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Post Grad Diploma - Class 2
ElasticityThe beauty of Marginal Cost and Marginal RevenueAccounting and Economic ProfitsDifferent types of Markets
The elasticity of demand
• Price elasticity of demand is a measure of how much the quantity demanded of a good responds to a change in the price of that good.
• Price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in price.
Computing the price elasticity of demand
• The price elasticity of demand is computed as the percentage change in the quantity demanded divided by the percentage change in price.
Price elasticity of demand =Percentage change in quantity demanded
Percentage change in price
Computing the price elasticity of demand
• Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand would be calculated as (ignoring the negative sign):
( )
( . . ).
1 0 81 0
1 0 0
2 2 0 2 0 02 0 0
1 0 0
2 0 %
1 0 %2
• Inelastic demand– Quantity demanded does not respond
strongly to price changes.– Price elasticity of demand is less than one.
• Elastic demand– Quantity demanded responds strongly to
changes in price.– Price elasticity of demand is greater than
one.
The variety of demand curves
The variety of demand curves
• Perfectly inelastic– Quantity demanded does not respond to
price changes.
• Perfectly elastic– Quantity demanded changes infinitely with
any change in price.
• Unit elastic– Quantity demanded changes by the same
percentage as the price.
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(a) Perfectly inelastic demand: elasticity equals 0
$5
4
Quantity
Demand
1000
1. Anincreasein price ...
2. ... leaves the quantity demanded unchanged.
Price
The price elasticity of demand
(b) Inelastic demand: elasticity is less than 1
Quantity0
$5
90
Demand1. A 22%increasein price ...
Price
2. ... leads to an 11% decrease in quantity demanded.
4
100
The price elasticity of demand
The price elasticity of demand
Copyright©2003 Southwestern/Thomson Learning
2. ... leads to a 22% decrease in quantity demanded.
(c) Unit elastic demand: elasticity equals 1
Quantity
4
1000
Price
$5
80
1. A 22%increasein price ...
Demand
The price elasticity of demand
(d) Elastic demand: elasticity is greater than 1
Demand
Quantity
4
1000
Price
$5
50
1. A 22%increasein price ...
2. ... leads to a 67% decrease in quantity demanded.
The price elasticity of demand
(e) Perfectly elastic demand: elasticity equals infinity
Quantity0
Price
$4 Demand
2. At exactly $4,consumers willbuy any quantity.
1. At any priceabove $4, quantitydemanded is zero.
3. At a price below $4,quantity demanded is infinite.
Total revenue and the price elasticity of demand
• Total revenue is the amount paid by buyers and received by sellers of a good.
• Calculated as the price of the good times the quantity sold.
• TR = P x Q
Total revenue
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Demand
Quantity
Q
P
0
Price
P × Q = $400(revenue)
$4
100
Elasticity and total revenue along a linear demand curve
• With an inelastic demand curve, an increase in price leads to a decrease in quantity that is proportionately smaller. Thus, total revenue increases.
How total revenue changes: inelastic demand
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Demand
Quantity0
Price
Revenue = $100
Quantity0
Price
Revenue = $240
Demand$1
100
$3
80
An Increase in price from $1 to $3 …
… leads to an Increase in total revenue from $100 to $240
Elasticity and total revenue along a linear demand curve
• 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.
How total revenue changes: elastic demand
Copyright©2003 Southwestern/Thomson Learning
Demand
Quantity0
Price
Revenue = $200
$4
50
Demand
Quantity0
Price
Revenue = $100
$5
20
An Increase in price from $4 to $5 …
… leads to an decrease in total revenue from $200 to $100
What are costs?
According to the law of supply, firms are willing to produce and sell a greater quantity of a good when the price of the good is high.This results in a supply curve that slopes upward.
What are costs?
The firm’s objectiveThe economic goal of the firm is to maximise profits.
Total revenue, total cost, and profit
Total revenue is the amount a firm receives for the sale of its output.Total cost is the amount a firm pays to buy the inputs into production.Profit is the firm’s total revenue minus its total cost.
Profit = total revenue − total cost
Costs as opportunity costs
A firm’s cost of production includes all the opportunity costs of making its output of goods and services.A firm’s cost of production include explicit costs and implicit costs.
•Explicit costs are input costs that require a direct outlay of money by the firm.•Implicit costs are input costs that do not require an outlay of money by the firm.
Economic profit versus accounting profit
Economists measure a firm’s economic profit as total revenue minus total cost, including both explicit and implicit costs.Accountants measure the accounting profit as the firm’s total revenue minus only the firm’s explicit costs.
Economic profit versus accounting profit
When total revenue exceeds both explicit and implicit costs, the firm earns economic profit.Economic profit is smaller than accounting profit.
For a business to be profitable from an economist’s standpoint, total revenue must cover all the opportunity costs, both explicit and implicit.
Economists versus accountants
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Revenue
Totalopportunitycosts
How an economistviews a firm
How an accountantviews a firm
Revenue
Economicprofit
Implicitcosts
Explicitcosts
Explicitcosts
Accountingprofit
Production and costs
• The production function: The production function shows the relationship between quantity of inputs used to make a good and the quantity of output of that good.
The production function
• Marginal product: The marginal product of any input in the production process is the increase in output that arises from an additional unit of that input.
The production function
• Diminishing marginal product is the property whereby the marginal product of an input declines as the quantity of the input increases.
•Example: As more and more workers are hired at a firm, each additional worker contributes less and less to production because the firm has a limited amount of equipment.
Hungry Helen’s Cake Factory
Number of workers
Output (quantity of
cakes produced per
hour)
Marginal product of
labourCost of factory
Cost of workers
Total cost of inputs
(cost of factory +
cost of workers)
0 0 50
1 50 40
2 90 30
3 120 20
4 140 10
5 150
Hungry Helen’s production function
Quantity ofoutput
(cookiesper hour)
150
140
130
120
110
100
90
80
70
60
50
40
30
20
10
Number of workers hired0 1 2 3 4 5
Production function
The production function
Diminishing marginal product The slope of the production function measures the marginal product of an input, such as a worker.When the marginal product declines, the production function becomes flatter.
From the production function to the total-cost curve
The relationship between the quantity a firm can produce and its total costs determines pricing decisions.The total-cost curve shows this relationship graphically.
Hungry Helen’s cake factory
Number of workers
Output (quantity of cakes produced per hour)
Marginal product of labour
Cost of factory
Cost of workers
Total cost of inputs (cost of factory + cost of workers)
0 0 50 $30 $ 0 $30
1 50 40 30 10 40
2 90 30 30 20 50
3 120 20 30 30 60
4 140 10 30 40 70
5 150 30 50 80
Hungry Helen’s total-cost curve
Copyright © 2004 South-Western
Totalcost
$80
70
60
50
40
30
20
10
Quantityof output
(cookies per hour)
0 10 20 30 15013011090705040 1401201008060
Total-costcurve
The various measures of cost
• Costs of production may be divided into two types:
−fixed costs and −variable costs.
Fixed and variable costs
Fixed costs are those costs that do not vary with the quantity of output produced.Variable costs are those costs that do vary with the quantity of output produced.
Fixed and variable costs
Total costs:Total fixed costs (TFC)Total variable costs (TVC)Total costs (TC)
TC = TFC + TVC
Thirsty Thelma’s Lemonade Stand
Quantity of lemonade (bottles per hour)
Total cost
Fixed cost
Variable cost
Average fixed cost
Average variable cost
Average total cost
Marginal cost
0 $3.00 $3.00 $ 0.00 — — — —
1 3.30 3.00 0.30 $3.00 $0.30 $3.30 $0.30
2 3.80 3.00 0.80 1.50 0.40 1.90 0.50
3 4.50 3.00 1.50 1.00 0.50 1.50 0.70
4 5.40 3.00 2.40 0.75 0.60 1.35 0.90
5 6.50 3.00 3.50 0.60 0.70 1.30 1.10
6 7.80 3.00 4.80 0.50 0.80 1.30 1.30
7 9.30 3.00 6.30 0.43 0.90 1.33 1.50
8 11.00 3.00 8.00 0.38 1.00 1.38 1.70
9 12.90 3.00 9.90 0.33 1.10 1.43 1.90
10 15.00 3.00 12.00 0.30 1.20 1.50 2.10
Average costs
• Average costs can be determined by dividing the firm’s costs by the quantity of output it produces.
The average cost is the cost of each typical unit of product.
Average costs
•Average costsAverage fixed costs (AFC)Average variable costs (AVC)Average total costs (ATC)
•ATC = AFC + AVC
Average costs
AFCFCQ
F ix ed co st
Q u an tity
AVCVCQ
V ariab le co st
Q u an tity
ATCTCQ
T o ta l co st
Q u an tity
Marginal cost
• Marginal cost (MC) measures the increase in total cost that arises from an extra unit of production.
Marginal cost helps answer the following question:
How much does it cost to produce an additional unit of output?
Marginal cost
M CTCQ
( ch an g e in to ta l co st)
(ch an g e in q u an tity )
Thirsty Thelma’s cost curves
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Costs
$3.50
3.25
3.00
2.75
2.50
2.25
2.00
1.75
1.50
1.25
1.00
0.75
0.50
0.25
Quantityof output
(glasses of lemonade per hour)
0 1 432 765 98 10
MC
ATC
AVC
AFC
Big Bob’s Bagel BinBagels (per hour)
Total cost
Fixed cost
Variable cost
Average fixed cost
Average variable cost
Average total cost
Marginal cost
0 $ 2.00 $2.00 $ 0.00 — — — —
1 3.00 2.00 1.00 $2.00 $1.00 $3.00 $1.00
2 3.80 2.00 1.80 1.00 0.90 1.90 0.80
3 4.40 2.00 2.40 0.67 0.80 1.47 0.60
4 4.80 2.00 2.80 0.50 0.70 1.20 0.40
5 5.20 2.00 3.20 0.40 0.64 1.04 0.40
6 5.80 2.00 3.80 0.33 0.63 0.96 0.60
7 6.60 2.00 4.60 0.29 0.66 0.95 0.80
8 7.60 2.00 5.60 0.25 0.70 0.95 1.00
9 8.80 2.00 6.80 0.22 0.76 0.98 1.20
10 10.20 2.00 8.20 0.20 0.82 1.02 1.40
11 11.80 2.00 9.80 0.18 0.89 1.07 1.60
12 13.60 2.00 11.60 0.17 0.97 1.14 1.80
13 15.60 2.00 13.60 0.15 1.05 1.20 2.00
14 17.80 2.00 15.80 0.14 1.13 1.27 2.20
Big Bob’s cost curves
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(a) Total-cost curve
$18.00
16.00
14.00
12.00
10.00
8.00
6.00
4.00
Quantity of output (bagels per hour)
TC
42 6 8 141210
2.00
Totalcost
0
Big Bob’s cost curves
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(b) Marginal- and average-cost curves
Quantity of output (bagels per hour)
Costs
$3.00
2.50
2.00
1.50
1.00
0.50
0 42 6 8 141210
MC
ATCAVC
AFC
Typical cost curves
Three important properties of cost curvesMarginal cost eventually rises with the quantity of output.The average-total-cost curve is U-shaped.The marginal-cost curve crosses the average-total-cost curve at the minimum of average total cost.
Economies and diseconomies of scale
• Economies of scale refer to the property whereby long-run average total cost falls as the quantity of output increases.
Economies and diseconomies of scale
• Diseconomies of scale refer to the property whereby long-run average total cost rises as the quantity of output increases.
• Constant returns to scale refers to the property whereby long-run average total cost stays the same as the quantity of output changes.
Average total cost in the short and long run
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Quantity ofcars per day
0
Averagetotalcost
1,200
$12,000
1,000
10,000
Economiesof
scale
ATC in shortrun with
small factory
ATC in shortrun with
medium factory
ATC in shortrun with
large factory ATC in long run
Diseconomiesof
scale
Constantreturns to
scale
The four types of Markets
Perfect Competition
Monopoly
Oligopoly
Monopolistic Competition
Perfect Competition
Monopolistic Competition
Oligopoly Monopoly
Firms Large number Large Number Small Number One
Products Identical Differentiated Similar. Differentiated
No close substitutes
Barriers to entry and exit
No barriers Freedom of entry and exit
Some barriers to entry
Effective barriers to entry
Control over market price
No Control Small Control Substantial control
Significant control.
Perfect Competition
A perfectly competitive market has the following characteristics:
There are many buyers and sellers in the market.
The goods offered by the various sellers are largely the same.
Firms can freely enter or exit the market.
As a result of its characteristics, the perfectly competitive market has the following outcomes:
The actions of any single buyer or seller in the market have a negligible impact on the market price.
Each buyer and seller takes the market price as given.
What is a competitive market?
Total revenue for a firm is the selling price times the quantity sold.
TR = (P Q)
Total revenue is proportional to the amount of output.
In a competitive firm
A v erag e R ev en u e =T o ta l rev en u e
Q u an tity
P rice Q u an tity
Q u an tity
P rice
Average Revenue = Price
Marginal revenue is the change in total revenue from an additional unit sold.
MR =TR/Q
Marginal Revenue
Revenue of a competitive firm
Quantity(Q)
Price(P)
Total revenue(TR = P X Q)
Average revenue
(AR = TR/Q)
Marginal revenue(MR = ΔTR/ΔQ)
1 lawn $20 $ 20 $20 -
2 20 40 20 $20
3 20 60 20 20
4 20 80 20 20
5 20 100 20 20
6 20 120 20 20
7 20 140 20 20
8 20 160 20 20
Profit maximisation
The goal of a competitive firm is to maximise profit.
This means that the firm will want to produce the quantity that maximises the difference between total revenue and total cost.
Marginal Revenue = Marginal Cost
Quantity(Q)
Total revenue
(TR)
Total cost(TC)
Profit(TR – TC)
Marginal revenue
(MR = ΔTR/ΔQ)
Marginal cost(MC = ∆TC/∆Q)
0 lawns $ 0 $ 10 –$10 - -
1 20 14 6 $20 $4
2 40 22 18 20 8
3 60 34 26 20 12
4 80 50 30 20 16
5 100 70 30 20 20
6 120 94 26 20 24
7 140 122 18 20 28
8 160 154 6 20 32
Profit maximisation
Profit maximisation
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Quantity0
Costsand
Revenue
MC
ATC
AVC
MC1
Q1
MC2
Q2
The firm maximisesprofit by producing the quantity at whichmarginal cost equalsmarginal revenue.
QMAX
P = MR1 = MR2 P = AR = MR
Profit maximisation When MR > MC, increase Q
When MR < MC, decrease Q
When MR = MC, profit is maximised
To shut down or to exit?
Shut Down – Short run decision to not produce anything
Permanent exit – Long run decision to exit the market.
Most firms cannot avoid fixed costs in the short run
Firms Decision to Shut Down Total Revenue < Total Variable Cost
Price < Average Variable Cost
Firms Decision to Exit Permanently Total Revenue < Total Cost
Price < Average Total Cost
If this is the exit then
Price > ATC – is the entry
The competitive firm’s short run supply curve
MC
Quantity
ATC
AVC
0
Costs
Firmshutsdown ifP< AVC
Firm’s short-runsupply curve
If P > AVC, firm will continue to produce in the short run.
If P > ATC, the firm will continue to produce at a profit.
Profit
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(a) A firm with profits
Quantity0
Price
P = AR = MR
ATCMC
P
ATC
Q(profit-maximising quantity)
Profit
Loss
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(b) A firm with losses
Quantity0
Price
ATCMC
(loss-minimising quantity)
P = AR = MRP
ATC
Q
Loss
The long run: Market supply with entry and exit Firms will enter or exit the market until profit is driven to zero.
In the long run, price equals the minimum of average total cost.
The long-run market supply curve is horizontal at this price.
Competitive firms and zero profit Profit equals total revenue minus total cost.
Total cost includes all the opportunity costs of the firm.
In the zero-profit equilibrium, the firm’s revenue compensates the owners for the time and money they expend to keep the business going.
Monopoly
A monopoly is a price maker
Competitive market P=MC
Monopoly P> MC
The monopolist profit is not unlimited because of the demand curve
Why monopolies arise
Simply its due to the barriers of entry
Monopoly resources – a key resource used for production is owned by one firm (Diamonds)
Government regulation – the government gives a single firm the right to produce some good or service (railways)
The production process – economies of scale so the costs are much lower in one firm over the others.
Economies of scale as a cause of monopoly
Quantity of output
Averagetotalcost
0
Cost
Monopoly production and pricing decisions
Monopoly is the sole producer
faces a downward-sloping demand curve
is a price maker
reduces price to increase sales
Perfect Competition is one of many producers
faces a horizontal demand curve
is a price taker
sells as much or as little at same price
Demand curves: Competitive and monopoly firms
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Quantity of output
Demand
(a) A Competitive firm’s demand curve (b) A Monopolist’s demand curve
0
Price
Quantity of output0
Price
Demand
A monopoly's revenue
Quantity of water Price
Total revenue
Average revenue
Marginal revenue
(Q) (P) (TR = P X Q) (AR = TR/Q) (MR = DTR/DQ)
0 litres $11 $ 0 — —
1 10 10 $10 $10
2 9 18 9 8
3 8 24 8 6
4 7 28 7 4
5 6 30 6 2
6 5 30 5 0
7 4 28 4 –2
8 3 24 3 –4
Demand and marginal-revenue curves
Copyright © 2004 South-Western
Quantity of water
Price
$1110
9876543210
–1–2–3–4
Demand(averagerevenue)
Marginalrevenue
1 2 3 4 5 6 7 8
Profit maximisation
A monopoly maximizes profit by producing the quantity at which marginal revenue equals marginal cost.
It then uses the demand curve to find the price that will induce consumers to buy that quantity.
Profit maximisation for a monopoly
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QuantityQ Q0
Costs andrevenue
Demand
Average total cost
Marginal revenue
Marginalcost
Monopolyprice
QMAX
B
1. The intersection of themarginal-revenue curveand the marginal-costcurve determines theprofit-maximizingquantity ...
A
2. ... and then the demandcurve shows the priceconsistent with this quantity.
A monopoly's profit
Profit equals total revenue minus total costs.
Profit = TR − TC
Profit = (TR/Q − TC/Q) Q
Profit = (P − ATC) Q
The monopoly’s profit
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Monopolyprofit
Averagetotalcost
Quantity
Monopolyprice
QMAX0
Costs andrevenue
Demand
Marginal cost
Marginal revenue
Average total cost
B
C
E
D
The inefficiency of monopoly
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Quantity0
Price
Deadweightloss
DemandMarginalrevenue
Marginal cost
Efficientquantity
Monopolyprice
Monopolyquantity
The inefficiency of monopoly
The monopolist produces less than the socially efficient quantity of output.
Price discrimination
Price discrimination is the business practice of selling the same good at different prices to different customers, even though the costs for producing for the two customers are the same.
Price discrimination
Examples of price discrimination
movie tickets
store brands
airline prices
discount coupons
quantity discounts
Between monopoly and perfect competition
Types of imperfectly competitive markets
Oligopoly
only a few sellers, each offering a similar or identical product to the others
Monopolistic competition
many firms selling products that are similar but not identical
Monopolistic Competition
A monopolistic competitive firm is inefficient. Average total cost is not at a minimum.
There is a lot of information for the consumer to collect and process to make the best decisions.
Advertising increases cost but advertising is essential to differentiate.
Markets with only a few sellers
Characteristics of an oligopoly market
Few sellers offering similar or identical products.
Interdependent firms.
Best off cooperating and acting like a monopolist by producing a small quantity of output and charging a price above marginal cost.
The demand schedule for water
Quantity (in litres) Price Total revenue (and total profit)
0 $120 $ 0
10 110 1100
20 100 2000
30 90 2700
40 80 3200
50 70 3500
60 60 3600
70 50 3500
80 40 3200
90 30 2700
100 20 2000
110 10 1100
120 0 0
A duopoly example
Price and quantity supplied
The price of water in a perfectly competitive market would be driven to where the marginal cost is zero:
P = MC = $0
Q = 120 Litres
The price and quantity in a monopoly market would be where total profit is maximised:
P = $60
Q = 60 Litres
A duopoly example
Price and quantity supplied
The socially efficient quantity of water is 120 litres, but a monopolist would produce only 60 litres of water.
So what outcome then could be expected from duopolists?
Competition, monopolies, and cartels
The duopolists may agree on a monopoly outcome.
Collusion is an agreement among firms in a market about quantities to produce or prices to charge.
Cartel is a group of firms acting in unison.
Game theory and the economics of cooperation
Game theory is the study of how people behave in strategic situations.
Strategic decisions are those in which each person, in deciding what actions to take, must consider how others might respond to that action.
Game theory and the economics of cooperation
Because the number of firms in an oligopolistic market is small, each firm must act strategically.
Each firm knows that its profit depends not only on how much it produces, but also on how much the other firms produce.
The prisoners’ dilemma
The prisoners’ dilemma provides insight into the difficulty in maintaining cooperation.
Often people (of firms) fail to cooperate with one another even when cooperation would make them all better off.
The prisoners’ dilemma
Kelly’ s decision
Confess
Confess
Kelly gets 8 years
Ned gets 8 years
Kelly gets 20 years
Ned goes free
Kelly goes free
Ned gets 20 years
gets 1 yearKelly
Ned gets 1 year
Remain silent
RemainSilent
Ned’sdecision
The prisoners’ dilemma
The dominant strategy is the best strategy for a player to follow regardless of the strategies chosen by the other players.
Cooperation is difficult to maintain, because cooperation is not in the best interest of the individual player.
