SIAM UNIVERSITY MBA International Program - Semester 3/2008 300605 Managerial Economics

Managerial Economics Study GuideRevised by Peter Masters (2009)

Instructor : Ajarn Vichit Class Room : 19-306

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Table of Contents

Introduction Relationship to Economic Theory The Objectives and Value of the Firm Law of Demand Equilibrium Consumer Demand Analysis - Indifference Curve Consumers Budget Constraint Consumer Equilibrium Derivation of the Consumers Demand Curve Consumers Response to Price Change - Income and Substitution Effect Individual and Market Demands - Market Demand Analysis for Decision Making Consumer Tastes and Preferences Characteristic of Demand - Price Elasticity of Demand Relationship between Price Elasticity of Demand and Total Revenue Point & Arc Elasticity of Demand Luxuries, Necessities, and Inferior Goods Income and Substitution Effects of a Price Reduction Price, Total Revenue, and Marginal Revenue Total Revenue, Demand & Marginal Revenue Theory of Production

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Marginal Product Curve Production with Two Variable Input (Long run) Isoquants Expansion path: Long Run and Short Run Return to Scale Cost Theory - Explicit and Implicit Costs - Accounting & Economic costs The Relationship between Product and Cost Long run Cost Curve Economies and Diseconomies of Scale Profit Maximization of a Competitive Firm in the Shot Run Short Run Supply Curve of the Competitive Firm The Theory of the Firm - Perfect Competition - Price Determination under Perfect Competition Monopoly - Price Discrimination Monopolistic Competition Oligopoly - The Kinked Demand Curve Model Strategic Behaviour and Game Theory - Payoff matrix for and Advertizing Game - Prisoners Dilemma Pricing of Multiple Products - Optimal Pricing for Joint Products Produced in Fixed Proportions Price discrimination - First and Second Degree Price Discrimination

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Introduction The subject of managerial economics started in the USA in 1940. It comprises of two important components: 1. Economics 2. Management The subject applies economic theory to management decision making in business, to enable the organization to allocate limited resources most efficiently and to meet the organizations objectives or goals, particularly profit maximization in business. What is Economics? Economics is the study of the allocation of scarce and limited resources, in order to satisfy unlimited human wants. Economics deals with 3 broad subjects, 1. Resource scarcity and the need to make choices 2. The assumption that humans behave rationally 3. Comparison between marginal cost and marginal revenue, in the production of the last unit. The point where marginal cost begins to exceed marginal revenue is the point when it is no longer profitable to produce the last unit. In application, we have economic methodology. Economic methodology is the study of methods, usually scientific method, in relation to economics (Boland, 1987, p. 455) and it comprises 5 main components. Five Main Components of Economic Methodology 1. The use of data in the real world 2. Using data to determine assumptions of causes and consequences 3. To test the accuracy of forecasts 4. The adjustment of assumptions as a result of the test in (3 )5. Continuous testing of various assumptionso

Results that are accepted become theory.4

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If theories are tested and are well accepted, they become laws or principles. These theories, laws and principles explain the economic behavior of individuals, institutions and the economic systems.

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There are economic policies that apply the theories to solve economic problems, or to achieve economic goals and objectives, for example economic growth, economic stability, exchange rate stability, inflation targets. These goals and targets have conflicts in themselves, for example too much growth produces inflation, or profit maximization may conflict with social objectives, which require goods at be available at low prices. Therefore, economists have to make decisions regarding the best choice for each situation: a compromise is the most common outcome. Management Is a set of functions which determine the efficient utilization of resources in order to achieve the objectives of the organization.

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Managerial Economics Is the application of economic theory and decision making analysis tools to examine ways an organization can achieve its aims or objectives in the most efficient manner and maxim profit. Figure 1. The Scope of Managerial Economics

Manag

As you know, there is a need to make management decisions in every kind of organization. - a firm - a non-profit organization - a government agency Every organization seeks to achieve goals or objectives, subject to some constraints.

Economic theor Microeconomic Macroeconomic

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MANA Applic and deci

For example, 1. A hospital may seek to treat as many patients as possible at an acceptable standard with its limited physical resources. - physicians - technicians - nurses - beds - equipments 2. A University will want to provide an adequate education at an acceptable standard to as many students as possible, subject to similar constraints, buildings, teachers, equipment, financing There are many similar examples, though the objectives and constraints may differ from case to case. But the basic decision making process is the same. How can it be done? The Process of decision-making

Identify objectives Define the problem Identify possible solutions Select the best possible solution Implement the decision

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Relationship to Economic Theory

Micro-economics involves economic behavior of the individuals. - consumers - resource owners - business firms

In a free enterprise system, the market mechanism and free consumer behaviour are key to resource allocation, which is limited, to satisfy the unlimited human needs. In a planned economy (communist economic system), there are controls on the allocation of limited resources. Macro-economics is the study of the total or aggregate level of the economy. - output - consumption - income - investment - employment - prices Micro-economic theory of the firm is the single most important element in managerial economics . However, the general macro-economic conditions of the economy - e.g. inflation, total demand interest rates plus the direction and trend of the economy are very important factors to the firms operations. Economic theories, both macro-economics and micro-economics are needed to explain and predict economic behavior, and consumer behavior. Economic models are often employed as a tool. The theory of the firm explains the firms behavior and assumes that the firm seeks to maximize profits.

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On the basis that the theory predicts how much of a particular commodity the firm should produce under different forms of market or organizational structure. While the firm may have multiple objectives, the profit maximization model can predict the behavior of the firm .

Relationship to Decision Science Managerial Economics is also closely related to the decision sciences. Decision Science is the tool of mathematical economics and econometrics, to construct and estimate decision models aimed at determining the optimal behavior of the firm.

How the firm can achieve its goal most efficiently to maximize profit.

Mathematical Economics is used to formalize equations or economic models made on the basis economic theory. Econometrics applies statistical tools (regression analysis) to real world data and to estimate the models built on economic theory. For example, the GDP equation is used to forecast changes in GDP

Y = C +I + G+ (X M)

Businesses use the Quantity demand function of a commodity Q = f ( P , Y , Pc , Ps ) P = price Y = Income of consumers Pc Ps = prices of complementary of substitutes commodities. By collecting data on Q P Y Pc and Ps; we can estimate relationship of these variables.

Determine know much Q would change with a change is P Y Pe and Ps Forecast future demand of Q

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This information is important for the management to achieve their goal of profit maximization and allows management to find optimal solutions to decision problems within the environment in which the firm operates.

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The Theory of the Firm.

Theory oThis is the central theme of managerial economics.

Combines and o the purpose of p services for sale Internalizes tran transactions cos10

Why firms exist? The firm is an organization that combines and organizes resources for the purpose of producing goods and services for sale. Figure 3 The firms role in society

What are different kinds of firms ? 1. Proprietorship (owned by an individual) 2. Partnership (owned by two or more) 3. Corporations (owned by shareholders) Firms exist because it is convenient and economic for a single unit to deal with a large a number of tasks and transactions in the process of production and distribution:

many suppliers many customers many service needs e.g. transport and banking

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The firm can enter into general long term contracts with labour to perform a variety of specific tasks for wages and benefits. This provides substantial savings in transaction costs. If the firm can achieve cost savings and efficiency, can it grow indefinitely? No, the firm can not continue to grow indefinitely because of limitations on management to effectively control and direct the operations of the firm. When the firm becomes too large, communication distance becomes too long for effective control, forcing costs to go up, and at this point the cost of producing certain services the firm needs for production would be higher than buying them from outside the firm. The function of the firm is to purchase resources or inputs of labour, service, capital and new material in order to transform them into goods and services for sale. Resource owners can then use the income they receive to purchase goods and services produced by the firm; this creates a complete circulation flow of income in the economy. The process provides employment for workers and taxes to the government, which enable the government to provide services to society that firms can not provide efficiently.

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The Objective and Value of the firm. The obvious objective of the firm is profit maximization, both short-term and longterm. The income that the firm receives over time determines the wealth and value of the firm. Income or profit that will be received in the future, has to be discounted to get the present value because has less value than at present (inflation). Wealth or value of the firm can be obtained from the following equation. Figure 6 The present value of the firms expected future cash flows

n 1 2 n t PV = + + + = (1 + r )1 (1 + r ) 2 (1 + r ) n t =1 (1 + r )t

n t TR TCt Value of Firm = = t t t t =1 (1 + r ) t =1 (1 + r ) n

Valu

Constraints on Operation of the Firm

The present va

The goals or objectives of the firm are to maximize wealth or value of the firm but there are many constraints or obstacles. The most important is the limited supply of inputs, especially.o o

Skilled labour Specific raw materials13

o o o o o

Factory and warehouse space Capital funds Legal constraints e.g. minimum wage law Health & Safety standards Pollution standards

Therefore, the maximization of wealth or value of the firm depends constraint optimization whereby the management must maximize the various constraints to achieve the objectives of the firm. Limitations of the Theory of the Firm To mazimize wealth or value of the firm may be criticized as objective that is too narrow and unrealistic in the real word. A broader theory is proposed.

to maximize o Sales o Management utility To be a satisficing firm A satisficing decision maker is one who is concerned simply with attaining a sought objective.

Everyones expenditures go somewhere: Consumption expenditure from the point of households represents the income of business firms The cost of production from the point of business firms represents the income of households. Figure 7 Every transaction must have two sides.

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Definiti

Business Prof the explicit or Funct production. Economic Pro the explicit and Profit is a sign production.15

Law of Demand Figure 8

LawQuantity Demanded vs. Demand Quantity demanded The quantities of a good or service that people will purchase at a specific price over a given period of time

Demand Graph of the total quantities of a good or service that purchasers will buy at different prices at a given time Demand

Individual demand The quantity of a good or service that an individual or firm stands ready to buy at various prices at a given time Market demand The sum of the individual demands in the marketplace16

A decrease in other things h increase in th the good. An increase in

Figure 9

Chan DChanges in Demand

Price

Change in Quantity Demanded Movement along the demand curve that occurs because the price of the product has changed Change in Demand Change in the amounts of the product that would be purchased at the same given prices; a shift in the entire demand curve

P1 P0

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Figure 10

Chan DFigure 11

Price

Chang18

Change in Buy P0

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ChangFigure 13

Price

ChangP019

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MarkFigure 15

Market equili intersection o and the mark Marke The equilibriu demanded to20

Price

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MarkeFigure 17

Price D0 P1 P0 Price

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Figure 18

MarkeFigure 19

Price D0

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P0 Price P1

Consumer Demand Analysis Consumers Tastes: Indifference Curves An Indifference Curve shows the various combinations of commodities X and Y that yield equal utility or satisfaction to the consumer. A higher indifference curve shows a greater amount of satisfaction and a lower one indicates less satisfaction. Marginal Rate of Substitution (MRS) refers to the amount of Y that a consumer is willing to give up in order to gain one additional unit of X (and still remain on the same indifference curve) Characteristics of Indifference Curve (IC) 1. Higher curves are preferred to lower curves. 2. ICs are negatively sloped throughout. 3. ICs neither meet nor intersect with each other. 4. ICs are convex: from below.

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Consumers Budget Constraint Budget line shows all the different combinations of the two commodities that a consumer can purchase, given his money income and the prices of the two commodities Figure 21

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Linear Equation PxQx + PyQy = M PyQy = M PxQx Qy = {M/Py - Px/Py} * Qx Where: Px Py Qx Qy M Price of x Price of y Quantity of x Quantity of y Money Income

What if there are changes in income or prices? Case 1: Money Income Suppose: Px = Py = $1 Money Income increases from $10 to $12 The effect of an increase in money income with prices unchanged is the budget line makes a parallel shift to the right.

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Figure 23 Case 2: Suppose: Px = $2, Py = $1 Money Income = $10

The effect of an increase in price of X with price of Y and money income unchanged is the budget line rotates around the Y intercept and becomes steeper (or rotates clockwise) Therefore, the consumer buys the same quantity of Y but can only buy half the quantity of X = Line shifts to the left so the consumer is less satisfied

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Consumer Equilibrium A consumer is in equilibrium when, given his income and price constraints, he maximizes his total utility or satisfaction from his expenditures. Therefore: A consumer is in equilibrium when, given his budget line, he reaches the highest possible indifference curve. Equilibrium occurs where the budget line is tangent to an indifference

curve (the slope of the budget line is equal to the slope of the indifference curve) Figure 24 Qy12

Oranges10

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Consumer Equilibrium continuedMarginal Rate of Substitution (MRS) refers to the amount of Y that a consumer is willing to give up in order to gain one additional until of X (and still remain on the same indifference curve) Slope of Budget line (in absolute terms) shows the relative prices of X and Y in the market. At N, the absolute slope of indifference curve I (which indicates what the consumer is willing to do in the market) exceeds the absolute slope of the Budget line (which indicates what the consumer is able to do in the market) That is, at N, this consumer is willing to give up 3 units of Y to obtain l more unit of X and still remain on indifference curve I. However, he can get one additional unit of X in the market by giving up only l unit of Y. So, by moving down along his budget line from point N toward point E the consumer increases his satisfaction. At R, the absolute slope of indifference curve I is less than the absolute slope of the budget line. This means the consumer can obtain more of Y in the market than he

wants by giving up l unit of X So, by moving up along his budget line from point R toward point E the consumer increases his satisfaction. At E, MRSxy = Px/Py MRSxy is the amount of Y that a consumer is willing to give up in order to gain one additional until of X and still remain on the same indifference curve; At N, MRSxy = slope of AC = AO / OC. Slope of Budget line (in absolute terms) shows the relative prices of X and Y in the market = slope of BL (at N, slope of Budget line = BO / OL) At N, the absolute slope of indifference curve I (which shows the amount of Y he is willing to give up for one X) exceeds the absolute slope of the Budget line (which shows the amount of Y he must give up for one X in the market). So, he should move down along the Budget line (BL) from N to E

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REVIEWA consumer is indifferent between two bundles of goods and services if the two bundles suit his tastes equally well. Indifference Curve is a curve that shows consumption bundles that give the consumer the same level of satisfaction. Marginal Rate of Substitution is the rate at which a consumer is willing to trade one good for another. The marginal rate of substitution is equal to the slope of the indifference curve. 1. Because indifference curves are not straight lines (in general), the marginal rate of substitution is not the same at all points on a given indifference curve. 2. The rate at which a consumer is willing to trade one good for the other depends on how much of each good he is already consuming

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What does the slope of the budget line equal? The slope of the budget line equals the ratio of the price of good X on the horizontal axis divided by the price of good Y on the vertical axis Price X / Price Y What conclusion can we draw? Consumer equilibrium occurs where the budget line is tangent to the highest attainable indifference curve. At this unique point, MRS = slope (price ratio of Px/Py)

What the Consumer Chooses The consumer would like to end up on the highest possible indifference curve, but he must also stay within his budget. The highest indifference curve the consumer can reach is the one that is tangent to the budget constraint. The point where they touch is called the optimum. At this point, the marginal rate of substitution is equal to the relative price of the two goods. Slope of Budget line (in absolute terms) shows the relative prices of X and Y in the market.

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Derivation of the Consumers Demand Curve Example 1 Figure 26

When the price of pens changes, shifting the consumers budget line from B1P1 to B1P2, the consumer equilibrium point changes with it, from a to c. The consumers demand curve for pens is obtained by plotting her equilibrium quantity of pens at various prices. At $5 a pack, the consumer buys fifteen packs of pens (point a). At $3 a pack, she buys twenty-two packages (point c).

c u d e m a n d t h e o f D e r i v a t i o n32

Derivation of the Consumers Demand Curve Example 2

Figure 27 The top panel shows that with Px = $2, Px = $1, and Px = $0.67, we have budget lines GFI, GF, and GFII, and consumer equilibrium points A, E, and H, respectively. From equilibrium points A, E, and H in the top panel we derive points AI, EI, and HI, in the bottom panel. By joining points AI, EI, and HI, we derive dx, the consumers demand curve for commodity x

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Separation of the Substitution and Income Effect of a Price Change Changes in price can affect buyers' purchasing decisions; this effect is called the income effect. Increases in price, while they don't affect the amount of your paycheck, make you feel poorer than you were before, and so you buy less. Decreases in price make you feel richer, and so you may feel like buying more. What if we're looking at two goods at once? For instance, a fast food chain sells hamburgers and hot dogs. If the price of hamburgers goes up, but the price of hot dogs stays the same, you might be more inclined to buy a hot dog. This tendency to change your purchase based on changes in relative price is called the substitution effect. When the price of hamburgers goes up, it makes hamburgers relatively expensive and hot dogs relatively cheap, which influences you to buy fewer hamburgers and more hot dogs than you usually would. Likewise, a decrease in hamburger price would cause you to eat more hamburgers and fewer hot dogs, according to the substitution effect. Figure 28

Fig.

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The individual is in equilibrium at point A with Px =$2 and at point E with Px = $1. To isolate the substitution effect, we draw hypothetical budget line G*F*, which is parallel to GF and tangent to U1 at point J. The movement along U1 from point A to point J is the substitution effect and results in the relative reduction in Px only (i.e. real income remaining constant). The shift from point J on U1 tp point E on U2 is then the income effect. The total effect (AE = 2X) equals the substitution effect (AJ = 1X) plus the income effect (JE = 1X). The change in the consumption of X and Y due to the change in relative

prices is the Substitution effect. At the lower price of X, she can purchase her original bundle of X and Y and still have money left over to purchase more X or Y . The purchasing power of her money income (or real income) has increased, making her better off by allowing her to move to the higher indifference curve. The change in the consumption of X and Y as the consumer moves to a higher Indifference curve is the Income effect.

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Consumers Response to Money Income Changes Figure 2914

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Income Consumption Curve

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Stage 1: Px = Py = $1, M=$10 Max. utility at E, Where Qx = 5 units , Qy = 5 units Stage 2: Px = Py = $1, M , M = $14 As M budget line shifts to the right Max. utility at S, Where Qx = 7 units , Qy = 7 units Income-Consumption Curve connects all the bundles chosen by the consumer at different income levels.

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Individual and Market Demands Market Demand Analysis for Decision Making The market demand in any particular product market is an important force in the economic system because it enters the product markets supported by the income that consumers expect to spend to maximize their utility. These consumer expenditures become sales revenue from the firms point of view. The market or aggregate demand for a commodity shows the relationship between quantity demanded by all the individuals in the market and the price levels. The market demand curve for a commodity is obtained by the horizontal summation of all the individuals demand curves for the commodity.

The demand curve refers to the relationship that exists between the quantity demanded of a particular product and the price of that product (own price), with all other influencing factors held constant. The demand function refers to the relationship that exists between the quantity demanded of a particular product and all determinants of demand. Independent Variables (or Determinants) in the Demand Function38

1. Prices: Own Price: quantity demanded varies inversely with the price of the product, while all other determinants of demand remain constant.

Px Px 1.

Qx Qx Prices of Related Products: Substitute Goods: If the price of one of the substitute products increases,

the demand for product X would also increase, since some consumers will switch away from that substitute product and toward other substitutes, including product X . Complementary Goods: Products that are typically consumed in

conjunction with product X , e.g. Coffee and cream; tennis racquet and tennis ball): If the price of one of the complementary products increases, the demand for product X would decrease. 2. Consumer Incomes: The relationship between consumer incomes and quantity demanded of product X can be either positive or negative, depending on the product and the level of consumer income. Superior (or Normal) Goods: When consumer income rises, the demand

for these goods also increases - demand and consumer income level move in the same direction. Inferior goods: the demand decreases when consumers income level

rises or increases when consumers income level falls.

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3. Consumer Tastes and Preferences: Tastes and Preferences of consumers could change as time goes by, with some people shifting their purchases toward a particular product and others shifting away, as consumers learn more about other products that are available and as they change their minds about what attributes are more important to them. If the product is more appreciated, or the strength of consumers desire for the product is increasing, this shift would cause an increase in the demand for that product. The Form of the Demand Function Qx = f (Px, Py, T, M) Where Qx = quantity demanded for commodity X by an individual per time period (year, month, week, day, or other unit of time) Px = Price per unit of commodity X Py = price per unit of related commodities ( i.e., substitute or complement) T = tastes of the consumer M = money income Movements Along versus shifts of the Demand Curve A movement along the demand curve will occur when there is a change in its own price (and consequently quantity demanded) while all other determinants of demand remain constant. Figure 30

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Px Px

Qx Qx

A shift of the demand curve will occur when any of the other determinants of demand change, but its own price remains constant. Figure 31

Questions: If x & y are substitutes, If x & y are complement, If x is superior ( or normal ), If x is inferior,

Py Py M M

Qx Qx Qx Qx

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Price elasticity of demand is defined as the percentage change in quantity demanded divided by the percentage change in price. If Px changes 1% how many % would demand for x change?

= % change in Qx = Qx * Px % change in Px Px * Qx Where (epsilon) = the price elasticity of demand The value of price elasticity of demand varies from minus infinity to approach zero from the negative side (- < < 0 ) price elasticity of demand is equal to -1 at the midpoint of the demand

curve. price elasticity of demand ranges from -1 to minus infinity above the midpoint and from -1 to zero below the midpoint Elastic & Inelastic demand is elastic when is > 1 P has a high impact on Qx demand is inelastic when is < 1 P has low impact on Qx demand is unitary elastic when is = 1 (at the midpoint of demand) Figure 32

Marginal Reve Elasticity oElastic region

EP > 1

EP = 1

EP < 1

Inelastic region

Price Elasticity ( p) equals 1 at the mid-point of the Demand Curve42

PX

Relationship between Price Elasticity of Demand and Total Revenue Example: as > > 1, let the price of X rise by 20% and demand falls by 40%, total revenue must fall because the reduction in Qx is proportionately greater than the increase in the price. With an elastic demand curve, an increase in the price leads to a decrease in quantity demanded that is proportionately larger. Thus, total revenue decreases. Figure 33

How Total Revenue Changes: Elastic DPrice

Change i

Example of Inelastic Demand

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How Total Revenue Ch $4.00 Changes: Inelastic DemPrice

Figure 3443

Relationship between Price Elasticity and Total Revenue Elasticity Value >> l elastic >> l unitary 0 < < l inelastic Figure 35 Price Increases TR falls TR constant TR rises Price Decreases TR rises TR constant TR falls

Determina Elasticity o

Demand for a com elastic if: Determina It has many close s Elasticity It is narrowly define More timefor availa Demand is a com44

Point & Arc Elasticity of Demand Point elasticity of demand represents the case of a very small price change (or a virtual point on the demand curve). It is defined as the relative responsiveness of quantity demanded to an infinitesimal (very small) change in price. Arc elasticity of demand represents the case of a more substantial price change (or a significant movement along the demand curve). It is defined as the relative responsiveness of quantity demanded to a discrete (significant) change in price. Point price elasticity of demand: point = Qx . Px Px Qx Arc price elasticity of demand arc = Qx * (P1+P2)/2 = Q1-Q2 * P1+P2 Px (Q1+Q2)/2 = P1-P2 Q1+ Q2 ########### Example: Good X P1 = $8 per unit, P2 = $7 per unit, sales (Q1) = 32 units per week sales (Q2) = 44 units per week

If all other determinants in the demand function have remained constant, the two price-quantity combinations above are points on the demand curve for good X. Point price elasticity of demand: At Px = $8 point = Qx * Px = (32-44) * Px Qx (8-7) 32 At Px = $7 point = (32-44) * 7 = -1.91 (8-7) 44 Arc price elasticity of demand arc = Qx * (P1+P2)/2 = Q1-Q2 * P1+P2 Px (Q1+Q2)/2 = P1-P2 Q1+ Q2 = (32-44) * (8+7) = -2.37 (8-7) (32+44) 8 = -3

Income elasticity of demand is defined as the percentage change in quantity demanded divided by the percentage change in consumer income.

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If M changes 1%, how many % would demand for X change? = %change in Qx = Qx * M % change in M M Qx

where i = the income elasticity of demand, M = consumer income Point income elasticity of demand i point = Qx * M M Qx Arc income elasticity of demand i arc = Q1-Q2 * M1+M2 M1-M2 Q1+Q2 [positive result = a normal good negative result = an inferior good]

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Figure 37

Figure 38

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Cross-Price elasticity of demand measures how much the quantity demanded of a good responds to a change in the price of another good. It is computed as the percentage change in the quantity demanded divided by the percentage change in the price of the second good. Cross elasticity of demand measures the degree of substitutability or complementarity between product X and some other product. xyarc = Q1-Q2 * P1+P2 P1-P2 Q1+ Q2

Where xy = cross elasticity of demand

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Substitutes & Complements Substitutes are pairs of products between which the cross elasticity of demand is positive Example: If tea and coffee are substitutes, an increase in the price of coffee will increase your demand for tea. The cross-price elasticity of demand is the percentage change in the quantity demanded of one good that results from a 1 percent change in price of some other good. We can now be specific about substitutes and complements: Two goods, x and y, are substitutes if an increase in price of good y increases demand for good x. Definition: x and y are substitutes if xy > 0.

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Two goods, x and y, are complements if an increase in price of good y decreases demand for good x. Definition: x and y are complements if xy < 0.

Cross Elasticity: xy = % Q of good x % P of good y Goods which are complements: Cross Elasticity will have negative sign (inverse relationship between the two)

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Goods which are substitutes: Cross Elasticity will have a positive sign (positive relationship between the two) Cross Elasticity Relationship > xy > 0 Substitutes xy ~ 0 Unrelated 0 > xy > - Complements Increase in Py Qx rises Qx unchanged Qx falls Decrease in Py Qx falls Qx unchanged Qx rises

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Income & Substitution Effects of a Price Reduction for a Superior goodFigure 40a

Figure 40b

Income & Substitution Effects of a Price Reduction for an Inferior good

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Giffen Good: A kind of inferior good whose quantity demanded varies directly with price. That is a price reduction would be followed by a decline in the quantity demanded, or a price increase would be followed by an increase in the quantity demanded. Technically, its large negative income effect could more than offset the substitution effect. THE DEMAND FOR SWEET POTATOES IN THE UNITED STATES Using the technique of regression analysis presented in Chapter 4 (Salvatore), Schrimper And Mathia estimated the following demand function for sweet potatoes in the United Sates for the period of 1949 to 1972 QDs = 7,609 2,606Ps + 59N + 9471 + 479Pw 27tp (3-4) Where QDs = quantity of sweet potatoes sold per year in the United States per 1,000 hundredweight (cwt) Ps = real dollar price of sweet potatoes per hundredweight received by farmers N = two-year moving average of total U.S. population, in millions I = real per capita personal disposable income in thousands of dollars Pw = real dollar price of white potatoes per hundredweight received by farmers T = time trend (t = 1 for 1949, t = 2 for 1950, up to t = 24 for 1972) The above estimated demand function indicated that the quantity demanded of sweet potatoes per year in 1,000-cwt (i.e. in 100,000-pound) unit in the United States (QDs) declines by 1,606 for each $1 increase in its price (Ps), increases by 59 for each 1 million increase in population (N), increases by974 for each $1,000 increase in real income (l), increases by 479 for each $ increase in the real price of white potatoes (Pw), but falls by 271 with each passing year ( the coefficient of t, the time trend variable) Implications: 1. The demand curve for sweet potatoes is negatively sloped. 2. It shifts to the right with an increase in population income (normal good) price of white potatoes (substitute) 3. It shifts to the left with each passing year (declining tastes) 4. Between 1949 and 1972, the impact on demand for sweet potatoes from the declining tastes and the decreasing Pw exceed the impact of the increase in

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population and income. Therefore, there was a shift to the left of demand for sweet potatoes between the 2 periods.

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It we now substitute into Equation 3-4 the actual values of N = 150.73, I = 1.76, Pw = 2.94, and t = 1 for the United States for the year 1949 we get the following equation for the U.S. demand curve for sweet potatoes in 1949. QDs = 7,609 1,606Ps + 59 (150.73) + 947 (1.76) + 479 (2.94) 271 (1) = 7,609 1,606Ps + 8,893 + 1,667 + 1,408 271 = 19,306 1,606Ps (3-5) By then substituting the value of $7 for Ps into Equation 3-5, we get QDs = 8,064. If Ps = $5.60 (the actual real price of sweet potatoes in the United States in 1949), QDs = 10,312. Finally, if Ps = $4, QDs = 12,882. This demand schedule is plotted as Dx in figure 3-3 On the other hand, if we substitute into Equation 3-4 the values of N = 208.78, I = 3.19, Pw = 2.41, and t = 24 for the year 1912 we get Equation 3-6 for the U.S. demand curve for sweet potatoes in 1972. QDs = 17,598 1606Ps By then substituting the same values as above for Ps into Equation 3-6, we get market demand curve Dx in Figure 3-3. Note that the reduction in tastes for sweet potatoes between 1949 and 1972 and in Pw tends to shift Dx to the left, while the increase in N and I tends to shift Dx to the right. Since the first set of forces overwhelms the second, Dx is to the left of Dx.

Table 3-3

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Estimated Short-Run and Long-Run Price Elasticity of Demand (p) for Selected Commodities, United States Table 4 Elasticity Commodity Short Run Long Run Radio and TV repairs 0.47 3.84 Motion pictures 0.87 3.67 Clothing 0.90 2.90 China and glassware 1.54 2.55 Household natural gas 1.40 2.10 Tobacco products 0.46 1.89 Electricity (household) 0.13 1.89 Foreign travel 0.14 1.77 Bus transportation (local) 0.20 1.20 Medical insurance 0.31 0.92 Jewelry and watches 0.41 0.67 Gasoline 0.20 0.60 Stationery 0.47 0.56 Implications: 1. The long-run price elasticity of demand for most commodities is much larger than the short-run price elasticity. 2. Price elasticity of demand is determined by the availability and affordability of the substitute good. For example, People are frustrated by rising radio and TV repair prices and tend to purchase new radios and TV sets in the long run. Price elasticity of demand for stationery rises only from 0.47 in the short run to 0.56 in the long run for stationery because people cannot find suitable substitutes for it even in the long run

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Table Estimated Income Elasticity of Demand (i) for Selected Commodities, United States Table5 Income Income Commodity Elasticity Commodity Elasticity Radio and TV repairs 5.20 Gasoline 1.36 Motion pictures 3.41 Beef* 1.06 Foreign travel 3.09 Tobacco products 0.86 Medical insurance 2.02 China & glassware 0.77 Electricity (household) 1.94 Chicken 0.28 Bus transportation (local) 1.89 Pork* 0.14 Stationery 1.83 Flour -0.36 Jewelry and watches 1.64 Margarine - 0.20 Implications: 1. The first ten commodities are luxuries. (i > 1) 2. Tobacco products, china & glassware, chicken, pork are necessities.( i < 1) 3. Margarine and flour are inferior goods. (i < 0)

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Table 6 Estimated Cross-Price Elasticity of Demand (xy) between Selected Commodities, United States Cross-Price Elasticity Cross-Price Commodity with Respect to Price of Elasticity Margarine Natural gas Pork Chicken Clothing Entertainment Cereals Sugar Cheese Butter Electricity Beer Pork Food Food Fresh fish Fruits Butter 1.53 Substitute 0.80 0.40 0.29 -0.18 -0.72 -0.87 Complement -0.28 -0.61

Implications: 1. The first four pairs of products are substitutes. (xy > 0) 2. Sugar & fruits, and cheese & butter are complements. (xy < 0)

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Price, Total Revenue, and Marginal Revenue Marginal Revenue is defined as the change in total revenue that results from a one unit increase in demand.

Marginal revenue is always less than the price of its good. The demand curve is downward sloping. When the price is decreased to sell one more unit, the revenue received from previously sold units also decreases. When a monopoly increases the amount it sells, it has two effects on total revenue (P Q). The output effectmore output is sold, so Q is higher. The price effectprice falls, so P is lower.

Marginal Revenue (Assuming no market competition)

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Average revenue (AR) is the ratio of total revenue divided by the amount of the output sold. Whenever MR is greater than AR, AR rises. Whenever MR is less than AR, AR falls. AR = TR = PQ = P

Q

Q

Average revenue is the slope of a line from the origin to a point on the total revenue curve. Marginal revenue (MR) is the change in total revenue attridutable to a one unit change in output. It is calculated by dividing the change in total revenue by the change in output. MR = TR Q Marginal revenue is given by the slope of the total revenue curve at each level of output. The General Form of a Demand Curve (or Average Revenue Curve) P = a bQ Where a > 0 (intercept), b > 0 (slope) TR = P * Q = (a bQ) * Q = aQ bQ2 And so MR = TR = a 2bQ Q Since this demand curve is linear, MR curve has the same intercept as the

demand curve. The slope of MR curve is twice as large (in absolute value) as the slope of the demand curve.66

Relationships between Demand, Marginal Revenue, and Total Revenue Figure 41

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Total Revenue, Average Revenue & Marginal Revenue Average revenue is the slope of a line from the origin to a point on the total revenue curve. (at Q1, AR = slope of OC = CQ1 / OQ1) Marginal revenue is the slope of the total revenue curve at each level of the output. (at Q1, MR = slope of AB = CD / AD)

Figure 42TR($) 10000

C G A

B F

TR O Q1 Q2

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Theory of ProductionFixed Input (K) is an input in the production of goods and services that does not change in the short run. The best examples of a fixed input are the factory, building, equipment, or other capital used in production. Variable Input (L), is an input that does change in the short run. The best examples of a variable input would then be the labor or workers who work in the factory or operate the equipment. Fixed and variable inputs are most important for the analysis of short-run production by a firm. In the short run (such as a day or so) a firm can vary the quantity of labor, but the quantity of capital is fixed. Short Run: A period of time in which the amount of at least one significant input cannot be changed. Long Run: A period of time long enough in which the amounts of all inputs can be changed. Therefore, in the Long Run there are no fixed costs. All costs are variable costs, and we refer to these variable costs in the long run with the notation LRAC. The LRAC curve is a composite of the ATC curves of an array of plants of different sizes (different amounts of K) (Note that in the textbook they never draw a "long run total cost" curve, only a Long Run Average Cost (LRAC) curve. Also they dont find it necessary to refer to "long run average variable cost" because it is well known that in the "long run" all costs are variable.) Production Function: The relationship between the Variable Input (applied to the Fixed Input) and resulting output. In general form: the quantity of output depends on the quantity of the inputs used Q = f (K, L) Where Q = the quantity of output K & L = the input levels of capital (fixed factor) and labour (variable factor), respectively.

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Production Function with One Variable Input Figure 43

Law of Diminishing Returns The law of diminishing returns states that as equal quantities of one variable factor are increased, while other factor inputs remain constant, ceteris paribus, a point is reached beyond which the addition of one more unit of the variable factor will result in a diminishing rate of return and the marginal physical product will fall. Total Product, Average Product and Marginal Product Marginal Product (MP) is the extra output produced by one more unit of an input (for instance, the difference in output when a firm's labour is increased from five to six units). Assuming that no other inputs to production change, the marginal product of a given input (X) can be expressed as: MP = Y/X = (the change of Y)/(the change of X).

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Marginal Product Curve The Marginal Product Curve The marginal product curve is a graphical representation of the relation between marginal product and the variable input. The "general" slope of this curve is negative, with incremental output declining for larger workforces. However, the marginal product curve is actually "hump" shaped, with a positive slope giving way to a negative slope.

Average Product (AP) is the ratio of total product divided by the amount of input used to produce this output. APL = Q / L Average produvt is the slope of a line from the origin to a point on the total product curve. Average product attains its maximum value when this line is tangent to the total product

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Figure 46

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MP & AP Both MP & AP first rise, reach a maximum, and decline thereafter. When MP is larger than AP, AP is rising. When MP is smaller than AP, AP is falling. When AP is at its maximum, AP and MP are equal. Three Stages of Production Stage I corresponds to usage of the variable factor from the origin to the point where AP is at its maximum. Stage II corresponds to usage of the variable factor from the origin to the point where AP is at its maximum to the point where AP is zero. Stage III covers the range over which the MP is negative.

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Notice: The producer would never produce in Stage III, since in this stage more

output can be obtained using less of the variable factor. Such inefficiencies in the use of production factors will always be avoided. In Stage I, AP of the variable factor is increasing, which implies the unit cost of producing output decreases as output is increased. In a competitive industry, the firm would never produce in this stage because by expanding output it can reduce unit costs while receiving the same price for each additional unit sold, and this means total profits will increase. Therefore, efficient production occurs in Stage II. Isoquants Isoquant - a curve that shows the efficient combinations of labor and capital that can produce a single (iso) level of output (quantity). Equation for an Isoquant: q = f (L, K). Figure 48

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Figure 49

Properties of Isoquants. 1. The farther an isoquant is from the origin, the greater the level of output. 2. Isoquants do not cross. 3. Isoquants slope downward

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Output Produced with Two Variable Inputs

Figure 50

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Marginal rate of technical substitution (MRTS) - the number of extra units of one input needed to replace one unit of another input that enables a firm to keep the amount the amount of output it produces constant MRTS L = Change in labor K Change in capital Properties of Isoquants. 1. The farther an isoquant is from the origin, the greater the level of output. 2. Isoquants do not cross. 3. Isoquants slope downward

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How the Marginal Rate of Technical Substitution Varies Along an Isoquant

Substitutability of Inputs and Marginal Products.

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Substitutability of Inputs

Figure 51 Perfect Substitutes Complementary Inputs

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Shapes of Isoquant Curve: If the two inputs are perfect substitutes, the resulting isoquant map generated is represented in fig. A; with a given level of production Q3, input X is effortlessly replaced by input Y in the production function. The perfect substitute inputs do not experience decreasing marginal rates of return when they are substituted for each other in the production function. If the two inputs are perfect complements, the isoquant map takes the form of fig. B; with a level of production Q3, input X and input Y can only be combined efficiently in a certain ratio represented by the kink in the isoquant. The firm will combine the two inputs in the required ratio to maximize output and minimize cost. If the firm is not producing at this ratio, there is no rate of return for increasing the input that is already in excess. Isoquants are typically combined with isocost lines in order to provide a cost-minimization production optimization problem.

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Expansion path: Long Run and Short Run It is a locus of the tangency points between various isoquants and various isocost Figure 52

Long run expansion path shows the least-cost combinations of L and K a firm would choose as it expanded its output level, if it were free to vary both inputs and if it were given constant factor prices and technology level. Short run expansion path is the horizontal line at the capital input level K* It is in fact the TP curve. Any isocost that intersects an isoquant on the TP line must lie farther to the right when compared with the isocost that is tangent to each isoquant That is except at B, it costs more to produce the output in the short run than it dose in the long run.

Effect of a Change in Input Prices If the price of one factor changes, with other factors unchanged, the firm will substitute away from the factor that has become relatively more expensive and in favor of the factor that has become relatively less expensive.

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Stage 1 : targeted output is Q1 Equilibrium at A: Q1 is produced efficiently by the factor combination K1 units of capital and L1 units of labor, and factor prices are such that the lowest attainable isocost line is MN. Stage 2: With an increase in w ( and constant r ) , if the firm wishes to maintain its output level at Q1, it will need to spend more money on the inputs to produce Q1 e.g., if MPL = MPK = 5, and w =$2, r=$1, That is, an increase in the wage rate causes the additional output resulting from spending $1 more on L to be Less than the additional output resulting from spending $1 more on K ( Over using L relative to K ) In the short run, the firm is constrained by K1, and so must produce Q1 at point A on isocost ST In the long run, to produce Q1, the firm can adjust both K and L and will increase K to K2 and reduce L to L2 at point B, given the new factor-price ratio. Returns to Scale The degree by which output changes as a result of a given change in the quantity of all factors used in production. 3 types Constant, increasing, and decreasing returns to scale If the quantity of all inputs used in production is increased by a given proportion, we have 1. Constant returns to scale if output increases in the same proportion. 2. Increasing returns to scale if output increases in the greater proportion. 3. Decreasing returns to scale if output increases in the smaller proportion.

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Figure 53

RetFlgure 6.14 Constant, Increasing, and Decreasing Returns to scale In all three panels of this figure we start with the firm using 3L and 3K and producing 100Q ( point A ). By doubling inputs to 6L and 6K, the left panel shows that output also doubles to 200Q ( point B ), so that we have constant returns to scale: the center panel shows that output triples to 300Q ( point C ), so that we have increasing returns to scale: while the right panel shows that output only increases to 150Q ( point D ), so that we have decreasing returns to scale.

Constant Returns to Scale

Increasing returns to scale arise because as the scale of operation increases, a greater division of labor and specialization can take place and more specialized and productive machinery can be used. Decreasing returns to scale arise because as the scale of operation increases, it becomes more difficult to manage the firm effectively and coordinate the various operations and division of the firm. Cost Theory86

Explicit and Implicit costs Explicit cost: The actual expenditures of the firm to hire, rent, or purchase the inputs it requires in production. e.g., the wages to hire labor, the rental price of capital equipment and buildings, and the purchase price of raw materials and semifinished products. Implicit costs: The value of the inputs owned and used by the firm in its own production activity. The amount for which the firm could sell or rent out these owned inputs to other firms represents a cost of production of the firm owning and using them. e.g., the highest salary that the entrepreneur could earn in his or her best alternative employment, and the highest return that the firm could receive from investing its capital in the most rewarding alternative use or renting its land and buildings to the highest bidder ( rather than using them itself ) Accounting & Economic costs. Accounting costs: The firms actual expenditures or explicit costs incurred for purchased or rented inputs. They are useful for financial reporting by the firm and for tax purposes. Economic costs: The opportunity costs of the inputs. They are useful for managerial decision-making purposes. EX: Inventory valuation. A firm purchased a raw material for $100, but its price subsequently fell to $60. Accountant: reports the cost of the raw material at its historical price of $100, Even after the price fell to $60. Economist: values the raw material at its current or replacement value. The fact that the firm paid $100 for the input is irrelevant to its current production decision since the firm could only obtain $60 if it sold the input now. The $40 reduction in the price of the raw material is a sunk cost which the firm should not consider in its current managerial decisions.

Short-Run Cost Functions

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Total fixed costs ( TFC ): The total cost of using the fixed input. e.g., interest payments on borrowed capital, rental expenditures on leased plant and equipment ( or depreciation associated with the owned plant and equipment ). Total variable costs ( TVV ): The total cost of using the variable input. E.g., costs of raw materials, labor costs. Total costs ( TC ): The total cost of using all the firms inputs. AFC = TFC + TVC Average fixed costs ( AFC ): The average cost of using the fixed input. AFC = TFC / Q Q = amount of output Average variable costs ( AVC ): The average cost of using the variable input. AVC = TVC / Q Average total costs ( AC ): The average cost of using all the firms inputs. AC = AFC + AVC = TC / Q Marginal Cost ( MC ): The change in a firms total cost ( or total variable cost ) resulting from a one unit change in output. MC = TC / Q = TVC / Q The Relationship between Production and Cost The cost function ( cost & output ) simply the production function (output & input) expressed in monetary rather than physical units. All assumptions used in the short-run production function apply to the short-run cost function. One additional assurnption is about the prices of the inputs which are assurned to be fixed i.e., the firm acts as a price taker in the input market, that is it can hire as many inputs as it desires, as long as it pays the market price for them. EX: The following table presents an example of the relationship between production and cost in the short run. The cost of using the variable input (Labor) is determined by multiplying the number of variable input used by the input price. Assume that each unit of labor costs $500 It shows that total variable cost is a mirror image of total product. When TP increases at an increasing rate (MPL is rising), TVC increases at a decreasing rate (MC is declining). When TP increases at a decreasing rate (MPL is declining), TVC increases at an increasing rate (MC is rising).

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FIGURE 7-1 Short Run Relationship Between Production and Cost Total variable cost (TVC) is associated with the variable input: Assume w=$500 per unit (price-taker)

Total Input (L) 0 1 2 3 4 5 6 7 8 9 TVC (wL) 0 500 1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500

Q (TP) 0 1,000 3,000 6,000 8,000 9,000 9,500 9,850 10,000 9,850

MP 1,000 2,000 3,000 2,000 1,000 500 350 150 -150

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TP and TVC are mirror images of each other

NOTE: TP and TVC are mirror images of each other.

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The top panel shows that TVC is zero when output is zero and rises as output rises. At point G the law of diminishing returns begins to operate. The TC curve has the same shape as the TVC curve and is above it by $60 (the TFC). The bottom panel shows U-shaped AVC, ATC and MC curves. AFC = ATC AVC and declines continuously as output rises. The MC curve reaches a minimum before the AVC and AT curves and intercepts them from below at their lowest points.

SR Relationship Between Production and CostTotal cost (TC) is the cost associated with all of the inputs. It is the sum of TVC C T and TFC. M = C Q TC=TFC+TVC Marginal cost (MC) is the change in total cost associated a change in output.MC = TC (TFC +TVC ) TFC TVC TVC = = + =0 + Q Q Q Q Q

Total Input (L) 0 1 2 3 4 5 6 7 8 9 TVC (wL) 0 500 1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500

Observe that: When MP is increasing, MC is decreasing. When MP is decreasing, MC is increasing.

Q 0 1,000 3,000 6,000 8,000 9,000 9,500 9,850 10,000 9,850

MP 1,000 2,000 3,000 2,000 1,000 500 350 150 -150

MC 0.50 0.25 0.17 0.25 0.50 1.00 1.43 3.33

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The Short Run Cost FunctionProduction cost graph or map

Important Map Observations

AFC declines steadily over the range of production. Why? In general, ATC is u-shaped. Why? MC intersects the minimum point (q*) on ATC. Why?

At Q* - ATC is minimized or inputs are used most efficiently given the production function

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A change in input prices will shift the cost curves. If fixed input costs are reduced then ATC will shift downward. AVC and MC will remain unaffected.

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A change in input prices will shift the cost curves. If variable input costs are reduced then MC, AVC, and AC all shift downward.Impacts of input price changes on the cost curves

will

Fixed input price declines: e.g. rental payment declines. It will reduce the firms fixed and total costs; therefore, the AC curve shifts downward. Variable input price declines: e.g. a reduction in wage rates or raw material costs. It will reduce the firms variable and total costs. Therefore, the AC, AVC and MC curves shift downward.

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Long-Run Cost Curves Long-run total cost (LTC) curve is derived from the firms Expansion path and shows the minimum long-run average (LAC) and marginal cost (LMC) curves are then derived from the LTC curves. LTC curve starts at the origin because there are no fixed costs in the long run Long-run average cost (LAC) curve shows the lowest average cost of producing each level of output when the firm can vary all input (i.e., the firm can build the most appropriate plant to produce each level of output.) LAC = LTC Q Long-run marginal cost (LMC) curve shows the change in LTC per unit change in output LMC = LTC = slope of the LTC curve Q

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From point A on the expansion path in the top panel, and w = $10, we get point A on the long-run total cost (LTC) curve in the middle panel. Other points on the LTC curve are similarly obtained. The LAC curve is given by the slope of a ray from the origin to the LTC curve. It falls up to point G (at output level = 4Q) because of increasing returns to scale and rises thereafter because of decreasing returns to scale. Relationship Between Long-Run and Short-Run Average Cost Curves

Top panel : Assume that the firm can build only four scales of plant in the long run. The top panel of the above Figure shows that the minimum average cost of producing I unit of output (IQ) is $80 and results when the firm operates the scale of plant given by SAC1 (the smallest scale of plant possible)at point A.

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The firm can produce 1.5Q at an average cost of $70 by utilizing either the scale of plant given by SAC1 or the larger scale of plant given by SAC2 at point B*. To produce 2Q, the firm will utilize scale of plant SAC2 at point C (at and average cost of $50) rather than the smaller scale of SAC1 at point C* (the lowest point on SAC1, which refers to the average cost of $67 ). Therefore, the firm has more flexibility in the long run than in the short run. To produce 3Q, the firm is indifferent between using plant SAC2 or larger plant SAC3 at point E* (at an average cost of $60). The minimum average cost of producing 4Q (at an average cost $30) is achieved when the firm operates plant SAC3 at point G (the lowest point on SAC3). In this case, the long run average cost curve of the firm is AB*CE*GJ*R Bottom panel : Assume that the firm can build an infinite scales of plan in the long run. As the number of scales of plant that the firm can build in the long run increase, the LAC curve becomes more smooth. The LAC curve is the tangent to envelope to the SAC curve and shows the minimum average cost of producing various levels of output in the long run. Only at point G (the lowest point on the LAC curve) does the firm utilize the optimal scale of plant at its lowest point. In the long run, the firm can build the plant that minimizes the cost of producing any anticipated level of output. Once the plant has been built, the firm operates in the short run. Learning Curves: show the decline in the average cost of production with rising cumulative total outputs over time. As firms gain experience in the production costs usually decline. That is, for a given level of output per time periods often provides the manufacturing experience that enables firms to lower their average cost of production. Contrast this to economies of scale, which refers instead to declining average cost as the firms output per time period increases. Firms that, until a few years ago, operated exclusively in the domestic market are now purchasing increasing quantities of inputs and components, and are shifting some of their production to foreign nations. For example, Malachi Mixon, an American medical-equipment company, now by parts and components in half a dozen countries, from China to Colombia; 10 years ago it did all of its shopping at home.

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Diseconomies of Scale Diseconomies of scale leads to rising long-run average costs LRAC rises due to firms expanding beyond their optimum scale Diseconomies are difficult to identify precisely They are often caused by the complex nature of managing large-scale firms and in managing the growth of a business (1) Costs of administration and coordination of the workforce (2) The growth of corporate bureaucracy (i.e. which might be seen in excessive layers of management) (3) The risk of worker alienation or shirking because of the problems in monitoring the effectiveness of workers (4) Differences in the optimum scale of units of capital (5) An increase in transportation costs to distant markets Diseconomies can lead to a misallocation of scarce resources if firms do not achieve long run productive efficiency External Diseconomies of Scale These occur when too many firms have located in one area Local labour becomes scarce and firms now have to bid wages higher to attract and retain new workers Land and factories become scarce and rents begin to rise The local traffic infrastructure become congested and so transport costs begin to rise

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Economic Profit & Accounting Profit Economic Profit: the difference between total revenue and total cost, where total cost includes all costs (both explicit and implicit as well as opportunity costs) associated with resources used by the firm. Accounting Profit: the difference between total revenue and all explicit costs incurred. Accounting Profit = Normal profit (opportunity cost of the resources owned by the firm) + Economic profit Example: A firm produces 100 units of output a week by using 10 units of K and 10 units of L. Let the weekly price of each factor be $10/unit, and the firm owns its 10 units of K. And output sells for $2.5/unit. The firms total revenue (TR) = P*Q = 2.5* 100 = $250 Explicit cost = L* w = 10*10 = $100 Implicit (or opportunity) cost (of capital) = K* r = 10*10 = $100 The firms total cost (TC) = 100+100 = $200 The firms weekly economic profit () = TR TC = 250-200 = $50 The firms weekly accounting profit = TR explicit cost = 250-100 = $150 Accounting Profit = $100 Normal profit (opportunity cost of the resources owned by the firm) + $50 Economic profit Profit Maximization Behavior of a Firm The primary goal or objective of the firm is to maximize its wealth or value or value of the firm, which is given by the present value of all expected future profits of the firm. Future profits must be discounted to the present because a dollar of profits in the future is worth less than a dollar of profit today. The wealth of the firm is given by12n

PV = (1 + r )1 + (1 + r ) 2 + + (1 + r ) 0 Where; PV = the present value of all expected future profits of the firm I = the expected profits in each of the n years considered r = the discount rate

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Profit Maximization of a Competitive Firm in the Short Run In the short run, some inputs are fixed, and so a firm has fixed costs whether it produces or not. Therefore, a firm should stay in business in the short run even if it incurs losses, as long as these losses are smaller than its fixed costs. The best output level for the firm in the short run is the one at which the firm maximizes profits or minimizes losses. The best output level of the firm in the short run is the one at which the MR of the firm equals its short - run MC. R Q

MR = MC

C Q

As long as MR exceeds MC, the firm should expand output because the firm will add more to its TR than to its TC (so that its total profits increase or its total losses decrease). In the bottom panel of figure 9-2, point H is the shut down point of the firm. i.e., below point H, the firm would not even cover its variable costs, and so by going out of business, the firm would limit its losses to be equal to its TFC. Short Run Supply Curve of the Competitive Firm The rising portion of the firms MC curve above the AVC curve or shut-down point represents the short-run supply curve of the competitive firm because it shows a unique relationship between P and Q, which is the definition of the supply curve. The short run market supply curve of the product is obtained by the horizontal summation of the individual firms supply curves.

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Market Demand The demand for a good or service is defined as: Quantities of a good or service that people are willing to buy at various prices within some given time period, assuming that other factors besides its own price held constant (ceteris paribus). Determinants of demand 1. Own price 2. Income 3. Prices of related products (substitutes or complements 4. Tastes and preferences 5. Population 6. Future expectation Market Supply The supply of a good or service is defined as: Quantities of a good or service that people are willing to sell at various prices within some given time period, assuming that other factors besides its own price held constant. (ceteris paribus). Example: the marker supply curve for aluminum shows that at the price of $0.50 per pound, there would be 2 million pounds of aluminum offered for sale annually. Determinants of supply 1. costs (e.g., factor prices) 2. Technology 3. Number of sellers 4. Future expectations 5. Weather Equilibrium Quantity Price Is the price and quantity at which the supply and demand schedules intersect. Equilibrium Quantity: The price that equates the quantity demanded with the quantity supplied. Equilibrium Quantity: The amount that people are willing to buy and sellers are willing to offer at the equilibrium price level. Shortage (Excess Demand): A market situation in which the quantity supplied, at a price below the equilibrium level.

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Surplus (Excess Supply): A market situation in which the quantity supplied exceeds the quantity demanded, at a price above the equilibrium level. Comparative Statistics Analysis: A method of economic analysis used to analyze the market Steps: 1. Begin by assuming that the model is in equilibrium. 2. Introduce a change in the model. Consequently, a condition of disequilibrium is created. 3. Find the new point at which equilibrium is restored. 4. Compare the new equilibrium point with the original one. The shift in demand or supply creates either a shortage or a surplus at the original equilibrium price. Thus, the equilibrium price has to rise or fall to clear the market Case a : An increase in demand causes equilibrium price and quantity to rise. Case b : A decrease in demand causes equilibrium price and quantity to fall. Case c : An increase in supply causes equilibrium price to fall and quantity to rise. Case d : A decrease in supply causes equilibrium price to rise and quantity to fall. Price Elasticity of Supply (es) : measures the relative responsiveness or sensitivity in the quantity of a commodity supplied to changes in its price .

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The Theory of the firms. Brings together - Demand analysis - Production or cost analysis So that equilibrium price and output are determined to achieve profit maximization in different market structures. 1) perfect competition 2) monopoly 3) monopolistic competition, and 4) oligopoly 1) Perfect competition - Many sellers and buyers of a product, each seller and buyers is too small to have an impact on price each supplier is a price taker. - Homogeneous product, - Perfect mobility of resources Sellers can enter & exit the market at will 2) Monopoly - A single firm selling a product with no substitute - Entry of a new producer into the market is impossible 3) Monopolistic Competition - large number of sellers acting independently - Product differentiation - Partial (and limited) control over product price - Entry and exit relatively easy 4) Oligopoly - Relatively few sellers - Either standardized of differentiated products - Control over price closely circumscribed by the interdependence of the competing firms - Relatively difficult to enter

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Perfect Competition

A market condition in which the market price and quantity of a product are determined exclusively by the forces of market demand and market supply for the product. As a price taker, the firm determines its profit max level of output in the short run and long run at the given market price.

Price takers: Since there is a great number of buyers and sellers of the product, and each seller and buyer is too small ( relative to the market ) to be able to affect the price of the product by his or her own actions. That is, a change in the output of a single firm will not affect the market price of the product. Similarly, each buyer of the product is too small to be able to demand from the seller any price reduction. The product of each competitive firm is homogeneous, identical, or perfectly standardized. This is another reason that a firm cannot sell at a price higher than the market price of the product, otherwise it would lose all its customers. Also, it will not sell at a price below the market price since it can sell any quantity of the product at the given market price.

Price Determination under Perfect Competition

The price of a product is determined at the intersection of the market demand and supply curves of the product. Therefore, the individual firm faces a horizontal or infinitely elastic demand curve for his product at the market price determined by the market demand and supply curves Since P is constant, the change in the total revenue per unit change in output ( MR ) is also constant and equal to P.

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The Equilibrium Price and the Demand Faced by Perfectly Competitive Firm Perfect Competition: Price Determination Figure 54

From the figure, the equilibrium price of the product is determined by the intersection of the competitive market demand and supply curves. The competitive firm is then a price taker and faces the infinitely elastic demand curve. Since the firm can sell any quantity of the product at price p *, the AR and the MR also equals p*. P = AR = MR

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Profit Maximization and the Competitive Firm's Supply Curve 1. The profit-maximizing quantity can also be found by comparing marginal revenue and marginal cost. If marginal revenue is greater than marginal cost, increasing output will raise profit. If marginal revenue is less than marginal cost, decreasing output will raise profit. Profit-maximization occurs where marginal revenue is equal to marginal cost. B. The Marginal-Cost Curve and the Firm's Supply Decision For a competitive firm, the firms price equals both its average revenue and its marginal revenue, which can be shown by a horizontal line. At the profit-maximizing level of output, marginal revenue is equal to marginal cost. Because the firm's marginal cost curve determines how much the firm is willing to supply at any price, it is the competitive firm's supply curve.

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Total Revenue and Cost

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The short-run production decision for a perfectly competitive firm can be graphically illustrated using total revenue and total cost curves, such as those displayed in the exhibit to the right. These total curves represent the total revenue and cost of zucchini production by Phil the zucchini grower.

Total Revenue: The straight TR line depicts the total revenue. The line is straight, with a constant slope, because the price is constant. Total Cost: The curvy TC line depicts the total cost incured in the production of zucchinis. The shape is based on increasing, then decreasing marginal returns. Profit: The vertical difference between these two lines is economic profit. If the total revenue line is above the total cost line in the middle of the diagram, economic profit is positive. If the total revenue line is below the total cost line at the far right and far left, economic profit is negative.

The key for the firm is to identify the production level that gives the greatest vertical distance between the total revenue and total cost curves in the middle of the diagram.

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Perfect Competition: Short-Run Equilibrium Firms Demand Curve = Market Price = Marginal Revenue Firms Supply Curve = Marginal Cost where Marginal Cost > Average Variable Cost Figure 55

Short Run Analysis of a Perfectly Competition Firm With d, the best level of output is 4 units and is shown in the top panel by point E, at which P= MR, and the firm earns profit EA= $ 10 per unit, and EABC= $40 in total. With d in the bottom panel the best level of output is 3 units, and is given by point E the firm minimizes losses. The shut-down point H. The rising portion of the MC curve above the AVC curve ( shut-down point ) is the firms short-run supply curve [MC=supply curve]

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Perhaps the most common method of identifying the profit-maximizing level of production for a perfectly competitive firm is using marginal revenue and marginal cost curves, such as those displayed in the this exhibit. Figure 56

Marginal Revenue: The horizontal line (MR) is the marginal revenue the firm receives for each extra unit produced, which is constant and equal to $4. Marginal Cost: The U-shaped curve (MC) is the marginal cost the firm incurs in the production process. The shape is based on increasing, then decreasing marginal returns. Average Cost: Two additional U-shaped curves included in the diagram are average total cost (ATC) and average variable cost (AVC). These curves are helpful when identifying the level of economic profit or loss and the firm's short-run supply curve. In this analysis, the firm needs to identify the quantity of output that achieves an equality between marginal revenue and marginal cost.

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Production Alternatives Figure 57 Profit and Loss

Fig.

A perfectly competitive firm faces three short-run production alternatives based on a comparison of price, average total cost, and average variable cost. P > ATC: Total revenue exceeds total cost and Phil receives a positive economic profit. In this case, the firm maximizes profit by producing the quantity of output that equates marginal revenue and marginal cost. This is the initial situation displayed in the graph. ATC > P > AVC: Total revenue falls short of total cost, meaning the firm incurs an economic loss (or negative economic profit). In spite of the loss, because the price exceeds average variable cost, the firm can maximize profit (minimize loss) by producing the quantity of output that equates marginal revenue and marginal cost. the firm receives enough revenue to cover ALL variable cost plus a portion of fixed cost. The loss from production is less than the loss from NOT producing, which is total fixed cost. P < AVC: Total revenue also falls short of total cost, and the firm incurs an economic loss (or negative economic profit). In this case the firm maximizes profit (that is, minimizes loss) by reducing the quantity of output to zero, or producing no output in the short run. The economic loss from producing is greater than the economic loss of NOT producing, which is total fixed cost.112

Shutdown or Exit?

A shutdown refers to a short-run decision not to produce anything during

a specific period of time because of current market conditions. Exit refers to a long-run decision to leave the market. Figure 58

Figure 3 The C

Costs

A firms Entry DecisionA firm will enter the industry if such an action would be profitable. Enter if TR > TC Enter if TR/Q > TC/Q Enter if P > ATC

If P wil pro

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A firms Exit DecisionIn the long run, the firm exits if the revenue it would get from producing is less than its total cost. Exit if Exit if Exit if

TR < TC TR/Q < TC/Q P < ATC

Figure 4 The Comp

Costs

Long-Run Supply CurveThe competitive firms long-run supply curve is the portion of its marginal-cost curve that lies above average total cost.

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SUMMARY Short-Run Supply Curve The portion of its marginal cost curve that lies above average variable cost. Long-Run Supply Curve The marginal cost curve above the minimum point of its average total cost curve. Figure 59

Figure 5 Profit as the A Average

(a) A Firm w Price

Figure 5 Profit as the Profit AveragP ATC

(b) A Firm

Price

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Long-Run Equilibrium

In the long run all inputs and costs of production are variable, and the firm can construct the optimum or most appropriate scale of plant to produce the profit maximizing level of output. At the end of the process of entry and exit, firms that remain must be making zero economic profit. The process of entry and exit ends only when price and average total cost are driven to equality. Long-run equilibrium must have firms operating at their most efficient scale.

Why do competitive firms stay in business if profit is zero? Profit equals total revenue minus total cost. Total cost includes all the opportunity costs of the firm In the zero-profit equilibrium, the firms revenue compensates the owners for the time and money they expend to keep the business going. The market price is determined for the managers by the forces of supply and demand. All that they have to do is to decide whether their cost structure will enable their firm to at least earn a normal amount of profit.

It is extremely difficult to make money in a highly competitive market. Actually, the only way for firms to survive in perfect competition is to be as cost efficient as possible because there is absolutely no way to control the price. In might pay for a firm to move into a market before others start to enter. This might mean entering a market before the demand is high enough to support an above-normal price. Spotting these market opportunities and taking the risk of going into these markets are key tasks of a good manager.

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MonopolyA monopoly is a market structure in which a single seller produces a product with no close substitutes Sources of Monopoly Control of essential inputs to a product Patents or copyrights Economies of scale: Natural monopoly Government franchise: Post office

Monopoly Profit Maximization

Monopoly Short-Run Equilibrium Demand curve for the firm is the market demand curve Firm produces a quantity (Q*) where marginal revenue (MR) is equal to marginal cost (MC) Exception: Q* = 0 if average variable cost (AVC) is above the demand curve at all levels of output

Mo Short-RuFigure 61117

Figure 62

LFigure 63 Social Cost of Monopoly

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Finding maximum24 22 20 d 18 16 Measuring the maximum profit using average curves 14 e 12 MC 10 8 6.00 AC a 4.50 6 b f 4 AR 2 Quantity 0 MR -2 1 2 3 -4

TR, TC, T ()16 12 8 4 0

T O T A L P R O F II T TOTAL PROF T

1

2

3

4

5

6

7

-4

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Deadweight Deadweigh

Ppc

Consumer surplus Producer surplusConsumer120

Deadweigh Deadweig

Equilibrium of indus monopoly:

MC

P2 P1 P3

x

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OligopolyThere are 3 oligopoly models namely: 1. Kinked demand curve model 2. Cartel arrangements 3. Price leadership Kinked Demand Curue Model Introduced by Paul Sweezy in 1939-to explain the price rigidity often observed in many oligopoly models. If an oligopoly firm raises its price, it will lose most of its customers to those oligopoly companies that do not follow. But on the other hand, as an oligopoly cannot increase its sales by lowering its market price because its competitors would immediately match by also lowering their price. Therefore, an oligopolist faces a demand curve that is kinked at the prevailing market price;-

It is highly elastic for a price increase Much less elastic for price decreases

Mutual Interdependence Since there are few companies in an Oligopoly industry, companies are very sensitive to the prices of their competitors. If one company lowers price and the other companies do not, customers may flock to the company with the lower price. As a result, price cuts are usually followed by all companies in the industry. If one company raises price, other companies see an opportunity to take that companys customers. As a result, price increases are generally ignored by competitors. Price tends to remain stable in an Oligopoly since all competitors will generally lose profit if price changes.

An oligopolist will try to keep his price constant even where there is change in costs or demand. Therefore, competition takes the form of Product quality122

- Advertising - Service - Other forms of non-price competition

123

A

Kinked Demand Curve Kinked Demand CurveEven large price Even small changes have price little impact oncause changes quantity customers many demanded. 124

Price Price

Supp price more will m In thi

to move to the

Assume that price is currently at Pe and prices are cut. If we Pe use the elastic demand curve, D2, then we ignore the is Assume that price decrease. With and currently at Pe elastic demand, we lose prices are increased. If many customers. we use the inelastic Logically, we are demand curve, D1, better offmatch the and then we using D1 matching With the decrease Pe increase. and keeping our we inelastic demand, customers. many do not lose customers, but we do 125 not take gain many

Price

Kinked Demand Curve

Ig

Price

Ign ore MR s Cu rv

Ig

Ign MR ores Cu rv

Qua

Kinked Price Demand CurveP0 P1

Assu is a at I

Price

Kinked Demand CurveP0

Will I the in if I di ignor

Quantity

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2) Cartel Arrangements

Kinked Demand CurvePriceP

To avoid price war and to maintain market sharee oligopolists can introduce Collusion by setting up centralized marketing arrangements.

Does MR Earlier we stated that Oligopolistic companies tend to follow a price decrease change in Price change generally leads to loss of profit. this and ignore a price increase. However, there is a of prices? range caveat here. If ALL companies get together and decide toincrease price at the same time, then all companies may gain profit. This is called Collusion.

Does MR = MC P OK throughout this Cartels price range? the USA, Australia and the UK, In some countries like cartels are illegal. Ptoo low But there are some international cartel arrangements Air fares (LATA)

Chemicals

Qua127

Thailand Tobacco Company

Tin , Rubber & Rice

OPEC is a prime example of a cartel that was formed specifically to collusively set price and quantity, and to divide markets.

Ce

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Price Leadership This model suggests that there is an understood leadcompany in the industry that other companies watch for cues as to when price should be raised or lowered. The dominant firm Sets price that maximizes its profits

Allows other firms to sell as much as they can at that price.

Therefore, other firms operate as if in perfect competition market and the dominant firm acts as the residual monopolistic supplier.

Price-

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Strategic Behaviour and Game Theory For oligopoly, game theory is useful in determine the action and reaction of competitors. Since there are very few firms, and each firm affects the others, reaction of others must be considered in determining the strategic actions;

Product pricing Quantity of production Level of advertising

Game theory deals with the choice of the optimal strategy in conflicting situations. To gain a competitive advantage over a rival, to avoid war and maximize profits. Payoff Matrix for an Advertising Game What is the optimal strategy for Firm A if Firm B chooses to advertise?

Firm A

Advertise Don't Advertise

Firm B Advertise Don't Advertise (4, 3) (5, 1) (2, 5) (3, 2)

If Firm A chooses to advertise, the payoff is 4. Otherwise, the payoff is 2. The optimal strategy is to advertise. What is the optimal strategy for Firm A if Firm B chooses not to advertise?

Firm A

Advertise Don't Advertise

Firm B Advertise Don't Advertise (4, 3) (5, 1) (2, 5) (3, 2)

If Firm A chooses to advertise, the payoff is 5. Otherwise, the payoff is 3. Again, the optimal strategy is to advertise. Regardless of what Firm B decides to do, the optimal strategy for Firm A is to advertise. The dominant strategy for Firm A is to advertise.

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What is the optimal strategy for Firm B if Firm A chooses to advertise?

Firm A

Advertise Don't Advertise

Firm B Advertise Don't Advertise (4, 3) (5, 1) (2, 5) (3, 2)

If Firm B chooses to advertise, the payoff is 3. Otherwise, the payoff is 1. The optimal strategy is to advertise. Regardless of what Firm A decides to do, the optimal strategy for Firm B is to advertise. The dominant strategy for Firm B is to advertise.

Prisoners DilemmaTwo suspects are arrested for armed robbery. They are immediately separated. If convicted, they will get a term of 10 years in prison. However, the evidence is not sufficient to convict them of more than the crime of possessing stolen goods, which carries a sentence of only 1 year. The suspects are told the following: If you confess and your accomplice does not, you will go free. If you do not confess and your accomplice does, you will get 10 years in prison. If you both confess, you will both get 5 years in prison. Payoff Matrix (negative values)

Individual A

Confess Don't Confess

Individual B Confess Don't Confess (5, 5) (0, 10) (10, 0) (1, 1)

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Prisoners DilemmaApplication: Price CompetitionFirm B Low Price High Price (2, 2) (5, 1) (1, 5) (3, 3)

Firm A

Low Price High Price

Dominant Strategy: Low Price

Firm A

Low Price High Price

Firm B Low Price High Price (2, 2) (5, 1) (1, 5) (3, 3)

Application: Nonprice CompetitionDominant Strategy: Advertise

Firm A

Low Price High Price

Firm B Low Price High Price (2, 2) (5, 1) (1, 5) (3, 3)

Application: Cartel CheatingDominant Strategy: Cheat

Firm A

Low Price High Price

Firm B Low Price High Price (2, 2) (5, 1) (1, 5) (3, 3)

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PRICINGTo maximize profits, a firm produces where MR=MC and change in prices indicated on the demand curve. This is true in all market structures, except under perfect competition, where a firm is a price taker and produces at P=MR=MC. All these are under the assumption that the firm is:

Producing one product In one market Has precise knowledge of demand and cost curves

However this is generally not true as firms produce more than one product and are in many markets. Also they do not have precise knowledge of demand and cost curves. Therefore they will have to examine new pricing aspects, for example price discrimination pricing of products in different markets transfer pricing cost-plus pricing.

Pricing of Multiple Products General Motors Company (USA) produces many Car models - Oldsmobile - Chevrolets When pricing one product they must consider the effect on other products; For example, lower price for Oldsmobiles, may reduce demand for Chevrolets, which is substitute. Therefore, output levels and prices of various products sold by the same firm should be determined jointly, not independently.

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For product A+B of same firm MBA = TRA + TRB QA QA MRB = TRB + TRA QB QB IF TRB and TRA are positive QA QB A and B and complimentary If they are negative they are substitutes. Therefore, output decisions must be made accordingly;

Producing more of both A and B or Producing more of A and less of B

Why does a firm produce more than one product ? Because after producing the best level of output MR =MC of a product the firm may have idle capacity. The price of each product will be determined by the respective demand curves. EMR is the point where MR of the least profitable product equals overall MC of the plant (producing all products) It would be profitable for the fir