2 What Is Economics ?Definition: Economics is defined as : The study of the use of scarce resources to satisfy unlimited human wants .Another definition of Economics :It is the science of choice . Therefore, it is the science that explains the choices we make .
3 The Aim of EconomicsTo help the people obtain the greatest possible satisfaction out of the resources at their disposal, which means to do the best they can with what they have .
4 What are the Society’s Resources ? 1. Natural Resources such as Land, Forests, and Minerals .2. Human Resources both mental and Physical .3. Manufactured aids to production such as tools, machinery, and buildings .
5 What is Scarcity ?Scarcity means that we do not have enough of everything , including time, to satisfy our every desire .Scarcity exists because human wants always exceeds what can be produced with the limited resources available .Scarcity implies that we must make choices .
6 ChoiceChoice is a trade off , which means that we give up something to get something else .Every choice involve a cost .
7 It is the best alternative given up or forgone. The Opportunity CostIt is the best alternative given up or forgone.It is the action that you choose not to do .
8 ExampleWhat is the opportunity cost of attending a 3 hours lecture in economics ?For a Jogger is the forgone 3 hours of exercise .For early sleeper is the forgone 3 hours in bed .And so on .
9 Example 2Consider the choice that must be made by your little brother who has SR 5 to spend and who is determined to spend it all on candy.Assume there are only two kinds of candy that he can buy ( Bubble Gum which sells for SR 0.50 each ) and ( Chocolates which sells for SR 1.00 each ) .What are the attainable combinations ?
11 Example 2 - continueAfter careful thought , your brother has almost decided to buy 6 bubble gums and 2 chocolate,But at the last moment he decided that he must have 3 chocolates .What will it cost to get this extra chocolate ?The answer is two bubble gums, so he has to give up 2 bubble gums to get one more chocolate . The 2 bubble gums is called by economists as the opportunity cost of the third chocolate.
13 Production Possibilities Production: Is the conversion of Natural, Human , and Capital resources into goods and services .Production Possibility Boundary:Makes the boundary between production level that can and can not be attained .
14 Example Assume the following : 1. There is only one producer ( Ahmed ) 2. There are only two goods to be produced( Corn and Cloth )3. Ahmed can work 12 hours each day .So, the amount of Corn and Cloth that Ahmed can produce depends on how many hours he devotes to producing them .
15 In addition you are given the following Table # 1 Hours worked Corn Grown Cloth producedper day pound per month Yards per month3 either or6 either or9 either or12 either orCalculate Ahmed’s Production boundary ?
16 Ahmed’s Production Possibility Boundary Possibility Corn Cloth(pound per month) (Yard per month)a andb andc andd ande and
17 Note:Points on the boundary is always better than points inside the boundary .Points on the boundary ( a,b,c,d, and e ) represent full and efficient use of society’s resources .While points inside the boundary represent either inefficient use of resources or failure to use all the available resources .
18 Four Key Economic Problems Whatever the economic system, most problems studied by economists can be grouped under 4 main headings :1. What is Produced and How ?2. What is consumed and by whom ?3. Why are Resources sometimes idle ?4. Is production capacity growing ?
19 I. What is Produced and How ? The allocation of scarce resources among alternative uses determines the quantity of various goods that are produced.Because resources are scarce, it is desirable that they be used efficiently .If resources are used efficiently, than at which point on the boundary will production take place ? .
20 What is Consumed and by Whom ? Will the economy consume exactly the same goods as it produces ?Or , will the country’s ability to trade with other countries permit the economy to consume a different combination of goods ?Who consume the goods and services produced depends on the income that people earns .
21 III. Why are Resources sometimes idle ? When an economy is in a recession some resources such as labor, factories and equipment, and raw materials are idle.Why are resources sometimes idle ? And should government worry about such idle resources ?
22 IV. Is productive capacity growing ? Growth in production capacity can be represented by an outward shift of the production possibility boundary .If an economy’s capacity to produce goods and services is growing, combinations that are unattainable today will become attainable tomorrow .Growth makes it possible to have more of all goods .
23 Alternative Economic Systems There are 3 types of economic systems . These are :1. Traditional Systems .2. Command Systems .3. Market Systems .
24 I. Traditional SystemsA traditional economy is one in which behavior is based primarily on Traditions, Customs , and Habits . Example :Young men follow their father’s occupations .Women do what their mother did .So , there is little change in the patterns of goods produced from year to year .
25 II. Command SystemsEconomic behavior id determined by some central authority ( Government ) which make most of the necessary decisions on :What to prodce ?How to produce it ?Who will gets it ?Such economies are characterized by the Centralization of Decision Making . Example : China and Cuba .
26 III. Market Systems ( Free-Market economy ) In such an economy, decisions relating to the basic economic issues are decentralized .Decisions are made by individual producers and consumers .
27 Mixed SystemsEconomies that are fully traditional or fully centrally planned or wholly free-market are pure types that are useful for studying basic principles.But in practice, every economy is a mixed economy in the sense that it combine significant elements of all three systems in determining the economic behavior .
28 Ownership of Resources Economies differ as to who own their productive resources. Example :Who owns a nation’s farms and factoriesWho owns a nation’s coal,mines,& forests ?Who owns a nation’s railways,airline, hotels, etc. ?
29 Private-Ownership Economy The basic raw materials, the productive assets of the society, and the goods produced in the economy are pre-dominantly privately owned.Example : the U.S.A. System .
30 Public-Ownership Economy Is one in which the productive assets are predominantly publicly owned . Example :China and Former Soviet Union
32 In this Chapter1. We need to understand what determines the demand for a particular product ?2. We will also study what determine the supply of a particular product ?3. We will see how demand and supply together determine the price of a product and the quantity that are exchanged in the market ?
33 The DemandWhat determine the demand for a product ?To answer this question , we have first to distinguish between two terms :1. Quantity Demanded2. Demand
34 Quantity DemandedIs the total amount of any particular good or service that the consumer wish to purchase in some time period for a given price .
35 The Term DemandRefers to the entire relationship between the quantity demanded of a product and the price of that product . Therefore :The quantity demanded represent a single point on the demand curve .
36 The Law of Demand A basic economic assumption is that : “ The price of any good and the quantity demanded of that good are negatively related, other things being equal . “ Therefore :The lower the price of a good, the higher the quantity demanded of that good . AndThe higher the price, the lower the quantity demanded .
37 The Law of Demand-continue This negative relationship between the price and the quantity demanded is called “ The Law of Demand “ . This relationship can be shown by : 1. Demand Schedule or2. Demand Curve .
38 The Demand ScheduleThe Demand Schedule is a table that shows the quantity demanded of a product at different prices .The Demand curve is a graphical representation of the demand Schedule .
39 Example Price of Carrots Quantity demanded ( per ton ) ( in thousands of tons)$
40 Factors that influence the Quantity Demanded 1. The product’s own price .2. The prices of related products .3. The Income .4. The Population .5. The Preferences or Tastes .6. The expected future prices .
41 Quantity Demanded and the price How the quantity demanded of a product changes as its price change ?
42 Change in Quantity Demanded If we assume that the price of a product may change, while other factors that influence the quantity demanded remain constant, then that causes a movement along the demand curve .Therefore, a movement along the demand curve shows a change in quantity demanded.
43 Change in DemandIf the price of the product is held constant, and other factors changes such as Income , population, preferences, etc. , that will cause a shift in the demand curve .Therefore, a shift in demand curve to the right or to the left shows a change in demand.
44 Determinants of Demand The determinants of demand are what cause consumers to change their view of how much they will buy of a given good or service at all possible prices that could be charged for it.These determinants depends on the good in question .
45 Some Determinants of Demand 1. Consumer Income2. Population ( # of consumers in the market)3. Prices o related products4. Preferences or Tastes .5. Expected Future Prices .
46 Consumer IncomeNormally as consumers’ income increases, they tend to purchase more goods and services . Therefore,If an individual consumer purchase more of a good when his income increases , that good is said to be Normal good.And if the consumer purchase less of a good when his income increases, that good is said to be an inferior good .
47 Consumer Income-continue For a Normal good : an increase in income will shift the demand curve to the right. And a decrease in income will shift the demand curve to the left .For an inferior good : an increase in income will shift the demand curve to the left . And a decrease in income will shift the demand curve to the right .
48 Prices of related Products The relation between the quantity demanded of a good and the price of related good depends on whether the two goods are substitutes or complements .
49 Substitute GoodsSubstitute goods are goods that can be used in place of other goods .Example : Tea and Coffee or Pepsi and CokeA good will be substituted in place of other good if it become relatively cheaper than other good.
50 Substitute goods - continue For substitute goods , there is a positive relation between quantity demanded of one product and the price of other product . Example :As price of coffee rises, the quantity demanded of tea rises . AndAs price of coffee falls, the quantity demanded of of tea falls .
51 ComplementsAre products that are tend to be used jointly or together .Example : Car and GasolineComputer and PrinterTea and SugarA fall in price of complementary product will shift a product demand curve to the right which means more will be purchases at each price .
52 Complements - continues A rise in price of complementary product will shift the demand curve of the product to the left.Therefore, there is a negative relationship between the price of complementary product and the quantity demanded of the product .
53 PopulationDemand also depends on the size of the population or # of consumers in the market :The larger the population, the greater is the demand for all goods and services , and that shift the demand curve to the right .And the smaller the population, the smaller is the demand for all goods and services, so the demand curve will shifts to the left .
54 Preferences or TastesA change in taste in favor of a product will increase the demand for that product, and shift the demand curve to the right .And a change in taste against the product will decrease the demand for that product and shift the demand curve to the left .
55 Expected Future Prices If the consumers expect that prices of the product will rise in the future, they will increase their demand for the product today. This will shift the demand curve of that product to the right .And if the consumers expect that prices of the product will fall in the near future they will decrease their demand today. This will shift the demand curve of that product to the left .
56 SupplyHere, we need to distinguish between Quantity Supplied and Supply .Quantity supplied of a product is :The amount that the producer plan to produce and sell during a given time period at a particular price .
57 SupplyRefers to the entire relationship between the quantity supplied and the price of the product .
58 Determinants of the Quantity Supplied 1. The price of the product2. Prices of resources used to produce theproduct . ( input prices )3. Technology4. The number of suppliers5. Prices of related goods produced6. Expected future prices
59 1. The quantity supplied & the price The Law of Supply:A basic economic assumption states that :For any product, the price of the product and the quantity supplied are positively related . Which means :The higher the price, the greater is the quantity supplied .
60 NoteThis positive relationship between the price and the quantity supplied can be shown by :1. Supply Schedule , or by2. Supply Curve
61 Supply ScheduleIt is a table that shows the positive relationship between quantity supplied and the price of the product , other things being equal .
62 Example Supply Schedule of X Price of X Quantity Supplied of X SR ,000,000,000,000And so on .
63 Supply CurveIs a graphical representation of the supply schedule .
64 Change in Quantity Supplied A change in the price of the product, holding other factors constant, will cause a change in quantity supplied in the same direction as the change in the price .The change in quantity supplied as a result of change in price will cause upward or downward movement along the supply curve
65 Change in SupplyHolding the price of the product constant, a change in any of the following factors will change the supply and cause a shift in the supply curve :1. Number of suppliers2. Prices of related goods produced3. Expected future prices .4. Prices of resources used in production
66 The Determination of Price How the two forces of the market (the Demand & Supply ) interact to determine the price of the product in the market ?To answer the above question let us look at the following schedule
67 Demand & Supply Schedule Price of X Quantity Demanded Quantity SupplySR
68 NoteWhen actual price is above the equilibrium price, then Quantity supplied > Quantity demanded , and that will create excess supply , which put pressure on prices to go down .When actual price is below the equilibrium price, then Quantity demanded > Quantity supplied, and that create excess demand , which put pressure on prices to go up .
69 NoteThe price at which quantity demanded exactly equals to quantity supplied is called “ Equilibrium price or Market Clsearing Price “ and and price where Quantity demanded does not equal Quantity supplied is called Disequilibrium Price .
70 1. A rise in demand 2. A fall in demand 3. A rise in supply Laws of Demand & Supply1. A rise in demand2. A fall in demand3. A rise in supply4. A fall in Supply
71 1. A rise in demandIf there is an increase in demand, that will shift the demand curve to the right, and increase both the equilibrium price and the equilibrium quantity exchanged.
72 2. A Fall in DemandIf there is a fall in demand then that will shift the demand curve to the left, and decrease both the equilibrium price and equilibrium quantity exchanged.
73 3. A rise in SupplyA rise in supply will shift the supply curve to the right and that will decrease the equilibrium price and increase the equilibrium quantity exchanged .
74 4. A Fall in SupplyA fall in supply causes a shift in the supply curve to the left and that will increase the equilibrium price and decrease the equilibrium quantity exchanged .
76 Price Elasticity of Demand It measures the responsiveness of quantity demanded of a product to the change in the market price . Therefore :PE = % change in quantity demanded% change in the price
77 Arc ElasticityMeasures the average responsiveness of quantity demanded to the change in the price over an interval of demand curve .Therefore , PEPE = Q2 – Q / P2 – P1___(Q1 +Q2) / (P1 +P2) / 2PE = Q2 – Q X (P1+P2)/2 .(Q1+Q2)/ P2 – P1
78 ExampleGiven the following demand schedule , Calculate the Arc price Elasticity of demand Price Quantity demanded$PE = 20 – X (20+40)/ = 240 – ( )/2
79 Point ElasticityIt measures the responsiveness of Quantity demanded to the change in price of a particular product at a particular point on the demand curve .
80 ExampleGiven the following demand schedule, Calculate the Point Elasticity of demand.Price of X Quantity demanded of x$PE = 20 – X =40 –
81 The Numerical Value of Elasticity The numerical value of elasticity vary from Zero to infinity . Therefore :1. PE = Perfectly inelastic demand< PE < 1 inelastic demand3. PE = unit elastic demand4. PE > elastic demand5. PE = infinity Perfectly elastic demand
82 Perfectly inelastic demand when PE = 0 When PE = 0 it means that quantity demanded does not respond at all to the change in the price of the product .Example : Price Quantity demanded$PE = 100 – 100 X (20+40)/2 = X 30 = 0( )/
83 Inelastic Demand 0<PE<1 When < PE < inelastic demandThis means that :% change in quantity < % change in the priceExample : Price of x Quantity demanded of x$PE = 80 – X ( )/2 = 0.3340 – ( )/2
84 Unit elastic demand , PE = 1 When PE = 1 , we have unit elastic demandThis means that :% change in quantity = % change in priceExample : Price Quantity demanded$PE = 50 – X ( )/2 = 1( )/2
85 Elastic Demand , PE > 1 When PE > 1 , we have elastic demand This means that :% change in quantity > % change in the priceExample : Price of x Quantity demanded$PE = 20 – X ( )/2 = 240 – ( )/2
86 Price elasticity and change in Total Revenue ( or total expenditure ) How does total revenue react to a change in the price of a product ?The response of total revenue depends on the price elasticity of demand which means it depends on whether thedemand is elastic, inelastic , or unit elastic ?
87 If the Demand is elastic, PE>1 In this case , the price and total revenue are negatively related . Therefore :A fall in the price , will increase total revenueA rise in the price, will decrease total revenueExample : Price Quantity Total$ $ 2000PE = 2
88 If the Demand is inelastic , PE <1 If the demand is inelastic , PE < 1 , thenPrice and total revenue are positively related, which means :A fall in price , will decrease total revenue , andA rise in price, will increase total revenueExample : Price Quantity Total revenue$ $ 2000PE = 0.33
89 If the Demand is Unit elastic , PE=1 When the demand is unit elastic, PE = 1 ,thenTotal revenue will not be changed ( constant ) which means :As price rises or falls , total revenue remain unchanged . Example : P Q TR$ $ 2000PE = 1
90 Determinants of The Price Elasticity of Demand The main determinant of elasticity of demand is the availability of substituteA product with close substitute tend to have elastic demand .While a product with no close substitute tend to have inelastic demand .
91 Other Demand Elasticity 1. Income Elasticity of Demand2. Cross Elasticity of Demand
92 Income Elasticity of Demand,Ei This elasticity measures the responsiveness of demand to a change in income .EI = % change in Quantity Demanded% change in IncomeWhere EI = Income elasticityThe income elasticity could be positive or negative.
93 Positive Income Elasticity , EI>0 Goods with positive income elasticity are called “ Normal Goods . Therefore , for Normal GoodAs income rises , consumption rises . AndAs income falls , consumption falls .Example : Income Quantity Demanded$EI = X = = 1.3
94 Example 2 Income Quantity Demanded $ 1000 100 3000 200 $EI = X = = 0.67
95 Negative Income Elasticity, EI<0 Goods with negative income elasticity are called “ Inferior Goods “ . Therefore for Inferior goods :As income rises , consumption will falls andAs income falls , consumption will rise .
96 Example Income Quantity Demanded $ 1000 100 3000 60 $EI = X =Since EI = < 0 negative EI , therefore X = an inferior good .
97 Cross Elasticity of Demand This elasticity measures the responsiveness of demand to the change in the price of another product. It is defined as :E x y = % change in quantity demanded of X% change in the price of YE x y = Q2 – Q1 X ( P y2 – Py1) /2P2 – P (Q x2 – Q x1) /2The Cross elasticity could be positive or negative
98 Positive Cross elasticity, Exy > 0 If the Cross elasticity is positive , thenBoth goods ( X and Y ) are SubstitutesIf the Cross elasticity is negative , thenBoth goods ( X and Y ) are Complements
99 Example Price of Coal Quantity demanded of Oil $ 10 100 20 300 $E xy = X = = 1.5Since E xy = 1.5 > 0 Positive Cross elasticityTherefore, X and Y are Substitutes .
100 Example 2 Price of Car Quantity demanded of Gasoline SR 50,000 100,000 30, ,000Exy = 100,000 X 40,000 =- 20, ,000Since Exy = < 0 , therefore,Car and Gasoline are complements .
101 Elasticity of Supply, Es This elasticity measures the responsiveness of the quantity supplied to a change in the product’s price and it is defined as :Es = percentage change in quantity suppliedpercentage change in the priceThe elasticity of supply range between zero and infinity , so 0 < Es < infinity
102 What Determines the Elasticity of Supply ? 1. The ability of the firm to shift the resources from the production of other commodities to the one whose price has risen .2. Cost behavior :If cost of production rises rapidly as output rises, then there is no incentive to expand the production , so supply will be less elastic ) . But if cost rises only slowly as production increases, then a rise in price will stimulate a large increase in quantity supply, so the supply will be more elastic .
103 Short-run and Long-run market adjustment Shift in demand or supply have different effects on equilibrium price and quantity depending on the degree of price elasticity .Shift in Supply: In the short-run , when demand is relatively inelastic, a shift in supply leads to sharp change in equilibrium price, but to only a small change in equilibrium quantity . But, in long-run , demand is more elastic , so shift in supply curve results in small change in equilibrium price and large change in quantity.
104 Shift in DemandIn the short-run, when supply is relatively inelastic, a shift in demand leads to sharp change in equilibrium price , but only to a small change in equilibrium quantity .However, in the long-run, when supply is more elastic than short-run, a shift in demand leads to a small change in equilibrium price , but to a large change in equilibrium quantity .
105 Demand and Supply in Action CHAPTER 6Demand and Supply in Action
106 Government Controlled Prices In some cases , government fix the prices of some products in the market .Government price controls are policies that attempt to hold the prices at some disequilibrium value .Some controls , hold the market price below its equilibrium value. This create a shortages .Other controls, hold price above equilibrium. This create a surplus at the control price .
107 Quantity ExhangedAt any disequilibrium price, we know that the quantity exchanged is determined by the lesser of quantity demanded or supplied. Therefore :For price below equilibrium price , quantity exchanged will be determined by the supply curve.For the prices above the equilibrium price, the quantity exchanged is determined by the demand curve .
108 Floor PriceIt is the minimum price that can be charged for a product .The floor price that is set at or below the equilibrium price has no effect because the equilibrium price remain attainable.But, if the floor price is set above the equilibrium price , it is said to be binding or effective .
109 Note The effective floor price leads to excess supply. Either unsold surplus will exist or some one must enter the market and buy the excess supply .
110 Ceiling PriceIs the Maximum price at which certain good or service may be sold .If the ceiling price is set above the equilibrium price , it has no effect because the equilibrium price is attainable .But , if ceiling price is set below the equilibrium price , it is said to be effective or binding .
111 NoteThe effective ceiling price will create excess demand or shortages and this invite what is called “ Black Market : where goods are sold at illegal price( the price is higher or lower than the controlled price ) .
112 Rent Control : A case study of price ceiling Rent controls are just special case of price ceiling .Here, we need to distinguish between short-run and long-run supply or rental accommodation .
113 Short-run SupplyThe short-run supply for Housing is quite inelastic because it takes years to plan and build new apartments .Therefore, the supply curve in short-run is perfectly inelastic , which means :An increase or decrease in demand will cause rent to change in short-run , but there is no change in quantity supplied.
114 Long-run SupplyThe Long-run supply curve of rental housing is highly elastic because :If the return on investment in new housing rises significantly above the return on comparative investment , there will be flow of investment funds into the industry of new rental housing.And if the return on investment in new housing fall below what can be earned on comparative investment , the fund will go elsewhere.
115 The effect of rent control in short and long run Rent Quantity Quantity Surplus +demanded supply or shortage -$Assume we have ceiling price at $ 30
116 NoteIf the ceiling rent is set below the equilibrium rent that will cause shortages in both the Short-run as well as in the Long-run, but the shortages in the Long-run will be greater because the supply curve in the long-run is more elastic.
117 Who gain and Who loss from rent control ? Tenants in rent control accommodations are the gainers .While Landlords and potential future tenants are the losers .Note: Chapter 6 up to page 121 onlyUp to ( Agriculture & Farm problem)
119 Main Points In this chapter, we will discuss : Marginal Utility & consumer choiceUtility Schedules & GraphsMaximizing UtilityMarginal & Total UtilityDerivation of consumer Demand curveConsumer SurplusIncome & Substitution Effects .
120 Marginal Utility & Consumer Choice Consumer choice is fundamental to market economies .Consumers make all kinds of decisionsEconomists assume that consumers are motivated to maximize their utility .How the consumer make decision based on utility maximization ?
121 Definition of Utility Utility is defined as follows : “ It is the satisfaction that the consumers drive from the goods and services that they consume .
122 Total UtilityIs the full satisfaction resulting from the consumption of that product by the consumer .
123 Marginal UtilityIt is the change in satisfaction resulting from consuming one more unit of the product . OrIt is the additional utility derived from consuming one more unit of the product.MU = Change in total utilityChange in number of unit consumed
124 Example Pizza Total utility Marginal utility 0 0 0 1 30 30 2 50 20
125 Diminishing Marginal Utility The basic hypothesis of utility theory is called “ Law of diminishing Marginal utility “ which means that :The utility that may any consumer drives from successive units of particular product diminishes as total consumption of that product increase, holding consumption of all other products constant
126 Maximizing Utility [ equilibrium] How can a household adjust its expenditure so as to maximize its utility ?The condition for utility maximization is :M U x = M U yP x P yWhere M U x = marginal utility per dollarP x spent on X
127 Equilibrium Condition Alternatively, we can write the equilibrium condition as follows :M U x = P x .M U y P yMU x = Relative marginal utility of bothMU y goods X and YP x = Relative prices of both goodsP y X and Y
128 ExampleAssume an individual who spend his income on two goods ( X and Y ) has an income of $ Assume also that the price of X = $ 60 and the price of Y = $ 30 . In addition you are given the following data :Q x TU x Q y TU yRequired :How many units ofX and Y thisconsumer shouldconsume to maximizehis utility ?
129 The Answer Q x TU x MU x MU x Q y TU y MU y MU y P x P y He should consume 2 x and 6 y to maximize his utility
130 Income and Substitution Effects How does the household react to a change in the price of one good ?A fall in the price of one good affects the consumer in two ways :1. Relative price change :This provide an incentive to buy more ofthe good which its price has fallen .2. The household real income increases .
131 Example Assume the following : Income = $ 360 Price of X = 12 Price of Y = 6Relative price of X to Y = $ 12 = 26What will happen if price of X fall to $ 6?
132 Substitution EffectIs the change in quantity demanded as a result of a change in relative prices with real income held constant .
133 Income EffectIs the change in quantity demanded as a result of a change in real income .
134 Note 1. The substitution effect is always negative . 2. Income effect could be positive or3. Goods with positive income effect arecalled “ Normal goods “4. Goods with negative income effect arecalled : “ Inferior goods “
135 Note 5. Normal goods always have downward demand curve . 6. Inferior goods may have downward orupward demand curve .7. Inferior goods with downward demandcurve is called : Non-Giffen goods “8. Inferior goods with upward demandcurve is called “ Giffen goods “
136 Note If substitution effect > negative income effect Then that good is called Non-Giffen goods .If substitution effect < negative income effect then that good is called Giffen good .
137 Production and Cost in the Short-run Chapter 8Production and Cost in the Short-run
138 Note In this chapter we will talk about - production of goods & servicesby the firms .- How we determine or measurethe cost as well as the profit ofthe firms .
139 Short-runIs a period of time where at least one or more of the input factors used in production can not be changed ( Fixed).Therefore, in short-run, we have1. Fixed inputs factors .2. Variable inputs factors .
140 Long-runIs a period of time where all factors of production used by the firm can be changed ( Variable )
141 Profit MaximizationEconomists usually assume that firms try to make their profit as large as possible which means to maximize their profit.Firms seek profit by producing and selling commodities .All production can be accounted for by the service of 3 kinds of inputs called Factors of production .
142 Factors of Production 1. Land 2. Labor 3. Capital The value of these inputs is called “ Cost “
143 Measurement of Cost There are two ways of measuring the cost 1. Historical cost [ cost of purchased andhired factors ]2. Opportunity cost : which is the cost ofall inputs used in production whether it is purchased, hired, or imputed cost .
144 It is the value of resources at prices actually paid for them . Historical CostIt is the value of resources at prices actually paid for them .It is the value of all purchased and hired input factors .
145 Opportunity Cost It is the cost of the best alternative given up . It is the cost of each input used in production whether it is purchased, hired , or imputed cost.Opportunity = cost of purchased + imputed costcost and hired factors= ( Explicit cost ) + ( Implicit cost)
146 Imputed cost ( Implicit cost ) It is the cost of inputs used in production which is neither purchased nor hired .It is the cost of inputs which its uses does not require payment to anyone outside the firm.Example:The owner’s services to the firm (time and effort ) .The owner’s investment in the firm .
147 The meaning of Economic Profits Profit = Revenue – CostSince we have different measurement of cost , we also have different measurement of profit each based on different measurement of cost .Accounting = Revenue – Historical costprofitEconomic = Revenue – opportunityprofit cost
148 Note When Revenue = opportunity cost , then Economic profit is = 0 this is called Normal profit .When Economic profit > 0 the firm is earning more than the normal profit .When economic profit < 0 the firm is earning less than the normal profit .
149 Example Assume you are given the following data for a firm . Revenue from sale SR 300,000Cost of goods sold SR 150,000Utilities & other services SR 20,000Wages ( hired ) SR 50,000Depreciation SR 22,000 ; Bank interestIn addition you know that the owner of the firm invested SR 115,000 of his own money in the firm and worked 1000 hours during the year in his firm where the rate per hour is SR 40 and rate of interest is 10% . Calculate the Accounting profit and the Economic Profit ?
150 Accounting Profit = Revenue – Historical cost Revenue SR 300,000Less: Historical cost :cost of goods sold SR ,000Utilities & other services 20,000Wages ( hired ) ,000Depreciation ,000Bank interest , ,000Accounting Profit SR ,000
151 Economic Profit = Revenue – Opportunity cost Revenue SR 300,000Less : Opportunity cost:Cost of goods sold SR 150,000Utilities & services ,000Wages ( hired ) ,000Bank interest ,000Fall in value of assets ,000Owner’s salary ,000Interest on owner’s money 11, ,500Economic Profit SR ,500
152 Short-run Production Function Give us the relationship between the inputs used in production and the output produced.The short-run production can be described by three ways :1. Total product curve2. Average product curve3 . Marginal product curve
153 Example Assuming a firm using only 2 inputs ( Labor & capital ) where Labor is the variable factor and capital is a fixed factor . In addition you are given the following data :Labor Capital Output
154 Total Product , TPIs the total amount that is produced during a given period of time .Total product will change as more or less of the variable input factor is used with the given amount of the fixed factor
155 The Average Product , AP AP = TP = Q L L Is the total product divided by # of units of the variable input used in production.AP = TP = QL LWhere : AP = Average productTP = Total productL = Labor
156 Example Labor Capital Total product Average product 0 2 0 0 1 2 4 4
157 Marginal Product , MPIs the change in total product (output ) resulting from the use of one more unit of the variable input factor .MP of L = change in total productchange in Labor
158 Example Labor Capital Output Marginal product 0 2 0 - 1 2 4 4 2 2 10 6
159 Relationship between AP and MP When MP > AP ……. AP is risingWhen MP < AP ……. AP is fallingWhen MP = AP …. AP is at its MaximumThe point at which AP is at its maximum is also called “ point of diminishing AP “
160 Short-run Variation in Cost How the firm’s cost vary as its varies its output ?First let us have a brief definition of several cost concept such as :Total cost ; Total fixed cost ;Total variable cost ; Average total cost ;Average fixed cost ; Average variable cost ; and Marginal cost .
161 Total Cost , TCIs the sum of the cost of all input used in production .Total cost is divided into two parts Total fixed cost and total variable cost . Therefore :TC = TFC + TVC
162 Total Fixed Cost , TFC This cost does not change as output changes . It is independent of the level of output .It is also called “ overhead cost “ or “ unavoidable cost “
163 Total Variable Cost , TVC This cost vary with the level of output .It is the cost of all variable input used in the production .It is also called “ Direct cost “ or “ avoidable cost “ .
164 Q Or ATC = AFC + AVC Average Total Cost , ATC It is the total cost per unit of output .ATC = TCQOr ATC = AFC + AVC
165 Marginal Cost ; MCIs the increase in total cost resulting from a unit increase in output .It is also called “ incremental cost .MC = change in total costchange in output
166 ExampleAssume that TFC = $ 25 per day , and a worker cost $ 25 per day . Assume Labor is variable input. In addition you are given the following data : Labor OutputRequired:Calculate TFC ; TVC ; TC ;AFC ; AVC ; ATC ;and MC
167 The Answer L Q TFC TVC TC AFC AVC ATC MC 0 0 25 0 25 - - - -
168 Notes 1. TFC is constant at $ 25 regardless of the level of output , so it has a horizontal cost curve .2. TVC and TC both increase as output rises .3. The vertical distance between TC and TVCcurves is equal to TFC .4. AFC decreases as output rises .5. AVC and ATC both take the U-shape which means they first decrease , reach a minimum and then rises .
169 Production and Cost in the Long-Run Chapter 9Production and Cost in the Long-Run
170 In the Long-Run All input factors are variables. No Fixed factors . There are different ways to produce the given output .
171 Capital Intensive Method Using more capital and less labor
172 Labor Intensive Method Using more labor and less capital
173 Profit Maximization & Cost Minimization To maximize the profit in the long-runThe firm should select the method that produces its output at the lowest cost possible .This implication is called “ Cost Minimization”
174 What can the firm do in the long-run to make its cost as low as possible? Choice of Factor Mix :The firm should substitute one factor (ex. capital)For another factor ( ex. Labor) as long as the Marginal product of one factor per dollar is greater than the marginal product of the other factor per dollar expended on it .
175 Condition for Cost Minimization MP K = MP LP K P LWhereMP K = marginal product of capital per dollarP K spent on capitalMP L = marginal product of labor per dollar spentP L on labor
176 NoteWhenever the two sides of the equation are not equal, there are possibilities to Substitute one factor for another to minimize the cost of production .
177 Example Therefore, the firm should use more capital and less labor . If MP K = last dollar spent on KP K added 10 units to theoutput .And If MP L = last dollar spent onP L Labor added 4 unitsto the output .Therefore, the firm should use more capital and less labor .
178 The cost minimization condition Can be rearranged as follows :MP K = P KMP L P L
179 Example So, the firm should use more capital and less labor . Assume that :MP K = so one unit of capital added 4MP L times as much as one unit oflabor would add to the output.PK = so one unit of capital is twice asPL expensive as one unit of labor .So, the firm should use more capital and less labor .
180 Long-Run Cost CurvesWhen all factors of inputs can be changed , then :There is a Least Cost Method of producing each possible level of output.LRATC curve shows the minimum achievable cost for each level of output .
181 The Shape of LRATC curve The LRATC curve :First fall , reach a minimum , and then rises as output rises .Therefore, The LRATC curve take a U-Shape .It separate the attainable cost from those unattainable cost .Any point on the curve or above is attainable costAny point below the curve is unattainable cost.
182 Decreasing costWhen the LRATC curve fall , we have Decreasing cost. In this caseAn expansion of output permits a reduction in cost . This is called Economies of Scale , so over this range the firm enjoy Increasing return to Scale .
183 Constant Cost Over the Flat portion of LRATC curve : The firm would have a constant cost.So, the firm will have constant return to scale
184 Over the range of output > qc : Increasing CostOver the range of output > qc :The firm has rising cost , so an expansion in the production will cause increase in LRATC , so the firm will have Decreasing Return to Scale.
185 Substituting between Labor and Capital to produce a given output Example:Method Capital LaborabcThe different combinations of capital & labor required to produce a given level of output give us The ISO – Quant (equal quantity) curve.
186 ISO-Cost LineThis curve shows different combinations of capital & labor that can be bought for a given total cost .
187 ExampleAssume a firm decided to spend $ 100 a day to produce certain output.Also, assume that a machine operator (L) can be hired for $ 25 per day .Assume a machine (K) can be rented for $ 25 per day . What are the input possibilities for this firm ?
189 The Least-Cost Technique It is the combinations of inputs ( K & L ) that minimize total cost ( TC).It is the point of tangency between ISO – Quant curve and ISO-Cost curve .
190 ExampleGiven the following information about ISO-quant and ISO-cost curves find the least cost method.Method K L QabcISO-cost 1 = TC 1 = $ 100ISO-cost 2 = TC 2 = $ 125Price of K = $ 25 ; Price of L = $ 25
191 The Relation between Long-run and Short-run Cost curves 1. SRATC curve shows the lowest cost of production when one or more of the factor inputs are fixed.While the LRATC curve shows the lowest cost of production when all factors are variable .2. The SRATC curve can not fall below the LRATC curve because the LRATC curve represent the lowest attainable cost for every output .
192 Continue3. Each point on the LRATC curve represent the minimum SRATC for a given level of output .
193 The Envelope CurveThe LATC curve is sometimes called an envelope curve because it consist of many SRATC curves .Each SRATC curve is tangent to the LRATC curve at the optimal level of output .
194 Very Long-RunIs a period of time where all factors of production are variable as well as technology is variable .
195 Kinds of Technological change 1. New Technique to produce the output.this is called [ process innovation ]2. New products: goods or services thatdoes not exist in the past. This is called[ Product innovation ] .3. Improvement inputs: such as improvement in health and education that raise the quality of labor . Also, improvement in raw materials raise the quality of the product .
198 1. Perfect Competition Market Is a market where there are many firms selling identical products [Homogenous ] products .
199 2. Monopoly MarketIs a market where there is only one firm operating in the marketOr, a market where there are many firms , but these firms behaving as one firm ( cartel )
200 3. Monopolistic Competitive Market Is a market where there are many firms each selling slightly different product .
201 4. Oligopoly MarketIs a market where there are few firms selling differentiated products .
202 NoteIn this chapter , we will focus on the Perfect Competition Market
203 Characteristics of Perfect Competition Market 1. All firms in the industry sell an identical products [ Homogenous products ] .2. Firms and buyers are completely informed about the prices of the products of each firm in the industry.3. The level of output of a firm is small relative to the industry’s total output .4. The firm is assumed to be a Price Taker.5. There is freedom of entry and exist .
204 NoteEach competitive firm can change its level of output, but it has no effect on the price of the good it sells .The demand curve for the individual firm is perfectly horizontal line.The price of the product for the firm is set by the market demand and supply.
205 Firm’s choices in Perfect Competition A perfect competitive firm has to make two key decisions :1. Whether to stay in the industry or to leave it.2. If the decision is to stay in the industry, then How much to produce ?
206 Rule # 1A firm should not produce at all , if the total revenue from sale does not equal or exceed the total variable cost of production . Which means:If TR > TVC the firm should produce , andIf TR < TVC the firm should shutdown .
207 Example Assume that TFC = $ 25 per day Selling price = $ 25 per unit In addition you are given the following data :Q TVC Required:Should the firm produce or notIf it should produce , then howmuch it should produce ?
208 The Answer Q TFC TVC TC TR Profit 0 $ 25 $ 0 $ 25 $ 0 $ - 25 $ $ $ $ $Since TR > TVC at all these levels of output,Therefore, the firm should produce .
209 Rule # 2Assuming that it pays the firm to produce at all, then the firm should produce the level of output where Price = Marginal revenue = Marginal cost .P = MR = MC
213 NoteAs long as MR > MC firm should increase outputAnd if MR < MC firm should decrease outputOnly when MR = MC the firm should not change its output because that is the optimal level of output .In our example above , the firm should produce Q = 9 because at that levelMR = MC = 25
214 Profits and Losses in the Short-run In the Short-run equilibrium , although the firm produces the profit maximizing output, it does not necessarily end up making an economic profitTo determine whether the firm is making profit or not, we need to compare total revenue with total cost, or equivalently, we compare price with average total cost .
215 Short-run Equilibrium If P > ATC a firm makes a positiveeconomic profit .If P < ATC a firm incurs an economicloss negative economic profit .If P = ATC a firm breaks even makingzero economic profit orNormal profit .
216 Derivation of Supply Curve for a competitive firm The Supply Curve: It shows how the firm’s output varies as the market price varies .In a perfect competitive market, the firm’s supply curve has the same shape as the portion of the firm’s marginal cost curve above the minimum AVC.
217 NoteFor a price below AVC [ P < AVC ] the firm will supply zero output [ so the firm will shutdown ].For a price above AVC [ P > AVC ] the firm will produce the level of output where P=MR=MC .The smallest output that the firm will supply is at the point where P = minimum average variable cost [ P = min AVC ] .
218 Derivation of the Supply Curve for the Industry The Short-run supply curve for an industry:It shows how the quantity supplied by all firms in the short-run varies as the market price vary.Therefore, to construct the supply curve for the industry, we sum horizontally the supply of all the individual firms in the industry.
219 ExampleSuppose a competitive market ( industry) consist of 1000 firms and has the following supply schedule :Price Quantity supplied Quantity suppliedby each firm by the industry$ or to 7000
220 Long-run Industry Supply curve under perfect competitive market It shows the relationship between the market price and the quantity supplied by all firms in the industry when they are in the long-run .The long-run industry supply curve could be :1. Perfectly flat [ horizontal ] .2. Slope upward3. Slope downward
221 I. Horizontal Industry Supply Curve This will happen when we have a constant cost industry .Constant Cost Industry:It means that an expansion of the industry [ due to the entry of new firms ] leave the long-run cost curve of the existing firms unchanged .
222 II. Upward Sloping Supply Curve This will occur when we have increasing cost industry.Increasing cost industry : means an expansion of industry due to the entry of new firms will increase the L-R cost of the existing firms . Therefore the Long-run cost curve shift upward.
223 III. Downward Sloping Supply Curve This will occur when we have decreasing cost-industry .Decreasing cost-industry: means an expansion of industry due to the entry of new firms will decrease the L-R cost , so the LRATC curve will shift downward .
224 Long-run Equilibrium under Perfect Competitive market The key to the L-R equilibrium under Perfect competitive market is the entry and exist .If the existing firms in the industry are making positive economic profit over all cost, then new capital will move to that industry because more firms will enter .And if the existing firms are earning negative economic profit (loss) , then capital will leave the industry because some firms will exit .
225 NoteProfits and losses are signals to which firms will respond in making entry or exit decisions .
226 The Effect of Entry If the existing firms are making profit, then : More firms will enterQuantity supplied by all firms will riseThe industry supply curve shifts to the right, this will increase the quantity supplied by the industry , but lower the equilibrium price .As the equilibrium price decreases, each firm will lower its output , and this will continue untilP = ATC , so Economic profit = zero .
227 The Effect of ExitIf the existing firms are making negative profit or Losses, then :Some firms will exit (leave the industry)Quantity supplied by the industry will fallThe industry supply curve shift to the left which will decrease the equilibrium quantity supplied for the whole market, but increase the equilibrium price.This encourage the individual firm to increase its output until P = ATC .
228 Conditions for L-R equilibrium for competitive industry 1. Each firm must maximize its S-R profit by producing at the level of output whereP = MR = MC2. Each firm is earning zero economic profit where P = ATC on its existing plant .3. Each firm is unable to increase its profit by altering the size of its plant . This means that :Each firm must be producing at the minimum ATC on the LRATC curve .
229 Change in TechnologyTechnological change means that industries are discovering low-cost technique of production .
230 The effect of introducing new technology 1. raise the output for the industry .2. lower the market price .3. The firms adapting the new technology willmake profit , but as more firms enter theindustry , the profit will continue to declineuntil P = ATC , so profit = zero .4. Firms using the old technology incurred lossesand may shutdown .
231 Declining IndustriesAs a result of permanent decrease in demand the number of firms in the industry become smaller and smaller
233 Definition Monopoly is an industry in which : There is only one supplier of a good or service .There is no close substitute for the product .There are some barriers preventing the entry of new firms .Also, Monopoly could be an industry where we have many firms , but they are behaving as one producer ( Cartel ) .
234 Reasons for Monopoly1. If one firm control the raw materials needed toproduce the output .2. If one firm can produce the product at theminimum ATC and be able to satisfy the entiredemand of the market ( Natural Monopoly )3. If one firm is awarded a patent to produce theoutput . Or awarded a Franchise to produce orsell the product [ Created Monopoly ]
235 How does a single –price monopolist determine the quantity to be produced and the price to be charged?To answer the above question ,we have to see the relationship between the demand for the good produced by the monopolist and the monopolist revenueThe demand curve facing the firm in the monopoly market is the same as the industry demand curve [ downward sloping demand curve ]
239 NoteMR curve is below the demand curve ,so at each level of output MR < PAs output rises, TR rises to a peak the decline .Over the output range where MR > 0AS P fall , TR risesOver the output range where MR < 0As P fall , TR fallWhen MR = 0 , then TR is at its maximum
240 Short-run Monopoly Equilibrium A Monopolist in the short-run might have :1. Positive economic profit , whenTR > TC or P > ATC2. Negative economic profit , whenTR < TC or P < ATC3. Zero economic profit , whenTR = TC or P = ATC
241 Short-run Monopoly Equilibrium To determine the output level and the price that maximize a monopolist profit, we need to study the behavior of both revenue and cost as output varies .
242 Example P Q TR MR ATC TC MC profit 20 0 0 20 - 20 18 1
243 Example – Continue P Q TR MR ATC TC MC profit 14 3 42 10 30 12 6 10 Q = 9 units because at that level of outputMR = MC = 8And the equilibrium price is $ 14
244 Long-run Equilibrium in a Monopoly Market 1. In a monopoly market, profit provide an incentive for new firms to enter .2. If new firms enter the industry, the equilibrium position will change and the firm will no longer be a monopolist .Therefore, for a monopolist to persist in the long-run , there must be some barriers preventing the new firms from entering ( either Natural or Created barriers ) .
245 NoteA monopolist may make profit even in the long-run , but only if there are natural or created barriers to the entry of new firms .
246 Cartel as Monopoly Monopoly can arise when : All firms in an industry agree to cooperate with one another to behave as if they were a single firm .All firms eliminate the competitive behavior among themselves .Such group of firms are called “ Cartel “ .
247 The Effect of Cartelization If the industry is cartelized , then1. profit can be increased2. output will be reduced3. price will increaseCartel tend to be unstable because of the incentive for individual firms to violate the output quotas needed to enforce the monopoly.
248 NoteIf one firm is cheating, it can increase it profit by increasing its output to the level whereMR = MC = PIn that case, the firm who is cheating will maximize its profit on the expense of all other firms .But, if all firms are cheating, then price will be pushed back to the competitive level and all firms will be back to zero economic profit whereP = ATC and profit = 0
249 Multi-Price Monopolist This is the practice of charging some customers higher price than others for identical good or service .Example : Charging children or students lower price than adults .
250 Perfect Price Discrimination This occur when a firm charge different price for each unit sold.and charge the customer the maximum price that he is willing to pay for each unit .
251 Forms of Price Discrimination 1. Discrimination among units ofoutput .2. Discrimination among buyers .
252 I. Discrimination among units of output When the firms charge the same consumerdifferent prices for each unit of outputor different prices for each group ofoutput .
253 II. Discrimination among Buyers The monopolist charge different prices to different groups of customers on the bases of:Age, education , employment , or other factors .This will work ( increase the profit ) only if each group has different price elasticity of demand for the product .Low price to group with high elasticity .High price to group with low elasticity .
255 Imperfect Competition Can be divided into two types :1. Imperfect Competition Among Many Firms.This is called “ Monopolistic CompetitiveMarket .”2. Imperfect Competition Among Few LargeFirms . This is called “ Oligopoly Market “
256 Monopolistic Competition Is a market structure characterized by a relatively large number of sellers with differentiated products .Each firm attempt to increase its market share by differentiating its product from the output of other firms .
257 Characteristics of Monopolistic Competitive Market 1. Many firms producing differentiated products,and each product is close substitute for theproduct produced by other firms .2. Each firm in the industry make decision basedon its own demand and cost conditions .3. There is freedom of entry into or exit from theindustry .
258 Prediction of the theory What does this theory of monopolistic competition predicts about the price and the quantity of each firm in the industry?To answer this question, we need to talk about the short-run and the Long-run equilibrium of the firm .
259 Short-run Equilibrium of the Frim In the short-run , a firm operating in a monopolistic competitive market is :1. Similar to a monopoly, so it faces a downwardsloping demand curve .2. It maximize its profit by equating MR withMC ( so MR = MC ) .3. It may have positive, negative, or Zero economic profit , depending on whether its price greater than, less than, or equal to its ATC .
260 Long-run Equilibrium of the Firm 1. If the existing firms in short-run are makingpositive profit, that provide an incentive fornew firms to enter the industry.2.Total demand for the industry product mustbe shared among larger number of firms.3. So, each firm get smaller share of total market. This shift the demand curve for each firm to the left and that lower the price .4. Each monopolistic firm in long-run must have zero economic profit where P = ATC
261 Excess Capacity Theorem Excess capacity means :Each firm in a monopolistic competitive market is producing an output less than that corresponding to the lowest point on its ATC curve .Therefore, in monopolistic competitive market, the output produced at a point where ATC is falling , while in perfect competitive market , firms produce their output at lowest possible cost.
262 Continue Excess capacity = Output produced – Output Of monopolistic by Perfect produced byCompetitive competitive monopolisticfirm firm competitivefirmTherefore :Excess capacity = Q c Q mc
263 II. Competition Among Few Firms (Oligopoly ) Is an industry that contains two or more firms , at least one of which produces a significant portion of the industry’s total product .
264 Characteristics of Oligopoly 1. It faces negatively sloped demand curve .2. It faces a few competitors .3. Oligopolies are aware if the interdependenceamong the decision made by the various firmsin the industry.4. Each firm may take its competitors expected reactions into account when deciding on any action.5. Prices are administered and products are differentiated .
265 Types of Oligopoly1. In some industries there are only few firms operating .2. In some other industries there are many firms but only few firms dominate the market .
266 Why Bigness ? Why many industries are dominated by few firms ? There are several factors , some of these are :1. Natural Factors2. Created Factors
267 Natural FactorsBigness can result naturally from Economies of Scale , i.e.Big firms with large scale have an advantage over small firms with small scale as a result of division of labor .So, Big firms will be more efficient by having lower cost .
268 Created Causes of Bigness The number of firms in an industry may decrease and the size of the remaining firms rises due to strategic behavior such as :1. Buying out rivals ( Acquisition )2. Merging with rivals ( Mergers )3. Driving rivals into BankruptcyThese practices will lead to a few firms dominate the market and increase the size and market share of these firms .
269 Is Bigness Natural or Created ? Most observers would agree that bigness result from a mix of both natural and firm-created causes.
270 Strategic Behavior and the basic Dilemma of Oligopoly In deciding on strategies, Oligopolies faces a basic dilemma between competing and cooperating .
271 Cooperative OutcomeIf the firms in an oligopolistic industry cooperate, they can maximize their joint profits.If they do this, they will reach what is called “ Cooperative Outcome “ which is similar to what a single monopolist would reach .
272 Non-Cooperative Outcome An industry outcome that is reached when all firms proceeds by calculating only their own gains without considering the reaction of others is called “ Non-Cooperative Outcome “ .
273 Game TheoryIs used to study decision making in situations in which a number of players compete, each knowing that others will react to their moves and each taking account of others’ expected reactions when making moves .When Game Theory is applied to Oligopoly, then- the players are the firms .- their game is played in the market .- their strategies are their price or output .- payoffs are their profits .
274 Duopoly This is a case of two – firm Oligopoly . In this game there are only two strategiesfor each firm :To produce an output equal to one-half of the monopoly output.To produce output equal to two-third of the monopoly output .
275 NoteIf the two firms cooperate with each other, each one will produce one-half of the monopoly output and that will maximize joint profits. But it leaves each firm with an incentive to alter its output.If A and B cooperate and each produce one-half of the monopoly output and receives one-half of the monopoly profit, the outcome is called “ Cooperative Outcome “ .
276 NoteIf A and B make their decision Non – Cooperatively , they reach the Non – Cooperative Outcome , where each produces two-third of the monopoly output and each make less profit than it would if the two firms cooperated .The Non-cooperative outcome is called :“ Nash – Equilibrium “ .
277 Nash EquilibriumIf Nash equilibrium is established by any means, no firm has an incentive to depart from it by altering its own behavior except through cooperation with the other firm.So , in Nash equilibrium, each firm’s best strategy is to maintain its present behavior given the present behavior of the other firm .
278 Cooperation Or Competition When firms agree to cooperate in order to restrict output and raise prices, their behavior is called “ Collusion “Collusive Behavior may occur with or without an explicit agreement .
279 Explicit CollusionWhen firms have an explicit agreement to restrict output and raise prices to ensure that they all will maintain their joint profit maximization output . Example : the cartel such as OPEC orAssociation of Coffee producing countries
280 Overt or Covert Collusion Where explicit agreement occur, economists speak of Overt or Covert Collusion .Overt Collusion means the agreement is open .Covert Collusion means the agreement is secret .
281 Tacit Collusion If there is no explicit agreement occur. Here all firms behave cooperatively without an explicit agreement .
282 Types of Competitive Behavior 1. Competition for Market Share2. Covert Cheating3. Very long-run Competition
283 Competition for market share Firms often compete for market –shares through various forms of non-price competition such as :AdvertisingVariations in the quality of their product
284 Covert CheatingCovert rather than overt cheating may occur and be more attractive in an industry that has many differentiated products and in which sales are often by contract between buyers and sellers .Example :Secret discountsRebatesThis covert cheating allow a firm to increase its sales at the expense of its competitors .
285 Very Long-run Competition When Technology & product characteristics change constantly , there may be advantages to behaving competitively .A firm that behaves competitively in very-long run may be able to maintain a larger market share and earn a larger profit than it would if it cooperate with other firms in the industry .
286 Cooperative or Non-cooperative Outcome Empirical research by economists suggests that ;The relative strengths of the incentives to cooperate and to compete vary from industry to industry depending on the characteristics of firms , markets , and the products .
287 Some of the Characteristics that affect the Strength of Cooperation The tendency toward joint profit maximization is greater for :1. Samller numbers of sellers .2. Producers of similar products .3. Growing market than in contractingmarket .4. Industry with dominant firm .5. When non-price rivarly is absent or limited .6. When Barriers to entry of new firms aregreater .
288 Economic Efficiency and Public Policy Chapter 13Economic Efficiency and Public Policy
289 In this chapter we will discuss Economic Efficiency- Productive efficiency- Allocative EfficiencyEfficiency and Market Structure- Perfect Competition- Monopoly- Efficiency in other market StructureAllocative Efficiency and Total SurplusAllocative Efficiency and Market Failure
290 Economic EfficiencyThis occurs when the cost of producing a given output is as low as possible.Therefore, Economic efficiency requires that resources not to be wasted .
291 Example of inefficient use of resources 1. If firms do not use the Least-cost method ofproduction .2. If the cost of producing the last unit is higherfor some firms than for others, which meansthat the industry’s overall cost of producingthe output is higher then necessary.3. If too much of one product and too little ofanother product are produced . In all of these cases resources are being used inefficiently.
292 Pareto-efficiencyEfficiency in the use of resources is often called “ Pareto Optimality “ or “ Pareto-Efficiency “ in honor of Italian economist ( Vilfredo Pareto )
293 Productive Efficiency This requires that the firm produce any given level of output at :1. the lowest possible cost.2. to reach the lowest cost , the firm mustcombine factors of production so that the ratioof marginal products of each pair of factors equal the ratio of their prices , example :MPL = PLMPK PK
294 NoteAny firm that is not being productively efficient is producing at higher cost than is necessary and that will have lower profit .Productive efficiency implies being on rather than inside , the economy’s production possibility curve .
295 Allocative Efficiency Resources are said to be allocatively efficient if it is impossible to produce different bundle of goods to make any one person better off without making at least one other person worse off .The allocation of resources is efficient when each product’s price equals its marginal cost of production . That means MC = P for each good
296 NoteIf an individual firm or an individual industry is productively efficient, it does not necessarily means that a given firm or industry is also allocatively efficient .Allocative efficiency is a property of the overall economy i.e. When P = MC in all industries simultaneously.If P > MC in an individual industry, we know that the economy is not allocatively efficient.
297 Note – continueAny point on the production possibility curve is productively efficient .But, not all points on this curve are allocatively efficient.Any point inside the curve is productively inefficient because it is possible to increase the output without using more resources.Allocative efficiency requires that MC = P for each good . Usually , only one point will be allocatively efficient on the curve .
298 Efficiency and Market Structure 1. Perfect Competition:In the long-run under perfect competition, each firm produces at the lowest point on its long-run average cost curve ( LRATC ) .No one firm could lower its cost by altering its own production .Therefore, every firm in perfect competition is productively efficient .
299 Perfect Competition - continue In perfect competition , all firms in an industry face the same price of their product and that they equate marginal cost to that price ( P = MR = MC ) .Therefore, because all firms in the industry have same cost of their last unit, no relocation of production among firms could reduce the total industry cost . Therefore, in perfect competition, the industry as a whole is productively efficient.
300 Allocative Efficiency in Perfect competition Since in perfect competition market, firms maximize their profits by equating P = MCTherefore, when the perfect competition is the market structure for the entire economy where price = Marginal cost, the market is allocatively efficient .
301 II. Monopoly Productive Efficiency: Monopolists have an incentive to be productively efficient because their profit will be maximized when they adopt the Lowest cost method to produce any given output.However, the monopolist creates allocative inefficiency because the monopolist’s price always exceeds its marginal cost . ( P > MC )
302 Efficiency in Other Market Structure Whenever a firm has any power over the market, the firm is called ( Price Maker ) therefore :1. It faces a negatively sloped demand curve .2. Its marginal revenue will be less than its price.3. Its marginal cost also will be less than its price.This inequality between the price and marginal cost implies allocative inefficiency. Therefore, Oligopoly, and Monopolistic competition are also allocatively inefficient just like the Monopoly.
303 Allocative Efficiency and Total Surplus Allocative efficiency occurs where the sum of consumer and producer surplus is maximized.The Consumer Surplus is the value of a good minus the price paid for it . Therefore :The Consumer = Maximum price – Actual priceSurplus the consumer is paidwilling to payThe Consumer Surplus is the area under the demand curve and above the market price .
304 The Producer SurplusThe producer Surplus is the price that producer receives for a product minus the lowest price that he is prepared to accept for selling it.Producer Surplus = Actual price – Lowest pricereceived by that producerthe producer is prepared toaccept for theThe producer surplus is the area productabove the supply curve and belowthe market price .
305 NoteThe sum of producer and consumer surplus is maximized only at the perfectly competitive level of output .This is the only level of output that is allocatively efficient .Since the demand curve represent Price.And supply curve represent marginal cost. Therefore : Demand curve tell us the price for each unit demanded , and the supply curve tell us the marginal cost of each unit produced .
306 Conclusion Therefore a competitive market is allocatively efficient . At the intersection point between demand and supply curves P = Mc which is the condition for allocative efficiency for the use of resources .Therefore a competitive market is allocatively efficient .
307 The Allocative inefficiency of Monopoly 1. The monopolist chooses an output below thecompetitive level .2. The monopolist chooses price higher than the3. As result of this, the consumer surplus will diminish and the producer surplus will increase.Thus, the monopoly is allocatively inefficient because it produces less and charge higher price relative to the competitive market.