Economics ss4

ECONOMICS
Introduction to Economics

Lecturer: Linh Tran
February 2011

1

Introduction: Overview of Economics

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

 What are the links between Economics & other subjects?

 What topics will we learn for CFA L1? Schedule?

2


CONTENT OF LEVEL 1

3


LINKS BETWEEN ECONOMICS AND OTHER SUBJECTS

4


SCHEDULE
Week 1 Week 2
Saturday 28‐Jan Saturday 4‐Feb
SS4 Introduction to Microeconomics LOS16 The Firm and Market Structures
AM LOS13 Demand & Supply Economics:
Introduction
Break Break
LOS14 Demand & Supply Economics: Consumer SS5 Introduction to Macroeconomics
PM Demand LOS17 Aggregate Output, Price and Economic
LOS15 Demand & Supply Analysis: The Firm Growth

Week 3 Week 4
Saturday 11‐Feb Saturday 18‐Feb
LOS18 Understanding Business Cycles SS6 Economics in a Global Context
AM
LOS20 International Trade & Capital Flows
Break Break
LOS19 Monetary & Fiscal Policy LOS21 Currency Exchange Rates
PM
Revision

5

ECONOMICS
SS4: Microeconomics Analysis
LOS13: Demand & Supply Analysis:
Introduction
Lecturer: Linh Tran
January 2012

Overview of Microeconomics

OVERVIEW THE PURPOSE OF MICROECONOMICS

7

Reading 13: Demand & Supply Analysis: Introduction

MIND MAP

8


 TYPES OF MARKETS

Factor Market Goods Market
• For factors of production: land, labor, • For finished goods & services
physical capital, materials, Capital Market
intermediate goods • For long-term financial capital
(equity, bond)

Sell labor services, land, entrepreneurial risk-taking ability
Save money => capital to “sell” to firms (i.e. lend/invest)

FIRMS HOUSEHOLDS
Sell finished goods & services
Raise funds (debt/equity) to invest in productive assets

9


 DEMAND FUNCTION
• Demand: the willingness & ability of consumers to purchase a given
amount of a good/service at given values of variables
• Demand Function: represents buyers behavior
Variables/Factors influenced: ________________________________

Example:

Exercise: Interpret the sign & magnitude for each coefficient:
 Own-price (Px)
 Income (I)
 Price of other goods (Py)

10


 DEMAND CURVE

“Law of Demand” • Holding other factors constant
(ceteris paribus)
Curve is downward sloping
• Inverse demand function:
i.e.
Price as a function of quantity
demanded

e.g. When I = 50, Py = 20

Source: CFA Curriculum 2012

Demand Curve: shows both the HIGHEST PRICE willing to pay for each
quantity, or the HIGHEST QUANTITY willing to purchase at each price

11


 SHIFTS & MOVEMENTS ALONG THE DEMAND CURVE
Movement Along the Curve Shift of the Curve
Px
Px
29.5
28 Change in quantity demanded 28
Change in demand as
as price changes other variables change

8
3 3
Qx
8 10 11.2 10 11.2 11.8 Qx

e.g. e.g.

• Holding other factors constant • Other factors change (e.g. Income,
(ceteris paribus) Price of other goods…)
• Slope does not change

12


 SUPPLY FUNCTION
• Supply: the willingness & ability of firms to sell a good/service at
given values of variables
• Supply Function: represents sellers behavior
Variables/Factors influenced: _________________________________
Output price, costs of input, technology level

Example:

Exercise: Interpret the sign & magnitude for each coefficient:
o Own-price (Px)
o Wage (W)

13


 SUPPLY CURVE
“Law of Supply”
• Holding other factors constant
Curve is upward sloping i.e.
(ceteris paribus)

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

e.g. Wage = 15, then


Supply Curve: shows both the HIGHEST PRICE willingly accepted for each
quantity, or the HIGHEST QUANTITY willingly supplied at each price

14


 SHIFTS & MOVEMENTS ALONG THE SUPPLY CURVE
Movement Along the Curve Shift of the Curve
Changes in quantity supplied as Changes in supply as other
price changes variables change
Px
Px
3.1
4 3
3
1.1
1 1

‐250 500 750
Qx ‐275 ‐250 475 500 11.8 Qx
e.g.
e.g.
• Other factors change (e.g. Wage, Price of
• Holding other factors constant
other goods…)
(ceteris paribus)
• Slope does not change
15


 AGGREGATING THE DEMAND & SUPPLY FUNCTIONS
• Aggregating rule: Sum up Demand/Supply Functions of each
individual/firm
=> Sum horizontally (quantity), not vertically (price)

Example: 1000 identical buyers, each has demand function:

 Derive the market aggregate demand function?
 Derive the inverse market demand function, hold I = 50, Py = 20
 Determine the slope of the market demand curve

16


 AGGREGATING THE DEMAND & SUPPLY FUNCTIONS
Graphic Illustration
Px Px
28 28
2 identical buyers

8 8

8 11.2 Qx 8 11.2 24 33.6 Qx

e.g. e.g.

• Sum up horizontally (quantity), not vertically (price)
• Market curve is less steep than individual curve

17


 MARKET EQUILIBRIUM & MECHANISM
• Equilibrium: Is where Supply meets Demand
Demand: curve: Px  28  2.5Q d
x Px
Excess supply S
Supply curve: Px  1  0 .004Q s
x
28

Question: Find equilibrium point?
o Solve for Px, Qx such that: 1
D
Excess demand
Q xd  Q xs ‐250 11.2
Qx

o Pe = ________, Qe = _________

• Mechanism to move towards equilibrium:
o If P < Pe: Demand exceeds supply => increase P
o If P > Pe: Supply exceeds demand => reduce P
18


• Exercise: Market Mechanism: Excess Demand/Supply
In the local market for e-books, the aggregate demand & supply are given by:
Q d  6, 360  4 00 Px
x

Q s   1,116  3 00 Px
x

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

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

19


 STABILITY OF EQUILIBRIUM
• Stable Equilibrium: • Unstable Equilibrium:
o Market can automatically return to o Once pushed away, market will not
equilibrium after shocks return to its old equilibrium
o Normal condition o Bubble condition

Excess supply or demand?
Excess supply or
Price or ?
demand?
Price or ?

Source: CFA Curriculum 2012 Source: CFA Curriculum 2012

20


 STABILITY OF EQUILIBRIUM: MULTIBLE EQUILIBRIA
• Non-linear supply curve
o Example: Labor supply
• 2 equilibria points:
o Stable: Where Demand
intersects Supply from above
o Unstable: Where Supply
intersects Demand from above


21


 AUCTION
• One of the most traditional methods to determine equilibrium price

• Types
o Common Value Auction
 Auctioned item has an actual value that is the same for every bidders

 Bidders have to estimate that true value.

 Example: oil lease contract

o Private Value Auction
 Each bidder have a subjective value of the item that is unique

 Example: unique price of art

22


 AUCTION MECHANISMS
• Ascending price (or English) auction:
o Begin at low price & raise it incrementally
o Open outcry => can learn about the true value by observing other bids

• First price sealed bid auction
o Submit bidding price in envelop => Cannot observe bid
o Tend to submit conservative bid to avoid Winner’s curse

• Second price sealed bid (or Vickery) auction
o To induce bidders to reveal their reservation prices
o Winner pays the price equal to the second-highest bid
o If bidding increments are small => Same result as English auction
23


 AUCTION MECHANISMS
• Descending price (or Dutch) auction:
o Start with a very high price => lower until there is a willing buyer

o Demand curve is negative-slope

o Multiple-unit format:
 Quoted price is per-unit

 Transactions could occurs at different prices for different buyer

o Modified Dutch Auctions: common practice in securities markets
 Establish a single price for all purchasers which clears the market

 Example: Auction of U.S. T-bill

24


• Example: Auction of U.S. Treasury bill
Auction of $90 billion T-bill with both competitive & non-competitive
 Non-competitive bids: willing to purchase at whatever the price

 What is the winning price? $99.9095 Source: CFA Curriculum 2012

 Bidders at that price will have their orders partially filled. How much is filled? (30%)

25


 CONSUMER SURPLUS = VALUE – EXPENDITURE
Is the difference between the amount a consumer is willing to pay (Value)
and the amount he must pay for it (Price)

Demand curve is also marginal value curve

Source: Schweser 2012

26


 PRODUCER SURPLUS = REVENUE – VARIABLE COST
Is the excess of market price (Price) over the variable cost of
production (Cost)
Supply curve is also marginal cost curve

TS  CS  PS


27


• Example: Calculating Consumer & Producer Surplus
o A market demand function is given by the equation:
Q d  180  2P
Determine the value of consumer surplus if price = $65.

o A market supply function is given by the equation:
Q s  -15  P
Determine the value of producer surplus if price = $65.

o Calculate total surplus at price = $65


28


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

Source: Schweser 2012 Source: Schweser 2012

Underproduction Overproduction
To the Left of the equilibrium To the Right of the equilibrium

29


 CAUSES OF DEMAND/SUPPLY IMBALANCE
• Imposition by governments: as quantity consumed/produced is not
the efficient quantity that maximizes total benefit => deadweight loss
o Price regulation (price floors/ceilings)

o Taxes, subsidies & quotas

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

o External costs

o External benefits

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

30


 GOVERNMENT REGULATION & INTERVENTION
• Why intervene?
o To correct for negative/positive externalities: market does not reflect the true
social benefit/costs (e.g. public goods)
o Social consideration: child labor law, human-trafficking

• Means:
o Price regulation: Price ceiling & price floor
o Per-unit tax: On Consumers (Excise tax) & On Producers
o Other means:
 Volume control: Tariffs on imported goods, quotas on import/exports
 Trade banning

31


 MARKET INTERFERENCE: PRICE FLOOR

Long-run Effects
-Excess supply
-Substitution away
from the price-
controlled goods

Example: Minimum Wage in the Labor Market:
1. Excess Supply of Labor -> Unemployment
2. Producers substitute Labor for Capital
3. Non-monetary benefits, working conditions, on-the-job training
32


• Example: Price floor
A market has demand & supply function
o Qd = 180 – 2P Qs = -15 + P
Calculate the amount of deadweight loss that would result from a price floor
imposed at a level of 72 P S

Solution: 90
72
- Solve for equilibrium price & quantity 65
- Draw the demand & supply curve 51
15 D
- Find the quantity demanded at price floor 72: QF
‐15 36 50 130 Q
- Find the price that would lead to supplier supply at QF
- Calculate deadweight loss (area of shaded triangle)

33


 MARKET INTERFERENCE: PRICE CEILING
Example: Rent ceilings in the Housing Market

Price ceiling transfer surplus (area a) from Long run Impacts
sellers to buyers, but create deadweight loss - Long waiting time to
to society
purchase (Opportunity
cost)
- Sellers discriminate
a
- Sellers take bribe
- Sellers reduce quantity


34


 MARKET INTERFERENCE: TAX
OR ? OR ?
Tax Imposition: Equilibrium Price Equilibrium Quantity
Tax Incidence: Statutory vs. Actual Incidence
Price Tax on producers Price Tax on consumers
Stax
D D
Tax S Dtax DWL S
Ptax Ptax
Revenue from buyers Revenue from buyers
PE E PE E
Revenue from sellers Revenue from sellers
PS PS
Tax
DWL

Qtax QE Quantity Qtax QE Quantity

Conclusion: Actual incidence is Independent on Who would pay
35


• Exercise: Calculate Effect of per-unit tax on Sellers
Market demand curve: Q d  180  2P
Market supply curve: Q s  -15  P
Where price is measured in $ per unit. A tax of $2 per unit is imposed on sellers.
1. Calculate the effect on the price paid by buyers & price received by sellers
2. Demonstrate that the effect would be unchanged if the tax has been imposed on the
buyers instead of sellers.
Hint:
1. Calculate pre-tax equilibrium price & quantity
2. Find the inverted supply & demand functions
3. Find the new equilibrium price & quantity
4. Find the tax burden bear by each party in each case & compare

36


 TAX AND ELASTICITY OF SUPPLY & DEMAND

• Supply Curve is more
steep => Sellers bear a
higher burden

• Demand Curve is more
steep => Buyers bear a
higher burden


37


 SUBSIDIES LEADS TO OVERPRODUCTION

• Subsidy is payment made
by governments to
producers (farmers)
• With Subsidy:
o Supply Curve shifts

o Quantity

o Equilibrium price


38


 QUOTAS LEADS TO UNDERPRODUCTION
• Quota is an upper limit imposed
on the quantity of a good that
may be produced over a specific
period by the governments
• With Quota:
o Supply Curve shifts

o Quantity

o Equilibrium price


39


 ELASTICITY: PRICE ELASTICITY OF DEMAND (PED)

• As the price of a normal good increases, quantity demanded
decreases (PED < 0)
o Elastic demand: % increase in price leads to a larger % decrease
in quantity demanded
o Inelastic demand: % increase in price leads to a smaller %
decrease in quantity demanded

40


 PED GRAPHICAL ILLUSTRATIONS


41


 ELASTICITY & REVENUE
ΔQ x Px
Reminder: Formula for PED  
(A): Elasticity = … ΔPx Q x
=> Elastic/Inelastic?
1.
(B): Elasticity = …
2. Price elasticity changes along the curve
(C): Elasticity = …
=> Elastic/Inelastic? Q: At which point is total revenue (P x Q)
is maximized?

A: At point B, where elasticity = -1
Total expenditure

Quantity
42


 FACTORS THAT INFLUENCE PED
• Availability and closeness of Substitutes
o Example?

• Proportion of income spent on the item
o Example?

• Time since the previous price change
o Example?

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

• Necessity of the goods:
o If goods is discretionary => less likely to reduce demand when price increases => less
elastic (example: staples

43


 INCOME ELASTICITY OF DEMAND (YED)
• Shows the sensitivity of quantity demanded in relation to changes in
income

• Elasticity > 0 : Normal goods: Income Demand

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

o Luxury: 1 < YED e.g.

• Elasticity < 0 : Inferior goods: Income Demand

e.g.
44


 CROSS PRICE ELASTICITY OF DEMAND (XED)

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

• XED > 0 : Goods are substitutes
e.g.

• XED < 0: Goods are complements
e.g.

45


• Exercise: Calculating PED, YED & XED
An individual consumer’s monthly demand for downloadable e-book is given by the
d
equationQ d  2  0 .4 Peb  0.0005I  0.15P hb , where Q eb equals the number of e-
eb

books demanded each month, I is the household monthly income, Peb is the price of e-
books and Phb is the price of hardbound books. Assume that price of e-book is $10.68,
household income is $2,300, and the price of hardbound books is $21.40.

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

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

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

46

ECONOMICS
SS4: Microeconomic Analysis
Reading 14: Demand & Supply Analysis:
Consumer Demand
Lecturer: Linh Tran
January 2011

Reading 14: Demand & Supply Analysis: Consumer Demand

MIND MAP

48


 CONSUMER CHOICE THEORY
• Two building blocks:
o Consumer preferences: What consumer would like to consume between
two goods/basket of goods?

Develop Indifference curve (willingness to consume)

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

Draw Budget constraint line to determine which set of bundles is possible
for consumption (Ability to consume)

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

49


 UTILITY THEORY
• Axioms of Consumer Choice Theory:
o Completeness: Must prefer either A or B or indifferent between A & B
o Transitivity: A > B, B > C => A > C
o Non-satiation: More is better, for at least one good

• Utility Function: U  f(Qx1 ,Qx2 ,...,Qxn )
o An “assignment rule” that translates each basket of goods & services into a
number that rank orders the baskets according to that particular consumer’s
preference
o That number = Utility of that basket (measured in utils, level of happiness)
o Utility function is ordinal ranking (differences of utility do not matter)

50


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

I IV

II III

• Marginal rate of substitution: Source: CFA Curriculum 2012

o MRUBW = How much wine is willing to give up to obtain a small increment of
bread, holding utility constant
o If diminishing as wine decreases => Indifference curve is Convex

51


 INDIFFERENCE CURVE MAPS
Wine Wine

Increase utility
Q: Can indifference
curves cross?

a
c

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

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

52


 GAIN FROM VOLUNTARY EXCHANGE
• Two consumers (A&B) with different preferences
o At a, MRSBW(A) = 0.8, MRSBW(B) = 1.25

Wine Q: Determine whether B would accept the trade of
1 of A’s bread in exchange for 1 of its wine.
A: ……………………………..

Q: Who has a relatively stronger preference for
breads?
a
A’s indifference curve A: ………………………

Q: Until when will trade stop?
B’s indifference curve
Bread
A: ……………………………..

53


 BUDGET CONSTRAINT
• Ability to consume/produce: is limited due to Scarcity of resources
Wine
(limited income, resources, time…)
I PB
• Budget constraint: PB QB  P QW  I
I/PW QW   QB
W PW PW
o No saving => PB QB  PW QW  I
Slope of the line
• Changing prices & income:
Wine I/PB Bread
Wine Wine

Increase in the Decrease in the Increase in
price of bread price of wine income

Bread Bread Bread

54


 THE PRODUCTION/INVESTMENT OPPORTUNITY SET
• Firms/investor face the same constraint as consumers

• Production opportunity frontier: maximum number of units of one good it
can produce, for any given number of the other goods

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

Juice per year
Return
Diversified
1 billion stock portfolio

10 billion Risk-free
rate of return

Milk per year
Risk level
55


 DETERMINATION OF CONSUMER’S BUNDLE OF GOODS
Wine
• Consumer equilibrium is achieved at (a)
o This is the tangency point of the curve & line
b
 Highest indifference curve reached

 Not violating budget constraint a
Wa

• At point a: MRUBW = PB/PW c

• At point b: MRUBW < PB/PW
Ba Bread

Willing to give up some wine to obtain more bread

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

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

56


 DERIVING A DEMAND CURVE
• Can derive a demand curve for
good A by changing the price of
that good while keeping other
prices & income constant.

• Law of Demand:
o As price decreases, quantity
demanded increase

Is this always true???


57


 SUBSTITUTION EFFECT & INCOME EFFECT
• Pure substitution effect: always purchasing more when price falls &
purchasing less when price rises. Why??
o Good A becomes relatively less costly as compared to other goods => Gets
substituted for other goods in the consumption basket (Diminishing MRU)

• Income effect: when price falls, real income rises => Amount of goods
that can be purchased increases
o Normal goods: increase in income => increase in quantity demanded

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

58


 SUBSTITUTION & INCOME EFFECT: GRAPHS

Wine
Normal Goods Inferior Goods
Wine

c
a a
c
b b

Ba Bread Bread
Bb Bc Ba Bc Bb
Substitution effect
Substitution effect Income effect Income effect

Substitution & income effects are in the Substitution & income effects are in opposite
same direction direction, but income < substitution

59


 GIFFEN GOODS & VEBLEN GOODS

Wine
Giffen Goods Veblen Goods
o Substitution & income o Conspicuous consumption: derive
c
are in opposite direction utility out of being known by others to
o Income > substitution consume a so-called high status good
a
b o Value a good more if it had a higher
price => Price DOES matter (signal the
status of who consumes it)
Bc
Bread => Violate the axioms of choice (why?
Ba Bb
Substitution effect Income effect o Consumer would be more inclined to
purchase Veblen Goods if its price rises

For both cases: results in a positive demand curve

60

ECONOMICS
Reading 15: Demand & Supply Analysis:
The Firm
Lecturer: Linh Tran
February 2011

Reading 15: Demand & Supply Analysis: The Firm

MIND MAP

62


 ACCOUNTING PROFIT, ECONOMIC PROFIT, NORMAL PROFIT
• Accounting Profit = Total revenue – Total accounting (explicit) costs
o Is Net income/bottom line in income statement
o Includes interest paid on debt financing, but no payment to equity owners

• Economic/Abnormal Profit = Accounting profit – Implicit opportunity costs
o or: Economic profit = Total revenue – Total economic costs
o Implicit costs: opportunity cost of equity owner’s supplied resources:
 Private firm: opportunity cost of supplied capital & time/entrepreneur ability
 Public firm: opportunity cost of equity owner’s investment in the firm

• Normal Profit: accounting profit that makes economic profit zero (= implicit cost)
o This is what an individual firm should earn in Equilibrium
o The firm cover all cost of productions => no incentive to leave/enter the industry

63


• Exercise: Calculating Accounting profit & economic profit
o Given the following information, calculate the accounting profit for ABC Co.

Account Amount
Total revenue $300,000
Expenses
Fiberglass $100,000
Electricity 30,000
Wages paid 55,000
Interest paid on debt 5,000

o Assume the owner took a pay reduction of $50,000 to start the company &
also invested in the business & could have earned $30,000 per year if he has
invested the funds elsewhere. Calculate the economic profit

64


 SOURCES OF ECONOMIC PROFIT
• Due to firm’s ability
o Competitive advantage (difficult to copy technology/innovation)
o Exceptional managerial efficiency or skill

• Due to nature of competitiveness in the market
o Exclusive access to less-expensive inputs
o Fixed supply of an output, commodity, resources
o Preferential treatment under government policy
o Have monopoly power (price control)
o Market barriers to entry that limit competition

• Due to large increases in demand where supply is unable to respond fully
65


 ECONOMIC RENT
• Arise when:
o A particular resource/good is fixed in supply (vertical supply curve)

o Market price > Cost to bring the good into the market & sustain its use
(normal profit) =>Economic rent > 0

o Firm can earn significant economic profits

• Example:
o Limited availability in nature (land, specialty commodities )

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

66


• Economic rent illustration: Gold demand & supply

Economic rent is
higher when supply is
inelastic


Year 2006 2007 2008 % change 2006 - 2008
Supply (metric tons) 3,569 3,475 3,508 -1.7
Demand (metric tons) 3,423 3,552 3,805 +11.2
Avg. spot price (US$) 603.92 695.39 871.65 +44.3
Source: GFMS & World Gold Council

67


 COMPARING MEASURE OF PROFIT
• Normal profit is fixed in the SR, but will vary with required rate of return
on equity investment in the LR

• Relationship between accounting profit & normal profit

Relation between Accounting Firm’s Market
Economic Profit
profit and Normal profit Value or Equity

Accounting profit > Normal profit Economic profit > 0 and firm is able to Positive effect
protect economic profit over the LR

Accounting profit = Normal profit Economic profit = 0 No effect

Accounting profit < Normal profit Economic profit < 0 implies economic Negative effect
loss

68


 TOTAL, AVERAGE AND MARGIN REVENUE
• Total revenue (TR) = P x Q
• Average revenue (AR) = TR / Q
• Marginal revenue (MR): increase in total revenue from selling one more unit.
Quantity Price Total revenue Average revenue
Marginal Revenue
(a) (b) (c) = (a)*(b) (d) = (c)/(a)
1 70 70 70 70
2 65 130 65 60
3 60
4 55
5 50
6 45
7 40

69


 PERFECT COMPETITION: TR, AR AND MR
• Horizontal demand curve

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


70


 IMPERFECT COMPETITION: TR, AR, MR
Revenue
• Downward-sloping demand curve TR

• Firms are price searchers (to sell a

greater quantity => must reduce

price)
Q0 Q1 Quantity of Output
• MR < Price (for Q >1) & MR  AR Revenue, Price

(Why???)

• Decrease in MR is more than
P = AR - Demand
MR
decrease in AR
Q0 Q1 Quantity of Output

71


 FACTORS OF PRODUCTION
• Inputs to the firm’s production include:
o Land o Capital (facilities, equipment, machinery)

o Labor (skilled & unskilled) o Materials (raw materials, manufactured inputs)

• Production function: Q = f(K,L) (subject toK  0, L  0 )
Holding capital constant: Total Product/Quantity

B
o L0 L1: increasing MP of labor Q2
TP
o L1 L2: decreasing MP of labor
A
o L1 …: MP of labor <0 Q1

At B, Total Product is maximized
L0 L1 L2 Quantity of Labor

72


 OUTPUT & TOTAL COST
Total Cost (TC) = Total Fixed Cost (TFC) + Total Variable Cost (TVC)

o Total fixed cost (TFC)
 Equals cost of fixed inputs & normal profit
 Is independent of firm’s output level in the
SR
 Example: rent, PPE

o Total variable cost (TVC)
 Equals cost of all variable production
inputs
 TVC increases as output increases
 Example: labor, raw material
73


 AVERAGE & MARGINAL COST CURVES

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

• ATC & AVC are U-shaped

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

• MC intersects AVC & ATC at their
Shirts minimum point
Source: Schweser 2012 per day

74


• Exercise: Calculate AFC, AVC, ATC & MC
Q TFC* TVC AFC AVC TC ATC MC
(1) (2) (3) (4)=(2)/(1) (5)=(3)/(1) (6)=(2)+(3) (7)=(4)+(5)

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

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

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

3 5,000 5,400

4 5,000 8,000

5 5,000 11,000

6 5,000 15,000

7 5,000 21,000

8 5,000 28,800
*: Include all opportunity cost

75


 SHUTDOWN AND BREAK-EVEN POINTS OF PRODUCTION
• Shutdown point: Where AR = AVC
o If AR < AVC: Firm stops production but still have to pay fixed costs

o If AVC<AR<ATC: firm starts to produce to cover variable cost & some fixed
cost. But does not break-even => only survives in the short run

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

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

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

TR >=TC Stay in market Stay in market
TR>TVC but TR <TC Stay in market Exit market
TR < TVC Shut down production to zero Exit market

76


• Perfection competition: shutdown and break-even points
Find shutdown point & break-even point in the following diagram


77


 OUTPUT OPTIMIZATION & PROFIT-MAXIMIZATION
• Profit maximization occurs when:
o Difference between TR & TC is the greatest

o MR = MC

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

78


• Illustration: Perfect Competition: Break-even & Profit maximizing
In a perfect competition market: TR is a straight line


79


• Example: Breakeven Analysis & Profit Maximization
Q Price TR TC Profit
In an imperfect competition market: (1) (2) (3)=(1)*(2) (4) (5)=(3)-(4)

Q1: What is the breakeven point? 0 10,000 0 100,000 (100,000)
10 9,750 97,500 170,000 (72,500)
20 9,500 190,000 240,000 (50,000)
Q2: Where is the region of profitability? 30 9,250 277,500 300,000
40 9,000 360,000
50 8,750 420,000
Q3: What is the profit-maximizing point? 60 8,500 480,000
70 8,250 550,000
80 8,000 640,000
Q4: Where does economic loss occur?
90 7,750 710,000
100 7,500 800,000
*: Include all opportunity cost

80


 LONG-RUN & SHORT-RUN COST CURVES
• Short run cost curves: apply to a specific size of plant (some
input quantities are fixed)
• Long run cost curves:
indicate the optimal
quantity at different plant
sizes (everything can be
adjusted).
• Firms can have the same
LRATC but at different
positions, depending on
their operating size
81


 ECONOMIES OF SCALE

Long Run Cost Curve = planning curve

1. Increasing bureaucracy
1. Mass production
2. Difficult to motivate workforce
2. Specialization 3. Barriers to innovation & entrepreneur activities
3. Experience 4. Principal-agent problem

82


• Illustration: Long-run profit maximization & Minimum efficient
scale under Perfect Competition


83


 INCREASING, DECREASING & CONSTANT COST INDUSTRY
• LR Industry supply: Relationship between quantity & output prices
o Firms are able to enter/exit based on level of ST profit

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

o Shapes depend on resources costs, technological level, production efficiency
& economies of scale of resource supplier


84


 TOTAL, MARGINAL & AVERAGE PRODUCT OF LABOR
• Productivity: measured in terms of output per workers/labor hour

• Cost minimizing/profit maximizing goal => maximize productivity

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

TP Q
o Average Product : AP  
L L
TP Q
o Marginal Product: AP  
L L
(assume other inputs are fixed)

measured productivity of an individual additional worker

85


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

86


 DIMINISHING MARGINAL PRODUCT OF LABOR

Diminishing
marginal returns to
labor occur

Maximum MP


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

87


 COST CURVES & PRODUCT CURVES


88


 CHOOSING INPUTS TO MINIMIZE COST
MPinput
• Firms want to maximize output per monetary unit of input costs:
Priceinput
• When using n different resources, the least cost optimization formula is:
MP1 MP2 MPn
  ... 
Price1 Price 2 Price n
o i.e. Additional output per dollar spent to employ one additional unit of each
input must be the same.

• Example: with two inputs Labor & Capital
o PL = $75, PK = $600, MPL= 5 units, MPK = 30 units

o Compute MPK/PK & L/PL

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

89


 MARGINAL REVENUE PRODUCT
• Marginal Product: Addition output of a final product produced from one
more unit of a productive input, holding other inputs constant

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

• Marginal Revenue Product (MRP)

Additional revenue gained from selling the marginal product from employing
one more unit of a productive input, holding other inputs constant
• MRP = Marginal Product x Marginal Revenue

= Marginal Product x Product Price (assume perfect competition)


 PROFIT MAXIMIZING UTILIZATION OF AN INPUT
• Profit-maximizing quantity of an input i: MRPi = Pi
o Firms can increase profits by employing another unit of input i as long as
MRPi > Pi

• With cost minimizing condition:
MP1  MR output MP2  MR output MPn  MR output
  ... 
Price1 Price 2 Price n

MRP1 MRP2 MRPn
=>   ...  1
P1 P2 Pn

ECONOMICS
Reading 16:The Firms and Market Structures

Lecturer: Linh Tran
February 2011


MIND MAP

93


 CHARACTERISTICS OF DIFFERENT MARKET STRUCTURES
• Differentiate based on
o Number of firms and their relative sizes

o Elasticity of the demand curves they face

o Ways that they compete with other firms for sales

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

Increasing degree of competition

Monopoly Oligopoly Monopolistic Perfect
Competition Competition

94


 CHARACTERISTICS SUMMARY

Perfect Monopolistic
Oligopoly Monopoly
Competition Competition

# of sellers Many firms Many firms Few firms Single firm

Barriers to entry Very low Low High Very high

Nature of Very good Good substitutes Very good No good
substitute substitutes but differentiated substitutes or substitute
product differentiated

Nature of Price only Price, marketing, Price, marketing, Advertising
competition features features

Pricing power None Some Some to significant Significant

95


 PERFECT COMPETITION: CHARACTERISTICS

1. Homogeneous products

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

3. No barriers to entry or exit

4. Market supply & demand determine market price

Example:

96


 PERFECT COMPETITION: FIRMS ARE PRICE TAKERS
1. No influence over market price
2. “Take” the equilibrium price as given
3. Firm’s demand curve is perfectly elastic => horizontal

MR = Price as all additional
units are sold at the same
(market) price


97


 PERFECT COMPETITION: MARKET & FIRM DEMAND CURVE


98


 PERFECT COMPETITION: SHORT RUN PROFIT


Economic profit > 0 when ??? Q: What happens next?
99


 EQUILIBRIUM IN PERFECT COMPETITION
A: New firms enter the market, market supply , price so that P = ATC


No Economic Profit!!
100


 PERFECT COMPETITION: SHORT-RUN LOSS

Q: will it continue operation?

Minimizing loss when
AVC < P < ATC

Shutdown point: P = AVC
P < AVC: shutdown, only pay
fixed cost

Economic Loss when ???

101


 PERFECT COMPETITION: FIRM & INDUSTRY SR SUPPLY CURVES


Market supply curve = horizontal sum of all firm supply curves

102


 INCREASE IN DEMAND
Price Price
SR Industry MC = SR Firm Supply
supply
P2 P2 D2
P1 D2 P1 D1
D1

Q1 Q2 Quantity Q1 Firm Q2 Firm Quantity

Economic profit -> New firm enters -> Industry supply curve shift
outwards -> equilibrium price, equilibrium output
Individual firms move down its supply curve-> economic profit
Economic loss -> …???
103


 PERMANENT DEMAND CHANGES


104


 DEMAND CHANGES & TECHNOLOGICAL IMPROVEMENT
Long run equilibrium price after a permanent increase in demand can be:
•Lower (economies of scale) (input •Higher (diseconomies of scale) (input
prices fall) => LR supply curve is prices increase) => LR supply curve is


105


 PERFECT COMPETITION: TECHNOLOGICAL CHANGES
• After adjustments take place for some firms
-> Firm & industry’s supply curve shift to the right
-> Higher quantity, lower price

• Short run: Economic profit for early adopters

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

106


 MONOPOLISTIC COMPETITION: CHARACTERISTICS
• A large number of independent firms
o Small market share, no power over price
o Only need to care about market price
o No collusion

• Differentiated products (substitutes to each other)
• Firms compete on price, quality, and marketing
• Low barriers to entry & exit

• Downward-sloping, highly elastic demand curve
Example: ???
107


 MONOPOLISTIC COMPETITION: OUTPUT DECISION

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

Price Price
MC
Short run profit MC Firms enter, price
ATC fall ATC
P*
ATC* P = ATC*
D
MC = MR D
MR MR
Q Quantity Q Quantity

No positive economic profits in the long run!

108


 MONOPOLISTIC COMPETITION VS. PERFECT COMPETITION


Mark up = P – ATC > 0 Excess capacity:
Q < efficient quantity (at min ATC)
109


 EFFICIENCY OF MONOPOLISTIC COMPETITION
• Allocative efficiency is not clear:
o Social cost of not producing where P = MC => Mark up for producers
o Long run average cost is not minimized => Excess capacity
o Additional costs of advertising, innovation & building brand names

• However, there are some benefits:
o Increased Product diversity, greater Product innovations

o More information from Brand names & advertising => signal quality for
better decision making (?)
Q: Does the benefit from advertising, innovation, differentiation of
products justify its costs??
110


 INNOVATION, ADVERTISING & BRANDING
• Innovation & Product Development
o Less elastic demand => can increase price & earn economic profits

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

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

• Advertising & Branding
o To inform the unique features & quality of their products

o Advertising cost for firms in monopolistic competition is the greatest. But if
advertising can greatly increase sales, ATC may fall because AFC falls

o Brand names are invaluable assets as it signals the quality

111


 OLIGOPOLY: CHARACTERISTICS
• A small number of sellers

• Interdependence among competitors

o Highly dependent upon the action of others

• Significant barriers to entry (economies of scale)

• Products may be similar or differentiated

Example: ???

112


 OLIGOPOLY MODELS
• Kinked-demand curve model
o Competitor will NOT follow a price INCREASE

o Competitor WILL follow a price DECREASE

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

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

• Nash equilibrium model (Prisoner’s dilemma)

• Stackelberg dominant firm model

113


 OLIGOPOLY: KINKED-DEMAND MODEL
Firms will not follow price Price
MR (P > P*)
increase
MCB
Current
Price P*
MCA

MR (P < P*)
Firms will follow price
decrease
Demand
Q* Quantity
Profit‐maximizing output

• Shortcoming: Model is incomplete as what determine the market price
(kinked price) is outside the scope of the model

114


 COURNOT DUOPOLY MODEL
• 2 firms (A & B) are identical, have constant marginal costs of production
o Previous quantities produced can be observed QA & QB

• Equilibrium mechanism:
o A assumes B will keep produce QB for the next period
o A derives its own demand curve (= market demand – QB) & marginal revnue
o A determines its profit-maximizing quantity & B does the same

• Results:
o Adjust until Q A = QB = Q/2
o Perfect competition price < Equilibrium price < Monopoly price
o If more firms are added: price falls to MC => perfect competition
115


 PRISONERS’ DILEMMA & OLIGOPOLY

Prisoner B
Why???
Optimal solution
Keeps silent Confesses
Keeps A gets 10 years Actual
Each gets 6 months
silent B is free result
Prisoner A
A is free
Confesses Each gets 2 years
B gets 10 years

Firm B
For Firms
Honors Cheats
Both earns (+) economic A has economic loss
Honors
profits B earns increased profits
Firm A
A earns increased profits Both earns ZERO economic
Cheats
B has economic loss profits

What will be the final result?
116


 TWO-FIRM OLIGOPOLY WITH & WITHOUT COLLUSIONS

Without Collusion


117


 TWO-FIRM OLIGOPOLY WITH & WITHOUT COLLUSIONS
With Collusion: Both firms collude to behave like a monopoly


=> Price fixing to earns Economic Profit
118


 OLIGOPOLY: WHEN COLLUSION IS POSSIBLE?
• Cheating is easy to detect

• Fewer firms in the market

• Threat of new entrants is low

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

119


 DOMINANT FIRM OLIGOPOLY
• A dominant firm (DF) with cost- Price
MCCF

advantage & a large market share MCDF

=> Acts like a monopoly, is a price-
setter, produces where MC = MR P*
Market
• Other competitive firms (CF) are Demand

price-follower and produce where DDF
MC = P
MRDF

QCF QDF Quantity

120


 MONOPOLY: CHARACTERISTICS
• One seller of a specific, well-defined product that has no good
substitute.
• Barriers to entry are high, due to:
o Economies of scale (natural monopoly e.g. electric utility)

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

o Resource control

121


 MONOPOLY: PRICING
• Monopoly faces a downward-sloping demand curve, unlike perfect
competition

• In order to increase quantity , a monopoly must reduce price as
there is a trade-off between price & quantity

• Price-setting strategy to maximize profit to firm:

1. Single-price

2. Price discrimination (if resell is impossible)

122


 MONOPOLY: COSTS, PRICE AND REVENUE

Optimal quantity Q* is in
the elastic range of the
demand curve
MC = MR


Monopolists are price searchers and have imperfect information
regarding market demand

123


 MONOPOLY: PRICE DISCRIMINATION
Price discrimination: charging different customers different prices for
the same produce or service. Examples: tickets

When is it possible?

• Have a downward-sloping demand curve

• Have at least 2 identifiable customer groups with different price
elasticities of demand for the product

• Can prevent customers from reselling the product

124


 MONOPOLY: PRICE DISCRIMINATION - GRAPHS

Efficient
quantity

A


DWL due to the reduction in Can capture the higher-elastic-
quantity & the increase in price demand group at a lower price $90

125


 MONOPOLY: PERFECT PRICE DISCRIMINATION
With perfect price discrimination:

• Charge each customer the maximum amount they would pay for

• Produce the same quantity as under perfect competition (point A)
(Capture all points on the demand curve )

• No Deadweight Loss

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

126


 MONOPOLY VS. PERFECT COMPETITION

Perfect competition: QPC & PPC

Monopoly:
QMON< QPC & PMON> PPC

=>Deadweight loss, as
(Producer surplus + Consumer
surplus) is not maximized

Rent seeking: producers spend time & resources to seek for
monopoly power
127


 NATURAL MONOPOLY
Significant economies of scale:
• Fixed costs are very high & variable costs are low
• ATC decreases as output increases => ATC is minimized only when
there is one firm
• Example ???

Economies of scope
• Production uses same capital resources
• ATC declines as ranges of goods produced increases
• Example ???

128


 REGULATING MONOPOLIES
Regulate the prices the monopoly may charges:
1. Average cost pricing:
• Reduce price to where ATC
intersects D
• Increase output & social welfare
• Economic profit = 0

A 2. Marginal cost pricing
• Reduce price to where MC
B intersects D
Source: Schweser 2012 • Efficient regulation
• May require subsidy, if MC < ATC
Problems with regulation:
• Lack of information • Quality regulation
• Cost shifting • Special interest effect
129


 IDENTIFYING MARKET STRUCTURE
• Econometric method: To estimate the elasticity of supply & demand by
regression methods (cross-sectional or time series)
o But requires lots of data

• Simpler method: Concentration ratio & HHI Index
o N-firm concentration ratio: sum of the % market share of the top N largest
firms

0% 40% 60% 100%

Competitive
Perfect Oligopoly
market Monopoly
Competition

130


 IDENTIFYING MARKET STRUCTURE (cont.)
• Simpler method:
o Herfindahl-Hirschman Index (HHI): sum of the squared % market share of
the top 50 largest firms

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

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

131

Economics ss4

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