (PED < 0)

o Elastic demand: % increase in price leads to a larger % decrease

in quantity demanded

o Inelastic demand: % increase in price leads to a smaller %

decrease in quantity demanded

41

PED GRAPHICAL ILLUSTRATIONS



42

ELASTICITY & REVENUE


(A): Elasticity = …=> Elastic/Inelastic?

(B): Elasticity = …

(C): Elasticity = …=> Elastic/Inelastic?

2. Price elasticity changes along the curve

Q: At which point is total revenue (P x Q) is maximized?

A: At point B, where elasticity = -1

1.

Tota

l exp

endi

ture

Quantity

Reminder: Formula for PED x

x

x

x

QP

ΔPΔQ

43

FACTORS THAT INFLUENCE PED

• Availability and closeness of Substitutes

o Example?

• Proportion of income spent on the item

o Example?

• Time since the previous price change

o Example?

o LR demand is much more elastic than SR demand => more time to adjust

• Necessity of the goods:

o If goods is discretionary => less likely to reduce demand when price increases => less

elastic (example: staples


44

INCOME ELASTICITY OF DEMAND (YED)


• Shows the sensitivity of quantity demanded in relation to changes in

income

• Elasticity > 0 : Normal goods: Income Demand

o Necessity: 0 < YED <1 e.g.

o Luxury: 1 < YED e.g.

• Elasticity < 0 : Inferior goods: Income Demand

e.g.

45

CROSS PRICE ELASTICITY OF DEMAND (XED)


• Shows the relationship between demand of good X in relation to price

of another good Y

• XED > 0 : Goods are substitutese.g.

• XED < 0: Goods are complementse.g.

46

• Exercise: Calculating PED, YED & XED

An individual consumer’s monthly demand for downloadable e-book is given by the

equation , where equals the number of e-

books demanded each month, I is the household monthly income, Peb is the price of e-

books and Phb is the price of hardbound books. Assume that price of e-book is $10.68,

household income is $2,300, and the price of hardbound books is $21.40.

1. Determine the value of own-price elasticity of demand for e-books.

2. Determine the income elasticity of demand for e-books.

3. Determine the cross-price elasticity of demand for e-books with respect to the price

of hardbound books.


hbebdeb 0.15P0.0005IP4.02Q d

ebQ

Lecturer:

ECONOMICSSS4: Microeconomic Analysis

Reading 14: Demand & Supply Analysis: Consumer Demand

Linh TranJanuary 2011

48

MIND MAP


49

CONSUMER CHOICE THEORY

• Two building blocks:

o Consumer preferences: What consumer would like to consume between

two goods/basket of goods?

Develop Indifference curve (willingness to consume)

o Budget constraint: What can be consumed with limited income?

Draw Budget constraint line to determine which set of bundles is possible

for consumption (Ability to consume)

• By changing price & income => build up consumer demand curve


50

UTILITY THEORY

• Axioms of Consumer Choice Theory:

o Completeness: Must prefer either A or B or indifferent between A & B

o Transitivity: A > B, B > C => A > C

o Non-satiation: More is better, for at least one good

• Utility Function:

o An “assignment rule” that translates each basket of goods & services into a

number that rank orders the baskets according to that particular consumer’s

preference

o That number = Utility of that basket (measured in utils, level of happiness)

o Utility function is ordinal ranking (differences of utility do not matter)


),...,Q,Qf(QUnxxx 21

51

INDIFFERENCE CURVE: GRAPHIC ILLUSTRATION• Non-satiation axiom: Must lie in QI & III

• Marginal rate of substitution: o MRUBW = How much wine is willing to give up to obtain a small increment of

bread, holding utility constant

o If diminishing as wine decreases => Indifference curve is Convex


• Convex indifference curve

I

IIIII

IV


52

INDIFFERENCE CURVE MAPS

o Completeness: Every point will have at least one indifference curve passing

through

o Transitivity: Two indifference curves cannot cross (a~b, a~c => b~c, but c>b)


Wine

Bread

Increase utility

Wine

Bread

a

b

c

Q: Can indifference curves cross?

53

GAIN FROM VOLUNTARY EXCHANGE

• Two consumers (A&B) with different preferences

o At a, MRSBW(A) = 0.8, MRSBW(B) = 1.25


Wine

Bread

A’s indifference curve

B’s indifference curve

a

Q: Determine whether B would accept the trade of

1 of A’s bread in exchange for 1 of its wine.

A: ……………………………..

Q: Who has a relatively stronger preference for

breads?

A: ………………………

Q: Until when will trade stop?

A: ……………………………..

54

BUDGET CONSTRAINT

• Ability to consume/produce: is limited due to Scarcity of resources

(limited income, resources, time…)

• Budget constraint:

o No saving =>

• Changing prices & income:


IQPQP WWBB

IQPQP WWBB

Wine

Bread

I/PW

I/PB

BW

B

WW Q

PP

PIQ

Wine

Bread

Wine

Bread

Wine

Bread

Increase in the price of bread

Decrease in the price of wine

Increase in income

Slope of the line

55

THE PRODUCTION/INVESTMENT OPPORTUNITY SET

• Firms/investor face the same constraint as consumers

• Production opportunity frontier: maximum number of units of one good it

can produce, for any given number of the other goods

• Investment opportunity Frontier: risk-free assets & diversified stock port.


Juice per year

Milk per year

1 billion

10 billion

Return

Risk level

Risk-free rate of return

Diversified stock portfolio

56

DETERMINATION OF CONSUMER’S BUNDLE OF GOODS

• Consumer equilibrium is achieved at (a)

o This is the tangency point of the curve & line

Highest indifference curve reached

Not violating budget constraint

• At point a: MRUBW = PB/PW

• At point b: MRUBW < PB/PW

Willing to give up some wine to obtain more bread

• Similarly, at point c: MRUBW > PB/PW

Willing to give up …………………. to obtain more ………………….


Wine

Bread

a

Ba

Wa

b

c

57

DERIVING A DEMAND CURVE

• Can derive a demand curve for

good A by changing the price of

that good while keeping other

prices & income constant.

• Law of Demand:

o As price decreases, quantity

demanded increase


Is this always true???


58

SUBSTITUTION EFFECT & INCOME EFFECT

• Pure substitution effect: always purchasing more when price falls &

purchasing less when price rises. Why??

o Good A becomes relatively less costly as compared to other goods => Gets

substituted for other goods in the consumption basket (Diminishing MRU)

• Income effect: when price falls, real income rises => Amount of goods

that can be purchased increases

o Normal goods: increase in income => increase in quantity demanded

o Inferior goods: increase in income => less quantity demanded


59

SUBSTITUTION & INCOME EFFECT: GRAPHS


a

Ba

Wine

Bread

b

Bb

c

Bc

Substitution effect Income effect

a

Ba

Wine

Bread

b

Bb

c

Bc

Substitution effectIncome effect

Normal Goods Inferior Goods

Substitution & income effects are in opposite

direction, but income < substitution

Substitution & income effects are in the

same direction

60

GIFFEN GOODS & VEBLEN GOODS


a

Ba

Wine

Bread

b

Bb

c

Bc

Substitution effect Income effect

Giffen Goods

o Substitution & income

are in opposite direction

o Income > substitution

Veblen Goods

o Conspicuous consumption: derive

utility out of being known by others to

consume a so-called high status good

o Value a good more if it had a higher

price => Price DOES matter (signal the

status of who consumes it)

=> Violate the axioms of choice (why?

o Consumer would be more inclined to

purchase Veblen Goods if its price rises

For both cases: results in a positive demand curve

Lecturer:


Reading 15: Demand & Supply Analysis: The Firm


62

MIND MAP


63

ACCOUNTING PROFIT, ECONOMIC PROFIT, NORMAL PROFIT• Accounting Profit = Total revenue – Total accounting (explicit) costs

o Is Net income/bottom line in income statement

o Includes interest paid on debt financing, but no payment to equity owners

• Economic/Abnormal Profit = Accounting profit – Implicit opportunity costs

o or: Economic profit = Total revenue – Total economic costs

o Implicit costs: opportunity cost of equity owner’s supplied resources:

Private firm: opportunity cost of supplied capital & time/entrepreneur ability

Public firm: opportunity cost of equity owner’s investment in the firm

• Normal Profit: accounting profit that makes economic profit zero (= implicit cost)

o This is what an individual firm should earn in Equilibrium

o The firm cover all cost of productions => no incentive to leave/enter the industry


64

• Exercise: Calculating Accounting profit & economic profit

o Given the following information, calculate the accounting profit for ABC Co.

o Assume the owner took a pay reduction of $50,000 to start the company &

also invested in the business & could have earned $30,000 per year if he has

invested the funds elsewhere. Calculate the economic profit


Account AmountTotal revenue $300,000Expenses

Fiberglass $100,000Electricity 30,000Wages paid 55,000Interest paid on debt 5,000

65

SOURCES OF ECONOMIC PROFIT

• Due to firm’s ability

o Competitive advantage (difficult to copy technology/innovation)

o Exceptional managerial efficiency or skill

• Due to nature of competitiveness in the market

o Exclusive access to less-expensive inputs

o Fixed supply of an output, commodity, resources

o Preferential treatment under government policy

o Have monopoly power (price control)

o Market barriers to entry that limit competition

• Due to large increases in demand where supply is unable to respond fully


66

ECONOMIC RENT

• Arise when:

o A particular resource/good is fixed in supply (vertical supply curve)

o Market price > Cost to bring the good into the market & sustain its use

(normal profit) =>Economic rent > 0

o Firm can earn significant economic profits

• Example:

o Limited availability in nature (land, specialty commodities )

o Constrained by government (e.g. telecommunication resources)


• Economic rent illustration: Gold demand & supply


Economic rent is

higher when supply is

inelastic

67

Year 2006 2007 2008 % change 2006 - 2008

Supply (metric tons) 3,569 3,475 3,508 -1.7

Demand (metric tons) 3,423 3,552 3,805 +11.2

Avg. spot price (US$) 603.92 695.39 871.65 +44.3

Source: GFMS & World Gold Council


COMPARING MEASURE OF PROFIT

• Normal profit is fixed in the SR, but will vary with required rate of return

on equity investment in the LR

• Relationship between accounting profit & normal profit


68

Relation between Accounting

profit and Normal profitEconomic Profit

Firm’s Market

Value or Equity

Accounting profit > Normal profit Economic profit > 0 and firm is able to

protect economic profit over the LR

Positive effect

Accounting profit = Normal profit Economic profit = 0 No effect

Accounting profit < Normal profit Economic profit < 0 implies economic

loss

Negative effect

69

TOTAL, AVERAGE AND MARGIN REVENUE• Total revenue (TR) = P x Q

• Average revenue (AR) = TR / Q

• Marginal revenue (MR): increase in total revenue from selling one more unit.


Quantity (a)

Price(b)

Total revenue(c) = (a)*(b)

Average revenue(d) = (c)/(a)

Marginal Revenue

1 70 70 70 70

2 65 130 65 60

3 60

4 55

5 50

6 45

7 40

70

PERFECT COMPETITION: TR, AR AND MR

• Horizontal demand curve

• All units are sold at the same price regardless of quantity: AR=MR=Price



IMPERFECT COMPETITION: TR, AR, MR

• Downward-sloping demand curve

• Firms are price searchers (to sell a

greater quantity => must reduce

price)

• MR < Price (for Q >1) &

(Why???)

• Decrease in MR is more than

decrease in AR


Revenue, Price

Quantity of Output

P = AR - Demand

MR

Q1Q0

Revenue

Quantity of Output

71

TR

Q1Q0

ARMR

72

FACTORS OF PRODUCTION

• Inputs to the firm’s production include:

o Land

o Labor (skilled & unskilled)

• Production function: Q = f(K,L) (subject to )

Holding capital constant:

o L0 L1: increasing MP of labor

o L1 L2: decreasing MP of labor

o L1 …: MP of labor <0

At B, Total Product is maximized


o Capital (facilities, equipment, machinery)

o Materials (raw materials, manufactured inputs)

0L 0,K

Total Product/Quantity

Quantity of Labor

TP

A

B

L0 L1 L2

Q1

Q2

73

OUTPUT & TOTAL COST


Total Cost (TC) = Total Fixed Cost (TFC) + Total Variable Cost (TVC)

o Total fixed cost (TFC) Equals cost of fixed inputs & normal profit

Is independent of firm’s output level in the

SR

Example: rent, PPE

o Total variable cost (TVC) Equals cost of all variable production

inputs

TVC increases as output increases

Example: labor, raw material


Shirtsperday

74

AVERAGE & MARGINAL COST CURVES


• MC initially, then , due to diminishing returns of labor

• AFC slopes downwards

• Vertical difference between ATC & AVC is equal to AFC (x)

• ATC & AVC are U-shaped

• MC intersects AVC & ATC at their minimum point


75

• Exercise: Calculate AFC, AVC, ATC & MC


Q(1)

TFC*(2)

TVC(3)

AFC(4)=(2)/(1)

AVC(5)=(3)/(1)

TC(6)=(2)+(3)

ATC(7)=(4)+(5)

MC

0 5,000 0 -- -- 5,000 -- --

1 5,000 2,000 5,000 2,000 7,000 7,000 2,000

2 5,000 3,800 2,500 1,900 8,800 4,400 1,800

3 5,000 5,400

4 5,000 8,000

5 5,000 11,000

6 5,000 15,000

7 5,000 21,000

8 5,000 28,800

*: Include all opportunity cost

76

SHUTDOWN AND BREAK-EVEN POINTS OF PRODUCTION

• Shutdown point: Where AR = AVC

o If AR < AVC: Firm stops production but still have to pay fixed costs

o If AVC<AR<ATC: firm starts to produce to cover variable cost & some fixed

cost. But does not break-even => only survives in the short run

So: Short run supply curve is the MC curve that lies above the AVC curve

• Break-even point: Where price = AR = MR = ATC, or TR = TC


Revenue‐Cost relationship Short‐run Decision Long‐term Decision

TR >=TC Stay in market Stay in market

TR>TVC but TR <TC Stay in market Exit market

TR < TVC Shut down production to zero Exit market

77

• Perfection competition: shutdown and break-even points

Find shutdown point & break-even point in the following diagram



OUTPUT OPTIMIZATION & PROFIT-MAXIMIZATION

• Profit maximization occurs when:

o Difference between TR & TC is the greatest

o MR = MC

o Revenue of the output from the last unit of input employed = the cost of

employing that input unit

78


• Illustration: Perfect Competition: Break-even & Profit maximizing

In a perfect competition market: TR is a straight line

79



• Example: Breakeven Analysis & Profit Maximization

In an imperfect competition market:

Q1: What is the breakeven point?

Q2: Where is the region of profitability?

Q3: What is the profit-maximizing point?

Q4: Where does economic loss occur?

80


Q(1)

Price(2)

TR(3)=(1)*(2)

TC(4)

Profit(5)=(3)-(4)

0 10,000 0 100,000 (100,000)

10 9,750 97,500 170,000 (72,500)

20 9,500 190,000 240,000 (50,000)

30 9,250 277,500 300,000

40 9,000 360,000

50 8,750 420,000

60 8,500 480,000

70 8,250 550,000

80 8,000 640,000

90 7,750 710,000

100 7,500 800,000

*: Include all opportunity cost

81

LONG-RUN & SHORT-RUN COST CURVES


• Short run cost curves: apply to a specific size of plant (some input quantities are fixed)

• Long run cost curves: indicate the optimal quantity at different plant sizes (everything can be adjusted).

• Firms can have the same LRATC but at different positions, depending on their operating size


82

ECONOMIES OF SCALE


Long Run Cost Curve = planning curve

1. Mass production2. Specialization3. Experience

1. Increasing bureaucracy2. Difficult to motivate workforce3. Barriers to innovation & entrepreneur activities4. Principal-agent problem

83

• Illustration: Long-run profit maximization & Minimum efficient

scale under Perfect Competition



84

INCREASING, DECREASING & CONSTANT COST INDUSTRY

• LR Industry supply: Relationship between quantity & output prices

o Firms are able to enter/exit based on level of ST profit

o Changes in output influence resource (input) prices in the LR

o Shapes depend on resources costs, technological level, production efficiency

& economies of scale of resource supplier



85

TOTAL, MARGINAL & AVERAGE PRODUCT OF LABOR

• Productivity: measured in terms of output per workers/labor hour

• Cost minimizing/profit maximizing goal => maximize productivity

• Measuring productivity:

o Total Product : TP = Q (L, K) (K fixed)

o Average Product :

o Marginal Product:

(assume other inputs are fixed)

measured productivity of an individual additional worker


LQ

LTPAP

LQ

LTPAP

86

• Example: Calculate Total, marginal & average product of labor


87

DIMINISHING MARGINAL PRODUCT OF LABOR


Diminishing marginal returns to labor occur

Marginal product, holding other inputs constant, first increases then decreases

Maximum MP


88

COST CURVES & PRODUCT CURVES



89

CHOOSING INPUTS TO MINIMIZE COST

• Firms want to maximize output per monetary unit of input costs:

• When using n different resources, the least cost optimization formula is:

o i.e. Additional output per dollar spent to employ one additional unit of each

input must be the same.

• Example: with two inputs Labor & Capital

o PL = $75, PK = $600, MPL= 5 units, MPK = 30 units

o Compute MPK/PK & L/PL

o What input to be reduced to reduce cost of production?


input

input

PriceMP

n2

2

1

1

PriceMP...

PriceMP

PriceMP n

MARGINAL REVENUE PRODUCT

• Marginal Product: Addition output of a final product produced from one

more unit of a productive input, holding other inputs constant

• Marginal Revenue: Additional revenue gained from selling one more unit of

output

• Marginal Revenue Product (MRP)

• MRP = Marginal Product x Marginal Revenue

= Marginal Product x Product Price (assume perfect competition)


Additional revenue gained from selling the marginal product from employing

one more unit of a productive input, holding other inputs constant

PROFIT MAXIMIZING UTILIZATION OF AN INPUT

• Profit-maximizing quantity of an input i: MRPi = Pi

o Firms can increase profits by employing another unit of input i as long as

MRPi > Pi

• With cost minimizing condition:

=>


1P

MRP...P

MRPP

MRP

n

n

2

2

1

1

n

outputn

2

output2

1

output1

PriceMRMP

...Price

MRMPPrice

MRMP

Lecturer:


Reading 16:The Firms and Market Structures


93

MIND MAP


CHARACTERISTICS OF DIFFERENT MARKET STRUCTURES

• Differentiate based on

o Number of firms and their relative sizes

o Elasticity of the demand curves they face

o Ways that they compete with other firms for sales

o Ease/difficulty with which firms can enter/exit the market


94

Monopoly Oligopoly Monopolistic Competition

Perfect Competition

Increasing degree of competition

CHARACTERISTICS SUMMARY


95

Perfect

Competition

Monopolistic

CompetitionOligopoly Monopoly

# of sellers Many firms Many firms Few firms Single firm

Barriers to entry Very low Low High Very high

Nature of

substitute

product

Very good

substitutes

Good substitutes

but differentiated

Very good

substitutes or

differentiated

No good

substitute

Nature of

competition

Price only Price, marketing,

features

Price, marketing,

features

Advertising

Pricing power None Some Some to significant Significant

PERFECT COMPETITION: CHARACTERISTICS


1. Homogeneous products

2. Large number of independent firms; each small relative to the total market

3. No barriers to entry or exit

4. Market supply & demand determine market price

96

Example:

PERFECT COMPETITION: FIRMS ARE PRICE TAKERS


1. No influence over market price

2. “Take” the equilibrium price as given

3. Firm’s demand curve is perfectly elastic => horizontal

MR = Price as all additional

units are sold at the same

(market) price

97


PERFECT COMPETITION: MARKET & FIRM DEMAND CURVE


98


PERFECT COMPETITION: SHORT RUN PROFIT


Economic profit > 0 when ??? Q: What happens next?

99


EQUILIBRIUM IN PERFECT COMPETITION


A: New firms enter the market, market supply , price so that P = ATC

NoEconomicProfit!!100


PERFECT COMPETITION: SHORT-RUN LOSS


Economic Loss when ???

Q: will it continue operation?

Shutdown point: P = AVC

Minimizing loss when AVC < P < ATC

P < AVC: shutdown, only pay fixed cost

101


PERFECT COMPETITION: FIRM & INDUSTRY SR SUPPLY CURVES


Market supply curve = horizontal sum of all firm supply curves

102


INCREASE IN DEMAND


Q1 Firm

P1

Price

Quantity

D1

MC = SR Firm Supply

D2P2

Q2 FirmQ1

P1

Price

Quantity

D1

SR Industry supply

D2

Q2

P2

Economic profit -> New firm enters -> Industry supply curve shift

outwards -> equilibrium price, equilibrium output

Individual firms move down its supply curve-> economic profit

Economic loss -> …???

103

PERMANENT DEMAND CHANGES


104


DEMAND CHANGES & TECHNOLOGICAL IMPROVEMENT


Long run equilibrium price after a permanent increase in demand can be:•Lower(economiesofscale)(inputpricesfall)=>LRsupplycurveis

•Higher(diseconomiesofscale)(inputpricesincrease)=>LRsupplycurveis

105


PERFECT COMPETITION: TECHNOLOGICAL CHANGES


• After adjustments take place for some firms

-> Firm & industry’s supply curve shift to the right

-> Higher quantity, lower price

• Short run: Economic profit for early adopters

• Long run: o Price = min ATC for new technology

o Zero economic profit

106

MONOPOLISTIC COMPETITION: CHARACTERISTICS


• A large number of independent firms

• Differentiated products (substitutes to each other)

• Firms compete on price, quality, and marketing

• Low barriers to entry & exit

• Downward-sloping, highly elastic demand curve

o Small market share, no power over price

o Only need to care about market price

o No collusion

Example: ???

107

Price

Quantity

DMR

ATC

MC

P = ATC*

P*

Price

Quantity

D

MR

ATCMC

MONOPOLISTIC COMPETITION: OUTPUT DECISION


ATC*

Q

MC = MR

Firms enter, price fall

Q

Short run Output decision for a firm Long run Output decision for a firm

Short run profit

No positive economic profits in the long run!

108

MONOPOLISTIC COMPETITION VS. PERFECT COMPETITION


Excess capacity:

Q < efficient quantity (at min ATC)

Mark up = P – ATC > 0

109


EFFICIENCY OF MONOPOLISTIC COMPETITION


• Allocative efficiency is not clear:

o Social cost of not producing where P = MC => Mark up for producers

o Long run average cost is not minimized => Excess capacity

• However, there are some benefits:

o Increased Product diversity, greater Product innovations

o More information from Brand names & advertising => signal quality for

better decision making (?)

Q: Does the benefit from advertising, innovation, differentiation of products justify its costs??

o Additional costs of advertising, innovation & building brand names

110

INNOVATION, ADVERTISING & BRANDING


• Innovation & Product Development

• Advertising & Branding

o Less elastic demand => can increase price & earn economic profits

o But this advantage will be erode over time. (Why ?)

o Firms must continually look for new innovation => additional costs

o To inform the unique features & quality of their products

o Advertising cost for firms in monopolistic competition is the greatest. But if

advertising can greatly increase sales, ATC may fall because AFC falls

o Brand names are invaluable assets as it signals the quality

111

OLIGOPOLY: CHARACTERISTICS


• A small number of sellers

• Interdependence among competitors

• Significant barriers to entry (economies of scale)

• Products may be similar or differentiated

Example: ???

o Highly dependent upon the action of others

112

OLIGOPOLY MODELS

• Kinked-demand curve model

o Competitor will NOT follow a price INCREASE

o Competitor WILL follow a price DECREASE

• Cournot Model

o 2 firms (duopoly), with identical & constant marginal cost of production

o Must determine quantity based on assumptions about other’s quantity

• Nash equilibrium model (Prisoner’s dilemma)

• Stackelberg dominant firm model


113

OLIGOPOLY: KINKED-DEMAND MODEL

• Shortcoming: Model is incomplete as what determine the market price

(kinked price) is outside the scope of the model


Firms will not follow price increase

Firms will follow price decrease

Profit‐maximizingoutput

114

Price

Quantity

Demand

Current Price P*

Q*

MR (P > P*)

MR (P < P*)

MCB

MCA

115

COURNOT DUOPOLY MODEL

• 2 firms (A & B) are identical, have constant marginal costs of production

o Previous quantities produced can be observed QA & QB

• Equilibrium mechanism:

o A assumes B will keep produce QB for the next period

o A derives its own demand curve (= market demand – QB) & marginal revnue

o A determines its profit-maximizing quantity & B does the same

• Results:

o Adjust until Q A = QB = Q/2

o Perfect competition price < Equilibrium price < Monopoly price

o If more firms are added: price falls to MC => perfect competition


PRISONERS’ DILEMMA & OLIGOPOLY


Prisoner BKeeps silent Confesses

Prisoner A

Keeps silent Each gets 6 months A gets 10 years

B is free

Confesses A is freeB gets 10 years Each gets 2 years

Optimal solution

Actual result

Why???

For Firms Firm BHonors Cheats

Firm AHonors Both earns (+) economic

profitsA has economic loss

B earns increased profits

Cheats A earns increased profitsB has economic loss

Both earns ZERO economic profits

What will be the final result?116

TWO-FIRM OLIGOPOLY WITH & WITHOUT COLLUSIONS


Without Collusion

117


TWO-FIRM OLIGOPOLY WITH & WITHOUT COLLUSIONS


With Collusion: Both firms collude to behave like a monopoly

=> Price fixing to earns Economic Profit

118


OLIGOPOLY: WHEN COLLUSION IS POSSIBLE?


• Cheating is easy to detect

• Fewer firms in the market

• Threat of new entrants is low

• Enforcement of anti-collusion laws & penalties for colluding are weak

119

120

DOMINANT FIRM OLIGOPOLY

• A dominant firm (DF) with cost-

advantage & a large market share

=> Acts like a monopoly, is a price-

setter, produces where MC = MR

• Other competitive firms (CF) are

price-follower and produce where

MC = P


Price

Quantity

DDF

MRDF

MCDF

QDF

P*

QCF

MCCF

Market Demand

MONOPOLY: CHARACTERISTICS


• One seller of a specific, well-defined product that has no good

substitute.

o Resource control

• Barriers to entry are high, due to:

o Economies of scale (natural monopoly e.g. electric utility)

o Government licensing (patents, e.g. pharmaceutical) & legal barriers (e.g.

broadcasting station, utility)

121

MONOPOLY: PRICING


• Monopoly faces a downward-sloping demand curve, unlike perfect

competition

• In order to increase quantity , a monopoly must reduce price as

there is a trade-off between price & quantity

• Price-setting strategy to maximize profit to firm:

1. Single-price

2. Price discrimination (if resell is impossible)

122

MONOPOLY: COSTS, PRICE AND REVENUE


MC=MR

Optimal quantity Q* is in

the elastic range of the

demand curve

Monopolists are price searchers and have imperfect information

regarding market demand

123


MONOPOLY: PRICE DISCRIMINATION


Price discrimination: charging different customers different prices for

the same produce or service. Examples: tickets

When is it possible?

• Have a downward-sloping demand curve

• Have at least 2 identifiable customer groups with different price

elasticities of demand for the product

• Can prevent customers from reselling the product

124

MONOPOLY: PRICE DISCRIMINATION - GRAPHS


Can capture the higher-elastic-

demand group at a lower price $90

Efficient quantity

A

DWL due to the reduction in

quantity & the increase in price

125


MONOPOLY: PERFECT PRICE DISCRIMINATION


With perfect price discrimination:

• No consumer surplus, the entire surplus goes to the monopoly

• Produce the same quantity as under perfect competition (point A)

(Capture all points on the demand curve )

• Charge each customer the maximum amount they would pay for

• No Deadweight Loss

126

MONOPOLY VS. PERFECT COMPETITION


Perfect competition: QPC & PPC

Monopoly:

QMON< QPC & PMON> PPC

=>Deadweight loss, as

(Producer surplus + Consumer

surplus) is not maximized

Rent seeking: producers spend time & resources to seek for

monopoly power127


NATURAL MONOPOLY


Significant economies of scale:

• Fixed costs are very high & variable costs are low

• ATC decreases as output increases => ATC is minimized only when

there is one firm

• Example ???

Economies of scope

• Production uses same capital resources

• ATC declines as ranges of goods produced increases

• Example ???

128

REGULATING MONOPOLIES


Regulate the prices the monopoly may charges:1. Average cost pricing:

2. Marginal cost pricingA

B

• Reduce price to where ATC intersects D

• Increase output & social welfare• Economic profit = 0

• Reduce price to where MC intersects D

• Efficient regulation• May require subsidy, if MC < ATCProblems with regulation:

• Lack of information• Cost shifting

• Quality regulation

• Special interest effect129


130

IDENTIFYING MARKET STRUCTURE

• Econometric method: To estimate the elasticity of supply & demand by

regression methods (cross-sectional or time series)

o But requires lots of data

• Simpler method: Concentration ratio & HHI Index

o N-firm concentration ratio: sum of the % market share of the top N largest

firms


0% 40% 60% 100%

Perfect Competition

Competitive market Oligopoly

Monopoly

131

IDENTIFYING MARKET STRUCTURE (cont.)

• Simpler method:

o Herfindahl-Hirschman Index (HHI): sum of the squared % market share of

the top 50 largest firms

• Limitations of Concentration Ration

o N-Concentration Ratio is insensitive to mergers of two large firms

o Both N-Concentration Ratio & HHI do not consider barriers to entry & potential

competition


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Economics ss4