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MODULE Microeconomics 38 Syll No BA0362 TOPIC N0 5 UNDERSTANDING THE CONCEPT OF ELASTICITY Keywords Price elasticity of demand total revenue income elasticity of demand cross price elasticity of demand price elasticity of supply Objective Students should be able to understand and apply the concept of elasticity in the industry 51 Define elasticity of demand 52 Explain the concept of price elasticity of demand and the meaning of its coefficient i Elastic ii Inelastic iii Unitary elasticity iV Perfectly elastic V Perfectly inelastic 53 Discuss the determinants of price elasticity of demand 54 Use the price elasticity of demand in the industry 55 Explain brie y the concept of income elasticity of demand 56 Interpret the coefficient of income elasticity of demand 57 Explain brie y the concept of cross price elasticity of demand 58 Interpret the coefficient of cross price elasticity of demand 59 Explain the concept of elasticity of supply Ref Books Economics 19th Edition by Campbell R McConnell Stanley L Brue amp Sean M Flynn McGraWHill Irwin 2012 Compiled by SP Business School Chapter 4 Singapore Polytechnic School of Business Economics Pearson Publishing 2009 Chapter 4 SP BUSINESS SCHOOL MODULE Microeconomics 39 TOPIC N0 5 Syll No BA0362 1 General definition of elasticity of demand A measure of the sensitivity or responsiveness of quantity demanded to changes in price of the good itself income or the price of other goods 3 types of demand elasticities G Price elasticity of demand Income elasticity of demand and Cross price elasticity of demand CD Price Elasticity of Demand Definition of Price Elasticity of Demand A measure of the responsiveness of quantity demanded to a change in its own price H Price elasticity of demand looks at a movement along a given demand curve Formula The midpoint formula for price elasticity of demand is Price Ed A Q APX QL2i2L1 Qg lg BLZLPJLI le PX22 where Q1 old quantity demanded Personal Notes Note P Ed is always negative because of the law of demand According to the law price and quantity demanded are inversely related Since the denominator and numerator of the equation moves in opposite directions hence the coefficient of P Ed is a always negative It is difficult to work with the negative figure hence drop the negative sign To change it into a positive figure economists take its absolute value MODULE Microeconomics 40 TOPIC N0 5 Q2 new quantity demanded P1 old price P2 new price Normally we use the simple formula below when calculating percentage changes P Ed AP Ag 29 APP AQXB AP Q However the use of the simple formula above will result in different answers for price elasticity of demand even though we are moving along the same points for example from Point A to B and from point B to A Price A 30 25 I I I I I L 10000 20000 Qty Example Syll No BA0362 Personal notes SP BUSINESS SCHOOL MODULE Microeconomics 41 TOPIC N0 5 Syll No BA0362 Suppose ticket prices for Stefanie Sun s concert is raised from 25 to 30 Calculate the P Ed given that the number of seats sold falls from 20000 to 10000 movement from point A to B 10000 200000 20 000 30 25 25 Observe what happens if ticket prices for her concert is lowered from 30 to 25 instead movement from point B to A PEd 20 20000 100000 10 000 25 30 30 PEd 100 59 17 The simple formula has a weakness we ended up with 2 different answers because Why use the midpoint formula The coefficient of P Ed remains the same 37 whether we move up point A to B or move down point B to A the demand curve Using the midpoint formula P Ed 10000 20000 33 37 20000 100002 9 30 25 25 302 2 Coef cients of price elasticity of demand The coefficients of price elasticity of demand can range from zero to infinity Personal notes Reason The base did not change regardless of whether P rose or fell since we are moving along the same range after all The bases in the mid point formula are made up of AVERAGE quantities and prices Note SP BUSINESS SCHOOL MODULE Microeconomics 42 TOPIC N0 5 Syll No BA0362 Based on how responsive quantity demanded is to changes in price P Ed can be divided into 21 Elastic demand P Ed gt 1 Elastic demand is a condition in which the percentage change in quantity demanded is greater than the percentage change in price Price Ed A g gt 1 A P gt A Q gt A P quantity demanded changes MORE than proportionately to a change in price gt graphically the demand curve is relatively at 22 Inelastic demand P E lt 1 Inelastic demand is a condition in which the percentage change in quantity demanded is less than the percentage change in price Price EdAg2 lt 1 AP gt A Q lt A P quantity demanded changes LESS than proportionately to a change in price gt graphically the demand curve is relatively steep 23 Unitary demand P Ed 1 Personal notes V V SP BUSINESS SCHOOL MODULE Microeconomics 43 Syll No BA0362 TOPIC N0 5 Unitary demand is a condition in which the percentage P change in quantity demanded is equal to the percentage A change in price I PriceEdAQ 1 AP gt A Q A P quantity demanded and price changes proportionately Q VU gt graphically a demand curve that is unit elastic is shaped like a rectangular hyperbola 24 Perfectly elastic demand P Ed 00 Personal notes Perfectly elastic demand is a condition in which a small percentage change in price brings about an infinite percentage change in quantity demanded P A D Price Ed Mg 00 A P gt demand is perfectly elastic when an unlimited amount of good is demanded at that one price 39 Q gt any change in price causes quantity demanded to fall to zero gt graphically a perfectly elastic demand curve is horizontal 25 Perfectly inelastic demand P E 0 Perfectly inelastic demand is a condition in which the quantity demanded does not change as the price changes SP BUSINESS SCHOOL MODULE Microeconomics 44 Syll No BA0362 TOPIC N0 5 Price Ed AQ 0 P D A P A gt demand is perfectly inelastic when a change in price results in NO change in quantity demanded gt graphically a perfectly inelastic demand curve is represented by a vertical straight line V Qo Q x Personal notes Elasticity need NOT be constant along a given demand curve Constant elastlclty It means that the coefficient of price elasticity of demand ElaStiCity is conStant only if calculated remains the same regardless of Where you are 0 demand is unit elastic P Ed 1 or 0n the demand CHIVC 0 demand is perfectly elastic P Ed 00 or 0 demand is perfectly inelastic P Ed 0 Elasticity CHANGES along a LINEAR negatively sloped demand curve B Demand is elastic above the midpoint of a linear negatively sloped demand curve unit elastic at the midpoint and inelastic below the midpoint 3 Usefulness of P Ed The concept of price elasticity of demand is closely linked to a firm s total revenue SP BUSINESS SCHOOL MODULE Microeconomics 45 TOPIC N0 5 Syll No BA0362 Definition of total revenue TR The total number of dollars a firm earns from the sale of a good or service which is equal to its price multiplied by the quantity sold Formula f where P price at which the good is sold Q quantity of the good sold From the formula above observe that Since price and quantity change in opposite directions what happens to TR will depend on which variable changes more How much price and quantity change in turn depends on the price elasticity of demand Knowledge of the concept of price elasticity of demand assist the producer firm in deciding whether to raise or lower its price which affects Q and hence TR in order to maximize its profit How is price elasticity of demand and TR related If demand is price elastic a 1 decrease in price increases the quantity sold by If demand is price inelastic a 1 decrease in price increases the quantity sold by If demand is unit elastic a 1 decrease in price increases the quantity sold by Personal Notes Profit TR TC SP BUSINESS SCHOOL MODULE Microeconomics TOPIC N0 5 46 Syll No BA0362 SUMMARY Inelastic O lt Ed lt 1 Unit elastic Ed 1 Elastic Ed gt 1 When PD 1 iinqdlt 1 111113 TRi 1irinqd1iinP 9 TR unchanged 1 tin qdgt 1 i inP in When PD 1 Iinqdlt 1 l inP 9TRi 1 inqd 1 inP 9 TR unchanged 1 i in qdgt 1 inP 9 TR KEY POINTS B When demand is elastic TR and P are inversely related ie TR B when P D B When demand is inelastic TR and P are directly related ie TR B when P D B When demand is unitary elastic TR remains unchanged no matter whether P D or D Recall that elasticity is not constant along a linear negatively Q As we move down the demand curve ie P D observe that demand is elastic above the midpoint of the demand curve unit elastic at the midpoint and inelastic below the midpoint sloped demand curve Personal Notes When demand is elastic HQ gt DP DTRD When demand is inelastic HQ lt DP V DTRD MODULE Microeconomics 47 TOPIC N0 5 Syll No BA0362 D a ex TR TR maximlllm I R Q Why is TR at its maximum when demand is unit elastic Unit elastic occurs at the midpoint of the demand curve The midpoint unit elasticity separates the elastic from the inelastic portion of the demand curve Since TR rises along the elastic portion of the demand curve and falls along the inelastic portion of the demand curve when price falls TR must be at its maximum when demand is unit elastic 4 Determinants of price elasticity of demand i Availability of substitutes The more and closer the substitutes the more elastic is demand Why When the price of a good increase ie becomes relatively more expensive it is easier to switch to consuming the when demand is unit elastic HQ DP D TR is at its maximum Personal notes Example SP BUSINESS SCHOOL MODULE Microeconomics 48 TOPIC N0 5 Syll No BA0362 substitute Demand for a good or service is price inelastic if the good has no close substitutes The availability of substitutes depends on how the good is de ned The narrower the definition the more substitutes there are 3 Demand for the good is elastic The broader the definition the less substitutes there are 3 Demand for the good is inelastic ii Share of budget spend on the product Demand for a good that takes up a small proportion of the consumer s budget tends to be inelastic Why The good is likely to be rather cheap Any percentage increase in the price of the good is likely to affect our budget only marginally However demand for a good that takes up a large proportion of the consumer s budget tends to be elastic Why The good is likely to be expensive Any percentage increase in the price of the good Will dent our budget significantly Example If the price of tobacco increase Example Demand for personal computers is inelastic Personal notes Example Example SP BUSINESS SCHOOL MODULE Microeconomics 49 TOPIC N0 5 Syll No BA0362 iii Time With time demand for a good tends to become more elastic because 0 more substitutes become available over time 0 given more time consumers become more willing to substituteswitch to other goods iv Luxury or necessity Demand for a luxury tends to be price elastic Demand for a necessity tends to be price inelastic SUMMARY Inelastic demand Elastic demand 0 Few substitutes 9 Many substitutes 0 Small of the budget 0 Large of the budget 0 Shorter time period 0 Longer time period 0 Necessity 0 Luxury 2 other types of elasticity of demand concepts Income elasticity of demand Income elasticity of demand measures the responsiveness of quantity demanded to a change in income Example Demand for petrol was inelastic during the OPEC oil price hike in the early 19703 as there was no other substitutes available The demand for petrol is Personal notes SP BUSINESS SCHOOL MODULE Microeconomics 50 TOPIC N0 5 Syll No BA0362 Formula For income elasticity of demand we must use the simple formula and NOT the midpoint formula Recall from the topic on demand that the direction of the shift of the demand curve when income changes depends on Whether the good is a normal good or an inferior good Q In other words the concept of income elasticity of demand measures horizontal shifts of the demand curve in response to a change in income The computed coefficient of income elasticity of demand can either be positive or negative Positive Y E coef cient 0 occurs When both income and quantity demanded changes in the same direction 0 the positive coefficient means that the good is a Negative Y E coef cient 0 occurs When income and quantity demanded moves in opposite directions 0 the negative coefficient means that the good is an Personal Notes SP BUSINESS SCHOOL MODULE Microeconomics 51 TOPIC N0 5 Syll No BA0362 Normal goods can be further subdivided into G luxuries and CD necessities Luxuries 0 these are goods Whose demand changes more than proportionately to the change in income 0 Y Ed gt 1 gt income elastic Necessities 0 these are goods Whose demand changes less than proportionately to the change in income 0 lt Y Ed lt 1 gt income inelastic Usefulness of the income elasticity of demand concept Knowledge of its income elasticity of demand enables a firm to predict its sales Cross price elasticity of demand Cross price elasticity of demand measures the responsiveness of the demand for one good shift of the demand curve to a change in the price of another related good Like income elasticity of demand the simple formula is used for calculating the cross price elasticity of demand coefficient Formula Cross price Ed 2 AQA If you know that income has increased by 5 and the Y Ed for a good is 15 then Personal Notes APB SP BUSINESS SCHOOL MODULE Microeconomics 52 TOPIC N0 5 Syll No BA0362 The cross price elasticity of demand coefficient can be either positive negative or zero Its sign depends on the relationship between the 2 goods Positive cross price Ed coef cient 0 Goods A and B are Negative cross price Ed coef cient 0 Goods A and B are Zero cross price Ed coef cient 0 Goods A and B are Observe that a change in price of good B has NO effect On the demand for good A 5 Price Elasticity of Supply The price elasticity of supply P E measures the responsiveness of the quantity supplied to a change in the price of the good itself Formula The midpoint formula for price elasticity of supply is change in quantity supplied of Good X P Es change in price of Good X MD PBD MD QdB D MD ddA MD PBD MD QdB D MD ddA Personal Notes m P Es is always positive since price and quantity supplied are directly related If the coefficient of the price elasticity of supply is greater than 1 elastic less than 1 inelastic equals to 1 unit elastic zero perfectly inelastic and infinity perfectly elastic MODULE Microeconomics 53 TOPIC N0 5 Syll No BA0362 Practise the calculations and discuss them during the tutorial session Determinants of Price Elasticity of Supply The determinants of price elasticity of supply include a 1 Resource Substitution Possibilities 21 Some goods can be produced by using unique or rare productive resources These items have a low or even zero price elasticity of supply For example Other goods and services can be produced using commonly available resources Such goods have a high elasticity of supply For example wheat can be grown on land that is almost equally good for growing corn The supply curve of wheat is almost horizontal and its elasticity of supply is very large Time 1 The relationship between time and elasticity of supply is distinguished by i ii iii i Immediate supply Personal Notes Pricei SP BUSINESS SCI OOL MODULE Microeconomics 54 Syll No BA0362 TOPIC N0 5 Assume the demand for the product increases suddenly from D to D1 During this period Pm producers cannot adjust the quantity supplied on such a short notice the supply curve is vertical and perfectly inelastic P0 D1 For example a farmer will sell the same quantity D of tomatoes Q0 but at a higher price P0 to Pm now because the farmer needs time to produce Q0 more tomatoes Quantlty ii Short run supply In the short run the farmer for instance do have Price A time to vary some productive resources such as labour and fertiliser However resources such as land and machinery are fixed The result is a PS greater output of tomatoes in response to an increase in demand Po The short run supply curve for tomatoes is thus upward sloping but steep Now the increase in demand is met by an increase in quantity QotO Qs SO Qo Qs D D Quantity Personal Notes iii Long run supply The farmer has allocated more land to grow A more tomatoes Furthermore more farmers are Price attracted to tomato production by the increased demand and higher price These adjustments cause an even more elastic supply S P1 SP BUSINESS SCHook MODULE Microeconomics 55 Syll No BA0362 TOPIC N0 5 The long run supply curve for tomatoes is thus P0 upward sloping but atter Now the increase in D1 demand 1s met by a larger 1ncrease 1n quant1ty Q0 to Q1 131 D Q0 Q1 Quantity NOTE There is no totalrevenue test for elasticity of supply The law of supply indicates a direct relationship between price and quantity supplied Regardless of the degree of elasticity or inelasticity price and total revenue move in the same direction 6 Summary of Topic 5 Do you know a what price elasticity of demand measures b what formula is used to compute the price elasticity of demand coefficient 0 why the coefficient of price elasticity of demand is always negative d the relationship between price elasticity and total revenue e what the determinants of price elasticity of demand are f what income elasticity of demand measures g how we compute the income elasticity of demand coefficient Is the midpoint formula used h what is the focus of the income elasticity of demand concept i what cross price elasticity of demand measures SP BUSINESS SCHOOL MODULE Microeconomics 56 Syll No BA0362 TOPIC N0 5 139 how we compute the cross price elasticity of demand coefficient Is the midpoint formula used k What is the focus of the cross price elasticity of demand concept 1 What price elasticity of supply measures and its formula m What the determinants of price elasticity of supply are SP BUSINESS SCHOOL MODULE Microeconomics 53 Syll No BA0362 TOPIC No 6 PRODUCTION AND ITS COSTS Keywords Total product average product marginal product law of diminishing returns total cost fixed cost variable cost average cost marginal cost long run average cost curve economies of scale diseconomies of scale Objective Student should be able to 61 Distinguish between fixed and variable inputs 62 Define short run and long run time periods Distinguish between the Law of diminishing returns and Returns to scale 63 Explain the following product concepts i Total Product ii Average Product i Marginal Product 64 Describe the relationship between i Total Product and marginal product ii Average product and marginal product 65 Understand the concept of costs and explain the following cost curves i Total Cost ii Fixed Cost iii Variable Cost iv Average Cost v Marginal Cost 66 Explain the averagemarginal costs relationship 67 Describe the shape of the long run average cost curve Ref Books Economics 19th Edition by Campbell R McConnell Stanley L Brue amp Sean M Flynn McGrawHill Irwin 2012 Compiled by SP Business School Chapter 10 Singapore Polytechnic School of Business Economics Pearson Publishing 2009 Chapter 11 SP BUSINESS SCHOOL MODULE Microeconomics 54 TOPIC No 6 Syll No BA0362 1 Decision Time Frames When we talk about production we usually look at 2 time frames Short run 9 a period of time so short that there is at least one fixed input Long Run 9 a period of time so long that all inputs are variable 2 Short Run Production There are 3 main product curves in the SR a Total Product b Average Product c Marginal Product Total Product The TP curve shows the output that is produced when additional units of variable input VI are added to the fixed input FI Personal Notes Kev Features of the SR 2 types of inputs a variable input input whose quantity can be changed during the period of time under consideration 6 g b fixed input Kev feature of the long run A typical short run TP curve can be represented by TPfK L Where K Capital fixed input FD L labour variable input VD MODULE Microeconomics 55 Syll No BA0362 TOPIC No 6 Personal Notes Labour input Total Output Marginal Product No of bushels of grapes bushels of grapes workers per per day per day day 0 0 1 10 10 2 22 12 3 33 1 1 4 42 9 5 48 6 6 50 2 7 48 2 A TP o In 00 ltr g TP m m l l S 0 1 2 3 4 5 6 7 39 No of workers Shape of the TP curve Short run TP curve is affected by the Law of Diminishing returns 3 SP BUSINESS SCHOOL MODULE Microeconomics 56 TOPIC No 6 Syll No BA0362 The Law of Diminishing Returns states that beyond some point the marginal product decreases as additional units of a variable factor are added to a fixed factor To understand the shape of the TP curve let s first understand the concept of marginal product Marginal product MP measures the change in total output resulting from the addition of an extra unit of variable input Graphically MP equals the gradient of a tangent drawn to any point on the total output curve 1 Our example shows us that MP initially increases as the 1st unit of worker employed adds 10 bushels of grapes per day to output and the 2nd unit of worker employed adds another 12 bushels of grapes per day to output Between 12 workers MP is rising Since the 2rld unit of worker employed adds more to output than the 1st unit 9 output is increasing at an increasing rate TP curve bends upwards 2 From 36 workers notice that each subsequent worker hired adds less and less to output MP is therefore declining Output is increasing at a decreasing rate TP curve bends downward Personal notes Formula A TP vertical Slope of tangent horizontal WHY When TP bends upwards a the firm is said to be experiencing increasing returns to the VI WHY When TP bends downwards SP BUSINESS SCHOOL MODULE Microeconomics 57 TOPIC No 6 Syll No BA0362 Total output is at its maximum at the 6th unit of worker Thereafter total output falls 3 For output to fall MP must be negative This means that each subsequent worker employed does not add more to output but instead reduces the output produced Figure to show the relationship between MP and TP TP I gt No of workers V MP This occurs because there are now too many VI and too little F1 to work with When output falls a Personal Notes Formula AP SP ULJLL LJLJLJ UVLLVVl J MODULE Microeconomics 58 Syll No BA0362 TOPIC No 6 Average Product AP Average product can be simply defined as total output divided by the number of VI used Personal Notes Shape of the AP curve AP A Like MP AP increases reaches a maximum and then declines AP Relationship between MP amp AP VI To understand the relationship between MP and AP it is important to remember that MP determines what happens to AP A MP AP 1 Both MP and AP have the same shape but they do not overlap each other AP 2 i when MPgtAP ii when MPltAP V1 MP It follows from i and ii that MP and AP are equal WHY when AP is at its maximum At AP maximum AP is neither T nor L AP is a constant For AP to remain a constant MP cannot be gt AP or else AP will T SP MP cannot be lt AP or else AP will l MODULE Microeconomics 59 TOPIC No 6 Syll No BA0362 MP must reach its maximum before AP reaches its maximum 3 This is to ensure that MP Will then fall fast enough to pull AP xL 3 Short Run Cost curves As mentioned earlier a firm operating in the short run uses both fixed and variable inputs This implies that in the short run a firm incurs both fixed and variable costs When it produces a good a Total Fixed Costs TFC Fixed costs are the costs of the firm s fixed inputs ie costs that do not vary as output varies and that must be paid even if output is zero The TFC curve is hence a horizontal line Note TFC curve can shift up T or shift down L When the FI e g plant size changes b Total Variable Costs TVC TVC are costs of the firm s variable inputs ie costs that are zero When output is zero and vary as output varies Personal Notes Example TFC outputr Example S 3 BUSINESS SCHOOL MODULE Microeconomics 60 TOPIC No 6 Syll No BA0362 TVC varies directly with the output level ie TVC T when output T because more VI are required Tvct Points to note when drawing the TVC curve i TVC curve must start from the origin ii As output increases TVC increases ie the TVC curve is positively sloped c Total Cost TC The sum of total fixed cost and total variable cost at each level of output Points about the TC and TVC Curves i At zero output 9 ii TC is always greater than TVC WHY iii TC and TVC have the same shape because TFC is a constant The vertical gap between TC and TVC TFC 1 Short Run Average Cost Curves The three average costs of production are S A TVC output 7 Personal Notes TC A TC TC TVC TFC TVC TFC output39 Formula AFC MODULE Microeconomics 6 1 TOPIC No 6 i ii iii Average Fixed Cost AFC Total fixed costs divided by the quantity of output produced AFC J as output T 9 The given amount of fixed cost is spread over a bigger output Average Variable Cost AVC Total variable cost divided by the quantity of output produced Shape Reason Diminishing returns means that as output increases even more VIs are needed to produce an additional unit of output Average Total Cost ATC Total cost divided by the quantity of output produced ATC Syll No BA0362 A Ei 0 LL lt AFC output Personal Notes Formula for AVC AVC AVC AVC A 33 Output SP BUSINESS SCHOOL MODULE Microeconomics 62 TOPIC No 6 Syll No BA0362 ie it measures the total cost per unit of output ATC Shape The Ushape of the ATC curve is because of i Spreading TFC over a larger output ii Diminishing returns When output increases TFC is spread over a larger output so AFC decreases ie AFC curve slopes downwards Although AVC decreases initially diminishing returns causes AVC to eventually increase and AVC curve to slope upward Shape of ATC curve combines the two effects Initially as output increases both AFC and AVC decrease so ATC decreases and ATC curve slopes downwards But as output increases further and diminishing returns set in AVC starts to increases AFC decreases more quickly than AVC is increasing 9 ATC curve continues to slope downward But eventually AVC starts to increase more quickly than AFC decreases so ATC starts to increase and ATC curve slopes upward Relationship between ATC and AVC i ii iii ATC is always greater than AVC Gap between ATC and AVC AFC Gap between ATC and AVC gets smaller as output increases Personal Notes WHY SP BUSINESS SCHOOL MODULE Microeconomics 63 Syll No BA0362 TOPIC No 6 iV Min AVC occurs at a smaller output than min ATC WHY to understand what happens remember that TC ATC AFC AVC and bear in mind that AFC is always falling AVC a Between the origin and output Qo I ATC J since both AFC and AVC are L I I AFC L r b Between Q0 and Q1 0 QQI Q1 output AFC l but AVC is T But AVC is T slower than AFC J c After output Q1 ATC T because Personal Notes iv Marginal Cost MC Formula for MC The change in total cost when one additional unit of output is A TC ATVC produced Shape 9 A Q A Q At small outputs MC decreases as output increases because of greater specialization and diVision of labour But as output increases MC increases because of the law of diminishing returns the output produced by additional worker VI decreases and to produce an additional unit of output even more workers are required and hence the cost of producing the additional unit increases V MC SP BUSINESS SCHOOL MODULE Microeconomics 64 TOPIC No 6 Syll No BA0362 Relationship between the Average and Marginal costs curves Consider our earlier discussion on the relationship between marginal product MP and average product AP The same AP and MP relationship also applies to the average and marginal costs curves ZQ MC determines what happens to the AVC and Relatiqp hip ATC curves MC ELAN betw en MC AVC 3 A and AT Key points to note ATC a When MC lt AVC or ATC AVC amp ATC AVC b When MC gt AVC or ATC AVC amp ATC 0 MC must AVC and ATC at their respective minimums When AVC and ATC are minimum their values are gt Output constant at that pomt Personal Notes MC cannot be gt AVC or ATC or else AVCATC will 7 MC cannot be lt AVC or ATC or else AVCATC will 7 Relationship between d MC must reach its minimum first so that MC can then MC AVC amp ATC rise fast enough to pull AVC and ATC up Note WHY MC is related to AVC and ATC BUT MC is NOT related to AFC Key Principles SP BUSINESS SCHOOL MODULE Microeconomics 65 TOPIC No 6 Syll No BA0362 4 Relationship between Cost Curves and Product Curves A firm s MP curve is linked to its MC curve Initially when the firm hires more workers VIs increase its MP rises and its MC falls As the firm hires more labour its MP decreases because of diminishing returns and its MC rises A firm s AP curve is linked to its AC curve Initially when the firms increases its labour its AP increases and its AVC decreases As the firm hires more labour its AP decreases Output and its AVC rises A Falling MP 390 and rising MC E 0 6 Tc rlsmg AP and g0 g E g falling AVC 5 395 0 395 gt e 3 e lt a E an AP MP A Rising MP and falling MC rising AP and falling AVC 5 SP BUSINESS SCHOOL MODULE Microeconomics 66 Syll No BA0362 TOPIC No 6 MC AVC Output Maximum MP and Minimum MC 5 Production in the Long Run There are no xed costs in the long run Given more time the firm can increase its scale of production by expanding its plant size The long run is therefore viewed as the firm s planning horizon Over this planning horizon the firm can decide on the best plant size it should have for the different output levels it expects to produce Kev points about the long run a All inputs are variable in the long run NO fixed input b As all inputs can be changed a firm in the LR can choose the best input combinm c Production in the long run is NOT affected by the Law of diminishing returns Instead it is affected by the concept of Returns to scale Concept looks at What happens to output when 1 Like the SR the LR cost curves are also Ushaped WHY i initially the firm experiences increasing returns to scale or What is the best input combination Long Run A vem oe nst A LRAC SP BUSINESS SCHOOL MODULE Microeconomics 67 TOPIC No 6 Syll No BA0362 ii iii SUMMARY Economies of scale occurs when a firm s output increases more than proportionately to the increase in ALL its inputs eg Cause As a firm initially expands its resources are able to better specialized or concentrate on doing what they are best at Specialisation 9 after a point the firm experiences decreasing returns to scale or Now output increases less than proportionately to the increase in ALL its inputs eg Reason When a firm becomes too big red tapes and management problem arises In between economies and diseconomies of scales the firm experiences constant returns to scale Output increases proportionately with the increase in ALL inputs When there is constant returns to scale 9 productivity does not change 9 therefore cost will not change Output Example 1 Are you able to differentiate between the short run and the long run 2 Do you know the difference between a variable input and a fixed input 3 Do you know what determines the shapes of the TP AP and MP curves 4 Are you able to calculate AP and MP SP BUSINESS SCHOOL L r MODULE Microeconomics 68 Syll No BA0362 TOPIC No 6 5 Do you know and understand the relationship between AP and MP 6 Do you know the link between the various product curves and the cost curves 7 Do you know what explains the shapes of various cost curves 8 What is the key principle linking the product curves and the cost curves 9 Can you calculate AVC ATC AFC and MC 10 Do you know and understand the relationship between MC AVC and ATC 11 Do you know which are the cost curves that are affected by changes in the variable cost and which are the ones that are affected when fixed cost changes 12 In the long run do you know what determines the shape of the LRAC curve 13 Are you able to explain the following 9 economies of scale diseconomies of scale and constant returns to scale SP BUSINESS SCHOOL MODULE Microeconomics 68 Syll No BA0362 TOPIC NO 7 MARKET STRUCTURE Keywords Market structure total revenue average revenue and marginal revenue Objective Students should be able to 71 Distinguish the firm and industry 72 Explain the meaning of market structure 73 Define the following i Total revenue ii Average revenue iii Marginal revenue 74 Profitmaximization rule Ref Books Economics 19th Edition by Campbell R McConnell Stanley L Brue amp Sean M Flynn McGraWHill Irwin 2012 Compiled by SP Business School Chapter 11 Singapore Polytechnic School of Business Economics Pearson Publishing 2009 Chapter 12 SP BUSINESS SCHOOL MODULE Microeconomics 69 Syll No BA0362 TOPIC NO 7 71 Distinguish between Firm amp Industry Personal Notes Introduction Cost is an important concern of the firm Equally important is the concept of revenue What is the revenue Total revenue is the total receipts from the sale of output TRPXQ The revenue of a firm will partly depend on i ii Therefore the decisions a firm makes depends on the market structure it is operating in Our focus in this chapter is on defining some terms and concepts Which Will be useful for discussion in subsequent chapters Definition of a firm and an industry Firm Industry An organisation that produces A group of firms that sells a goods and services All producers well defined product or closely are called firms no matter how related set of products big they are or what they produce SP BUSINESS SCHOOL MODULE Microeconomics 70 Syll No BA0362 TOPIC NO 7 72 Definition of Market Structure Personal Notes What is market structure A classification system for the key traits of a market including i ii iii The above 3 main factors determine the market power of the firm ie ability to alter the market price of a good or service Our focus will be on 4 types of market structures Perfect Monopoly Competition 73 Define Total Revenue TR Average Revenue AR and Marginal Revenue MR i TR Total number of dollars a firm earns from the sale TR of a good or service RECALL When price changes along a linear downward sloping demand curve total revenue at first rises reaches a maximum and then falls Refer to topic on Elasticity U P BUSINESS SCHOOL MODULE Microeconomics 71 Syll No BA0362 TOPIC NO 7 However when price is constant ie demand curve is horizontal total revenue is a ray from the origin Personal Notes ii AR Revenue per unit sold AR iii MR MR Addition to total revenue resulting from the sale of one more unit of output 74 Pro tmaximization Rule What is the objective of the firm TR amp TC TR 2 ways to find the best output level profitmaximization output for the firm This will be elaborated in the next few TC chapters I i TR TC Maxirlnum prolllit Profitmaximizing output is I where TR TC is at a maximum 9 Quantity I Graphically the vertical distance between TR and TC is Profit I I I the greatest at that output level I I I SP BUSINESS SCHOOL MODULE Microeconomics 72 Syll No BA0362 TOPIC NO 7 Maximum profit 0 9 Quantity ii MR MC Price Firm compares the amounts that cost each additional unit of output MC would add to TR and to TC When MR gt MC 9 output P I Why MR I When MR gt MC producing one more unit adds more to revenue than to cost I 9 profit 9 Quantity When MR lt MC 9 W output Why When MR MC 9 pro tmaximizing output Why NOTE Graphically MR curve intersects MC curve establishes profit maximizing output level SP BUSINESS SCHOOL MODULE Microeconomics 73 Syll No BA0362 TOPIC NO 7 Focus is on MR MC to determine the profitmaximizing output This will also apply if firm is making losses SUMMARY 1 Do you know the difference between a firm and an industry 2 Do you know the meaning of a market structure 3 Are you able to calculate TR AR and MR 4 What are the 2 ways to determine the profitmaximizing output level SP BUSINESS SCHOOL MODULE Microeconomics 77 Syll No BA0362 TOPIC NO 8 PERFECT COMPETITION Keywords Perfectly elastic demand curve profit maximisation economic profitloss normal profit Objective Students should be able to 81 Describe the characteristics of perfect competition 82 Understand why the perfect competitive firm faces a perfectly elastic demand curve even though the market demand curve is downward sloping 83 Explain profit maximisation under perfect competition 84 Explain the meaning of economic profit normal profit and economic loss 85 Describe the equilibrium position of the perfectly competitive firm in the short run and in the long run Ref Books Economics 19th Edition by Campbell R McConnell Stanley L Brue amp Sean M Flynn McGrawHill Irwin 2012 Compiled by SP Business School Chapters 11 amp 12 Singapore Polytechnic School of Business Economics Pearson Publishing 2009 Chapter 12 SP BUSINESS SCHOOL MODULE Microeconomics 78 TOPIC NO 8 Syll No BA0362 81 Characteristics of Perfect Competition PC Characteristics 1 Large number of small firms Therefore each firm has a small share of the market even when it changes its output no ability to affect the product s price each rm acts independently rather than coordinating decisions collectively 2 Homogeneous or identical product All firms produce a standardized or homogeneous product assumption rules out rivalry among firms in advertising buyers are indi erent as to which seller s product they buy 3 Perfect knowledge It is assumed that PC firms are operating in an environment of certainty participants buyers and sellers are fully informed about price availability of resources output and the production techniques impossible for a rm to sell its output at a di erent price 4 Freedom of entry and exit This implies that firms and resources are completely mobile to freely enter or exit a market Personal Klnfpo Example There are thousands of independent egg farmers in the US If any egg farmer raises the price the going market price for eggs is unaffected Example Farmer Brown s wheat is identical to Farmer Jones s wheat This condition ensures that the number of firms in PC remains large gt gt firms can only earn normal profit in the long run SP BUSINESS SCHOOL MODULE Microeconomics 79 Syll No BA0362 TOPIC NO 8 No real world market examples of PC Examples close to PC are farm products markets stock market foreign exchange market 82 Demand Curve for PC Firm Characteristics 1 2 and 3 make it impossible for PC firm to have the market power to affect the market price The PC firm is a price taker What is a price taker A price taker is a seller that has no control over the price of the product it sells If the PC firm is a price taker What then determines the price at Which it can sell Price is determined by the market forces of demand and supply and given to the firm The PC firm accepts the market price e g 25 per unit and it can only sell at this one price The PC firm s demand curve is therefore horizontal perfectly elastic a Market supply and demand b Individual firm demand Price A Price A S 25 39 39 3925 DP MRAR I I I D I 60 Quantity Quantityr thousands of units per hour units per hour Implications SP BUSINESS SCHOOL MODULE Microeconomics 80 TOPIC NO 8 Syll No BA0362 If firm raises price it will sell zero output Reason There are many other rms selling the same product at 25 per unit Will a PC firm lower its price instead If firm lowers price it will reduce revenue as firm can sell all it wants at the going price Therefore a lower price would reduce revenue Points to note In PC the firm s MR P AR Demand curve which is horizontal WHY 1 MR ATRAQ However the PC firm is a price taker and cannot change the price on its own Therefore MR constant P X AQAQ ie MR P 2 AR TRQ AR constant P X QQ ie AR P 83 Pro tmaximisation under Perfect Competition While a PC firm has no control over price it can still decide what quantity of output to produce in order to maximises profit RECALL Two ways to find profitmaximisation output a TR TC b MR MC Since P MR under PC therefore we can also say that profit is maximised when P MC Personal Notes Profit maximisation output is where TR TC is the highest gtXltgtXltFirm compares the amounts that each additional unit of output would add to TR and TC SP BUSINESS SCHOOL MODULE Microeconomics 81 Syll No BA0362 TOPIC NO 8 Focus is on MC MR method to determine the profit maximisation output Profit is maximised when 2 conditions are met i MC MR Refer to explanation in Topic 7 When MR gt MC output When MR lt MC output When MR MC 9 profit maximisation ii MC is also rising Refer to diagram below MC MR at 2 output levels Q1 and Q2 But profit is not maximised at Q1 where MC is falling though MC MR WHY Firm maximises pro t only if it expands output beyond Q to the next MC MR at Q2 Profitmaximisation of PC firm MC MR method Price A cost MC PMRARD L Q1 Q2 Quantity Below is a hypothetical example to illustrate the 2 approaches to find profit maximisation output level SP BUSINESS SCHOOL MODULE Microeconomics 82 Syll No BA0362 TOPIC NO 8 Output Price Total Total Profit Marginal Marginal units Revenue Cost TR TC Cost Revenue ATCAQ ATRAQ MR P 1 13 13 15 2 13 2 13 26 22 4 7 13 3 13 39 3 1 8 9 13 4 13 52 44 8 13 13 5 13 65 61 4 17 13 Profitmaximising output 4 units 84 Economic Pro t Normal Pro t amp Economic Loss Having determined the condition for profit W maximisation does it mean that a firm should always produce when MR MC It depends on whether revenue can cover cost at the pro tmaximising lossminimising output Before defining what is economic profit normal profit or economic loss it is important that we understand the difference between the accountant and the economist way of measuring costs Definitions of Total Cost amp Profit Economist Accountant Cost 0 Sum of explicit and implicit costs Explicit costs Payments to nonowners of a firm for their resources EgWages paid to labour rental charges for a plant Implicit costs Cost 0 Explicit costs only SP BUSINESS SCHOOL MODULE Microeconomics TOPIC NO 8 83 Syll No BA0362 Opportunity costs of using resources owned by the firm Eg salary that owner gave up to start his own rm Pro t Profit TR Explicit costs Implicit costs Pro t Profit TR Explicit costs To assess whether a firm is making profit or loss 1 compare TR with TC 2 compare P with ATC AC In the short run a PC firm can be making either a economic supernormal pro t or 9 normal zero economic pro t or c economic loss subnormal pro t 3 Economic Pro t Supernormgl Pro t Economic profit is made when the revenue earned by a firm is over and above all its costs of production Suppose Price 70 Profitmaximising output MC MR P 9 units ATC 47 at 9 units At profitmaximising output P gt ATC The firm s total profit would amount to Profit TR TC PXQATCXQ 70x 9 47x 9 630 423 207 economic pro t Personal TA Would this firm want to stay in business or shutdown Answer gtlltgtllt Stay in business as revenue can cover all the costs at the pro tmaximising output MODULE Microeconomics 84 TOPIC NO 8 Syll No BA0362 Short run Economic Profit of PC Firm Price A cost MC TC 70 9 I PMRARD I gt 9 Quantity b Normal Pro t Zero Economic Pro t Normal profit is made when a firm s revenue just covers its costs of production firm is said to be breaking even Profits can be reduced or loss incurred due to 1 fall in market price resulting in fall in TR ampor 2 rising cost of production Suppose Price falls to 43 Profitmaximising output MC MR P 7 units ATC 43 at 7 units At profitmaximising output P ATC The firm is earning normal profit because P ATC or alternatively stated TR TC Profit TR TC PXQATCXQ gt 43 x 7 43 x 7 Personal Notes Would this firm want to stay in business or shutdown Answer gtlltgtllt Stay in business as the revenue can cover all the costs explicit and implicit costs MODULE Microeconomics 85 TOPIC NO 8 Syll No BA0362 301 30 0 normal pro t Short run Normal Profit of PC Firm Price A cost MC Breakeven point ATC 43 I PMRARD 7 Quantity c Economic Loss A firm is making economic losses when its revenue cannot cover all the opportunity costs of production Suppose Price falls to 35 Profitmaximising output MC MR P 6 units ATC 34 6 at 6 units At the lossminimising output P lt ATC Loss per unit is therefore 11 The firm s total loss would amount to Profitloss TR TC PXQ ATCXQ 35 x 6 46x 6 210 276 66 economic loss Break even point of PC firm P minimum ATC Personal Notes SP BUSINESS SCHOOL MODULE Microeconomics 86 Syll No BA0362 TOPIC NO 8 Short run Economic Loss of PC Firm Price A cost MC ATC 46 Loss 66 35 PMRARD 6 Quantity Will a rm facing losses still continue to produce or will it shut down NOTE To understand how a firm decides whether to produce or shut down when it is making losses we need to bear in mind that Fixed costs must be borne regardless of whether the rm produces or shuts down in the short run Decision criteria when the firm is making economic losses P lt ATC i if P gt AVC the rm should produce so as to minimise its loss ii if P lt AVC the firm should shut down so as to minimise its loss to the xed cost i When P gt AVC SP BUSINESS SCHOOL MODULE Microeconomics 87 TOPIC NO 8 Syll No BA0362 Price cost ii Price Cost P OA Profitmaximising lossminimising output Q At Q units ATC QC Loss if produce ABCD Reason TR OADQ is able to cover TVC OFEQ and part of TFC FADE Loss if shutdown FBCE ie the TFC r m gtlltgtllt Firm should produce to minimise losses to on amount that is less than TF C PMRARD L V O Q Quantity When P lt AVC P OA Profitmaximising lossminimising output Q At Q units ATC QC Loss if produce ABCD Reason TR OADQ is only able to cover part of TVC and cannot cover all the TFC FBCE and the remaining part of TVC AFED A Loss if shutdown FBCE ie the TFC Personal TA4 nn m gtlltgtllt Firm should shut down as producing would incur more losses SP BUSINESS SCHOOL MODULE Microeconomics 88 Syll No BA0362 TOPIC NO 8 MC ATC AVC A i V PMRARD V O Q Quantity If P minimum AVC P OA Profitmaximising lossminimising output Q At Q units ATC QC m Loss if produce ABCD Reason Firm is indi erent as to TR OADQ is just enough to cover TVC OADQ Firm whether to produce or still needs to bear loss ABCD ie the TFC Shutdown WHY In either case it must bear Loss if shutdown ABCD ie the TFC the full F C NOTE The shutdown point in PC firm P minimum AVC PriceA cost MC ATC B AVC Loss Shutdown point A I PMRARD I I I V SP BUSINESS SCHOOL MODULE Microeconomics 89 Syll No BA0362 TOPIC NO 8 O Q Quantity Table to Summarize the Production Alternatives f0 39 a PC Firm TR amp TC P amp AC MR amp MC Production Outcome TR gt TC P gt AC MR MC Economic Profit TR TC P minimum AC MR MC Normal Profit Breakeven point TR lt TC P lt AC MR MC Economic Loss P lt AC MR MC Continue to produce BUT Loss minimisation P gt AVC P lt AC MR MC Indifferent AND 1 Shutdown point P min AVC Either to produce or shut down firm bears full FC P lt AC MR MC Shut down AND Loss minimisation P lt AVC PC Firm s Short Run SuDDlV Curve PC firm s demand curve is horizontal What is the shape of the PC firm s short run supply curve RECALL 1 WHY Firm will never produce at price below minimum AVC Personal Notes SP BUSINESS SCHOOL MODULE Microeconomics TOPIC NO 8 90 Syll No BA0362 Price cannot cover all the AVC and AFC 2 Minimum output produced is Q2 when market price increases to P2 WHY Price just covers AVC loss AFC per unit minimise losses 3 Firm will produce when market price increases above P2 WHY Price is able to cover all the AVC and part or all of AFC depending on the position of ATC More important issue now is where will it produce Answer MC MR PC Firm s SuDDlv Curve A Price cost Supply curve VMC P4 MR4 l AVC P3 I MR3 I Shutdown point P2 I I MR2 P1 I I 39 P MR1AR V I I I I l L Q2 Q3 Q4 Quantity 85 Short run and Long run Equilibrium for a Perfectly Competitive Firm RECALL 1 In the short run a PC firm is in equilibrium when it produces at output level where MC MR In short the PC fi s supply curve is the MC curve above the shutdown point ie minimum AVC How to obtain the industry supply curve The PC industry s short run supply curve is the horizontal summation of all firms MC curves above each firm s shutdown point Personal Notes SP BUSINESS SCHOOL MODULE Microeconomics 91 TOPIC NO 8 Syll No BA0362 2 The PC firm can be in equilibrium earning a Economic profit or b Normal profit or 0 Economic loss gtlltgtllt PC firms in the long run can earn only normal pro ts PC firm will still produce where MC MRP AC Reason gtllt gtllt There are no barriers to entry and exit Suppose a PC firms are earning economic profits new firms enter the industry supply curve shifts right 9price falls until economic pro ts reach zero normal pro ts in the long run Refer to diagrams Long run Perfecth Competitive Equilibrium PC Firm Market Economic Profit to Normal Profit SP BUSINESS SCHOOL MODULE Microeconomics 92 Syll No BA0362 TOPIC NO 8 Price A PriceA S cost MC S 1 gt AC P P N i W MR P l t l w MR1 I I I L Quantity Q1 Quantity On the other hand suppose Personal b PC firms are incurring economic losses existing firms leave the industry supply curve shifts left 9price rises until economic losses are eliminated normal pro ts in the long run SUMMARY 1 Do you know the characteristics of perfect competition Do you know the difference in the shape of the demand curve for the PC firm and the market Do you know what is profit maximisation under perfect competition Do you know the difference between the economist and accountant way of measuring cost and profit Do you know the meaning of economic profit normal profit and economic loss Do you know how would a PC firm decide to shut down or continue to produce when it is incurring economic loss Do you know the equilibrium position of the PC firm in the short run and in the long run TA4 nn SP BUSINESS SCHOOL MODULE Microeconomics 92 Syll No BA0362 TOPIC No 9 MONOPOLY Keywords Market power barriers to entry Objective Student should be able to 91 describe the characteristics of monopoly 92 explain the meaning of barriers to entry in the monopoly industry 93 explain profit maximization under monopoly 94 describe the equilibrium position of the monopoly in the short run and the long run Ref Books Economics 19th Edition by Campbell R McConnell Stanley L Brue amp Sean M Flynn McGraWHill Irwin 2012 Compiled by SP Business School Chapter 13 Singapore Polytechnic School of Business Economics Pearson Publishing 2009 Chapter 13 SP BUSINESS SCHOOL MODULE Microeconomics 93 Syll No BA0362 TOPIC No 9 1 Introduction Personal notes The market structure at the opposite extreme from perfect competition is monopoly Example When a firm is the only seller of a good or service in the market it is called a monopoly or monopolist Monopoly is a market structure characterised by Singapore Power is a monopoly since there is M only one 1 a single seller ofa unique product and government 2 strong barriers to entry approved supplier of utilities to the inland nmrntrv 2 Characteristics of a monopolist and its implications a A single rm selling a unique product Implication The monopolist s demand curve is the market demand p EXam 163 curve Microsoft IS the world s largest and most powerful personal computer software producer Through its Windows operating products it possesses a monopoly in the market for Recall from the topic on demand that the market demand curve is negatively sloped This means that the monopolist s demand curve must also be negatively sloped What is the significance of the negatively sloped dem curve Monopolist must lower its price if it wants to increase its sales operating system software for Intel compatible P A Figure 1 personal computers SP BUSINESS SCHOOL MODULE Microeconomics 94 TOPIC No 9 Syll No BA0362 b Can a monopolv fix both price and quantitv at the same time No The monopolist is constrained by its market demand curve For a given market demand the monopolist can only choose to either set the price or the quantity that it wants to sell What happens if it chooses to set the price or quantitv If it chooses to set the quantity it wants to sell the market demand will determine the price that it will be sold at If it chooses to set the price the market demand will determine the quantity that will be sold A monopolist is thus said to have market power as it can in uence the price or the quantity sold The fact that a monopolist sells a unique product explains why a monopolist s demand curve is very inelastic since there are hardly any substitutes available Implication Advertising is unnecessary as the products sold are unique In reality some monopolists do advertise Advertising if any is mainly for public relations purposes ie to keep the public informed of its activities Strong barriers to entry Implication Personal notes A monopolist s market power is derived from gtlltgtllt 9 its Size amp 0 it sells a unique product It is a price maker The more the market power the more inelastic the monopolist s demand curve is SP BUSINESS SCHOOL MODULE Microeconomics 95 TOPIC No 9 Syll No BA0362 Monopolist can continue to make economic profit even in the long run How did a monopoly come about ie why is the monopolist the only rm in the industry Strong barriers to entry block entry of new firms into the industry What are barriers to entrv gtlt These are obstacles that make it di icult or impossible for new rms to enter an industry These barriers are so effective that only one firm exist in the industry 2 categories of barriers to entry gtllt G legal barriers to entry and 3 natural barriers to entry Legal barriers to entrv include G Government license Government granted licenses restrict entry into some industries and occupations Franchise Ownership of the franchise gives the firm the exclusive right to sell a good or service Personal notes Example Microsoft unlawfully maintained its monopoly by using exclusionary and anti competitive contracts to market its PC operating system software To stop this conduct the United States sued Microsoft in July 1nnA Example Doctors amp lawyers require a license to practice Example The franchise for Burger King is held by Bon Food Pte Ltd SP BUSINESS SCHOOL MODULE Microeconomics 96 Syll No BA0362 TOPIC No 9 Patents The government grants patents to inventors thereby legally prohibiting other firms from producing and selling the patented product for a specified time period Natural barriers to entrv occur G when economies of scale is experienced Where economies of scale are very significant a firm s LRAC curve will decline over a wide range of output Because new firms cannot hope to produce and sell output equal or close to that of the firm enjoying economies of scale they will not enter the industry This results in a single firm becoming so efficient that it is able to produce for the entire market at the lowest cost Q This gives rise to a natural monopolist when a firm has exclusive rights to the ownership of resources or of a major share of essential resources required to produce a good 4 Demand and revenue of a monopolist Recall The demand curve facing a monopoly is the market demand curve Personal notes Example Singapore Power In such industries cost will be far lower if one firm produces for the entire market as the high capital outlay can be spread over a huge volume of output Example DeBeers a South African corporation DeBeers owns most of the diamond mines in the world It also controls 80 of all the diamonds sold in flan xtrnvq r1 SPB USINESS SCHOOL MODULE Microeconomics 97 TOPIC No 9 Syll No BA0362 for the product since the monopoly is the single market supplier 1 The monopolist s demand curve is negatively sloped 2 When the demand curve is negatively sloped see Figure 2 below I DdARPhlT ARi Why is MR at AR for a monopolist Assume that the monopolist does not price discriminate It thus charges the same price for ALL units sold The monopolist has to lower its price to sell more In order to sell one extra unit the monopolist NOT only lowers the price for that unit but for all previous units as well Example Output per Price Total Marginal hour AR revenue revenue 2 16 32 10 3 14 42 Observations MR from selling the 3rd unit 10 lt P AR 14 Why is this so Note This is true only if the monopolist charges a singleuniform price for all units sold ie there is no price discrimination Personal notes SPB USINESS SCHOOL MODULE Microeconomics 98 Syll No BA0362 TOPIC No 9 To sell one more unit of output the firm reduces price by 2 from 16 to 14 for all the 1 2Ild and 3rd units Rationale When the 1 2rld and 3rd units are sold at the SAME price gt the firm loses 2 each for 1st and 2rld unit as they are now sold at 14 not 16 ie 4 for the 2 units gt for the 3rd unit sold the firm adds 14 to its TR Personal notes gt hence the firm s revenue increases by 10 when one more unit of output is sold This addition to TR as a result of selling an additional unit of output is MR MR lt AR when monopolist does not price discriminate Position of MR curve in relation to AR Since MR lt AR where precisely do you draw the MR curve in Figure 2 below SP BUSINESS SCHOOL MODULE Microeconomics 99 Syll No BA0362 TOPIC No 9 AR MR Figure 2 Midpoint Dd AR I gt Q MR A I TR I I I I I I SP BUSINESS SCHOOL I MODULE Microeconomics 100 Syll No BA0362 TOPIC No 9 TR v O Recall from the topic on elasticity that 0 when demand is elastic ie above the midpoint TR T as P xL Graphically MR equals the slope of a tangent to the TR curve Since the tangent is positively sloped in this region MR is thus positive although declining as the tangents are getting atter Personal notes 0 when demand is inelastic ie below the midpoint TRxLastL MR is negative tangents drawn to TR is now negatively sloped 0 when demand is unit elastic ie at the midpoint TR is at its maximum Slope of a tangent to TR at the midpoint is horizontal therefore MR is thus 0 at the midpoint Observation of the MR curve in Figure 2 Since the MR curve cuts the Xaxis at its midpoint therefore the MR curve is twice as steep as the AR demand curve 5 Pro t maximization in monopoly SP BUSINESS SCHOOL MODULE Microeconomics 101 Syll No BA0362 TOPIC No 9 What is the objective of the monopolist Profit maximization We shall use the MR MC approach to profit maximisation to to determine the monopolist s profit maximizing output level 6 SR equilibrium in monopoly In the short run a monopolist just like the PC firm can make either G economic pro t or 3 normal pro t or 3 economic loss Personal notes i Economic pro t P gt ATC or TR gt TC MC 100 ATC 75 D AR SP BUSINESS SCHOOL MODULE Microeconomics 102 TOPIC No 9 Syll No BA0362 ii MR Figure 3 Monopolist Economic pro t Profitmaximising output level 4 units Where MR MC Profitmaximising price 100 Monopolist s TR TC and pro t TR P x Q 100 x 4 400 TC AC X Q 75 X 4 300 Economic profit TR TC 400 300 100 Normal pro t P ATC or TR TCl A ATC 100 V The price charged by a monopolist is read from the demand curve at the profit maximising n11fn11f19 791 Will the monopolist produce when it is making economic profit De nitely Since it can cover the AC all of its r39nc39fc39l Personal notes SP BU SINESS SCHOOL MODULE Microeconomics 103 TOPIC No 9 Syll No BA0362 D AR V 4 MR Q Figure 4 Monopolist Normal pro t Profitmaximising output level 4 units Where MR MC Profitmaximising price 100 Monopolist s TR TC and pro t TR P x Q 100 x 4 400 TC AC x Q 100 x 4 400 Normal profit TR TC 400 400 0 Observe that TR TC when the firm is making normal profit Economic loss P lt ATC or TR lt TC A iii 125 ATC 100 Will the monopolist produce when it is making normal profit Yes Since it can cover the TR can cover all its TC Personal notes SPB People often assume that the monopolist cannot make losses As with the PC firm the profit or losses made by the monopolist depends on a demand for its product amp b cost of production MODULE Microeconomics 104 Syll No BA0362 TOPIC No 9 D AR V MR Figure 5 Monopolist Economic loss Profitmaximising output level 4 units Where MR MC Will the Profitmaximising price monopolist produce when it is 100 making economic loss As with the PC Monopolist s TR TC and economic loss firm whether the monopolist will TR P x Q 100 X 4 400 produce or not depends on TC ATC x Q 125 X 4 500 whether it is able to cover its Economic loss TR TC 400 500 100 variable costs of production It is true in reality that a monopolist is more likely to make earn economic profit as Personal notes G its cost may be lower due to economies of scale its P gt MC pricing implies a higher profit margin Recall Fixed costs must be borne in the short run irrespective of Whether the monopolist produces or shut down Hence so long as SP BUSINESS SCHOOL MODULE Microeconomics 105 Syll No BA0362 TOPIC No 9 its VC can be covered the monopolist should produce and minimize its loss to an amount that is less than its TFC RULE OF THUMB When economic loss is incurred a monopolist will G produce if TR can cover TVC OR When P can cover the AVC Why It can minimize its loss to an amount less than the TFC Figure 6 Economics loss P lt ATC but P gt AVC A MC ATC AVC P V D AR gt 0 Q Q MR Personal notes Monopolist s TR TC TVC TFC and economic loss TR P x Q OPRQ TC ATC x Q 0TSQ TVC OVUQ SP BUSINESS SCHOOL MODULE Microeconomics TOPIC No 9 106 Syll No BA0362 TFC VTSU If the monopolist produces Economic loss TR TC PTSR If the monopolist shuts down produce zero output Economic loss TR TC VTSU TFC shut down if TR cannot cover TVC OR when P lt the AVC Why Losses will exceed TFC if the firm continues to produce omics loss P lt TC but P lt AVC Figure 7 Ecor MC ATC Should the monopolist produce when AVC lt P lt ATC Yes it will minimize its loss to an amount lt TF C Personal notes SP BU V SINESS SCHOOL MODULE Microeconomics 107 Syll No BA0362 TOPIC No 9 AVC D AR 7 Q MR Monopolist s TR TC TVC TFC and economic loss TR P X Q OPCQ TC ATC X Q OTAQ Should the monopolist TVC OVBQ produce when P lt ATC and P TFC VTAB lt AVC No it should If the monopolist produces Shutdown and limit its loss to Economic loss TR TC PTAC TFC only If it produces its losses will If the monopolist shuts down produce zero output exceed TFC Economic loss TR TC VTAB TFC Personal notes SP BUS MODULE Microeconomics 108 Syll No BA0362 TOPIC No 9 be indifferent as to whether to produce or shut down when P lt ATC but P AVC Whether the monopolist chooses to produce or shut down its losses will still be equal to TFC Try drawing the diagram on your own Observations a The monopolist will produce in the ELASTIC portion of the demand curve as this is where MR MC Why is this so MC is always positive ie gt 0 as cost is always positive where MR MC MR must also be positive MR is positive only when demand is elastic b When P AR gt MR this means that P gt MC when MR MC profit maximizing output 7 LR equilibrium in monopoly As with the PC firm the monopolist will not produce in the long run if it is making losses In other words a monopolist must make at least normal profit for it to remain in business in the long run However while a PC firm can only make normal profit in the long run a monopolist can make C normal pro t or 3 economic pro t in the long run Why is economic profit possible in the long run Because of the presence of strong barriers to entry SP BUSINESS SCHOOL MODULE Microeconomics 109 Syll No BA0362 TOPIC No 9 8 PC and monopoly compared Personal notes Assume both are in LR equilibrium earning normal profit Observe that a monopolist G produces a smaller output but charges a higher price for its output compared to PC firms A PC firm in LR equilibrium produces at the minimum LRAC because its demand curve is perfectly elastic A monopoly however can never produce at minimum LRAC because its demand curve is downward sloping In view of its downward sloping demand curve a monopolist will always produce to the left of the minimum LRAC the declining portion of the LRAC curve ie at a smaller output QM but higher price PM A MC LRAC PM D MRPC Ppc D QM QPC Q S L INESS SCHOOL MODULE Microeconomics 110 Syll No BA0362 TOPIC No 9 MR Personal notes SUMMARY 1 Do you know the characteristics of a monopoly 2 Do you know what barriers to entry are 3 Do you know what profit maximization is under a monopoly 4 Do you know why a monopolist must produce in the elastic portion of the demand curve 5 Do you know the equilibrium position of the monopoly in the short run and the long run 6 Does the monopoly and the perfectly competitive firm produce the same output level and charge the same price for their products SP BUSINESS SCHOOL MODULE Microeconomics 107 Syll No BA0362 TOPIC No 10 MONOPOLISTIC COMPETITION Keywords Product differentiation nonprice competition excess capacity Objective Student should be able to 101 Explain the characteristics of the monopolistically competitive market 102 Determine the profit maximizing output under monopolistic competition in the short run and long run Ref Books Economics 19th Edition by Campbell R McConnell Stanley L Brue amp Sean M Flynn McGraWHill Irwin 2012 Compiled by SP Business School Chapter 14 Singapore Polytechnic School of Business Economics Pearson Publishing 2009 Chapter 14 SP BUSINESS SCHOOL MODULE Microeconomics 108 Syll No BA0362 TOPIC No 10 1 Introduction Personal notes Between the 2 extremes of perfect competition and monopoly lie intermediate forms of imperfect competition such as Monopolistic Competition and Oligopoly This type of market structure Monopolistic competition is a market structure characterised by is common in the real world a many small sellers especially in b a differentiated product and fetall and SCIVICC c minimal barriers to entry and exit SCCtOrS 0f the economy 2 Characteristics of MC and its implications 3 A large number of relatively small firms Implication b Sells differentiated products Implications i The market power is derived from the differentiated products products sold are close but not perfect substitutes for one another which the MC firm sells Product differentiation is the process of creating real or apparent differences between goods and services A differentiated product has close but not perfect substitutes Product differentiation can be real or perceived SP BUSINESS SCHOOL MODULE Microeconomics TOPIC No 10 109 Syll No BA0362 Regardless of whether product differentiation is real or perceived more importantly is the fact that consumers are willing to pay a different price for the goods ii Because of product differentiation it means that the MC firm s demand curve is negatively sloped but relatively more elastic than that of a monopolist as the monopolist has more market power Negatively sloped demand curve implies that When MC firms increase their price they will lose some not all customers If the MC firm reduces its price it can sell more as it is able to draw away some sales from its competitors iii MC firms engage in nonprice competition such as different packaging to make the products more attractive to their customers advertising to differentiate their goods so as to create distinct positive image in the consumers minds etc Why is there a need for nonprice competition G To increase the demand for its product MC firm s curve shifts right Observe that advertising not only results in an increase in demand but also increases cost As long as the increase in demand is greater than the increase in cost profits will rise Personal notes SP BU SINESS SCHOOL MODULE Microeconomics 110 Syll No BA0362 TOPIC No 10 c Minimal barriers to entry and exit MC firms face low barriers to entry Hence it is rather easy for the MC firm to enter and exit the industry Personal notes Implication 3 Short run equilibrium MC Assumption A11 MC firms that produces the same products for e g jeans tissue papers faces identical demand and cost curves in both the short run and long run The short run equilibrium positions of the MC firm is rather identical to that of the monopolist since both face downward sloping demand curves except that the MC firm s demand curve is more elastic than that of the monopoly s Since MC firm demand curve is negatively sloped this means that AR gt MR 0 Condition for profit maximization Where MR MC 0 In the short run the MC firm can make SP BUSINESS SCHOOL MODULE Microeconomics 111 Syll No BA0362 TOPIC No 10 MC Economic profit P gt ATC MC Normal profit P ATC A ATC SP BUSINESS SCHOOL MODULE Microeconomics 112 Syll No BA0362 TOPIC No 10 V MR MC Economic loss P lt ATC Personal notes 4 Short run Decision criteria as to whether to produce or not G MC firm should produce Whenever economic or normal profit is made Why CD What if the MC firm incurs an economic loss P lt ATC i Produce if P gt AVC ie TR gt TVC Why Its losses Will be minimized to an amount less than TFC if it produces Note If it shuts down losses Will be equal to TFCI Q MC Economic loss Plt ATC but P gt AVC MC ATC TR 0er TC OTaQ AVC TFC V Tac TVC VcQ V SP BUSINESS SCHOOL MODULE Microeconomics 113 TOPIC No 10 Syll No BA0362 Loss if produce PTab Loss if shutdown VTac Decision Continue to produce ii Shutdown ie don t produce if P lt AVC TR lt TVC Why To minimize losses to TFC ii MC Economic loss Plt ATC and P lt AVC Loss if produce PTXZ Loss if shutdown A ATC AVC T I x MC TR OPzQ I I TC OTXQ I TFC xy I TVC OVy I J V I p z I I I I SP BUSINESS SCHOOL MODULE Microeconomics 114 Syll No BA0362 TOPIC No 10 VTxy D Decision Shutdown gt o 0 Q MR iii Can either produce of shutdown if P AVC TR TVC Why iii MC Economic loss P lt ATC but P AVC A MC ATC C I a AVC TR OPbQ I I TC OCaQ i I TFC PCab I I TVC o Q i Loss if produce I PCab I P i Lossif I shutdown I PCab SP BUSINESS SCHOOL MODULE Microeconomics 1 15 Syll No BA0362 TOPIC No 10 Decision D Can either produce shutdown 39 o 0 Q MR Personal notes 5 LR equilibrium under monopolistic competition The MC firm can only make normal profit in the long run Why Q However the way in which economic profit or loss is eliminated in the MC firm is different from that in PC Why How does a MC firm adjust to its LR position Assume that the MC rm earns economic pro t l New firms enter the industry and take away some customers from existing firms ie existing firms39 market share drops 1 Demand curve of the existing firms shifts leftwards l New firms stop entering when firms in the industry earn only normal profit i V SPB Recall In a PC firm new firms can enter easily no barriers to entry and exit This increases industry supply and shifts the industry supply curve rightward The equilibrium market price will fall and hence bring the demand down until it is tangent to minimum ATC there is now zero economic profit MODULE Microeconomics 116 TOPIC No 10 Syll No BA0362 This occurs when at the profit maximizing output level the firm s demand curve is now tangent to the ATC curve ie P ATC gt MC firm is making NORMAL profit Diagram below shows the adjustment to long run equilibrium P1 ATC1 MR1 MR2 The process above is reversed when the MC firm makes economic loss Assume that the MC rm makes economic loss i The economic loss leads to some existing firms leaving the industry l Market share of the existing firms that remains in the industry increases i Demand curve of the existing firms shifts rightwards i SP BU W Unlike PC entry of new firms into and exit of existing firms from the MC industry due to economic profit and loss respectively shifts the firm s demand curve not the industry supply curve MODULE Microeconomics 117 TOPIC No 10 Syll No BA0362 Existing firms stop leaving when firms in the industry earn only normal profit At the profit maximizing output level the firm s demand curve is now tangent to the ATC curve ie P ATC gt MC firm is making NORMAL profit 6 Monopolistic competition and PC compared Both PC and MC firms make only However the MC firm in the long run produces an output smaller than that which minimises ATC but charges a higher price compared to PC Why Reason In the long run the MC firm will always produce on the declining portion or to the left of the minimum LRAC This arises because the MC firm s demand curve is negatively sloped it can never produce at minimum LRAC even if it is making normal profit Under MC exists as it produces less than the optimal output ie output minimum LRAC The PC firm s demand curve is perfectly elastic horizontal Hence it produces at minimum LRAC in the long run Personal notes SP BU Excess capacity is the difference between the ideal output ie output at minimum LRAC which is obtained by the PC firm in the long run and the MC firm s output in the long run MODULE Microeconomics 1 18 Syll No BA03 62 TOPIC No 10 PMc Ppc SUMMARY 1 Do you know the characteristics of monopolistic competition 2 Do you know why there is a need for nonprice competition in this market structure 3 Do you know how to determine the profit maximizing output level under monopolistic competition in the short run and long run 4 Is there any difference between perfect competition and monopolistic competition SP BUSINESS SCHOOL MODULE Microeconomics 1 18 Syll No BA0362 TOPIC NO 11 OLIGOPOLY Keywords Dominant firms kinked demand curve collusion and cartels price leadership Objective Students should be able to 111 Characteristics of oligopoly 112 Describe brie y the kinked demand curve in oligopoly 113 Describe cooperative behaviour in oligopoly Ref Books Economics 19th Edition by Campbell R McConnell Stanley L Brue amp Sean M Flynn McGraWHill Irwin 2012 Compiled by SP Business School Chapter 14 Singapore Polytechnic School of Business Economics Pearson Publishing 2009 Chapter 15 SP BUSINESS SCHOOL MODULE Microeconomics 1 19 TOPIC NO 11 Syll No BA0362 1 Introduction Oligopoly an imperfectly competitive market structure in which a few large firms dominate the market 2 Characteristics of oligopoly a 1 Small number of relatively large firms A few large firms supplying most of the output in the market Small number of firms gives each firm a substantial degree of market power but also generates mutual interdependence What is mutual interdependence Homogeneous or differentiated products Under oligopoly firms can produce either a homogeneous or a differentiated product Oil sold by Saudi Arabia is identical to the oil from Iran Similarly zinc copper and aluminium are standardized products Cars tyres bread are also differentiated products sold in oligopolies Personal Notes Examples Industries such as steel aluminium cars aircrafts oil Example When General Motors GM considers a price hike or style change it must predict how Ford and DaimlerChrysler will change their prices and styling in response SPI EUSINESS SCHOOL MODULE Microeconomics TOPIC NO 11 120 Syll No BA0362 Implication Firms in an oligopoly often compete through nonprice competition such as advertising and product differentiation to try to capture business away from their rivals This explains why i Advertising expenditures are large in soft drink athletic shoe and car industries amp ii Research amp development function is so important c Barriers to entry Similar to monopoly barriers to entry in an oligopoly protect firms from new entrants Price amp Output Decisions for An Oligopolist The presence of mutual interdependence among firms in an oligopoly more difficult to analyse than perfect competition monopoly or monopolistic competition WHY There are many models to explain oligopoly but we shall focus on 2 broad models Personal Notes WHY SPB US m Collusion is a situation in which firms act together and in agreement collude to fix prices divide a market or otherwise restrict competition MODULE Microeconomics 121 Syll No BA0362 TOPIC NO 11 1 No collusion kinked demand curve and 2 Collusion cartel price leadership Personal Notes Kinked Demand Curve This model tries to explain the price rigidity often observed in oligopolistic industries The kinked demand curve is a demand curve facing an oligopolist that assumes rivals Will match a price This model assumes that decrease but ignore a price increase the current price and quantity are given Implications 1 The demand curve facing the firm is highly elastic When it increases its price above the current level Reason 2 The demand curve facing the firm is very inelastic When it decreases its price below the current level Reason Since demand is elastic above the current price and inelastic below it there is a kinked in the demand curve facing the firm at the current price SP BUSINESS SCHOOL MODULE Microeconomics 122 Syll No BA0362 TOPIC NO 11 strong tendency for oligopolists not to change the prevailing price Refer to Figure Kinked demand curve facing an oligopolistic firm Price costs D Q Quantity MR2 Demand curve facing the oligopolist is DD1D2 The kink is at point D1 price is at P and quantity is at Q The demand curve is much more elastic above the kink than below it MR curve is DABMR2 SP BUSINESS SCHOOL MODULE Microeconomics 123 Syll No BA0362 TOPIC NO 11 Note that every demand curve has its own corresponding MR curves DA is the MR curve corresponding to the demand curve DD1 BMR2 is the MR curve corresponding to the demand curve D1D2 The kink at D1 on the demand curve causes the discontinuity in the MR curve ie between A and B The presence of this discontinuity in the MR curve means that any shifts in marginal costs between A and B no change in price or quantity MC Will continue to equal MR at P and Q Weaknesses of model 1 Empirical evidence do contradict the theory as price increases are sometimes matched by rivals Whereas price decreases sometimes remain unmatched 2 Firms do change their prices When cost conditions change Cartels Mutual interdependence in the oligopoly market structure and the intense competition encourages firms to collude to maximise profits This is particularly true if the firms are selling standardized products One form of collusion is the cartel When firms form a cartel they act like a monopoly What is a camel The goal is to reap monopoly profits by cooperation to control output and therefore increasing the price For example members of Organisation of Petroleum Exporting Countries OPEC divide crude oil output among themselves according to quotas agreed upon at meetings Problems of cartels 1 Firms find it difficult to agree on the amount each SP BUSINESS SCHOOL MODULE Microeconomics 124 Syll No BA0362 TOPIC NO 11 will reduce its output to push up the price 2 Once price is raised individual firms may cheat by offering secret discounts or producing more than their quota to increase profit This will destroy the cartel s monopoly power 3 Difficult to enforce the agreement since no penalties are imposed on the offending nation Price Leadership a model of informal collusion Personal Notes Price leadership is a pricing strategy in which a dominant firm sets the price for an industry and the other firms follow Firms in an industry simply match the price of perhaps but not necessarily the biggest firm For example suppose GM increases the price per car Other car makers quickly follow the leader s example and boost the price of their cars by an equal amount SUMMARY 1 Do you know the characteristics of an oligopoly 2 Do you know the meaning of mutual interdependence 3 Can you explain the kinked demand curve model 4 Can you explain nonprice competition cartels and price leadership SP BUSINESS SCHOOL MODULE Microeconomics 125 Syll No BA0362 TOPIC NO 11 SP BUSINESS SCHOOL
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