PRICE SYSTEM & THE MICROECONOMY

PRICE SYSTEM & THE MICROECONOMY
Broad topic aims. Explain consumer equilibrium Describe producer equilibrium Discuss the short run and long run cost curves Describe the various market structures

Concept of utility What is utility?
Utility is the level of happiness or satisfaction derived from the consumption of a product. Its assumed that utility is measurable in subjective units called ‘utils’. Total utility (TU): It’s the entire satisfaction derived from the use of various combinations of goods and services overtime.

Marginal utility (MU):
it’s the additional utility derived from the use of a further/extra unit of a product. give formulae Disutility Dissatisfaction derived from consuming a good. Occurs when Consumption yields negative utility. Self assessment task page 145 (Draw the graphs)

Observations TU increases as successive units of lemonade are consumed, reaches a maximum and then starts falling. MU decreases as successive units are consumed due to the law of diminishing marginal utility. Law of DMU states as additional units of a product are consumed, ceteris paribus, MU diminishes overtime.

Top tip The use of extra units may end up yielding negative utility (disutility). Understanding utility theory (mind bites video) Video : 00:04:33

Calculating Marginal utility
Bottles of Soda consumed Total Utility Marginal Utility 1 10 2 19 3 27 4 34 5 37 6 35

Equimarginal principle
It defines consumer equilibrium when a consumer maximizes TU. It assumes that Consumers- Have limited income. Behave in a rational manner. Seek to maximize their total utility. Equilibrium occurs when the MU per dollar from every good consumed is the same (MU= P) hence consumers cant switch expenditure from one good to another so as to increase their TU

Assuming that goods x, y, z……
Assuming that goods x, y, z…….n are consumed the equilibrium condition is given by:

Where MU- marginal utility,
P – price per unit consumed x, y, z…..n are the products consumed K is a constant

Task Use the equimarginal principle to solve the following. Assume that a consumers CPI basket has Food, Housing, Education and clothing only. If the MU from consuming food is 10 units when price is $2, calculate the price of Housing, education and clothing given that the MU is 30, 25, and 5 respectively?

Q /31/M/J/2013. The table shows the total utility that an individual derives from consuming different quantities of a good. The individual’s marginal utility of money is $1 = 2 units of utility. What is the maximum quantity of the good that the individual will buy when its price is $6? A 2 units B 3 units C 4 units D 5 units

Practice question The schedule shows the total utility derived by a consumer of a good X at different levels of consumption. The consumer obtains three units of utility from the last $ she spends on each good that she purchases. What is the maximum number of units of X that she will consume if the price of X is $5? A 3 B 4 C 5 D 6

Question The table shows the total utility that an individual derives from consuming different quantities of a good.

The individual’s marginal utility of money is $1 = 2 units of utility
The individual’s marginal utility of money is $1 = 2 units of utility. What is the maximum quantity of the good that the individual will buy when its price is $6? A 2 units B 3 units C 4 units D 5 units Extension: Draw a graph of the TU and MU on the same axis and comment on their relationship.

Utility video – funkyteacher
Utility maximization video 00:06:15 Task: Q2 9708/31/O/N/2012 Q2 9708/31/w/2010 Q2 9708/03/W/2009

Example The table shows the marginal utility derived by a consumer who devotes the whole of his weekly income of $42 to two goods X and Y, whose unit prices are $3 and $6 respectively.

In order to maximize his utility, which quantities of X and Y should the consumer purchase?

Derivation of dd curve from MU
It can be derived from the equi marginal principle The law of dd states that more quantities will be bought at lower prices than at higher prices ceteris paribus. Consumers equilibrium is given by; MUA/PriceA=MUB/PriceB=MUC/PriceC=K

At equilibrium , with a given level on income, a consumer can not switch from using good A to B or C so as to increase total utility. Assuming price of good A increases, holding price of good B & C constant, the value of the MU per $ received from using good A falls

The MU of good A per $ spent will be less than that of B & C
The consumer maximizes utility by buying less of good A and more of B & C. This leads to a negatively sloping dd curve according to the law of demand

NB:  The dd curve is equal to the positive section of the MU curve
Limitations of the law of equi marginal principle handout Q2a 9708/42/w/2011 Q2b 9708/43/s/2012 Q2a 9708/41/w/2012

Discussion task- page 146 Are consumers always rational?
Read and write down the instances where consumers behave in an irrational way. BUDGET LINES: Review of the determinants of demand from AS What is the major determinant? P and Y

A line showing all the combinations of two goods obtainable with a given income and prices
Equation of the budget line: Y = Px . Qx + Pz . QSz Y – consumer income Px - price of good x Py – Price of good y Qx - Quantity of good x Qy – Quantity of good y

Task Assume that a student can only buy a soda and ice cream per day from the tuck shop given a pocket money of $20 per term. Let the price of a soda be $2 and that of ice cream be $1 per unit

Combinations of sodas & ice creams that can be bought
Quantity of soda (US $ 2 each) Quantity of ice cream (US $ 1 each) 10 9 2 8 4 7 6 5 12 3 14 16 1 18 20

Task Use a graph paper to represent the above info. Plot quantity of sodas against quantity of ice creams. Scale: Qty of sodas 1:1 Qty of ice creams 1:2

Observations Each combination of sodas & ice creams will cost the student $ 20. Any point along the budget line shows combinations of sodas and ice creams for which the student maximizes utility. Top tip  1. When the price on of one good changes, with income remaining unchanged, the budget line pivots or tilts 2. when the consumers income changes, prices of the two goods remaining the same, the budget line shifts.

Drawing tasks 1. Re-draw the diagram to show how it would change if;
i) Price of soda increased , leaving the price of ice cream unchanged ii) If the price of ice cream decreased , leaving the price of soda unchanged

Definitions to learn Money income
This is the nominal value of money which is in actual currency terms. i.e. not adjusted for inflation Real income Its the quantity of goods and services a given money income can buy at the current market prices.

i.e. its adjusted for inflation.
It increases as price falls and vice versa.

The effects of a price change
A price change of a good leads to two effects in the market which may occur simultaneously. i.e. P.E.= S.E. + I.E. Where P.E. Price effect S.E. Substitution effect I.E. Income effect

Substitution effect This is the change in quantity demanded following a change in relative prices. i.e. following a price change, a consumer buys more of the inexpensive product. This causes the budget line to tilt/pivot inwards or outwards Show diagram

Income effect. This is the change in quantity demanded due to changes in real income. This causes the budget line to shift inwards or outwards Show diagram Task:  Copy the key terms from page 147 Prep task: Explain the factors that may cause a movement along the budget line and a shift

Q3 9708/3 Jun03 The diagrams show a change in a consumer's budget line from an initial position of LL1 to LL2. Which diagram shows the effect of a fall in the price of X, money income remaining unchanged?

Q3 9708/03/M/J/07 In the diagram a consumer's budget line shifts from JK to JH.

What can definitely be concluded from the diagram?
A There has been no change in the price of good Y. B There has been a reduction in the price of good X. C There has been an increase in the consumer's money income. D There has been an increase in the consumer's real income

Q39708/03/M/J/09 In the diagram a consumer’s budget line shifts from JK to GH.

Which statement must be correct?
A There has been an increase in the consumer’s money income. B There has been a decrease in the consumer’s real income. C Good Y has become relatively more expensive. D The price of good X has increased.

Indifference curves Apart from price and incomes, consumers buy because of their preferences Give examples of your most preferred brands What features makes you buy them? Consumer preferences are graphically represented by indifference curves.

An indifference curve shows various combinations of two goods that give equal satisfaction to a consumer. Show the diagram (fig 7.2 page 148) Observations Points X, Y & Z provides the same utility though they indicate a trade off in quantities of good A and B A movement down the curve (From X to Z) makes the consumer to substitute good A for B.

The rate at which a consumer is willing to substitute good A for B is called the Marginal Rate of Substitution (MRS)-or slope of the indifference curve. MRS increases as you move down the curve MRS = MU of good A / MU of good B Characteristics of indifference curves They never intersect. If they did, it would indicate same level of utility for 2 curves which is impractical.

Downward/negatively sloping- meaning what??
They are concave or bowed inward to the origin. Higher indifference curves (superior) represents higher satisfaction & vice versa Top tip:  A family of indifference curves is called an indifference map

Video Properties of indifference curves video
C:\Users\pnduati.PEPONISCHOOL\Documents\Class notes 2014\A 2 Econ\Lecutre notes \Price system \Price system

The consumers equilibrium
It occurs where the budget line is tangent to the indifference curve and the consumer maximizes/optimizes the utility

Effect of change in income on consumers optimal choice
The optimal choice occurs at the point of tangency between the budget line and indifference curve. If real income increases the consumer buys more or less depending on whether the good is normal or inferior. NB: Normal goods have positive income effect while inferior goods have negative income effect.

Task: Draw fig 7.3 from page 148.
Observations Budget line shifts rightwards due to increases in income Changes from E1 to E2 is the income effect showing more units of good A and B being consumed. Goods A and B are normal

Income & Substitution effect of a price change using indifference curves
Recall that the total price effect = S.E. + I.E. Normal goods have positive I.E. & S.E. Inferior goods have positive S.E. & negative I.E Giffen goods have a Positive S.E and a very negative I.E. e.g. rice among the poor communities in India NB: S.E. is positive for all goods. Give handout

Inferior goods These are goods with negative I.E. and usually cheap and low quality products. When consumers real income rises less of inferior goods are bought and more of superior goods eg Desktop PC’s & laptops The IE works against the SE however the SE is larger and so overall the consumers do buy more Give numerical example…

Giffen goods These are very inferior goods that are staple foods for the poor whose I.E is very negative When the general price increases consumers will have less income to buy other luxury foods and hence will buy the staple food. The SE and IE works in the opposite directions but the IE outweighs the SE. Give numerical example…… Hence, overall the quantity demanded increases as price rises leading to a positively sloping demand.

Case 1: I.E. and S.E. of a price fall in the case of a normal good. Let the CPI basket contain two goods A (normal) and good B which is unknown If price of good A falls, holding price of good B and money income constant, we can isolate the price effects as follows.

Following the fall in price, consumers real income rises hence more units of good A can be bought.
This causes the budget line to tilt/pivot upwards/outwards as shown in the diagram below. Draw the diagram: …..(page 149)

Observations E1 is the initial equilibrium before the price change.
E3 is the new equilibrium following the tilt of the budget line. Since the optimal point E3 is unattainable with the present level of income, the consumer must be compensated so that he maximizes his utility on the initial indifference curve.

This is done by shifting the new budget line (B2) downwards until it is tangent to the initial indifference curve (IC 1). Compensation means that the consumers welfare is made better off as the price falls. The compensating budget line is line BC E2 is the new feasible optimal point of consumption where more units of good A are consumed and less units of B are consumed

Top tip 1.The movement along the initial indifference curve (E1 to E2) is the substitution effect since the consumer buys more of the cheaper good A and less of B which is relatively expensive. 2.The shift upwards to a higher indifference curve (E2 to E3) is the income effect. 3.I.E. causes more units of both goods to be bought due to rise in the purchasing power

4. S.E. is negative for good B but the fall in consumption is to some extent offset by the positive I.E. Task: Q3 9708/31/O/N/2012 C:\Users\pnduati.How to draw I.E and S.E. 00:6:56

Practice question Let the CPI basket contain two goods: Other goods and apples (normal) Let the price of apples fall ceteris paribus. Obtain the SE and IE graphically Y axis : other goods X axis : apples.

Case 2 inferior goods They have negative income effect i.e. as real incomes rises…….. Let the CPI basket contain 2 goods: other goods and rice (inferior good) Assume that the price of rice is falling ceteris paribus Draw the diagram and identify the I.E. and S.E. NB: Point E3 is to the left of E2.

Case 3 giffen goods They have very negative income effect
Let the CPI basket contain 2 goods: other goods and beans (giffen good) Assume that the price of beans is falling ceteris paribus Draw the diagram and identify the I.E. and S.E. NB: Point E3 is to the far left of E2. Prep: Q2(a) 9708/41/M/J/2012

Principles of production
Production is the creation of utility or the process of converting raw materials into finished products. Firms can either use capital intensive or labour intensive methods of production The producer/firm/business entity demands factor inputs so as to create products. The demand for factor inputs is a perfect case of derived demand.

Definition of derived demand
Explain the ‘picks & axes’ strategy during the industrial revolution in Britain- gold rush The producer uses the least cost factor combination (most efficient) of capital & labour in order to maximize output and profits.

Reading task Read the intro on page 150. Study the diagram showing the prodn of 100 units of an output using different labour- capital combinations. Points A,B,C shows the amounts of L & K need to make 100 units of output. Joining these point produces a curve called an isoquant Diagram from page 150

Observations. The lines shows 3 prodn lines that can be used by a firm to produce 100 units of output Points A,B,C shows the amounts of L & K need to make 100 units of output. Joining these point produces a curve called an isoquant

Isoquant - isocost analysis
Isoquants (production contours) It’s similar to indifference curves in the consumer theory It’s a curve that joins various combinations of two factor inputs that produce the same level of output.

Task: copy the key term from page 150
Characteristics of isoquants Convex to the origin Negatively sloped Never intersect Superior isoquants denotes higher output on the isoquant map

Top tip  An isoquant map shows different production possibilities of a firm at constant technology. The isoquant map defines the firms long run production function Q6 9708/W/31/2013

  An isoquant map for a cloth manufacturer .

The isocost (aka cost line)
It’s a line joining various combinations of two factor inputs that can be bought with a given monetary cost outlay. It is similar to the budget line in the consumer theory It’s a line of constant relative costs for the factor inputs Draw the diagram here

The producer equilibrium
Its defined when the isocost line is tangent to the isoquant curve. This point of tangency defines the least-cost combination of K & L used to maximize output i.e. point of cost minimization Draw the diagram here

Top tip Equilibrium is also defined when the ratio of marginal product to price of the factor is the same for all factors hired. This is similar to the equi marginal principle. For a firm using three factors A,B and C, the equilibrium occurs when

MPA/PriceA=MPB/PriceB=MPC/PriceC=K
Marginal product is the change in total output due to hiring an extra worker. Task : state the equilibrium for a firm using land(Ld) , labour(L) and capital (K).

Limitations of isoquant-isocost analysis
Isoquants are theoretical in nature and its hard to determine them The assumption of switching factors in the LR is not always easy Some employers may not be willing to switch labour for capital due to the opportunity cost of bad publicity of unemployment.

The production function
It’s a technical representation showing various input combinations required to produce a given level of output Production occurs in two main periods: Short run period(SR): Period during which at least one of the factors of production is fixed. Firms can only expand output by hiring more workers

Long run period (LR): Period during which all the factors of production are variable making the firm to use different factor combinations in the most technically efficient way possible. Defining the LR video 00:05:55

Short run production function
It is the total output produced by a firm at a given time. AKA total product(TP) or total output or the total physical product curve (TPP). The TPP increases as more workers are hired

Marginal physical product
Also called the marginal product MPP = change in total product/change in variable factor(number of workers). It’s the extra output gotten from hiring an extra worker. Average Physical Product (APP) Also called the Average product APP= Total product/ units of variable factor (labour) It’s the total output per worker

Case study  Assume that a shoe making factory can only use labour as a variable factor to produce. Fill the missing figures

No of workers Output of shoes Marginal product Average product - 1 5 5.0 2 13 8 6.5 3 23 4 34 44 6 51 7 55 56 9 54 6.0

Drawing task On the same axis plot, TPP,MPP & APP Y axis: MPP, TPP, APP X axis: no. of workers Observations: When TPP is at the optimum, MPP=0 This is the condition for maximization of output.

When MPP=APP, then TPP is rising
The 3 stages of production are due to the law of DMR/variable proportions The shape of the TPP can be explained by the law of DMR. Revision questions Q4 9708/03/M/J/2007 Q4 9708/31/O/N/2012 2012 C

Compare with this

The law of diminishing marginal returns (DMR)
Aka law of variable proportions. It states that as additional units of the variable factor are hired the marginal product declines overtime Or……As additional units of a variable factor are applied to the fixed ones the contribution of each extra worker to the total output will begin to fall.

Assumptions of the law of DMR
(1)Only one factor is variable while others are held constant. (2) All units of the variable factor are homogeneous. (3) There is no change in technology. (4) It is possible to vary the proportions in which different inputs are combined.

(5) It assumes a short-run production situation.
(6) The product is measured in physical units e.g. KG’s , tonnes etc. Production function & Law of DMU video 00:05:47

Top tip The law of DMU explains the shape of TPP. i.e the 3 stages of production - increasing returns, diminishing returns & negative returns Q4 9708/31/M/J/2013 ANS B

Annotate the 3 stages

Compare with this diagram

Q /31/M/J/11 Which diagram correctly shows the relationship between the average product (AP) and the marginal product (MP) of labour given that the quantities of other factor inputs remain constant?

The long run(LR) production function
AKA firms expansion path. It is derived from an isoquant map. It shows the path followed by a firm as its produces more output in the long run Task: draw fig 27.9(b) on page 153

9708/31/M/J/11 6. What is the name for the relationship between a firm’s output and the quantities of factor inputs that it employs? A a long-run average cost function B a long-run production function C productive efficiency D returns to scale

5 The diagram shows the total product of labour curve for a firm whose only variable factor input is labour What explains the shape of the curve? A diminishing marginal disutility of work B increasing marginal disutility of work C technical diseconomies of scale D the law of variable proportions

9708/31/O/N/11 A firm employs two factors of production, capital and labour. The curves in the diagram show the different combinations of capital and labour a firm needs to produce given levels of output.

What does the diagram show?
A the firm’s long-run production function B the firm’s long-run total cost function C the firm’s short-run production function D the firm’s short-run total cost funct

9708/31/O/N/13 6 In the diagram the heights of the vertical broken lines show the levels of output a firm can produce with different combinations of labour and capital.

What is the relationship between factor inputs and the level of output shown in the diagram
called? A a long-run cost function B a long-run production function C a short-run cost function D a short-run production function

The firms cost structure
A firm is the smallest economic decision making unit involved in production. A collection of similar firms make an industry Costs are production expenses paid out at a particular time and place. Production costs are incurred both in the SR & in the LR.

A firm must bear private costs incurred directly by the entrepreneurs and social costs to some extent. Recall: Private costs + external costs = Social costs.

 Economists vs Accountants  view of costs
Accountants view costs as expenditures or prodn expenses paid out. The economist view of costs encompasses both the private cost(PC) as well as the opportunity cost (OC) i.e. TC = PC + OC  Example : Q /03/M/J/09 An economist calculates that a firm has incurred the following costs over the course of a year.

By how much does total cost as defined by an economist exceed the total cost as defined by an accountant? A $ B $ C $ D $85 000

The short run costs (SRC)
Are incurred during the SR period when most factor inputs are fixed. 1. Total Fixed costs incurred on all fixed factors of production and are independent of output produced . Fixed factors are those that can not be varied in the short run e.g. land

2. Total Variable costs: They are directly related with the level of output produced e.g. raw materials & labour . Charged on all variable factors Variable factors are those that can be varied to increase prodn

3. Total costs They are given by the sum total of the TFC and TVC
TC= TFC + TVC Task: Draw the diagram (fig.7.7) from page 152

4. Average costs These are the unit costs per unit of output.
Recall that TC= TFC + TVC Dividing the TC by output(Q) gives the average costs AFC = TFC/Q AVC= TVC/Q ATC = TC/Q= AFC + AVC

Task: 9708/03/M/J/07 The short-run total costs of a firm are given by the formula SRTC = $( X2) where X is the level of output. Required; State the TFC & TVC What are the firm’s AFC, AVC, & ATC?

Average total cost (ATC)
It measures the cost per unit of any output produced . ie both the AFC & AVC hence it’s the most important cost curve for a firm. Recall: ATC = AFC+AVC It is the basis of cost plus pricing strategy

ATC is U shaped since as more output is produced costs rise
As the firms output rises the AFC will fall since the TFC will be spread over the many units being produced AVC will however be rising due to the diminishing returns to the variable factor outweighing the falling effect of the AFC causing the ATC to rise

Shape of the ATC

Extension Derivation of the ATC from TC.
ATC is given by the average of TC at every given point Observations Draw rays from the origin to various points along the TC Get the gradients of the rays and map them on a lower axis to map out the U shaped ATC.

Gradients of line 0A>0B>0C
Q7 9708/31/O/N/2011 B

The Average fixed cost –AFC 
It is the TFC per unit of output produced. Its given by TFC divided by output It has the shape of a rectangular hyperbola. Show the Diagram.  C:\Users\pnduati. AFC 00:04:30

Reason for the shape: As the firms output rises the AFC will fall since the TFC will be spread over the many units being produced The average variable cost: It is the TVC per unit of output produced. Its given by TVC divided by output It is a U shaped curve. Show the Diagram. 

Extension: Derivation of AVC from TVC
It’s given by the averages at any given point on the TVC Observations: Draw rays from the origin to various points along the TVC Get the gradients of the rays and superimpose them on a lower axis to map out the U shaped AVC

Draw rays from the origin ANS B
The AVC initially falls due to the benefits of specialization and then rises due to the law of DMR. Self assessment task: page 155 Q7 9708/31/M/J/2013 Draw rays from the origin ANS B

Marginal cost It measures the change in total costs as a result of producing an extra unit of output. Or extra costs incurred by creating an extra product It can be said to be a variable cost since it varies with output produced Formulae : Change in TC/Change in output

Note MC is the slope of the TC at any given point!!

Top tip 1.Producing more output will raise the TC hence the MC will be positively sloping 2. The increasing MC reflects the principle of diminishing marginal returns (DMR) 3.The law of DMR/variable proportions causes the marginal costs and variable costs to rise . Q8 9708/03/O/N/2010

Extension : derivation of MC from TC
MC can be derived by getting the gradient of the TC at any given point Observations: Draw tangents at various points along the TC Get the gradients of the tangents and map them on a lower axis to get the MC

Relationship between MC, ATC & AVC
MC will always cut the AVC & ATC at their lowest points since the most efficient output for the firm is where the unit cost is lowest. Such output is called optimum output occurring where the firm is productively efficient though its not necessarily the most profitable. This defines the SR equilibrium Task: draw fig 7.1(a) page 155

Observations. To the left of optimum output, the firms experiences increasing returns i.e. fixed factors are efficiently used. To the right of optimum output, the firms experiences diminishing returns reflected in rising costs Video 00:7:54 C:\Users\pnduati.marginal and variable costs

Complete the following table: costs are in $’s
Total cost TFC TVC AFC AVC MC ATC 100 - 1 220 120 2 300 80 3 360 60 4 400 40 5 450 50 6 540 90

Relationship btn MC, AVC, ATC AFC
A decision to increase output will raise the average total costs marginally. Firms will produce more when TR expected is greater than the TC. As TC rises MC will also be rising Rising MC causes diminishing marginal returns causing the MC and the AVC to rise.

As more output is produced AFC falls since TFC are spread over many units while AVC rises due to DMR

Video 00:10:24 Putting the curves together mind bites video
Q7 9708/31/S/2002

Q /31/M/J/14 The diagram shows the short-run cost curves of a firm.

Q7 9708/31/S/2002 Which statement is correct?
A Curve 1 is the marginal cost curve. B Curve 2 is the average variable cost curve. C Curve 3 is the average fixed cost curve. D Curve 4 is the average total cost curve. Q7 9708/31/S/2002

Costs in the Long run The LR is the time when firms can alter all its inputs, fixed & variable, to increase output. Firms are able to operate on a bigger scale using more quantities of factor inputs. Firms will make planning decisions in the LR to hire more cost efficient technology.

Firms will seek to minimize their cost structures in the long term.
The most important curve in the LR is the long run average cost curve (LRAC) THE LRAC: AKA planning/envelope curve It shows the least cost combination of producing a given output.

The LR comprises of several SR planning periods.
Diagram page 155 Observations: The LRAC is derived from a series of SRAC curves. Point B represents the minimum efficient scale of output maximization

Distance A to B represents economies of scale
LRAC is tangential to all the SRAC curves facing a firm since firms seek to minimize costs in the LR. It’s a U shaped curve & flatter than the SRAC

Top tip:  A firm producing the minimum efficient scale (lowest unit cost in the LR) will have maximum efficiency. The MES defines the LR equilibrium

   GRAPHICAL REPRESENTATIONS OF THE LRAC
LOOK AT THE GRAPHS HEREAFTER SINCE ____ PICTURE EQUALS________ WORDS.   

The planning curve

Class task Plotting the LRAC on the board_

Q2 9708/31/O/N/2011 Video 00:15:12 SRAC and LRAC Q5 9708/31/M/J/2013 Ans D

The law of returns to scale (RTS)
It describes the relationship between outputs and the scale of inputs in the LR when all the inputs are increased in the same proportion. The firm increases its scale/size of production by using more space, machines and workers.

Assumption of RTS (1) All factors (inputs) are variable but enterprise is fixed. (2) A worker works with given tools and implements. (3) Technological changes are absent. (4) There is perfect competition. (5) The product is measured in quantities

The three phases of RTS

Constant returns to scale
Occurs if a proportional increase in all inputs under the control of a firm results in an equal proportional increase in production. E.g. a 10 % increase in labor, capital, and other inputs, results in a production increase equal to 10 %

Decreasing returns to scale
Occurs if a proportional increase in all inputs under the control of a firm results in a less than proportional increase in production. E.g. a 10 % increase in labor, capital, and other inputs, results in a production increase < 10 %

Increasing returns to scale
Occurs if a proportional increase in all inputs under the control of a firm results in a greater than proportional increase in production. E.g. a 10 % increase in labor, capital, and other inputs, results in a production increase > 10 %

Students task Q6 9708/31/M/J/2013 Solution: Work out the % changes ANS D

Video 00:7:12 Returns to scale video

 ECONOMIES OF SCALE  These are benefits of large scale production that leads to a reduction in the unit costs/ATC. Internal economies of scale: These are the benefits that accrue to a firm due to large scale prodn. They occur due to increasing returns to scale: i.e. firms output rising proportionally faster than the inputs hired.

External economies of scale
These are the advantages that accrue to a firm due to growth and expansion of the entire industry. E.g. Safcom benefiting from free call termination services offered by CCK(Communications Commission of Kenya) Concentration of Electronic firms in Cambridge benefits from R&D links with the university More examples …page 156

Types of economies of scale
Technical economies: They occur due to the employment of more efficient production lines that can produce more output at lower cost. Firms enjoy this due to technological improvement of their production lines making them more cost effective & efficient

E.g. mass production of cheap Nano cars in Mumbai by Ratan Tata.
Marketing economies: Large firms are able to promote their products on the media at lower rates by buying huge amounts of space & airtime on TV

They also allocate huge amounts for the advertising budget.
Purchasing /trading economies: They occur when a firm receives trade discounts due to bulk purchase of inputs e.g. raw materials.

This helps to save the average costs.
E.g.US retail giant chain, Walmart uses its purchasing powers to buy stocks at rock bottom prices. Financial economies Large firms are more credit worthy compared to small firms in terms of accessing credit financing.

They can negotiate for lower interest rates
They also have a good capital base for loan security Managerial economies: Large scale producing firms may be able to hire specialised and highly skilled personnel since they pay well

Specialist managers adopt lean prodn methods that save on costs & wastes e.g. div of labour
This will translate to a reduction in production costs. Risk bearing economies; Large firms diversify their products and markets so as to minimize their risks of failure.

E.g. Coca cola has produced a wide range of products and also ventured in to various global markets.
Technological economies……page 156 Economies of scale video- a quick explanation 00;07:12

Top tip 1. As firms expand, they may lower their ATC by producing in large scale causing their profits to rise. 2. Low costs may create a natural monopoly and hinder other firms from joining the industry as they may not manage to match such prices

Diseconomies of scale:
These are disadvantages of growth & expansion Occurs when the unit costs of a firm begin to rise due to growth and expansion of the firm. C:\Users\EQBL overwhelmed by growth

Students research task
Make short notes on diseconomies of scale: Ref: page 156-7 Any other online/textbook source.

Examples Communication problems due too many workers in a large firm
Shortages of skilled labour Traffic congestion hence high distribution costs Poorly motivated workers due to impersonal relationships in a large firm Task case study page 157

Further reading on law of DMR, RTS & economies of scale

The firms total revenue(TR)
Revenue=income TR is the total income received from the sale of output TR= SP X Q E.g. Apple LTD produced 5,000 iphones last year. If each iphone was sold at $ 900, calculate the total revenue earned

Average revenue This is income received from the sale of each unit of output. it is the same as the selling price and demand since products are demanded at their own price. AR=P=D AR=TR/output

Marginal revenue(MR) This is the change in TR due to the sale of an extra unit of output. Give the formulae. MR always lies below the AR since to sell more, firms must reduce price Top tip  1. The optimal goal for most firms is to maximize the difference between revenues and costs Profit= total revenue – total cost

2. If TR= TC, the firm is making normal profits i. e
2. If TR= TC, the firm is making normal profits i.e. profits that are sufficient to recover the costs of production at the BEP 3. If TR are greater than TC, the firm makes supernormal/abnormal profits i.e. profits that are over and above the normal profits 4. If TC are greater than TR the firm makes losses. Self assessment task page 158

MARKET STRUCTURES A mkt structure refers to the way in which products are supplied by firms in a particular market. i.e. how a market is organized in terms of number of firms & barriers to entry for new firms. Task Copy the key terms from the top LHS of page 160

Classification of markets
MARKET STRUCTURES imperfect compettion monopoly monopolistic competition oligopoly perfect competition Market structures 1st layer/rung 2nd layer/rung

Ways of identifying a market structure
Counting the number of firms: many firms indicates perfect competition Use of concentration ratio: Gotten by adding the % market shares of the biggest 3,4 or 5 firms.

A huge share point to oligopoly or monopoly
3. Identifying the barriers to entry: many barriers indicates less competitive markets. 4. Economies of scale: Oligopolies have huge cost advantages

The spectrum of competition
Draw fig 7.13 page 160 C:\Users\pnduati.Understanding mkt structures.(market videos) Study the competition road map from page

Perfect competition: 
It’s an ideal market structure that does not exist in practice. It exists in utopian economies It s a benchmark model in the study of market competition for a real world

Characteristics/ features:
Complete freedom of entry into and exit of firms from the industry All firms pursue profit maximization objective. Product homogeneity- similar or identical Large no of buyers and sellers with perfect market knowledge about prices & products

Over reliance on market forces of dd and ss to determine market price and output due to absence of govt control Firms are price takers ( as determined by market forces) hence individual firms have no control on market price.

 The firms dd curve  Its perfectly elastic as shown below:
All units are sold at the same ruling price hence D=AR=MR The firms equilibrium (when profits are maximized) occurs when MR=MC If the TR is greater than the TC, the firm makes an abnormal profit

This happens in the SR as shown below
Diagram on page 164 (fig 7.15 a) Observations In the SR diagram, firms make supernormal profits (shaded area). In the LR new firms enter the industry causing the industry ss to shift rightwards.

The firms dd shifts down till it becomes tangent to the ATC.
This clears all the abnormal profits making the firms to make normal profits Task : draw the LR diagram on page 164 – fig 7.15 b

observations New firms enter to scramble for the excessive profits causing the industry ss to shift rightwards. Abnormal profits are competed away and only the productively & allocatively efficient firms survive in the LR. LR equilibrium occurs where D=AR=MR=MC=ATC & firms make normal profits.

Plenary When TC >TR firms makes losses and may consider exiting the market. Is this always the case? Firms may continue producing & making losses in the SR so long P(AR)=AVC i.e. revenue received is just enough to pay for operational costs e.g. labor & raw materials.

Plenary…contd. Firms thus makes losses equal to the fixed costs hoping that prices will rise in the LR When P(AR) = AVC the firm is said to be operating at the shut down price. At this point the firm is not sure whether to should shut down or continue producing since fixed costs are not paid. The firms continues to produce so long as P> AVC at least in the SR

Q /31/M/J/10 The table shows information about a profit-maximising firm.

What should the firm do? A close down immediately because it is not covering its fixed costs B close down immediately because it is not covering its average costs C close down immediately because it is not covering its total costs D continue production in the short run because it is covering its variable costs

Holiday assessment tasks
Page 162 Page 165

Monopolistic competition 
Its similar to perfect competition only that the products are highly differentiated in terms of packaging, coloring, flavoring, tastes…etc..eg the Fast food; detergents etc Characteristics: Large no of buyers n sellers Firms seek to maximize profits only

There are few barriers to enter in to the market
There’s wide consumers sovereignty(choice) due to presence of many differentiated products. Firms have some influence on the price and hence are price makers [ since high price can be charged due to exclusive qualities in a product)

The firms dd & revenue curves
The firm operates under stiff competition from many rivals It is faced with normal dd curve but relatively price elastic due to the presence of close substitutes and the fact that firms are price makers The MR curve lies below the dd/AR since the firm can only sell more by charging a lower price Show the diagram here..

Equilibrium determination
In the SR, the firm can make abnormal profits since they can set high prices for exclusive products. Firms may use price & non price competition so as to ensure brand loyalty. Successful promotion will help reduce PED (make it inelastic) strengthening brand loyalty. But this may make the ATC to rise causing little benefit to the dd curve.

In the SR firms can operate at the portion of the dd where PED<1 and hence make supernormal profits as shown below. Draw fig 7.17 a page 166 Observations SR equilibrium occurs at the profit maximizing point (MR=MC). AR > ATC hence supernormal profits are realized.

The LR equilibrium Supernormal profits will be competed away due entry of new firms and further product differentiation by rivals. This shifts the dd curve to the left till the firms make normal profits In the LR firms can only earn normal profits to cover prodn costs and the opportunity cost of capital.

Draw the diagram fig 7.17b page 166.
Observations; The AR is tangent to the ATC though the firm is producing above the minimum point of the ATC. LR equilibrium occurs when AR is tangent to the LRTC & firm makes normal profits

Top tip Firm is not efficient both in the SR and LR because;
P >MC hence allocatively inefficient Its producing just above the lowest point of the ATC hence productively/technically inefficient Task: Think about typical examples of businesses in this market structure. Self assessment task: page 167.

 Barriers to entry  These are obstacles that prevent new firms from entering a market to compete with existing firms. They assist in understanding monopoly & oligopoly models in the spectrum of competition. They give firms some degree of market power in determining price and output decisions

 Examples of barriers: 
1. Govt/legal/natural monopoly: Occurs thru formation of state owned firms licensed by the govt to provide particular facilities. Aim is to achieve some socio-political & economic objectives. e.g. Eurostar rail travel serving the EU though it has been privatized. Task: Copy the natural monopoly definition from page 167

2 High start up capital 3. Presence of sunk costs
It limits entry of firms in to a market due to high intial costs. Only large firms with huge cost advantages can undertake ventures like aircraft & car production. e.g. airbus 3. Presence of sunk costs Costs that cant be recovered/transferred to other uses when a firm winds up/shuts down

4. Successful advertising
Risk of entering & high cost of failure deters potential entrants e.g. drones manufacture. 4. Successful advertising It creates brand loyalty while reducing the PED i.e. makes it inelastic! This gives the firm a strong market power that keeps off competitors eg Microsoft Vs Ubuntu (Linux)

5. Economies of scale These are cost advantages enabling firms to produce at lower unit costs. Large firms keep rivals at bay thru destroyer/predatory pricing ie selling at low prices since they are able to produce at low average costs. 5. Patents/copyrights: Production is legally protected thru a patent and/copyright so as to reward innovative & inventive entrepreneurs

A Patent lasts for 17 years & covers intellectual properties.
Copyrights are permanent and covers works of art e.g. music. 6. Monopoly access to factor inputs &retail outlets This prevent news entrants in to the business

7. Technological advancements:
eg a case of vertical integration when a car manufacturer merges with a showroom dealer. 7. Technological advancements: A high pace of product innovation thru advanced tech causing firms to launch new product generations constantly may keep others off. eg Apple company & iphones

8. Cartels: A cartel is an collusion btn firms to control price & output for their own benefit. Cartels may offer a limit price (low price) so as to kill competition E.g. OPEC which offered to accept $20 per barrel in Jan 2015 so as to kick out the American oil producers

10. An economic downturn (recession).
It may make it hard for other firms to join an existing market due to severe market conditions  Top tip  Strong barriers make the market to be less competitive while few barriers make the market to be more competitive.

Oligopoly  It’s a market structure dominated by few large scale firms that are interdependent in output and pricing decisions. Duopoly is an extreme oligopoly where the market is dominated by two giant firms/players eg BAT & Mastermind in Kenya's cigarette industry

Characteristics: 1.There exists significant barriers to entry.
2.Products may be homogeneous or differentiated. 3. The firms are interdependent i.e. they must consider & anticipate actions of rivals before embarking on a marketing strategy

4. Market is dominated by few large scale firms.
5. Price rigidity: caused by uncertainties regarding price competition due to a ‘kinked’ dd curve……see the diagram. Examples: Telecommunication firms; car manufacturing firms, Supermarket chains, Media companies etc

Pricing & output determination 
Firms can either be ever competing or tending towards cooperation and collusion. Firms are price makers and this may therefore lead to destructive price wars. Price wars occur when firms engage in constant price reductions so as to increase market share.

The war may occur to defend the market share e. g
The war may occur to defend the market share e.g. TESCO may reduce it’s prices so as to beat Walmart. Price wars may be destructive especially when rivals retaliate by the same token.

Advertising and promotion; Persuasive & informative adverts
Since firms are price makers and interdependent, they prefer non price competition. This occurs thru’ Advertising and promotion; Persuasive & informative adverts Brand proliferation: Saturating the market with different brands so as to close market gaps

Product innovation: Differentiating products before consumers thru extra features. Market segmentation: creation of niches and catering for their special needs effectively e.g prestige banking services Process innovation: Improving prodn process that allows prices to be cut without sacrificing profits

Oligopoly videos C:\Users\pnduati. PEPONISCHOOL\Documents\Class notes 2014\A 2 Econ\price system\New videos

Equilibrium under oligopoly 
It occurs when the MC cuts thru the discontinuity btn the MR. Top tip:  MR is discontinuous at the level output corresponding to the kink due price rigidity in this market Task Draw the diagram-

 Observations:  It represents a duopoly with two firms faced with an elastic and an inelastic dd curve Equilibrium occurs when MC cuts thru the discontinuity in MR. The discontinuity in MR implies that there’s a range within which costs may change & the firm still maximizes profits

  If the price inelastic firm decides to raise the price so as to earn more revenue, the rivals will watch it price itself out of the game! This may be worse off than b4 the price increase! Prices are therefore rigid at the kink

Note  Regardless of the price elasticity, a price increase by one firm, if not copied by the rival will be destructive The oligopolist may overcome competition thru vertical integration or by seeking to earn satisficing profits .

Cooperation and collusion btn oligopolists
Occur when costs are very high (e.g. R & D) or when the pace of technology is very high for some firms in the market. All firms agree on technical standards & may form joint ventures e.g. OPEC Collusion is an anticompetitive action by producers which may be informal or formal.

An informal/tacit collusion:
It involves an unwritten agreement between firms not compete using price wars. Occurs thru price leadership where the dominant firm sets the price and the others follow so as to maximize the profits of whole enterprise. Price leader is large and sets the ruling market price.

Example Citti Hoppa & Double M (bus companies in Kenya) may agree not to cut fares in order to compete. They may also agree not to develop new routes that duplicate each others services!

Cartel/formal collusion:
Occurs when collusion is a legal price/output agreement to restrict competition e.g. Organization of petroleum exporting countries- OPEC When a cartel holds, the enterprise becomes a monopoly. Collusion survives well when There is a small number of participants A strong element of trust exists

They have similar cost structures
There is a clear leader. Agreement can be policed. There is no danger from new entrants. Market conditions are stable. Government will not intervene. Task: Read from page & make notes on threats to a cartel

Monopoly A pure monopoly occurs where the market is dominated by a single supplier called a monopolist. Practically , it occurs where a firm has a dominant market share in an industry with no close substitutes. UK standards > 25% of market share The monopolist is protected from competition by strong barriers to entry.

Characteristics Strong barriers to entry No close substitutes
A single seller The monopolist is a price maker. The firms dd & revenue curves A monopolist is faced with an inelastic normal dd curve since he is a price maker dealing with products that do not have close substitutes.

The MR lies below the dd curve implying that the monopolist must lower the price so as to raise more revenues …..see diag…. In theory, a monopolist makes supernormal profits both in the SR & LR. In practice, a monopolist can make losses only when fixed costs are very high making him to charge a very price e.g.

The monopolists equilibrium
The firm is also the industry in this model hence the same equilibrium will occur both in the SR and LR. This is due to presence of strong barriers that prevent entry by competitors. Task: draw fig 7.19 page 170

Observations The profit maximizing condition for the monopolists is MR = MC. The output (Q) will be over the price range where dd is price elastic which is P. TR(P XQ) is greater than TC (P1 X Q) hence shaded area represents _____profits

Some notes on monopoly:
A monopolist can earn higher profits by charging different prices to different market segments. This is called price discrimination. The natural monopoly Occurs where a monopolist has a huge cost advantage due to: sole ownership of a factor input Sole ownership of production rights or where its expensive & wasteful for competitors to duplicate the rights.

The natural monopoly Occurs where a monopolist has a huge cost advantage due to: sole ownership of a factor input Sole ownership of production rights or where its expensive & wasteful for competitors to duplicate the rights.

It justifies the case for public ownership of services like power, water, gas, canals, railways etc.
Fixed costs are high as a % of total costs. As output rises AFC falls due to economies of scale E.g. for the Eurostar, the LRAC per truck using the line will fall since the TC are spread over the many trucks

Task: draw fig 7.20 page 171 Observations:
LRAC is falling due to economies of scale. Equilibrium occurs when MR=MC leading to price P1 and output Q1 being produced hence supernormal profits. If the monopoly behaves like a competitive firm, it will produce

Where P=LRMC at price P2 and output Q2 making a loss.
This will only occur if the government is prepared to offer a subsidy shown by the shaded area. The alternative is for the service to be provided by the public sector.

Students task Read and make notes from page 171-172.
Subtopic on comparing monopoly with perfect competition.

Contestable markets This is a market which is highly debatable & contestability varies from country to country!  TASK: copy the key term from page 172. Perfectly contestable markets occur where there are zero sunk costs i.e. no costs of entry & exit.

i.e.. sunk costs are irrecoverable costs
Only perfect competition matches this ideal, monopolistic competition & oligopoly to some extent. It can be seen as a means by which govts deregulate the market so as to increase competition. E.g. the removal of barriers to entry in the UK service sector has made the market highly contestable.

Features or characteristics:
1. Freedom of entry: all firms will have a cost structure like that of perfect competition. 2. All firms are subject to same regulations and govt control regardless of their size 3. Cross subsidization is eliminated since firms can not make normal profits if they sell at low prices

i.e. charging higher prices to one group of consumers in order to subsidize lower prices for another group 4. Normal profits can only be earned in the LR 5. Number & size of firms is irrelevant 6. There are mechanisms that prevent unfair pricing strategies eg predatory pricing

Example Prior to deregulation the airline market was regulated by the govt thru IATA (International Air Transport Association). The US airline industry "open skies policy’ which has led to many national carriers. In the US & UK, low cost airlines have

Entered the market e.g. fast jet, easy jet Ryanair etc to challenge the national carriers.
Other examples include; Telecommunications Personal & corporate banking Local bus and rail services, electricity, gas etc

The firm concentration ratio
This is the combined market share of the biggest 3,4 or 5 firms as a % of the industry total . Its calculated by adding the % market shares in terms of volume of sales or sales revenue. The bigger the %, the closer the industry will be to be a monopoly or oligopoly Task page 162.

Growth and survival of small firms
There's is no working definition of small firms since a small firm in one place could be large in another. Small firms employ few people and have limited capital base. They exist despite the benefits of large scale firms because of the following;

Reasons behind survival of small firms.
They deal with specialist skills possessed by few people To offer personalized services with a personal touch eg dentistry. To fill a market niche left by large firms e.g. Apple’s revolutionary IT products by Steve Jobs They occur where market can be served efficiently by small firms

They have few legal requirements to start up compared to large firms
They require less start up capital. Firms may remain small as entrepreneurs wish to retain total control of the business. Technological advancement in IT e.g. the use of tablet computers for small research firms

The govt initiative to assist the small firms technically and financially through micro finance programmes. Economic recession and unemployment may cause many to be small entrepreneurs. Disintegration of large firm’s in order to cut costs & to focus on more profitable ventures.

The growth of firms Most firms pursue growth for;
Profit maximization: Profit= TR-TC To benefit from economies of scale- Reduction in ATC To acquire a huge market share (monopoly motive) To capture resources of other businesses thru mergers & takeovers

To diversify the product range- to reduce risks of failure
To diversify the product range- to reduce risks of failure. This is called economies of scope e.g Wide product range for Coca Cola Self assessment task Page 175

Ploughing back profits
How do firms grow?? Growth of firms External Mergers Takeovers Diversification Internal Ploughing back profits

Internal growth: Occurs when firms decide to plough back some profits rather than paying it out. This is done through re investments in to capital intensive activities so as to increase the productive capacity. External growth: Occurs when businesses expand by joining with others via takeovers or mergers.

The aim is to increase the market share and to benefit from economies of scale.
Takeover bids occurs through purchase of shares more than 51% e.g. EABL vs Castle lager in Kenya. Mergers mostly occur during an economic downtown e.g. Brookside vs Delamere dairies.

Class discussion Which type of growth is better? Diversification
Occurs where a firm produces or sells a range of different products e.g. Coca-cola Aim is to spread the risks of failure & to exploit new market segments

Integration Refers to how different parts of a business come together either thru a merger or a take over. Task: draw fig 7.22 page 176 Forms of integration Horizontal integration It’s a merger or acquisition of businesses in the same sector

E.g. United airlines merger with continental airlines.
Aim is to; Reap benefits of economies of scale. Access to new markers. Increase market power.

Reduce competition Opportunity to make high profits,. Pool resources cost effectively etc The issue is that government can regulate so as to control monopoly abuse.

Vertical integration Involves firms moving into a forward or backward stage in the supply/prodn chain. E.g Nestle buying out a cocoa and dairy firm (backward/forward). BMW producers buying out all the show rooms in Germany_____________. Merits includes improved security & quality of supplies & reduced supply chain costs.

Demerits includes higher costs of running the new enterprise.
Self assessment tasks from pages

Lateral integration Occurs when business in different economic sectors come together. The entity formed is called a conglomerate. E.g. A vehicle manufacturing company buying out a tea farm.

The firms objectives 1. Profit maximization: ie the difference btn the TR and TC. A firm making the minimum level of normal profit is said to be at the [break-even-point] BEP where TR=TC. Profits over and above the normal profits are called_____________

The profit maximizing condition is given by MR=MC i. e
The profit maximizing condition is given by MR=MC i.e. when the cost of producing an extra product is equal to the revenue from selling. Draw the diagram on page 179 Observations Output Q is the profit maximizing output.

Beyond Q, MC>MR and to the left of Q, MR>MC.
In practice, firms will not produce where MR=MC because; Its hard to identify this output and firms use cost plus pricing so as to maximize profits!

2. Sales revenue maximization
Occurs thru charging a lower price so as to increase market share e.g. penetration pricing. Condition for this is MR=0 i.e. when extra sales adds nothing to TR. Its pursued when mgt salaries are linked to value of sales.

This may conflict with shareholders profit motive & may be solved thru offering managers some shares. Task: Complete the table below and draw TR, AR and MR graphs

Complete the table below
PRICE(P) Units sold(Q) TR= P* Q MR AR= TR/Q 10 9 1 8 2 7 3 6 4 5

Draw the AR and the MR curve on the same axis (Price/MR vs quantity).
Plot also TR vs quantity directly below the above  Observations:  The dd curve is downward sloping implying that the product is a normal good.

Beyond this point, the PED‹ 1 since further price cuts reduces TR.
As the price falls from $ 10, sales rises more than proportionately giving PED >1 until the output of 5 when TR is at its peak. Beyond this point, the PED‹ 1 since further price cuts reduces TR. In the elastic section of the dd curve when PED >1 , MR is +ve and TR is increasing

When PED =1,TR is at its peak, MR = 0 since the extra unit sold will yield a lower return.
When PED‹ 1 , MR is negative , causing the TR to fall. Top tip  : A firm operating in the elastic part of the dd curve, would reduce price so as to raise revenues

A firm operating in the inelastic section of the dd curve should raise its price so to earn high revenues. 3.Sales maximization Deals with selling more output Condition: Producing at the BEP where TR=TC. Occurs mostly in state owned firms that are pursuing other social objectives eg provision of services. They may keep prices low at a point where TC are recoverable.

4 Satisficing profits: Involves making reasonable profits, not necessarily at BEP, to make majority of stakeholders happy. Occurs when firms seek to satisfy all shareholders. Satisficing profits may also be pursued by firms that have enjoyed high market share over a long time.

Practice question The diagram shows a range of possible output positions of a monopolist

What conditions for the firms objectives are implied by the output a, b, c and d
Answer 8 d Sales revenue is maximised where marginal revenue is 0. a is the profi t maximising output, b is the productively effi cient output, and c is the allocatively effi cient output.

5. Loss minimization Occurs when a firm is facing serious threats e.g. economic recession or other external shocks. Such firms seek to survive hoping that conditions will improve. Firms will thus operate at the shutdown point i.e. P=AR= AVC. E.g. music stores whose profits have been affected by internet freedom of ripping music

6. Ethical objectives The are social econ objectives embedded in the firms CSR. They are aimed at giving back and to create a positive image of the firm e.g. Environmental conservation thru green and clean production, charitable programmes etc Ethical objectives “eat into profits” but consumers restrain from using unethically produced items!

Principal - agent problem
The principal is the business owner who hires an agent to run the business in return for a salary E.g. In PLC’s there’s a divorce between ownership & ctrl where promoters(principals) employ directors/managers(agents). In setting business objectives, agents may implement objectives that are inconsistent with those of principals.

E.g. principal may advocate for profit maximization while agents may pursue satisficing profits.
This is due to info failure/gap since the principal may not full info of how the agent is acting. This causes a conflict of interests which may spillover to other stakeholders.

Pricing strategies and the prisoners dilemma
Introduction clip:

Prisoners dilemma A paradox in decision analysis in which two individuals/firms acting in their own best interest pursue a course of action that does not result in the ideal outcome. It helps understand what governs the balance between cooperation and competition in business, in politics, and in social settings.

Illustration Imagine 2 prisoners are being convicted separately;
The prosecutor separates them and offers them a deal as follows; The results are shown in a payoff matrix; NB: they cannot collude!

Prisoner 2 Prisoner 1 Confess deny 8,8 0,10 Deny 10,0 1,1

The rows represents the payoffs(jail sentence) given to prisoner 1.
The columns represents the payoffs(jail sentence) given to prisoner 2. What would be the rational decision to take?

Application to economics
Prisoners dilemma is used in game theory & information economics to study how firms determine pricing strategies. Task: copy the key term from page 182. Like in the case of prisoners, firms in a cartel are unlikely to trust each other.

E.g. if members of a cartel agree to raise prices, some may decide to cheat in order to gain market share. This can be illustrated in the case of a duopoly i.e. an oligopoly with 2 firms only.

Oligopolists are price makers and firms can collude to form a cartel or pursue cut throat competition. Their behaviour can be studied using game theory or the kinked demand curve (discussed earlier)

Game theory & the oligopolistic behaviour
The theory of the kinked dd curve suggests that prices are always rigid at the point of the kink due to differences in PED of the firms. In practice, prices may be rigid due to other commercial practices. The ‘game’ is the action of firms making decisions about the price and output levels to produce.

Firms take decisions independently assuming that rivals will behave in a certain way.
Example: Consider a game between American airlines (AA) and KLM over airfares charged for first class travel from Heathrow to Stockholm.

Suppose that initially there’s no price competition & each charges $ 1,000.
To increase market share, both firms agree to reduce their prices by 10% to $900. The table below shows the profit payoffs resulting from adopting the different price strategies.

Game matrix profit payoffs.
KLM AA $ 1000 $ 900 $ 2M each $1M (AA) $2.2M (KLM) $ 2.2M (AA) $ 1M (KLM) $1.5M each

Explanations If each firm charge $ 1,000, each makes an annual profit of $2,000. If AA reduces its air fare to $900, its profits would rise to $2.2M. This would not be good for KLM which has maintained a price of $ 1,000 causing its profits to fall to $1M.

Alternatively, KLM would cut its airfare to $900 leaving AA to charge $1,000.
KLM would earn $2.2M while AA profits would fall to $1M. If both firms offer a price of $900, their profits would fall to $1.5M.

What would be the best pricing strategy for the firms?
Collude & charge $1,000! Note: Such a collusion would be illegal since it would hurt consumers.

Pricing policies Price discrimination, limit pricing & price leadership. 1. Price discrimination. Selling of products at different prices in different niches/market segments. It is possible when product quality is identical in all the niches & consumers are willing to buy.

E. g. transport providers e. g
E.g. transport providers e.g. rail/airline company offering economy, 1st class, 2nd class, 3rd class services for the same journey.

Conditions for effective discrimination
There should be a clear separation of submarkets (logical or technical) Different submarkets must have different PED’s for their products. Monopolist must the the sole supplier in the market. There must be no close substitutes in the market

Types of price discrimination
1. First degree: Firm sells each unit of a product to a different consumer charging a maximum price that they are willing to pay. E.g. a private doctor a high consultation fee to a rich patient and a lower one to a ‘poor’ patient

Price is unique to each transaction hence the dd curve is the same as MR. i.e. D=MR=P.
Second degree: Occurs where consumers are willing to purchase more of a product if price falls as more units are being purchased.

E.g. progressive discounts offered to watch EPL football- 1st ticket may go for $5 and subsequent ones go for 10% less! Third degree Most common & discriminates consumers assuming that they have different PED’s for their products.

If the consumers PED is low (inelastic) their dd is insensitive to price hence they can be charged a higher price. If PED is high (elastic) low price will be charged so as to attract more consumers.

Examples Airfares: flights booked earlier are cheaper compared to flights booked closer to departure! Why is this? Rail travel has different prices for peak and off-peak hours.

Price discrimination for a monopoly
Task: draw the diagram from page 185 Observations If the monopolist sells at a single price for profit maximization (MR=MC) then TR= 3*40= 120. TC= 3*45=135 TR- TC= =-15 (loss)

If the output was sold separately in 3 different niches the total revenue would be 60+50+40= 150
TR-TC= =15(abnormal profit). If triangle A is of the same size with triangle B on the diagram, the firm will break even but if larger, firm makes abnormal profit.

Limit pricing Used by monopolies and oligopolies.
Involves setting a lower SR price to deter new firms from entering a contestable market. The lower price acts as a temporary barrier to entry. E.g. in an unregulated taxi business, a firm might reduce rates & increase it’s fleet size simultaneously

Price leadership Common under oligopolies.
All firms accept and follow the price set by the market leader which is often the brand leader. They set prices around the price set by the leader The firms change prices as the leader changes so as to maintain their market share.

E.g. Coca Cola in the soda industry
Task: draw the diagram from page 186 Observations There are 2 firms in the market A & B faced with the DD (demand curve). Firm A is the low cost producer

& price leader which maximizes profits at A (MC=MR).
Its output OA is sold at PA. Firm B’s ideal price is PB but this cannot compete with firm A. Its thus compelled to lower its price to PA with lower profits due its higher costs of production

Reading task (prep) Read and make short notes on “ comparisons of performance of firms- some conclusions” page Read the summary on page 188 Attempt the questions from page for prep THE END!!  

PRICE SYSTEM & THE MICROECONOMY

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