Eco Lecture Notes 20

Lecture 1 & 2: Introduction to Economics & the Market Economy
Objectives
After working through this topic you should be able to: Explain the concepts of scarcity and opportunity cost Identify the basic choices facing any economy Describe the essential structure of a market economy/system Explain and use the supply and demand model. Identify and explain the role of prices in the market system
Key Concepts
scarcity opportunity cost allocation of resources circular flow model demand supply equilibrium equilibrium price comparative statics role of prices
Scarcity, Choice & Cost

Virtually all resources (i.e. land, labour, capital) are scarce - i.e. there are not enough to satisfy all the wants of all people in any given period. Hence: Choices have to be made amongst all the alternative uses of the resources - all the goods that could be produced Such choice inevitably involves a cost in terms of the foregone alternatives - the opportunity cost Opportunity cost = value of the most highly valued foregone alternative = value of the resource in its next best alternative use
Allocation of Resources
Because of scarcity, every economy/society has to have some means of organising the allocation of resources such that three major decisions are made: 1. What to Produce - what goods & in what quantities 2. How to produce the goods - the methods of production 3. Who gets the output - a fair distribution
Now try seminar question 1

Economic Systems
An economic system is the method of organising the allocation of resources. Two polar cases are: Market system - a mode of organisation in which resource allocation is determined by the independent decisions and actions of individual consumers and producers. Centrally planned economy - a mode of organisation in which all resource allocation is determined by the decisions of government bodies The UK, in common with most other industrial societies, relies primarily on a market system. However, there is also some government direction of resource allocation - the UK is an example of a mixed economy.
The Workings of a Market Economy

Structure
The following diagram shows the basic structure of a market system (ignoring the role of government)
Expenditure
Product Markets
Revenue
Goods demanded
Goods supplied
Households
Inputs supplied
Firms
Inputs demanded
Incomes
Factor Markets
Costs
Flow of goods and services Flow of money
Figure 1-1: The Circular Flow Model
Firms sell goods to households and buy inputs from households. Households buy goods from firms and sell inputs to firms The demand and supply in product and factor markets determine the prices of goods and inputs respectively.
Demand and Supply Model

How are all the individual buying and selling decisions taken in a market system co-ordinated? Answer - via price changes. Prices are determined by and, in turn, co-ordinate buying and selling (i.e. demand and supply) decisions in markets. The demand and supply model shows how prices fulfil this crucial co-ordinating role
Demand
A demand function for a good A can be written as follows:
D A = F ( PA , Y , Ps , PC , T ) i.e. the demand for a good A (DA) depends upon: Price of the good (PA) Income of consumers (Y) Prices of related goods - complements (PC) and substitutes (PS) Tastes (T) - preferences of consumers A demand schedule shows the relation between the market price (PA) and the quantity demanded of a good during a given time period, all other determinants held constant (ceteris paribus) Numerical example: Demand Schedule Pri ce pe r uni t Q ua nti ty pe r pe ri od 19 18 17 16 15 14
2 4 6 8 10 12
14 12 Price per unit 10 8 6 4 2 0 0 10 20 30 Quantity per period D
If the price changes - a movement along the demand curve
If another variable changes - a shift in the demand curve e.g. an increase in income shifts the demand curve to the right (normal good) or to the left (inferior good)

Supply
A supply function for a good A can be written as follows: S A = F ( PA , PF , T ) i.e. the supply of a good A (SA) depends upon: Price of the good (PA) Prices of inputs (factors) (PF) Technology - the available production methods A supply schedule shows the relation between the market price (PA) and the quantity of a good firms are willing to supply in a given period of time, all other determinants held constant (ceteris paribus) Numerical example: Supply Schedule Pri ce pe r uni t Q ua nti ty pe r pe ri od 4 8 12 16 20 24
2 4 6 8 10 12
14 12 Price per unit 10 8 6 4 2 0 0 10 20 30 Quantity per period S
If the price changes - a movement along the supply curve If another variable changes - a shift in the supply curve e.g. if the wage rate paid to labour increases, the supply curve shifts to the left.

Equilibrium
The concept of equilibrium is central to microeconomic models. Equilibrium is a position of balance, which persists because there is no incentive for anyone to change their behaviour. Market equilibrium exists when demand = supply ; i.e. when the amount consumers want to buy at a particular price equals the amount firms want to sell at that price. The price which equates demand and supply (i.e. clears the market) is the equilibrium price. Numerical example: Market equilibrium Pri ce pe r uni t Qua ntity dem ande d per peri od 19 18 17 16 15 Qua ntity supp lied per perio d 4 8 12 16 20
2 4 6 8 10
12
14
24
14 12 Price per unit 10 8 6 4 2 0 0 10 16 D 20 30 S
Quantity per period
The equilibrium price is 8 and the equilibrium quantity traded is 16 If price is above equilibrium - excess supply (glut) - price falls If price is below equilibrium - excess demand (shortage) - price rises
Comparative Statics
What happens if one of the held constant variables determining demand and/or supply changes? Clearly, a new equilibrium price and quantity will occur. Numerical example: Decrease in Income Suppose that consumers incomes decrease (and the good is normal) - the demand curve shifts to the left as less is demanded at every price. Assume that demand falls by 5. Pri ce pe r uni t Ol d Qu ant ity de ma nd ed pe r pe rio d Ne w Qu ant ity de ma nd ed pe r pe rio d Q u a n ti t y s u p p li e d p e r
p e ri o d 2 4 6 8 10 12 19 18 17 16 15 14 14 13 12 11 10 9 4 8 1 2 1 6 2 0 2 4
14 12 Price per unit 10 8 6 4 2 0 0 10 12 16 D1 20 30 D2 S
Quantity per period
The new equilibrium price is 6 and quantity traded is 12; i.e. both quantity and price fall.
Now try seminar questions 4 & 5
The Role of Prices

The demand and supply model clarifies the fundamental role of prices in the market system. Specifically, prices perform the following essential functions: Prices convey information - about relative scarcity or abundance of goods and inputs to households and firms Prices ration scarce resources - by equating demand and supply
Prices determine incomes - a households income from the market depends on the prices of the inputs it supplies to the market.
The Market Economy: Seminar Questions

1. Evaluate each of the following statements: a) b) c) 2. A society can always produce more automobiles if it chooses to do so. Hence, there can never be any real scarcity of automobiles. Governments have the power to raise all the money they want by taxation. Hence, scarcity is not a problem for governments. Citizens of Sweden are lucky because they have free health care, while citizens of the United States have to pay for it.
Explain what happens to the demand curve for a good when the following changes occur, ceteris paribus. a) b) c) A rise in the price of a substitute good A rise in the price of a complementary good A fall in the price of the good
3.
Explain what happens to the supply curve for a good when the following changes occur, ceteris paribus a) b) c) A fall in the price of components used to make the good An improvement in the productivity of the labour producing the good A rise in the price of the good. D = 80 2 P + 5I
4.
Suppose that the market demand curve for haircuts in some town is:
where D is quantity demanded per month, P is price per haircut, and I is consumer income (in tens of thousands of pounds). The supply curve is: S = 2P where S is the quantity supplied per month. a) b) c) 5. According to this model, are haircuts a normal or inferior good? Suppose I = 3. find the equilibrium price and quantity of haircuts. Because of a recession, I falls to 2. What happens in the haircut market?
In the late 1980s, improvements in technology led to a dramatic lowering in the price of fax machines. Use a supply and demand model to predict the impact of this development on the overnight document-delivery business. Use the diagram to predict changes in the number of pieces of overnight mail, and the price per piece.
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Lecture 3 & 4 : Consumer Choice
Objectives
After working through this topic you should be able to: Describe the fundamental axioms of consumer preferences Explain the concept of an ordinal utility function Define and explain the properties of indifference curves Define and explain the consumers budget constraint Predict the effects of changes in prices and/or income on the budget line Describe and explain the conditions for consumer equilibrium
Key Concepts
completeness consistency/transitivity non-satiation ordinal utility function indifference curve marginal rate of substitution budget line relative prices consumer equilibrium utility maximisation
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Basic Model of Rational Choice

The model of rational choice is fundamental to microeconomic analysis. Given scarcity, individuals (and firms) must make some choice about how to use their scarce resources. Microeconomics assumes that these decisions are made rationally - i.e. resources are allocated so as to maximise the benefit gained from them. The consumer choice model (and all other models of choice) contains three essential elements (or steps): 1. Preferences - what the consumer wants to do 2. Budget constraint - what the consumer can afford to do 3. Consumer equilibrium - the rational choice given the consumers preferences and budget constraint - the choice that maximises benefit subject to the budget constraint
Preferences
The consumer is assumed to have preferences over different combinations (bundles) of goods which obey certain basic rules (axioms)
Axioms
Completeness - given any two bundles A and B the individual either prefers A to B, B to A, or is indifferent between them. Consistency (Transitivity) - given any three bundles A, B and C, if A is preferred to B and B to C then A must be preferred to C. Non-satiation - the consumer always prefers more to less. So if bundle A contains more of at least one good and no less of any other than bundle B, then bundle A is preferred to B

Ordinal Utility Function
In order to rank bundles according to a consumers preferences we could attach some (arbitrary) number to each bundle. Call this number the utility of the bundle and use the notation U(A) to indicate the utility of bundle A. These numbers comprise an ordinal utility function with the following properties If U(A) > U(B) then A is preferred to B. If U(A) = U(B) then the consumer is indifferent between bundles A and B
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U(A) > U(B) simply means that A is preferred to B, but we cannot say by how much; utility is ordinal not cardinal. Assuming 2 goods, X and Y, in each bundle we can write the utility function as: U = U ( X ,Y) where: X = units of good X Y = units of good Y U = utility of bundle X, Y
Indifference Curves
An indifference curve shows the bundles of two goods (e.g. X and Y) which have the same level of utility: i.e. U = U ( X ,Y) where U is fixed at some chosen level of utility. The axioms of preferences imply that indifference curves have the following important properties: 1. Negatively-sloped - this follows from the assumption of nonsatiation. See the diagram below.
Good Y
More preferred region E U
Less preferred region
Good X
Consider the bundle of X and Y shown by point E. All bundles to the north east must be preferred to E as they include more of at least one of the goods (or more of both). All bundles to the south west must be less preferred to E as they include less of at least one of the goods (or less of both). Hence, only bundles in the other two quadrants (which include more of one good and less of the other) can be indifferent to E. Thus, the indifference curve U must be negatively sloped. The slope of an indifference curve is called the Marginal Rate of Substitution (MRS) MRS = the amount of one good the individual is willing to give up for an additional unit of the other good whilst remaining as well off (i.e. on the same indifference curve)
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Y MRSY , X = X The MRS can also be expressed in a different way as the following shows: Given the utility function: U = U ( X ,Y) the change in utility (U) is as follows: U = MU X X + MU Y Y i.e. the change in utility equals the marginal utility of good X (MUX) times the change in units of X ( X) plus the marginal utility of good Y (MUY) times the change in units of Y (Y) Marginal utility is the increase in total utility gained from consumption of one more unit of the good Now, along an indifference curve U = 0 (by definition). Hence, MU X X + MU Y Y = 0 and, finally, rearranging this expression gives the following: Y MU X = X MU Y Thus, we can see that the MRS is equal to the ratio of the marginal utilities; i.e. MRSY , X = MU X MU Y
2. Convex to the origin - this property results from the assumption that the MRS diminishes as we move along an indifference curve. See the following diagram.
Good Y U2 > U1 2 1 0.5 1 U2 U1 Good X
When the individual has a relatively large amount of good Y he/she is willing to give up 2 units of Y in return for one more
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unit of good X and still feel as well off. However, as we move down the indifference curve, the individual will only sacrifice less of Y (e.g. 0.5 units) for one more unit of X as he/she begins to have to relatively more of X than Y. 3. More utility the further from the origin - because of nonsatiation, indifference curves further from the origin (with more of both goods) must represent higher levels of utility. (See diagram above where U2 > U1) 4. Cannot intersect - the axiom of transitivity implies that indifference curves cannot intersect each other.
Budget Constraint
The individuals consumption possibilities depend on his/her income (I) and the prices of the two goods (PX & PY). Together these three parameters determine the budget constraint. The budget line shows the maximum amounts of each good that could be purchased by spending all the income.
Budget Line
The equation of the budget line is as follows: PX X + PY Y = I i.e. the amount spent on good X (= price per unit of X times the number of units bought) plus the amount spent on Y (= price per unit of Y times the number of units bought) must equal the total income available. Numerical example: Budget Constraint Assume: U n i t s o f X 0 1 0 I = 20, PX = 4, PY = 2 U n i t s o f Y
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1 2 3 4 5
8 6 4 2 0
A Budget Line
12 10 8 Good Y 6 4 2 0 0 1 2 3 Good X 4 5 6
Note that the two endpoints of the budget line are equal to income divided by the respective price (I / P), as they represent the units bought of one good when all income is spent on that good
Slope of the Budget Line

The slope (gradient) of the budget line can be deduced as follows: I PY P Y ( Absolute) Slope = ( ) = = X I X PY PX i.e. the slope of the budget line equals the relative price of good X to good Y. In other words, the slope tells us the rate at which the individual can trade off one good for the other - e.g. the amount of Y that has to be foregone in order to purchase one more unit of X Numerical example The gradient of the budget line above is: PX 4 = =2 PY 2 i.e. two units of Y have to given up in order to buy one more unit of X
Shifts in the Budget Line

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Any change in one or more of the parameters of the budget line (income and prices) will clearly result in a shift in its position. A change in income shifts the budget line parallel to the original line - relative prices are unchanged. A change in the price of one good shifts the budget line and changes its slope - relative prices are different. An equal percentage change in the price of both goods shifts the budget line parallel to the original - relative prices are unchanged Numerical example Assume that the price of good Y rises to 4, so that the parameters of the budget line are now: I = 20, PX = 4, PY = 4 Units of X 0 1 2 3 4 5 Units of Y (Old) 10 8 6 4 2 0 Units of Y (New) 5 4 3 2 1 0
A Budget Line
12 10 8 Good Y 6 4 2 0 0 1 2 3 Good X 4 5 6 New Old
A rise in the price of good Y, ceteris paribus, swivels the budget line inwards. The relative price of good Y to good X is now equal to one.
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Consumer Equilibrium
The rational consumer wants to maximise his/her utility subject to their preferences and budget constraint; i.e. he/she will choose from the affordable bundles of goods the one which gives them the most utility.
Utility Maximisation
Specifically, the consumer chooses the point on the budget line which is on the highest attainable indifference curve - point E in the following diagram.
Good Y C At point E MRS = PX / PY
Y* D
E U2 U1 B X* Good X
At E, utility is maximised subject to the budget constraint. Why? Because any other point on the budget line (e.g. points A & B) or within it (e.g. point D) is on a lower indifference curve. Bundles beyond the budget line (e.g. point C) are, of course, unobtainable. At point E the consumer is in equilibrium as they have no incentive to consume another bundle given their preferences and budget constraint.
Equilibrium Conditions
Looking at the diagram it is clear that two conditions characterise the optimum point E: 1. All income is spent - the individual must choose a point on the budget line not within it. 2. The slope of indifference curve (U2) equals the (absolute)slope of the budget line: i.e. MRSY , X = PX PY
In other words, at the equilibrium bundle, the rate at which the consumer is willing to trade good X for good Y (MRS) is exactly equal to the rate at which he/she can trade good X for Y (relative price). Why should this be so?
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Consider point A. Here the MRS > relative price; e.g. the consumer is willing to give up, say, 2 units of Y to get one extra unit of X, whilst the actual trade off (relative price) is, say, 1:1. The consumer can thus increase utility by buying more of X and less of Y; e.g. buy 2 units less of Y and buy 2 units of X instead. But at point A only one more unit of X would have compensated for giving up 2 units of Y - getting 2 units of X means the consumer is better off. Thus at point A the consumer was not maximising utility. Only when the MRS = relative price will a reallocation of expenditure between the two goods produce no further gains in utility.

Note: We can express the consumer equilibrium condition in another way. Remember that the MRS equals the ratio of the marginal utilities; Hence we can write the (second) equilibrium condition as: MU X P = X MU Y PY i.e. in equilibrium, the ratio of the marginal utilities equals the ratio of the prices. Alternatively, we can rearrange this condition to read: MU X MU Y = PX PY This tells us that, in equilibrium, the marginal utility of the last pound spent is the same for each good.
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Consumer Choice: Seminar Questions

1. A computer expert is offered a choice between 10 floppy disks and 5 software manuals, or 9 floppy disks and 20 software manuals. All you know about the persons preferences for disks and manuals is that they satisfy the three axioms. On the basis of this information alone, can you predict which bundle the person will choose? Explain why indifference curves cannot intersect. What would the indifference curves look like for the following types of goods: a) b) c) 4. Perfect substitutes? Perfect complements? Good X much more preferred to good Y by an individual?
2. 3.
Given the following information about an individuals consumption possibilities between two goods, X and Y. I = 100; PX = 10; PY = 5 a) b) Calculate and draw the individuals budget line Show what happens to the budget line when: i) ii) iii) Income decreases by 20% PY rises by 40% Both prices fall by 10%
Start from the original budget line in each case 5. Explain why the consumer would not be in equilibrium at point B in the following diagram. What should the consumer do?
Good Y
Y*
E U2 U1 B X* Good X
6.
Explain why consumer equilibrium requires that the marginal utility per last pound spent on each good must be equal. (Hint: explain why the rational consumer would change his/her expenditure if they were not equal.)
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7.
The following table gives four indifference curves of an individual. U1 A B C F G a) b) c) d) X 3 4 6 9 14 Y 12 7 4 2 1 X 6 7 9 12 15 U2 Y 12 9 6 4 3 X 8 9 11 15 19 U3 Y 15 12 9 6 5 X 10 12 14 18 20 U4 Y 13 10 8 6.4 6
Using graph paper, plot the four indifference curves on the same set of axes. Label the points A, B, C, F & G on U1. Calculate the marginal rate of substitution between the various points on U1 Can we tell how much better off is the individual on U2 than on U1? Suppose that the individual has an income (I) of 15 per time period, the price of good X (PX) is 1 and the price of good Y (P Y) is also 1. i) ii) iii) What is the equation of the budget line of this individual? What is its slope? Draw the budget line on your graph.
e)
Where is the individual maximising utility? (Label it point E) How much of X and Y should he/she purchase at the optimum? What are the general conditions for utility maximisation subject to the budget constraint? Why is the individual not maximising utility at point A? At point G? Why cant the individual reach U3 or U4?
f) g)
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Lecture 5 & 6 : Comparative Statics & Demand
Objectives
After working through this topic you should be able to: Derive the individuals demand curve for a good Show the effects of a change income on consumption of normal and inferior goods Define and calculate price elasticity of demand Explain the relationship between price elasticity and total expenditure Explain how price elasticity varies along a linear demand curve Define and calculate income elasticity of demand Define and calculate cross-price elasticity of demand
Key Concepts
price consumption curve individual demand curve income consumption curve Engel curve market demand curve price elasticity of demand point elasticity arc elasticity total expenditure linear demand curve income elasticity of demand cross-price elasticity of demand
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Price Change: Derivation of Demand Curve

A change in the price of one of the goods, ceteris paribus, will clearly change the position (and slope) of the budget line leading to a new equilibrium bundle. Hence the amount consumed of each good will change. The following diagram shows how to derive the individuals demand curve for good X.
Good Y
E1
E2
E3
PCC U2 U1 U0 Good X
Price of good X
DX
X1
X2
X3
Qty of Good X
As PX falls the optimum point changes. The line drawn through the optimum points is called a price consumption curve (PCC) As PX falls the quantity the individual would like to consume of good X rises. Hence, in the bottom half of the diagram, we can derive the individuals demand curve for good X given income, price of good Y and preferences. The model of rational consumer choice predicts that an individuals demand curve for a good is downward-sloping (the reasons why this is generally the case are discussed more explicitly in the next topic - see income and substitution effects)
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Income Change
When the persons income changes, ceteris paribus, the budget line will shift parallel to the original. Note that as the prices of the goods are constant this represents a change in both nominal and real income.
Normal Good
For a normal good a rise in income will lead to a rise in the consumption of the good. The diagram below illustrates this case.
Good Y
ICC Y2 Y1 E2 U2 U1 X1 X2 Good X
E1
Both goods here are normal - as income increases, consumption of both goods rises. The line connecting the points of equilibrium is called an income consumption curve (ICC).
Inferior Good
Some goods are inferior - i.e. when income increases, ceteris paribus, consumption of the good falls. A possible explanation is that consumers regard these goods as being of low quality compared to other alternatives - once their income has risen sufficiently they switch their expenditure to the alternative goods. Possible examples of inferior goods include tobacco, coal, bread & cereals, black & white T.V.s.

Deriving an Engel Curve
An Engel curve shows the relationship between income and the amount consumed of a commodity, ceteris paribus. It can easily be derived via the income consumption curve, as the following diagram shows:
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Good Y
ICC E2 U2 U1 Good X Income I2 I1 I3 Engel curve
E3
E1
X3
X1 X2
Qty of Good X
This shows the Engel curve for good X - as X is normal, the Engel curve will be positively sloped.
Market Demand Curve

Above we derived an individuals demand curve for a commodity. When looking at the market for a particular commodity, we are more concerned with the total market demand for the commodity - i.e. the total demand for the good at each price. The market demand curve of a good shows the relationship between the price and the quantity demanded by all market participants, ceteris paribus. To derive the market demand curve we simply add up at each price the amount demanded by each individual - as quantity is measured on the horizontal axis, this is referred to as the horizontal summation of the individual demand curves. (See Katz & Rosen, p 71, Figure 3.13)
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Elasticity of Demand
Elasticity of demand measures the responsiveness of the quantity demanded of a good to a change in one of its determinants, ceteris paribus. It tells us how much demand changes when own-price, income or the price of another good changes, ceteris paribus. Elasticity uses percentage changes - it is unit free Elasticity tells us how many times greater the percentage change in quantity demanded is compared to the percentage change in price etc. Three demand elasticities can be calculated - (own-)price, income, cross(-price)
Price Elasticity of Demand

Price elasticity of demand () measures the percentage change in the quantity demanded per period with respect to the percentage change in the price of the good, ceteris paribus (i.e. assuming income and prices of other goods remain constant). The formula is as follows: = ( ) % X % P
where %X is the percentage change in the quantity demanded of good X and %P is the percentage change in the price per unit of good X Because demand curves slope downwards, the percentage changes in quantity and price have opposite signs, and their ratio is negative. Hence the minus sign at the front simply makes the elasticity a positive number. This is OK as it is the magnitude (not the direction) of the change in demand which we are concerned with.
Calculation of Price Elasticity

There are two ways to compute the value of price elasticity depending on whether small or large changes in price are being considered: 1. Point Elasticity - this is used when the price change is small. It is calculated as follows: = ( ) X / X P / P X P = ( ) P X
where X and P represent the initial quantity and price respectively. Note that the second line of the formula indicates that point elasticity
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can be calculated by multiplying the inverse of the slope of the demand curve (X/P) at a particular point by the corresponding ratio of P to X - hence the term point elasticity. Numerical example Calculate the price elasticity of demand for good X when price changes from 20 to 20.50 and quantity demanded changes from 300 units to 290 units per month. X = 290 - 300 = -10; X = 300; P = 20 Hence, = ( ) X / X P / P 10 / 300 = ( ) 0.5 / 20 - 0.033 = ( ) 0.025 = 1.32 P = 20.5 - 20 = 0.5
2. Arc Elasticity - this is used when the price change is relatively large. It is calculated using the following formula: = ( ) X / X P / P
where X-bar and P-bar are the average quantity and average price respectively; i.e. X = P= Numerical example Calculate the price elasticity of demand for good X when price changes from 20 to 25 and quantity demanded changes from 300 units to 220 units per month. X = 220 - 300 = -80; 300 + 220 X = = 260 2 20 + 25 P= = 22.5 2 Hence, P = 25 - 20 = 5
( X1 + X 2 )
2 ( P1 + P2 ) 2
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= ( )
X / X P / P 80 / 260 = ( ) 5 / 22.5 - 0.308 = ( ) 0.222 = 1.387

Range & Meaning of Elasticity
Price elasticity can range between a value of zero and infinity. The values of zero, one and infinity are special cases. In general, elasticity will be either less or greater than one. Inelastic demand ( < 1). A given % change in price leads to a smaller % change in demand. Elastic demand ( > 1). A given % change in price leads to a larger % change in demand. Perfectly inelastic ( = 0). A given % change in price leads to no change in demand - a vertical demand curve. Unit elastic ( = 1). A given % change in price leads to an equal % change in demand. Perfectly elastic ( = ). Any increase in price (however small) leads to zero demand. Hence, a horizontal demand curve consumers will purchase as much as they want at the going price, but only at that price.
Determinants of Price Elasticity

What makes the demand for some goods elastic and the demand for others inelastic? The main determinants of price elasticity of demand are as follows: Substitutability - the ease with which one good can be substituted for another. The more and closer substitutes available for a good, the more elastic the demand tends to be. Hence, narrower categories of good tend to have a higher elasticity than broader categories (see figures below) Commodity share - the proportion of income spent on the good. In general, the larger the % of income absorbed by the good, the higher the elasticity, ceteris paribus. Time - demand tends to be more elastic in the long-run as consumers often need time to adjust their spending patterns (e.g. find substitutes)
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Empirical Estimates of UK Demand

The following table gives some estimates of price elasticity of demand for various categories of good in the UK. Category of Good Pric e Elas ticit y 0.47 0.52 0.83 0.89 1.02 0.05 0.22 1.40 1.63 2.61
Fuel & Light Food Alcohol Durables Services Dairy Produce Bread & Cereals Entertainment Expenditure abroad Catering
Price Elasticity & Total Expenditure

An important relationship exists between the price elasticity of demand and the total expenditure by consumers on a good. Total expenditure is the total amount of money spent by consumers on a commodity. It is computed as the price per unit (P) times the number of units purchased (X); i.e. Total expenditure = P x X On a diagram, total expenditure is shown by an area under the demand curve, as indicated below:
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Price per unit
P1
Total expenditure
X1
Qty per period
As the price of a commodity falls, the quantity demanded rises (ceteris paribus) - i.e. they move in opposite directions. But as total expenditure is price times quantity its clear that total expenditure may either rise or a fall depending on which is the largest change, the price fall or the quantity increase. The former tends to reduce expenditure, the latter to increase it. (Obviously, the same considerations apply for a price rise/quantity fall). The size of the change in price and quantity must be measured in percentage terms, not absolute units (as different units give different answers). And, of course, price elasticity tells whether the percentage change in price or quantity is the largest. Hence we can deduce the results shown in the following table: If demand is Elastic Inelastic and price rises falls rises falls then total expenditure falls rises rises falls
Linear Demand Curve

By definition a linear (i.e. straight line) demand curve has a constant slope, where the slope is the ratio of the absolute change in quantity to the absolute change in price. But remember elasticity is defined as the ratio of the percentage changes. Thus, price elasticity and the slope of a demand curve, although connected, are not the same. And, a linear demand curve will not have a constant elasticity at each point.
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To see how elasticity varies along a linear demand curve, we can use the relationship between price elasticity and total expenditure. Consider the following example: Price per unit 2 4 6 8 10 12 14 16 Quantity demanded per week 50 45 40 35 30 25 20 15 Total expenditure 100 180 240 280 300 300 280 240
Here we have a linear demand curve (with a slope equal to -5/2). Note that when price rises from 2 through to 10 total expenditure is rising - i.e. for that price range, demand is price inelastic. As price rises from 12 up to 16 (and above), total expenditure is falling hence in this price range demand is price elastic. The conclusion is that along a linear demand curve, elasticity is less than one at relatively low prices, and greater than one at relatively high prices. And thus at some price in the middle elasticity must be equal to one. From the table, its clear that = 1 at price = 11

The following diagram neatly shows how price elasticity varies along a linear demand curve.
Price per unit = >1 =1 <1 D =0 Qty per period
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Income Elasticity of Demand

Income elasticity (I) measures the percentage change in the quantity demanded with respect to the percentage change in consumers income, ceteris paribus. Its is calculated using the following formula: = % X % I
where %X is the percentage change in the quantity demanded of good X and %I is the percentage change in income
Range & Meaning

Income elasticity can be either positive (normal good) or negative (inferior good). If 0 < I < 1, then quantity demanded rises by smaller percentage than income implying that consumers do not spend much of any increase in income on this particular good; if I > 1 then quantity demanded rises by larger percentage than income implying that quantity demanded is quite responsive to changes in income. The former goods are often called necessities and the latter luxury goods. The following table summarises this information. If income elasticity is Negative Positive (and < 1) Positive (and > 1) the good is Inferior Normal & a Necessity Normal & a Luxury
Empirical Estimates
The following table gives some estimates of income elasticity of demand for various commodity groups in the UK. Category of Good Tobacco Fuel & Light Food Alcohol Clothing Durables Services Coal Income Elasticity -0.50 0.30 0.45 1.14 1.23 1.47 1.75 -2.02
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Bread & Cereals Dairy Produce Vegetables Travel abroad Recreational goods Wines & spirits
-0.50 0.53 0.87 1.14 1.99 2.60

Cross-Price Elasticity of Demand
Cross-price elasticity (xy) measures the percentage change in the quantity demanded of good X with respect to the percentage change in the price of good Y, ceteris paribus. Its is calculated using the following formula: xy = % X % PY
where %X is the percentage change in the quantity demanded of good X and %PY is the percentage change in the price of good Y.
Range & Meaning

Cross-price elasticity can be either positive or negative. If xy > 0, the two goods are substitutes for each other as an increase in the price of Y induces a rise in the quantity demanded of good X. Conversely, if xy < 0, the two goods are complements. Also, the greater the absolute value of the cross elasticity the greater the degree of substitutability or complementarity between the two goods. The following table summarises these results. If cross-price elasticity is Negative Positive the goods are Complements Substitutes
Empirical Estimates
The following table gives some estimates of cross-price elasticity of demand for various commodity groups in the UK. With respect to a 1% change in price of
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% change in quantity demanded of Food Clothing & Footwear Travel & Communication
Food 0.37 0.19 0.42
Clothing & Footwear -0.03 0.30 -0.01
Travel & Communication -0.12 -0.23 0.61
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Comparative Statics & Demand: Seminar Questions

1. Draw a diagram to illustrate the effect on the individuals utility maximising choice of an increase income such that good Y is an inferior good. Read pages 72 to 74 in Katz & Rosen and then answer the following questions; a) Consider an individual who spends his/her weekly income on food and all other goods, whose current equilibrium position in shown in the diagram below.
2.
All other goods
Y1
E1 U1
X1
Food
Suppose the government gives the individual an in-kind transfer of food (which cannot be resold by the individual). Show the effect on the budget line b) Suppose that instead of an in-kind transfer the government gives the individual a cash transfer equal to the market value of the food transfer. Show the effect on the initial budget line. Add indifference curves to show the cases where: i) ii) d) 3. the individual prefers the cash transfer the individual is indifferent between the cash and in-kind transfers
c)
What difference does it make if the in-kind transfer of food can be resold by the individual?
Calculate price elasticity of demand in the following cases using the most appropriate method. a) b) When the price of good Z falls from 3000 to 2500, the quantity demanded rises from 4 million to 5 million units per year. When the price of good Y rises from 50 to 51, the quantity demanded falls from 120 to 110.
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4.
Referring to the empirical estimates of price elasticity shown in the table: a) b) c) How would you explain the estimates shown in the table? If the price of alcoholic drinks increased by 5%, ceteris paribus, what would happen to the quantity demanded If the government (for energy conservation reasons) wanted to reduce consumption of fuel and light by 20%, how much would it have to raise the price?
5.
The diagram below provides information on Maries consumption of cake before and after an increase in the price of cake. According to the diagram, is Maries price elasticity of demand for cake greater, less than, or equal to one?
All other goods
Cake
6.
Confirm the change in elasticity along a linear demand curve by calculating the price elasticities for the following price and quantity changes taken from the demand schedule in the text. a) b) c) Price rises from 4 to 6, quantity falls from 45 to 40 Price rises from 12 to 14, quantity falls from 25 to 20 Price rises from 10 to 12, quantity falls from 30 to 25
7.
Between 1980 and 1987 the percentage share of total consumers expenditure in the UK taken by spending on food fell from 15.4% to 13.3%, whilst the share of services increased from 26.4% to 29.4%. How can the empirical estimates of the income elasticities of food and services help explain this data? Referring to the empirical estimates of cross-price elasticity of demand shown in the table: a) b) what are the figures in the diagonal (from top left to bottom right)? Are food and clothing substitutes or complements?
8.
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c)
Which commodity group has the highest cross-price elasticity? What would happen to the quantity demanded of this commodity if the price of the other good increased by 10%, ceteris paribus.
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Lecture 7 & 8 :
Price Changes & Consumer Welfare
Objectives
After working through this topic you should be able to: Distinguish between the income and substitution effects of a price change Illustrate the income and substitution effects diagrammatically Distinguish between an inferior good and a Giffen good Explain and illustrate the concepts of compensating and equivalent variation Explain and apply the concept of consumer surplus as a monetary measure of the change in consumer welfare.
Key Concepts
substitution effect income effect inferior good Giffen good compensating variation equivalent variation marginal valuation willingness to pay consumer surplus
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Income & Substitution Effects

As we deduced in the last topic, the model of rational consumer choice predicts that when the price of a good changes, ceteris paribus, the consumer will consumer more of the good (hence the downward sloping individual demand curve). Can we say more about the reasons why this negative relationship exists (and when it might not)? The answer is yes, if we consider exactly what happens to the consumers budget line when the price of one good changes, ceteris paribus. The budget line moves position implying that the consumers real income has changed (remember nominal income is assumed constant) The slope of the budget line changes implying a change in the relative prices of the two goods. This means that we can separate (analytically) the effect of a change in the price of one good (the total price effect) into its two components: 1. SUBSTITUTION EFFECT - the effect on consumption of a good resulting only from the change in its relative price (i.e. the slope of the budget line) 2. INCOME EFFECT - the effect on consumption of a good resulting only from the change in real income (i.e. the position of the budget line)
Example: A Fall in the Price of a Normal Good

The following diagram shows to separate the income and substitution effects of a fall in the price of good X, ceteris paribus.
All other goods (Y)
Y1 Y3 Y2
E1 E2
Substitution effect: E1 to E2 Income effect: E2 to E3 E3 U2 U1
X1 X2 X3
Good X
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The consumer is initially maximising utility at point E1. When the price of good X falls, the consumer moves to point E3, consuming more of good X (and less of all other goods). To separate out the income and substitution effects we employ the following technique Draw a budget line parallel to the new budget line which is tangential to the indifference curve the consumer was originally on. Using this method we get the line going through point E 2. What we have effectively done is to take away from the consumer the increase in real income brought about by the fall in the price of good X, so that he/she is back at their original level of utility but with the new set of relative prices. E1 to E2 is the pure substitution effect resulting from the change in relative price alone. It is always negative as the consumer will always consume more of the good whose relative price has fallen. E2 to E3 is the pure income effect - it is negative for normal goods (as in this case) but positive (i.e. a price fall leads to less consumption) for inferior goods. Hence in this example of a normal good the substitution and income effects reinforce each other to produce a downward sloping demand curve.
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Inferior & Giffen Goods

If a good is inferior then the income effect will be positive and will counteract the substitution effect. Two possibilities therefore can occur: 1. The positive income effect is less than the negative substitution effect and the good still has a downward sloping demand curve. 2. The positive income effect is greater than the negative substitution effect and the good has an upward sloping demand curve (as price falls, so does demand). This exceptional case is called a Giffen good.
Compensating & Equivalent Variations

A price fall (increase) makes the individual better (worse) off. Can we measure how much better or worse off? Comparing utility levels is invalid because utility numbers are arbitrary (remember that utility is ordinal not cardinal). Hence we need a monetary measure of welfare change. Our indifference curve analysis suggest two possible measures. Compensating Variation (CV) - the minimum (maximum) amount of money that has to be given to (taken away from) an individual to make them as well off as before the price rise (fall) Equivalent Variation (EV) - the minimum (maximum) amount of money which would have to be given to (taken away) an individual to make them as well off as they would have been after the price fall (rise) The following diagram illustrates these two measures for an increase in the price of good X, ceteris paribus.
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All other goods (Y) Y2
CV = Y2 - Y1 EV = Y1 - Y3
Y1 Y3 E2 EV EC E1 U2 U1 Good X
Compensating Variation
When the price of good X rises, the consumers equilibrium moves from point E1 to E2. To compensate him/her for this price rise we need to move the new budget line back till it touches the original indifference curve U2 - at point EC. Hence the compensating variation is given by the amount (Y2 - Y1)
Equivalent Variation
To compute the EV we need to measure the (maximum) amount of money we would need to take away from the individual to make them as worse off as they would be when the price of good X rises. So, move the original budget line back till it just touches indifference curve U1 - at point EV. The EV is then the loss of income given by amount (Y1 - Y3).
Comparing the CV & EV

Note that the CV and EV measures of welfare change are not equal. The reason why is that each one is measured at different relative prices. CV is measured at the new relative price ratio EV is measured at the original relative price ratio
Now try seminar questions 4, 5 & 6
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Consumer Surplus
Although useful concepts for accurately measuring welfare change, both CV and EV require knowledge of the individuals indifference map. This is difficult to obtain, so an alternative, more practical (but less accurate) measure of changes in consumer welfare is needed. The most commonly used measure is ordinary (Marshallian) consumer surplus. Consumer surplus is the difference between what a consumer is willing to pay for a good and what he/she has to pay. It is measured as the area under the demand curve and above the going price To see why consumer surplus is derived from the demand curve, we need to interpret a demand curve as a marginal valuation (or willingness to pay) schedule.
The Demand Curve as a Marginal Valuation Schedule

The standard interpretation of a demand curve is that it shows the amount the consumer would buy at each particular price (ceteris paribus). But we can also view the relationship between price and quantity the other way round; i.e. the demand curve shows the maximum price the individual is willing to pay for each additional unit. Now the price represents what the consumer is willing to give up of other goods, i.e. the value placed on each extra unit, so the demand curve can also be seen as a marginal valuation curve - it shows the value placed on each additional unit by the consumer where value is measured as the maximum price he/she is willing to pay. The following diagram illustrates the concept of marginal valuation for a good which is consumed in discrete units.
Price per unit 40 MV1 = 40 MV2 = 24
24 15 10
Qty per period
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The consumer is willing to pay a maximum price of 40 for the first unit, 24 for the second unit, etc. Hence the marginal valuation (MV) of the first unit is 40, MV of the second unit is 24 and so on. Note that the MVs are given by the areas under the demand curve hence the total value (willingness to pay) for any given number of units is measured by the total area under the demand curve up to that number of units.

Consumer Surplus
To calculate consumer surplus we need to know the actual going price paid by the consumer for each unit. The diagram below shows the consumer surplus when the market price is 15 per unit.
Price per unit 40 CS1 = 25 CS2 = 9
24 15 10
Qty per period
At price 15, the consumer buys 3 units per period. But on the first two units he is willing to pay more than 15. Hence he/she receives a consumer surplus of 25 (40 - 15) on the first unit, and 9 (24 15) on the second unit. A total CS of 34. Its clear from this that the total consumer surplus of a given number of units all bought at the going market price is the area under the demand curve and above the going price.
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Smooth Demand Curve

When the demand curve is a continuous curve rather than a step function the same principles for measuring marginal and total willingness to pay and consumer surplus still apply. The marginal value placed on a particular unit is the vertical distance from the horizontal axis up to the demand curve. The total willingness to pay is the area under the demand curve. Consumer surplus is the area under the demand curve and above the market price The two diagrams below illustrates these concepts.
Price per unit
Total value of consuming X1 units
P1
MV of X1 st unit = P1
X1
Qty per period
The total value of (or willingness to pay for) X1 units is equal to the shaded area. The MV of the X1st unit is equal to price P1.
Price per unit
Consumer surplus of consuming X1 units
P1
X1
Qty per period
The total consumer surplus gained from consuming X1 units of the commodity per period is equal to the shaded area in the diagram.
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Using CS to measure Welfare Change

Finally, we can use the CS to measure the effect on the consumers welfare of a change in the price of the good, ceteris paribus. Consider the diagram below which shows the effect of a rise in the price of a good from P1 to P2.
Price per unit Loss in consumer surplus created by the price increase P2 P1 D
X2
X1
Qty per period
Clearly, when the price rises from P1 to P2 the area of consumer surplus falls. The loss in consumer surplus (shown by the darker shaded area) is a monetary measure of the loss in welfare suffered by the consumer. More generally, When the price of a commodity changes from P1 to P2, the area behind the demand curve and between the two prices is a money measure of the resulting change in welfare.
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Price Changes & Consumer Welfare: Seminar Questions

1. 2. Draw a diagram to show the income and substitution effects of a RISE in the price of a good, ceteris paribus. This question continues on from question 7 in seminar 2. a) Assume the price of good X rises to 2. Draw the new budget line on your graph. What is the new optimum point? How much of X and Y is consumed at this point? On the diagram separate out the substitution and income effects of this price rise. Is either X or Y an inferior good? Finally, assume the price of good X falls to 0.50 (P Y still 1, I still 15). Add this new budget line to your graph. What is the optimum combination of X and Y with this budget line? (Label it point H). From your diagram, derive the price-consumption curve and the individuals demand curve for good X. (You will need to draw a separate diagram for the demand curve).
b) c)
d)
3.
Draw appropriate diagrams to show the income and substitution effects of a fall in the price of good X, ceteris paribus, where: a) b) X is an inferior good but not a Giffen good X is a Giffen good.
4.
The local swimming pool charges non-members 10 per visit. If you join the pool, you can swim for 5 per visit, but you have to pay an annual fee of F. Use an indifference curve diagram to find the value of F that would make it just worthwhile for you to join the pool. Suppose that the pool charged you exactly that value. Would you swim more or less than you did before joining? Use income and substitution effects to explain your answer. Read pages 107 to 110 in Katz & Rosen and then answer the following questions; a) Assume that low income households are choosing between food (measured in calories per week) and consumption of all other goods (measured in pounds). Show the equilibrium position on a diagram. Now suppose that the government agrees to subsidise these poorer households by paying 50% of their food bills. How will the budget line change? Show the new equilibrium. Show on the same diagram the minimum amount of income supplement the government would have to give households instead of subsiding their food bills to make them as well off as they were in situation (b).
5.
b)
c)
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d) 6.
Which policy is cheaper? Which should the government choose?
Read pages 110 to 114 in Katz & Rosen and then answer the following questions: a) b) Explain the difference between an ideal cost of living index and a Laspeyres index. Calculate the Laspeyres index for the following data showing an individuals consumption of food and fuel in 1990 and 1991 and the prices of the two commodities in those years. Quantity of food Quantity of fuel Price of food Price of fuel c) 1990 60 100 3 10 1992 40 50 4 12
Why does compensation for a price increase according to a Laspeyres index overcompensate the individual?
7. 8. 9.
What is the MV of the 3rd unit? The 4th unit. What is the total willingness to pay for 4 units? If the market price is 10, what is the CS on the 1st, 2nd, 3rd & 4th units? Calculate the total CS. Using the following diagram, calculate the change in welfare when the price rises from 12 to 15.
Price per unit ()
15 12 D
70
80
Qty per period
10.
Boriss demand curve for tennis games, D, is shown below. At the local tennis club, the cost per tennis game for member is Pt pounds. In order to become a member, one must pay an annual fee. Show on the diagram the largest fee that Boris would be willing to pay.
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49
Lecture 9 & 10 : The Firm & its Goals
Objectives
After working through this topic you should be able to: Identify the firms goal and define economic profit Distinguish between economic profit and accounting profit Define and calculate the user cost of capital Use the total revenue and total cost curves to calculate the maximum profit output level Explain and apply the marginal output rule to determine the maximum profit output level Explain the shut-down rule
Key Concepts
economic profit total revenue economic cost user cost of capital economic depreciation marginal revenue marginal cost marginal output rule shut-down rule
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Firms Objective: Profit Maximisation

All firms which operate in markets buy inputs to produce outputs to sell. A firm has to decide: 1. What to produce 2. How to produce the output 3. How much to sell and at what price 4. How to promote the product. To determine solutions to these four decisions the firm needs to have a goal (objective). Hence, to predict firm behaviour we need to be clear about the objective of a firm. The standard assumption in microeconomic theory of the firm is that: The firms goal is to maximise its economic profit
Economic Profit
Economic profit is defined as follows: Economic Profit = Total Revenue - Total Economic Cost Total revenue is the sum of the payments the firm receives from the sale of its output. What about economic cost? The following distinctions between the economists and the accountants concept of cost must be borne in mind when calculating a firms economic cost: Economic costs are opportunity costs - i.e. the value of inputs in their best alternative use. Economic cost is generally not equal to accounting cost Economic cost may be greater or less than accounting cost. Sunk expenditures are not economic costs. A sunk expenditure is a factor expenditure that, once made, cannot be recovered.
Examples
1. The owner(s) of a firm must include the opportunity cost of their labour as part of total economic cost, otherwise total accounting cost will understate total economic cost 2. Suppose that four years ago a firm leased a machine for five years at a rent of 2000 per year. What is the economic cost of using the machine for one more year? 2000? This is the accounting cost but not necessarily the economic cost. The economic cost depends on the value of the machine in its best alternative use. If the firm cannot sublet the machine then the opportunity (economic) cost is zero. And the 2000 rental payment is a sunk expenditure - it cannot be recovered by the firm. Thus, where the
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firm has sunk expenditures, accounting cost will tend to overstate total economic cost.

User Cost of Capital
What is the economic (i.e. opportunity) cost to a firm of owning and using an asset (also known as the user cost of capital)? To calculate this we need to consider what the firm foregoes by using the asset rather than selling it now. The total economic cost of using an asset is the sum of the economic depreciation and the foregone interest. Economic depreciation is the difference between the current value of the asset and the value at the end of the period i.e. it is the fall in the value of the asset over a given period of time. In other words, it is the amount the firm foregoes by not selling the asset now. The forgone interest is the amount that could be earned by selling the asset now and investing the proceeds in the next best alternative use. The value of the user cost of capital will depend on whether the firm is considering purchasing an asset, or whether it already owns it. The reason for the difference is that in the latter case some of the expenditure on the asset may be sunk (i.e. unrecoverable) Example 1: A firm is considering buying a machine for 10,000. At the end of one years use it could sell the machine for 4,000. The best alternative use for the 10,000 is to invest it in government stock which yield 10% per annum. Economic depreciation = 10,000 - 4,000 = 6,000 Foregone interest = 10,000 x 10% = 1,000 User cost of machine = 6,000 + 1,000 = 7,000 Example 2: A firm owns a machine that originally cost 10000, but now has a market value of 7000. At the end of the another years use it could be sold for 3000. The best alternative use for money is to invest it in government stock which yield 10% per annum. The economic cost is the foregone interest on the 7000 that could be raised by selling it now, plus the economic depreciation (i.e. fall in market value). Thus: Economic depreciation = 7000 - 3000 = 4000 Foregone interest = 7000 x 10% = 700 User cost of machine = 4000 + 700 = 4700
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N.B. The difference between the original (historic) cost of the machine (10000) and the current market value (7000) is a sunk expenditure which therefore does not represent an economic cost.
The Profit-Maximising Level of Output

As weve seen, economic profit is the difference between total revenue and total economic cost. Hence, to determine how the firm chooses output so as to maximise profit we need first to consider how total revenue and cost vary with the level of output
Total Revenue
Total revenue is the amount the firm receives from selling its output. This can be calculated by multiplying the units of output by the maximum price at which each unit can be sold . How can we determine the maximum price per unit for each level of output? From the firms demand curve. (N.B. not the market demand curve.) Numerical Example: Firms Demand & Total Revenue Out put per wee k (00 0s) 1 2 3 4 5 6 7 8 Price per unit () Total Revenue per week (000)
20 18 16 14 12 10 8 6
20 36 48 56 60 60 56 48
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Total Revenue Curve

70 60 50 000 per week 40 30 20 10 0 0 2 4 6 8 10 Output per w eek (000) R
The first two columns show the firms demand curve for its product. The third column shows the total revenue the firm would receive from selling each particular level of output. Clearly, it is calculated by multiplying the level of output by the corresponding (maximum) price per unit at which the firm can sell all that output (i.e. column one times column two) The diagram graphs total output against total revenue to show the firms total revenue curve. Note that it has an inverted U-shape.
Total (Economic) Cost

How does the firms total economic cost vary with the level of output? (This will be discussed in more detail in topic 7.) The following points can be made: Total cost will vary positively with output - to produce more units of output the firm will need to use more inputs, hence the total cost will be higher. Total cost represents the minimum expenditure on the inputs necessary to produce the output Total cost depends on the prices of the inputs and the firms technology - these are assumed to be constant.
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Numerical Example: Firms Total Cost Output per week (000s) 0 1 2 3 4 5 6 7 8 Total Cost per week (000) 0 10 18 24 26 30 38 50 70
Total Cost Curve

80 70 60 000 per week 50 40 30 20 10 0 0 2 4 6 8 10 Output per w eek (000) C
Note that as output rises initially total cost rises at a decreasing rate (the curve gets flatter). But as output continues to rise, total cost starts to go up much more quickly (the curve gets steeper). The reason for this particular relationship between total cost and output will examined in topic 7.
Total Economic Profit

Given the information on the firms total revenue and total cost we can calculate total profit and hence determine the output which maximises profit. Remember that: Economic Profit = Total Revenue - Total Economic Cost
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Numerical Example: Total Profit Output per week (000s) 0 1 2 3 4 5 6 7 8 Total Revenue per week (000) 0 20 36 48 56 60 60 56 48 Total Cost per week (000) 0 10 18 24 26 30 38 50 70 Total Profit per week (000) 0 10 18 24 30 30 22 6 -22
Total Profit Curve

40 30 20 000 per week 10 0 0 1 2 3 4 5 6 7 8
-10 -20 -30
Ouput per w eek (000)
Maximising Profit
Its clear that, in the example above, total profit is maximised at a output level of 4000 (or 5000) units per week. This gives a total profit of 30,000 per week. As profit is equal to revenue minus cost, profit is maximised at the output level where the difference between revenue and cost is at its greatest; i.e. where the vertical distance between the total revenue and total cost curves is greatest. This is illustrated in the following diagram.
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Profit Maximisation
80 70 60 000 per week 50 40 30 20 10 0 0 1 2 3 4 5 6 7 8 Ouput per w eek (000) R C Profit

Alternative Approach
The problem with finding the maximum profit output level using the total revenue and cost is that the firm needs to look at its entire revenue and cost curves all at once. This requires a lot of information which the firm may not have. An alternative, more useful approach is to divide the decision into two parts: 1. If the firm is in business, how much should it produce? 2. Should the firm be in business at all, or should it shut down?
The Marginal Output Rule

Assume the firm is producing some given level of output. Does this output level maximise profit? The answer is no if producing more (or less) output would increase profit. And profit would rise if the increase in output added more to total revenue that it did to total cost. So we need to look at the change in revenue and cost when output changes - i.e. the concepts of marginal revenue and marginal cost.
Marginal Revenue
Marginal Revenue (MR) is the change in revenue due to the sale of one more unit of output. It is calculated by dividing the change in revenue by the change in output: i.e. MR = R Q
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Numerical Example: Marginal Revenue Out put per wee k (00 0s) 0 1 2 3 4 5 6 7 8 Total Revenue per week (000) Marginal Revenue (000)
0 20 20 16 36 12 48 8 56 4 60 0 60 -4 56 -8 48
Marginal Revenue Curve

20 15 10 000 5 0 0 -5 MR -10 Ouput per w eek 1 2 3 4 5 6 7 8
Marginal Cost
Marginal Cost (MC) is the change in total cost due to the production of one more unit of output. It is calculated by dividing the change in cost by the change in output: i.e.
58
MR =
C Q Marginal Cost (000)
Numerical Example: Marginal Cost Out put per wee k (00 0s) 0 1 2 3 4 5 6 7 8 Total Cost per week (000)
0 10 10 8 18 6 24 2 26 4 30 8 38 12 50 20 70
Marginal Cost Curve

20 18 16 14 12 000 10 8 6 4 2 0 0 1 2 3 4 5 6 7
MC
Ouput per w eek
Marginal Output Rule
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The change in profit when the firm produces one more unit of output equals marginal revenue minus marginal cost. Hence if MR > MC the firm should produce the additional unit as its total profit will rise. In other words, at the current output level it could not have been maximising profit. On the other hand, if MR < MC then the firm should not produce the additional unit as doing so would reduce total profit. So, to maximise profit a firm should raise production whilst MR > MC and continue to do so until on the next additional unit of output MR < MC. Logically, this implies that to maximise profit the firm should produce at the output level where MR = MC. Numerical Example: Profit Maximisation O ut pu t pe r w ee k (0 00 s) T o t a l C o s t p e r w e e k ( 0 0 0 ) 0 10 1 2 3 4 5 1 0 8 1 8 6 2 4 2 2 6 4 3 60 56 4 30 48 8 30 36 12 24 20 16 18 Ma rgi nal Co st (0 00) Tot al Re ve nu e per we ek (0 00) Ma rgi nal Re ve nu e (0 00) Tot al Pro fit per wee k (0 00)
0 20 10
60
0 8 6 7 8 3 8 12 5 0 20 7 0 48 56 -8 - 22 60 -4 0 22
Profit Maximisation
20 15 10 000 5 0 0 -5 -10 MR 1 2 3 4 5 6 7
MC
Ouput per w eek
Both the table and diagram show that MR > MC on the first 4 units of output - hence the firm can raise profit by producing these units of output. On the fifth unit MR = MC hence the change in profit is zero, and profit remains at 30,000. But, if the firm produced 6 units per week profit would be lower because MR < MC on the sixth unit. Hence the firm will maximise profit by producing 5 units of output per week; i.e. where MR = MC. This gives the marginal output rule as follows: Marginal Output Rule: If the firm does not shut down, then it should produce output at a level where marginal revenue is equal to marginal cost. Note: 1. Because, in our example, output is measured in discrete single units, profit is also maximised at 4 units of output. For the same reason, MR does not cross the MC curve at 5 units of output in the diagram (they cross instead at 4.5 - the midpoint between 4 and 5 units). However, if output can vary continuously so that the MR and MC curves are smooth curves, then Profit will be maximised at a single level of output where MR=MC. See the diagram below.
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per period
MC
MR Ouput per period
2. The marginal output rule is perfectly general. Although the precise shapes of the MR and MC curves depend on the particulars of the market in which the firm operates, the rule that the firm should produce at a point where MR = MC is valid for any profit-maximising firm.
Shut-Down Decision
How does a firm decide whether or not to be in business at all? It should compare its economic profit when it does produce with the economic profit it would earn if its shut down instead. If a firm shuts down and sells no output total revenue is obviously zero. But total economic cost will also be zero. Why? because economic cost equals opportunity cost - the amount the firm loses by not using its inputs in their best alternative use. If the firm shuts down the inputs will actually be put to their best alternative use. hence the opportunity/economic cost of the inputs is zero. Thus if revenue and cost are both zero, economic profit is zero. A firm should therefore shut down if it makes less than zero economic profit by producing output; i.e. if it makes economic losses.
Shut-Down Rule
When will the firm make an economic loss? Clearly when total revenue is less than total cost at every level of output. We can also state this condition for making an economic loss in terms of average revenue and average cost Average revenue (AR) is total revenue divided by the units of output produced: i.e. it is the revenue earned per unit
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AR =
R Q
Average cost (AC) is total cost divided by the units of output produced: i.e. it is the cost per unit. AC = C Q
When total cost is less than total revenue, then AR < AC. Using these concepts we can therefore state the shut down rule as follows: Shut-Down Rule: If for every choice of output level the firms average revenue is less that its average cost, the firm should shut down. The following diagram shows the case of a firm which should shut down.
per period AC M
H Q1
AR Ouput per period
Total revenue of output Q1 is equal to shaded area H. Total cost is equal to area H + M. Hence total economic loss is shown by area M. Since AC lies above AR for all levels of output, the firm cannot make an economic profit by producing and hence would do better by shutting down.
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The Firm & its Goals: Seminar Questions

1. Suppose that a young chef opened his own restaurant. To do so, he quit his job, which was paying 28,000 per year; cashed in a 5000 certificate of deposit that was yielding 5% (to purchase equipment); and took over a building owned by his wife which had been rented out for 1000 per month. His expenses for the first year amounted to 50,000 for food, 40,000 for extra help, and 4000 for utilities.
The chef is trying to decide whether he would have been better off not being in business last year. He knows how to calculate his revenues, but he needs help with the cost side of the picture. What were the chefs economic costs? 2. A firm is considering borrowing 50000 from the bank at 8% p.a. to buy a machine. At the end of one years use they estimate it could be sold for 35000. a) b) c) 3. Calculate the user cost of the machine for the first year. What would be the economic cost of the machine if it was worthless to anyone else but this firm? Would the answer to part (b) be the same if the firm had already purchased the machine?
Total revenue () 0 15 29 41 51 60 66 70 Total Cost () 0 7 14 22 31 42 55 70
Given below are some data on total revenue and total cost for a firm
Total output per month 0 1 2 3 4 5 6 7
a) b) c) 4. a) b) 5.
Plot the total revenue and total cost curves on the same graph Calculate total profit and plot the total profit curve on a separate graph What is the output level that maximises profit Calculate the firms marginal cost and marginal revenue curves and plot them on the same graph. Indicate the profit-maximising level of output
Using the data given in question 3:
Many firms incur a one-time set-up cost to begin production. For instance, whether to sell one copy of a word-processing program or a
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thousand, a company needs to write the basic computer code one time. As a result of set-up costs, the marginal cost of the first unit may be extremely high - going from 0 to 1 unit of output triggers the need to bear the entire set-up cost. More generally, costs may be such that marginal cost initially is greater than marginal revenue. The figure below illustrates a firm whose marginal cost curve crosses its marginal revenue curve at two different points.
per unit A MC
MR B
Ouput per year
a) b)
How much output, if any, should this firm plan to produce? How is your answer affected by the relative sizes of areas A and B?
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Lecture 11 & 12 : Production
Objectives
After working through this topic you should be able to: Explain the concepts of a firms technology and associated production function Distinguish between the short run and long run production periods Define an isoquant and explain its properties Explain the concept of returns to scale and distinguish between the three possible cases. Derive a short run production function. Explain and calculate the marginal physical product of an input. Distinguish between increasing, constant and diminishing returns to a factor Derive and explain the relationship between the MRTS and the MPP of the inputs
Key Concepts
technology production function short run long run isoquant marginal rate of technical substitution returns to scale marginal physical product increasing and constant returns diminishing returns
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Technology: The Production Function

A firm options for combining inputs into outputs is called its technology. The firms technology is summarised by its production function A production function shows the maximum output that can be produced from any given combination of inputs: Q = F( L , K) where Q = units of output L = units of labour input K = units of capital input
Why maximum output? Because it is assumed that only technologically efficient methods are used by the firm - this implies that using more of one input and either the same amount or more of the other input must increase output. Numerical Example: Production Function Unit s of Lab our per day Unit s of Capi tal per day O u t p u t p e r d a y 500 300 1 6 0 1 6 0 1 6 0 1 8 0 1 8
1000
200
1300
170
500
350
1000
220
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0 1300 190 1 8 0

Long Run & Short Run
The production possibilities available to a firm depend on the time horizon over which the firm makes its input choices. In general, the more time a firm has to make its decisions, the more input choices it has. In particular, an important distinction exists between the long run and short run production periods. The short run is defined as the period of time during which the quantity of only one of the firms inputs can be varied - all the others are fixed. The long run is defined as the period of time long enough for the quantity of all the firms inputs to be varied. Note: An input (factor) whose level can be varied over the relevant time period is known as a variable factor. An input which cannot be varied is called a fixed factor.
Long Run Production Function

The long run production function shows the maximum output the firm can produce when all its inputs can be varied. Assuming two inputs, capital and labour, we can write this using the same notation as before: i.e. Q = F( L , K) The numerical example shown above is a long-run production function given that both capital and labour can be freely varied by the firm. To graph the long run production function we need to make use of the concept of an isoquant.
Isoquants
An isoquant shows the combinations of the two inputs (e.g., capital and labour) which produce the same level of output. The production function shown above illustrates two isoquants - one for 160 units of output per day, and another for 180 units. Lets look at the input combinations which produce 160 units per day. Numerical Example: An Isoquant
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Units of Labour per day 500 1000 1300
Units of Capital per day 300 200 170
Output per day 160 160 160
An Isoquant
450 400 Capital per day 350 300 250 200 150 100 50 0 0 250 500 750 1000 1250 1500 1750 Labour per day 160
Marginal Rate of Technical Substitution

The slope of an isoquant is called the marginal rate of technical substitution (MRTS). It shows the rate at which one input (e.g. capital) can be substituted for one more unit of the other (labour) whilst the level of output remains constant. The MRTS is equal to the (absolute) ratio of the change in capital input to the change in labour input: i.e. MRTS K , L = ( ) K L
Example: Referring to the isoquant in the diagram above, if the firm changes from using 500 units of labour and 300 units of capital to using 1000 units of labour and 200 units of capital, the MRTS is: MRTS K , L = ( ) 100 = 0.2 500
This tells us that for every extra unit of labour input the firm uses 0.2 units less of capital input.

Properties of Isoquants
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The following diagram shows a set of isoquants (known as an isoquant map) which describes the firms production function (i.e. its technology). The diagram illustrates the key properties of isoquants:
Units of capital A 2 B 1 0.5 C 1 Q1 Units of Labour D Q2 Q3
1. Negatively-sloped. Technological efficiency implies that an isoquant must slope downwards from left to right - using more of one input to produce the same level of output must imply using less of the other input. 2. Convex to the origin. The MRTS is not constant, it diminishes as the firm moves along an isoquant: e.g. as the firm uses more and more units of one input (e.g. labour) and less of the other (e.g. capital), the amount of the other input that can be foregone diminishes. For example in the diagram, when the firm has a relatively large amount of capital to labour (point A) then if it uses one more unit of labour, it can afford to use two units less of capital and still produce the same output. Further down the isoquant, we see that as the firm continues to substitute more labour for less capital, the amount of capital that can be foregone decreases; e.g. the second example in the diagram shows that when the firm has a relatively small amount of capital to labour (point C) then using one more unit of labour to produce the same output implies giving up only 0.5 units of capital. Why does the MRTS diminish? To answer this question properly, we need to invoke the concept of marginal product, which is described in detail later in this topic. For the moment, we can argue that when, as at point A, the firm has a relatively large amount of capital to labour it can afford to give up a lot of capital in return for more labour and still maintain its output level. At point D, the situation is reversed. Here labour is the relatively more plentiful input - hence the firm could afford to give up a lot of labour in return for a bit more capital. 3. The further the isoquant from the origin, the higher the level of output. This is obviously the case as using more of both inputs must increase output. Hence, Q3 > Q2 > Q1.
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Returns to Scale
Another important property of a long run production function is the concept of returns to scale. This refers to what happens to output when the quantity of all inputs is increased by a certain proportion. There are three possibilities: Increasing Returns: output increases by a larger percentage than the increase in inputs Constant Returns: output increases by the same percentage as the increase in inputs Decreasing Returns: output increases by a smaller percentage than the increase in inputs Numerical Example: Returns to Scale Consider a firm whose technology is represented by the following production function: Q=KxL We can construct the following table: Unit s of Lab our per day Unit s of Capi tal per day O u t p u t p e r d a y 10 10 1 0 0 2 2 5 4 0 0
15
15
20
20
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Its clear that this technology exhibits increasing returns to scale: for example, when both capital and labour are increased by 50% from 10 units each to 15 units, output increases by 125%.
Short Run Production Function

The short run production function shows the maximum output the firm can produce when only one of its inputs can be varied, the others remaining fixed. Assuming two inputs, capital and labour, and that capital is fixed and labour is the variable factor, we can write we can write the short run production function as follows: Q = F( L , K ) where the bar over the symbol for capital units indicates that it is a constant amount.
From the Long Run to the Short Run

We can derive the firms short run production function from its isoquant map by fixing the level of capital input and looking at what happens to output as the amount of labour input is increased.
Units of capital 10 25 40
50
12
28
Units of Labour
In this example, the firm has a fixed quantity of 50 units of capital (e.g. machines) and can vary the amount to labour it employs. With 5 units of labour, it can produce a maximum output of 10 units per period. If labour input is increased to 12 units, output is increased to 25 units per period. And with 28 units of labour it can produce 40 units per period. This relationship between the variable input (e.g. labour) and total output constitutes the firms short run total product curve. In particular we are interested in how much total output increases when the firm uses more of the variable input.
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Example: Short Run Production Function

Un its of Ca pit al pe r da y Un its of La bo ur pe r da y To tal Pr od uc t pe r da y M ar gi na l (P hy si ca l) Pr od uc t 10 30 30 30 30 30 30 30 1 2 3 4 5 6 7 10 12 22 15 37 15 52 15 67 11 78 8 86
30
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Total Product per day

100 90 80 Units of capital 70 60 50 40 30 20 10 0 0 2 4 6 8 Units of labour TP
As the firm increases the amount of labour it employs with its fixed quantity (30 units) of capital, the maximum total output produced increases. But notice that it doesnt increase at a steady rate throughout. At first, total product increases quite quickly (the total product curve gets steeper). Then it increases at steady rate (the slope of the TP curve is constant. Finally, TP rises at a slower rate (the slope gets flatter). This pattern in the rate of increase in total output is measured by the marginal physical product of labour.
Marginal Physical Product (MPP)

The marginal physical product of an input is the extra amount of output that can be produced when the firm uses one additional unit of an input, holding all other inputs constant. It is given by the ratio of the change in total product to the change in the input; i.e. MPP = Q F
where: Q = change in units of total product F = change in units of input For example, the marginal physical product of labour (MPP L) would be given by the ratio of the change in total product to the change in labour input; i.e. MPP = Q L
The table above shows the MPP L for our example short run production function.
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Increasing, Constant & Diminishing Marginal Returns

As weve seen, the key concept with regard to the firms short run production function is marginal physical product (MPP). To use MPP to describe the production function we need to know what happens to the MPP of a factor as the firm increases its use of that factor. There are three possibilities: Increasing Marginal Returns - the MPP of an input increases as more of the input is used Constant Marginal Returns - the MPP of an input remains constant as more of the input is used. Diminishing Marginal Returns - the MPP of an input decreases as more of the input is used (i.e. the famous law of diminishing returns) Our example short run production function shows a typical case where there is increasing marginal returns to labour at first, then a period of constant returns, and eventually diminishing marginal returns to labour begin to occur. If we graph the MPP of labour against output we get the following MPP of labour curve.
Marginal Product Curve
16 14 12 10 Output 8 6 4 2 0 0 1 2 3 4 5 6 7 Units of labour MPP

Relationship between MRTS and MPP
The long run concept of the marginal rate of technical substitution (MRTS) and the short run concept of marginal physical product (MPP) are related. We can derive the relationship between them as follows:
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Q = F( L , K) hence, Q = MPPL L + MPPK K i.e. the change in total output (Q) equals the change in labour input (L) times the MPP of labour plus the change in capital input ( K) times the MPP of capital. But, by definition, along a given isoquant the change in output is zero (Q = 0). Thus, MPPL L + MPPK K = 0 and, rearranging, we see that, ( ) K MPPL = L MPPK MPPL MPPK
Recall that the MRTSK,L = - K/L. So we find that, MRTS K , L = In other words, The marginal rate of technical substitution between two inputs is equal to the ratio of the marginal physical products of the inputs. This relationship helps to explain the diminishing MRTS along an isoquant. When a firm has a relatively large amount of capital to labour, the MPP of labour will be relatively high and the MPP of capital relatively low. Hence when the firm uses more labour it can afford to give up quite a lot of capital and still maintain output at the same level, because the extra labour is more productive than the capital foregone. But as the firm continues to substitute more labour for less capital, the productivity of the extra labour begins to fall relative to the capital given up. Hence the firm can only forego smaller and smaller amounts of capital while keeping its output at the same level.
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Production: Seminar Questions

1. Given the production function: Q= complete the following table:
Units of Labour (L) per week 5 10 25 16 32 64 Units of Capital (K) per week 500 250 100 400 200 100 Units of Output (Q) per week
LK
2.
Continuing from question 1. a) b) Plot the two isoquants on a graph Calculate the MRTS along each isoquant as the firm substitutes more labour for less capital
3.
Consider a company that assembles electric toasters using labour and robots. Suppose that in 1950, robots were so crude that they were useless in the assembly of toasters, so that toasters had to be assembled completely by hand. Draw an isoquant map illustrating this situation. Now suppose that as a result of progress in the design and manufacture of robots, robots can be used as a substitute for labour. Draw an illustrative isoquant map. How would the isoquant map you have drawn change if further improvements were made in robots so that one new robot could do the work of two old robots? Draw an isoquant map to illustrate the case where: a) b) Two inputs which are perfect substitutes No factor substitution is possible
4.
(Hint: Read Katz & Rosen, pp. 259 to 261) 5. 6. Does the production function in question 1 exhibit increasing, constant or decreasing returns to scale? Using the production function in question 1, assume the firms capital stock is fixed at 250 units per week a) b) Write down the short run production function Complete the following table:
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Units of Capital Units of Labour Total Product per week per week per week 250 250 250 250 250 30
c) 7.
Marginal (Physical) Product
0 10 20 30 40 50
What happens to the MPP of labour as more labour is employed?
Draw an appropriately shaped total product curve to illustrate each of the following cases: a) b) c) The MPP of labour is always increasing. The MPP of labour is constant The MPP of labour is always diminishing.
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Lecture 13 & 14 : Cost
Objectives
After working through this topic you should be able to: Distinguish between the firms costs in the short run and long run Calculate short run total, marginal and average cost Explain the relationship between short run marginal cost and the marginal returns to labour Explain the relationship between marginal cost and average cost Define an isocost line and draw an isocost map Identify the long run, economically efficient input combination and explain the corresponding equilibrium condition Derive the expansion path and associated long run total cost curve Define and the explain the reasons for economies and diseconomies of scale Calculate and explain the relationship between long run average and marginal cost
Key Concepts
short run long run short run total cost short run marginal cost marginal factor cost short run average cost economically efficient isocost line isocost map equilibrium condition long run total cost expansion path long run average cost economies of scale diseconomies of scale long run marginal cost
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Deriving Total Cost: 2 Key Points

A profit-maximising firm clearly has to produce its chosen output level at a minimum cost. To determine the minimum total cost of producing any level of output (i.e. the firms total cost function), the firm has to bear in mind two key points. 1. Costs are measured as economic (opportunity) costs. Recall that to maximise economic profit the firm must calculate its total economic, not accounting, cost. 2. Short Run & Long Run Periods. The input choices open to the firm depend on whether it is considering a short or long run decision. Hence the cost of using those inputs will vary accordingly. We need to distinguish therefore between short and long run costs.
Cost in the Short Run

Recall that the short run production function shows the maximum output the firm can produce with any amount of the variable factor (labour) together with the fixed amount of the other factor (capital). Turning this around, its clear that the short run production function also shows the minimum amount of variable input required (with the given amount of fixed factor) to produce any chosen level of output. So the firm can use its short run production function to determine the minimum total cost of each level of output - i.e. the firms short run total cost function.
Calculating Total Cost

To calculate the short run total cost of a given level of output the firm would need to take the following steps: 1. Use the short run production function to determine the minimum amount of labour input required to produce the output. 2. Multiply the quantity of labour by the wage rate to get the total labour cost Should the firm then add on the cost of using the fixed amount of capital? NO! Because in the short run, expenditures on capital are a sunk expenditure - they are therefore NOT an economic cost. Why is this? Because capital is a fixed factor in the short run, and therefore, by definition, there is no alternative use for it. Hence, the short run economic (opportunity) cost of capital is zero.
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So, short run total economic cost consists only of the firms expenditure on its variable factors (here labour), and thus excludes expenditure on the fixed factor (capital)
Example: Short Run Total Cost Curve

Using the short run production function from topic 6, and assuming a daily wage rate per worker of 30 we can calculate the firms total costs as shown in the table below. U n i t s o f L a b o u r p e r d a y 0 1 2 3 4 5 6 7 0 10 22 37 52 67 78 86 30 30 30 30 30 30 30 30 0 30 60 90 12 0 15 0 18 0 21 0 To tal Pr od uct pe r da y W ag e R at e pe r d ay ( ) To tal C os t pe r da y ()
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250 200 per day 150 100 50 0 0 20 40 60 80 100 Output per day CSR
Note that this total cost curve has the same shape as the one in topic 5 (The Firm & its Goals). But this time we have explicitly derived total cost from the firms short run production function. Its clear, then, that the shape of the total cost curve depends on the shape/properties of the underlying production function. To examine this relationship between production and cost we need to look more closely at the concept of marginal cost, first introduced in topic 5.
Marginal Cost
Recall the definition of marginal cost: Short run marginal cost (MCSR) is the change in short run total cost due to the production of one more unit of output. As MC is derived from total cost which in turn ,as weve seen, is derived from the firms short run production function, its clear that MC also depends on the production function. Lets see how. If the firm wants to produce one more unit of output it will need to employ some extra units of the variable input (labour). How many extra units. To answer this the firm needs to look at the MPP of labour. If the MPP of another unit of labour is 4 units of output, then to produce one extra unit of output the firm would need to employ 0.25 (i.e. 1/4) extra units of labour. So, in general: Extra units of variable factor required to produce one more unit of output = 1/MPP Now the MC of this extra unit of output will equal the cost of employing these extra 1/MPP units of variable input. To calculate this the firm needs to multiply 1/MPP by the cost of employing each extra unit of input. This latter amount is known as the marginal factor cost; i.e.
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The marginal factor cost (MFC) is the additional amount that the firm has to pay for a factor when it hires one more unit of the factor. So, have deduced the following relationship between short run MC and the firms technology (represented by the MPP): MCSR = MFC 1 MFC = MPP MPP
Remembering that, in the short run, the wages paid to labour are the only economic cost, we can write the formula for short run marginal cost as follows: MCSR = MFC L MPPL
Finally, we can simplify this key formula still further if we assume that the firm is a price-taker in the market for its labour - i.e. it takes the market price of labour (the wage rate) as a constant, outside of its control, at which it can purchase as much labour as it wants. In this case, the MFC of labour must equal the going wage rate (w), as every time the firm hires another worker it costs it an extra w. Thus when the firm is a price-taker in the labour market, short run MC is equal to the given wage rate ( w ) divided by the MPP of labour; i.e. MCSR = w MPPL
This formula tells us that, ceteris paribus, the higher the marginal physical product (MPP) of labour, the lower the marginal cost of output. It also makes explicit the relationship between the slope of the short run production function (MPPL) and the slope of the short run total cost curve (MCSR)
Marginal Cost & Marginal Returns to Labour

Lets look at this relationship by using the formula to calculate short run MC for the total cost example curve shown above. Un its of La bo ur pe r da y To tal Pr od uct pe r da y M ar gi n al P h ys ic al P ro W ag e Ra te pe r da y () To tal Co st pe r da y () M a r gi n al C os t ( )
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d uc t 0 1 2 3 4 5 0 10 10 12 22 15 37 15 52 15 67 11 6 78 8 7 86 30 21 0 30 18 0 3. 7 5 30 15 0 2. 7 3 30 12 0 2 30 90 2 30 60 2 30 30 2. 5 30 0 3
Its immediately apparent from the table that when the marginal product of labour rises (increasing returns), short run marginal cost falls; when MPPL is constant (constant returns) so too is MC SR; and when the MPPL falls (diminishing returns), MCSR rises. This, of course, is exactly what the formula for MCSR shows would happen. This relationship between MPP and MC makes sense. With diminishing marginal returns to labour, for example, as the level of total output rises, producing an additional unit of output requires increasingly large increments of labour. Hence the extra (labour) cost of producing more output becomes increasingly large too. If we graph the short run MC curve and display below the MPP L curve the inverse relationship between the two is made even clearer see the graphs below.
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Marginal Product Curve

16 14 12 10 Output 8 6 4 2 0 0 1 2 3 4 5 6 7 Units of labour MPP
Short Run Marginal Cost Curve

5 4.5 4 3.5 per day 3 2.5 2 1.5 1 0.5 0 0 10 20 30 40 50 60 70 80 Units of Output MC SR

Average Cost
Recall from topic 5 that the firms average cost plays a crucial role in determining whether or not a firm should shut down rather than produce. When making a short run shutdown decision, the relevant measure of average cost is short run average cost, defined as follows: Short run average cost (ACSR) is the short run total cost divided by the number of units of output: i.e.
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ACSR =
CSR Q
The following table (and graph) shows short run average cost for our total cost curve example, together with the MC SR figures calculated earlier. To tal Pr od uct pe r da y T o t a l C o s t p e r d a y ( ) 0 10 0 3 3 0 3 2 . 5 22 37 52 6 0 9 0 1 2 0 1 5 0 2.7 3 2 2.4 3 2 2.3 1 2 67 2.2 4 2
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Av er ag e Co st ()
M a r g i n a l C o s t ( )
. 7 3 78 1 8 0 2.3 1 3 . 7 5 86 2 1 0 2.4 4
Short Run Average Cost Curve

4.5 4 3.5 3 per day 2.5 2 1.5 1 0.5 0 0 10 20 30 40 50 60 70 80 90 Units of Output AC SR
As the table and graph both show, short run average cost initially falls as output increases, but eventually, as the firm continues to raise output average cost in the short run starts to increase. Why this particular shape for the short run average cost curve here? The answer lies with marginal cost.
Relationship between Marginal Cost & Average Cost

From the table, its apparent that when MC < AC, AC falls; but when MC > AC, then AC rises. The reason for this relationship is intuitively clear. If producing an additional unit of output adds less to total cost than the previous unit (MC is falling) then the total cost per unit (average cost) must go down. For example, if 10 units cost 100 to produce (AC = 10), and 11 units cost 108 (MC = 8), the AC falls to 9.82 (= 108/11). Conversely, if producing an additional unit of output adds more to total cost than the previous unit (MC is rising) then the total cost per unit (average cost) must rise.
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Recall that the shape of the MC curve depends on the firms technology via the MPP of labour. Weve just seen that AC is related to MC, hence it follows that the shape of the AC curve is also related to the firms underlying short run production function. How? If, for example, the MPP of labour is increasing, then as the firm produces more output it needs fewer and fewer units of labour per additional unit of output. Since each additional unit of output requires less labour than did the earlier units of output, the average amount of labour per unit of output falls as the output level rises. But short run AC equals the given wage rate multiplied by the average amount of labour per unit of output (remember in the short run labour is the only economic cost). Hence when the firm experiences increasing marginal returns to labour, short run average cost falls as output rises. In summary, the relationship between marginal and average cost is as follows: Whenever marginal cost is below average cost, average cost falls Whenever marginal cost is above average cost, average cost rises Hence, we can also conclude that: The short run marginal cost curve crosses the short run average cost curve at the point where average cost is at a minimum. The following diagram (where output varies continuously - hence smooth curves) illustrates these three points.
ACSR MCSR
Q1
Units of output
Cost in the Long Run

The firms costs in the long run differ in two key ways from the short run:
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1. Since all factors are variable in the long run, the (explicit and imputed) expenditures on all inputs are economic costs in the long run. 2. Since the levels of more than one factor can be varied, it may be possible for the firm to substitute quantities of one factor for another. Factor substitution means that the firm has to choose the particular combination (mix) of factors which minimises the cost of producing the desired level of output: i.e. from all the possible technologically efficient combinations shown by the isoquant it has to choose the economically efficient mix of inputs. An input combination is economically efficient when it has the lowest opportunity cost of those input combinations that can be used to produce the desired output. To choose the minimum cost mix of inputs, the firm needs to know the total cost of each possible combination - this is shown by isocost lines.
Isocost Lines
An isocost line shows all the combinations of the inputs (e.g. capital and labour) which have the same total cost. To draw an isocost line we need to know the values of three parameters: the price per unit of capital (user cost, r), the price per unit of labour (wage rate, w) and the total cost of using the quantities of the two inputs (C) (N.B. It is assumed that the firm is a price-taker in the input markets, hence the prices of capital and labour are taken as given by the firm) The equation of an isocost line is thus: C = wL + rK i.e. the total cost of the inputs (C) equals the amount spent on labour (wage rate, w, times the units of labour employed, L) plus the amount spent on capital (user cost per unit, r, times the units of capital employed, K). Numerical example: Isocost Line Assume: w = 20 per day, r = 50 per day, C = 500 per day Then, the isocost line equation is: 500 = 20 L + 50 K Using this equation, we can construct the following table and graph which shows various combinations of capital and labour which have the same total cost of 500 per day: Uni ts of Unit s of capi
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lab our per day 0 5 10 15 20 25
tal per day 10 8 6 4 2 0
An Isocost Line
12 10 Capital per day 8 6 4 2 0 0 5 10 15 20 25 30 Labour per day
Slope of an Isocost Line

Note that the two endpoints of the isocost line are equal to total cost divided by the respective input price, as they represent the units bought of one input when total expenditure is only on that input. Hence, we can easily deduce the slope (in absolute value) of an isocost line to be as follows: ( Absolute) Slope = ( ) C K w = r = L C r w
Thus, the (absolute) slope of the isocost line is equal to the ratio of the input prices; i.e. the relative price of labour to capital. Numerical Example The slope of the example isocost line shown above is: w 20 = = 0.4 r 50
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i.e. in order to buy purchase one more unit of labour, the firm has to forego 0.4 units of capital. Notice the similarity between this and the slope of the households budget line (see topic 2: Consumer Choice). This, of course, is no coincidence. Clearly, the firms isocost line is the equivalent of the households budget line. Both show the available trade-off between the two inputs (the firm) or goods (the household) whilst keeping total expenditure constant. The slope of an isocost line shows the amount of one input the firm needs to forego in order to purchase one more unit of the other input whilst keeping total cost the same.
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Isocost Map
As weve seen, an isocost line can be drawn for given factor prices and a given total cost. If the factor prices remain constant, then for different levels of total cost there will be a set of parallel isocost lines each one representing a specific level of total cost. This set of isocost lines is called an isocost map. Obviously, the higher the total cost, the further the isocost line will be firm the origin, as more of both inputs can be purchased by the firm at the given factor prices. Numerical Example: An Isocost Map Assume the same factor prices as before (w = 20, r = 50), and consider two total costs: C1 = 500, C2 = 300. C1 = 500 U n i t s o f l a b o u r p e r d a y 0 5 1 0 1 5 U n i t s o f c a p i t a l p e r d a y 1 0 8 6 4 U n i t s o f l a b o u r p e r d a y 0 5 1 0 1 5 C2 = 300 U n i t s o f c a p i t a l p e r d a y 6 4 2 0
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2 0 2 5
2 0
An Isocost Map
12 10 Capital per day 8 6 4 2 0 0 5 10 15 Labour per day 20 25 30
IC300
IC500

Cost Minimisation: Economically Efficient Input Mix
To find the economically efficient input mix (i.e. the particular combination of inputs which minimises the cost of producing the desired level of output) the firm has to find the point on the isoquant which is on the isocost nearest to the origin. This is shown in the following diagram.
Capital
K*
Q1
L*
Labour
To produce output level Q1 at minimum cost in the long run, the firm should operate at point E; i.e. it should use K* units of capital and L* units of labour. To see why note that any other feasible input
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mix, e.g. points B and D, is necessarily on an isocost line further from the origin which, by definition, implies a higher total cost. Point E represents the firms equilibrium input choice - given its desired output and technology (represented by the isoquant) and the factor prices, having chosen input mix K*, L* there is no incentive for it to change.
Equilibrium Condition
At point E the isoquant is tangential to the isocost line, i.e. they have the same slope. Thus the condition for cost minimisation in the long run is: MRTS K , L = w r
In other words, to minimise long run cost the firm should operate at a point where the marginal rate of technical substitution between capital and labour equals the factor price ratio. Recall that the MRTS is equal to the ratio of the marginal physical products of labour and capital: i.e. MRTS K , L = MPPL MPPK
Hence, we can also write the equilibrium condition as: MPPL w = MPPK r This says that to minimise long run cost the firm should operate at a point where, at the margin, the ratio of marginal physical products is equal to the ratio of the factor prices. Finally, rearranging the last equation, we can express the equilibrium condition in another useful way as follows: MPPL MPPK = w r This states that to minimise long run cost, the firm should choose the combination of inputs such that the marginal product of the last pound spent on an input is the same for each input. Notice that this condition is very similar to the equilibrium condition for utility maximisation for a household (where the marginal utility per last pound spent was the same for each good).

Deriving the Long Run Total Cost Curve
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To derive the firms long run total cost (CLR) curve, we simply need to use the equilibrium condition to find the minimum cost of producing each level of output. The relationship between (minimum) total cost and output is then the firms long run total cost schedule/curve. The following diagram illustrates the derivation of CLR for three output levels.
Capital IC1500
IC1400 expansion path IC1000 Q200 Q150 Q100 Labour
From the diagram we get the following long run total cost schedule: O u t p u t p e r p e r i o d 1 0 0 1 5 0 2 0 0 Long Run Total Cost ( per period)
1000
1400
1500
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Properties of Long Run Costs

What can we deduce about the shape of the long run total cost curve? Obviously it is positively sloped - more output implies using more inputs that, with given factor prices, must increase total cost. To say more about the properties of the long run total cost curve, we need to consider the two associated cost concepts: long run average cost (ACLR) and long run marginal cost (MCLR).
Long Run Average Cost

Long run average cost (ACLR) is the long run total cost (CLR) divided by the number of units produced (Q): i.e. AC LR = C LR Q
What happens to long run average cost as the firm increases its output level? Note first that since, in the long run, the firm will vary all its inputs simultaneously, the firm will be altering the scale of its operations. Do average costs rise or fall as the firm gets bigger and produces more output? If long run average cost falls as output rises, costs are said to exhibit economies of scale. If long run average cost rises as output rises, costs are said to exhibit diseconomies of scale. A major determinant of economies (or diseconomies) of scale is the degree of returns to scale of the firms underlying long run production function. For example, if the firm experiences increasing returns to scale when it, say, doubles the amount it uses of all its inputs then it will more than double its output level. But, with given factor prices, doubling the inputs will double the total cost. Hence, long run average cost, which is total cost divided by output, must fall as total cost has doubled but output has more than doubled. Thus we can state the following conclusions: When the production function exhibits increasing returns to scale, long run average cost declines as output rises. When the production function exhibits constant returns to scale, long run average cost stays constant as output rises. When the production function exhibits decreasing returns to scale, long run average cost increases as output rises. Numerical Example Lets calculate ACLR for the total cost curve derived above. O Long Run Long Run
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u t p u t p e r p e r i o d 1 0 0 1 5 0 2 0 0
Total Cost ( per period)
Average Cost ( per unit)
1000
10
1400
9.33
1500
7.5
Its apparent that this long run total cost curve exhibits economies of scale, as long run average cost is declining as the firm increases its output level. A fairly typical situation would be where the firm experienced economies of scale at first, then ACLR remained constant, and finally diseconomies of scale would start to occur. Such a situation would give rise to a long run average cost curve similar to the one illustrated in the following diagram.
ACLR
Output per period
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Long Run Marginal Cost

Long run marginal cost (MCLR) represents the slope of the long run total cost curve. It is obviously defined as follows: Long run MC is the change in long run total cost due to the production of one more unit of output: i.e. MC LR = C LR Q
Recall that marginal cost is related to average cost. Thus we can deduce that: When the firm experiences economies of scale (ACLR is falling), long run MC must be below average cost. When the firm experiences diseconomies of scale (ACLR is rising), long run MC must be above average cost. Numerical Example The following table shows long run MC (and average cost) for our example total cost curve. O u t p u t p e r p e r i o d 1 0 0 1 5 0 2 0 0 Lo ng Ru n To tal Co st ( pe r pe rio d) Lo ng Ru n Av era ge Co st ( pe r uni t) Lon g Run Mar gina l Cos t ( per unit )
10 00 14 00 15 00
10 8 9.3 3 2 7.5
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Comparing Long Run & Short Run Total Cost

The firms input choices differ in the long run and the short run. Hence the total cost of producing a given level of output may also differ. How do short and long run costs compare? There are two key differences: In the short run, any expenditures on the fixed factors (capital) are sunk - they are not economic (opportunity) costs. However, in the long run, all factors are variable and there are no sunk expenditures - everything counts as an economic cost. Because there are more costs, long run total cost will be larger than short run total cost. The possibility of factor substitution in the long run enables the firm to produce a given output at a lower cost than in the short run. In terms of their effects on the relationship between long run and short run total cost, these two differences work in opposite directions. Consequently, in some cases, the short run total cost of a given level of output may be greater then the long run total cost, and in other cases less.
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Cost: Seminar Questions

1. Bobs Fun Fill is an independent petrol station. Bobs has a 10,000 gallon tank that holds petrol. Just prior to a recent increase in wholesale petrol prices, the station bought petrol wholesale to fill its tank at a price of 0.80 per gallon. Shortly, thereafter, the wholesale price rose to 1.00 a gallon. Roberta, the owner of Bobs, is trying to figure out how to price petrol. She knows that she has 5,000 gallons left in the tank. a) Assuming the petrol station is self-service, what is the marginal cost of a gallon of petrol? Would your answer change if Roberta had 6,000 gallons left in the tank?
A new regulation is passed that prohibits self-service petrol, and henceforth all petrol must be pumped by an employee. Each gallon of petrol pumped requires 1 minute of employee time. Roberta pays $6 per hour. Employee time not spent pumping petrol is spent doing car repair work for which Roberta receives 18 per employee-hour (Roberta only charges for time actually spent doing the repair work). Roberta has enough repair business to keep two workers busy full time. b) Suppose that Roberta has one worker (she herself does not work). What is the marginal cost of a gallon of petrol, assuming Roberta cannot fire the worker, change the number of hours he works, or hire new workers over the relevant decision-making horizon? What would the marginal cost of a gallon of petrol be if Roberta could fire her present worker, change the number of hours he works, or hire new workers over the relevant decision-making horizon?
c)
2.
Draw the short run total cost and marginal cost curves for a price-taking firm whose production function is characterised by increasing marginal returns to labour. Calculate short run total cost, marginal cost and average cost for a firm with the following production function. Assume the given wage rate is 50 per week.
Labour per week 1 2 3 4 5 6 7 8 Total Product per week 50 110 170 230 280 320 340 355
3.
4.
Draw the short run average cost curve for a price-taking firm whose production function is characterised by constant marginal returns to labour at all levels.
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5.
Given a wage rate per week of 80, and a user cost of capital of 40 per week, draw the isocost map corresponding to the following three total costs per week: 60,000, 80,000, and 100,000. Suppose that a firm can hire as many workers as it wants at the going wage rate of 100 per day and can employ robots (capital) at a constant daily cost of 200 each. At present, the firm is producing 200 cars per day with an input combination for which MPPK = 0.3 and MPPL = 0.1. Is this firm using an economically efficient input combination? Read pages 285 to 286 in Katz & Rosen and then answer the following question.
6.
7.
A firm producing 50 units per day is in long run equilibrium at point E 1 in the following diagram.
Capital
K1
E1 Q50
L1
Labour
a) b) 8.
Show the effect of a fall in the price of labour on the firms economically efficient input combination. Will the total cost of producing 50 units per day rise or fall?
The following table shows some of the long run costs for the United Kingdom Production Company:
Output 50 51 52 53 52000 1038 5000 Total Cost Average Cost 1000 Marginal Cost
a) b) 9.
Fill in the missing values Over this range of output levels, does the firms production function have increasing, decreasing or constant returns to scale?
Draw long run total, marginal and average cost curves for a firm whose production function exhibits economies of scale everywhere. Is the
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average cost curve upward or downward sloping? What is the relationship between the marginal cost curve and the average cost curve? What can you say about the shape of the long run total cost curve? 10. Consider a software company that is planning to develop a new computer spreadsheet program. The development costs are projected to be 300,000. One the program is written, it can be put onto disks for 1.00 per copy. Draw the long run marginal and average cost curves for this product. Write down a formula for average cost.
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Lecture 15 & 16 : The Price-Taking Firm
Objectives
After working through this topic you should be able to: Define the concept of a price-taking firm Apply the marginal output and shut-down rules to a price-taking firm Derive the price-taking firms short-run supply curve Derive the price-taking firms long-run supply curve Define and apply the factor hiring rule Derive the price-taking firms short-run factor demand curve Distinguish between the output and substitution effects of a factor price change
Key Concepts
price-taking firm marginal output rule shut-down rule short-run supply curve long-run supply curve Derived demand marginal revenue product marginal factor cost factor hiring rule derived factor demand curve output effect substitution effect
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A Price-Taking Firm
In this topic we will consider the output and input decisions of a firm which is a price-taker in both the market for its output and the markets for its inputs. A price-taking firm chooses its actions under the assumption that it cannot influence the prices of the output that it sells or the inputs that it buys. When will a firm be a price-taker? When it is so small in relation to the total market that any change in the amount of output it sells or inputs that it buys has a negligible effect on the total supply or demand and hence no effect on the market equilibrium price. A price-taking firms behaviour can be completely summarised by its supply curve in its product market and by its input demand curves in its factor markets.
Supply in Product Markets

The supply curve of a price-taking firm shows the amount the firm would be willing to sell at each particular prevailing price. Recall that to determine the output of a profit-maximising firm we make use of two basic rules: 1. Marginal Output Rule: If the firm does not shut down, then it should produce output at a level where marginal revenue is equal to marginal cost 2. Shut-Down Rule: If for every choice of output level the firms average revenue is less that its average cost, the firm should shut down So we need to use these two rules to determine the output of a pricetaking firm at any given price for its product.
Marginal Output Rule

To maximise profit the firm will produce the output where marginal revenue (MR) equals marginal cost (MC). Weve seen (in topic 7) how the firm can determine its MC from its underlying production technology. But what about MR? As we saw in topic 5, MR is derived from total revenue which in turn depends on the firms demand curve. What will the demand curve and hence MR curve for a price-taking firm look like. Consider the following numerical example:
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Numerical Example: Demand & MR for Price-Taking Firm Quantity per month 0 1 2 3 4 Price per unit () 20 20 20 20 20 Total Revenue per month () 0 20 20 20 40 20 60 20 80 Marginal Revenue ()
The example reveals clearly two features: A price-taking firms demand curve is horizontal (i.e. perfectly elastic) at the given market price. Marginal revenue is constant and equal to the given price. Its easy to see the explanation for the second point. If the firm sells every unit of output at the same price, then, clearly, when it sells an additional unit the extra revenue must equal the price it received. Note one other point. Average revenue must also equal price - if all units are sold at the same price, then the revenue per unit (the average revenue) is obviously identical to the price per unit. Thus, for a price taking firm, the demand curve, the marginal revenue curve and the average revenue curve all coincide. They are represented by a horizontal line at the given market price - see the diagram below.
per unit
20
D, MR, AR
Quantity per month
Now that we know the shape of the MR curve, we can combine this with the firms MC curve to determine the profit-maximising output. This is shown in the following diagram.
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per unit MCSR 20 D, MR, AR
60
Quantity per month
At a given price (and MR) of 20 per unit, the firm chooses to produce 60 units per month in order to maximise economic profit. Thus, for a price-taking firm we can restate the marginal output rule as follows: Marginal Output Rule for a Price-Taker : If the firm takes the price of its output as given, then unless the firm shuts down entirely, it should produce output at a level where the price is equal to marginal cost
Shut-Down Rule
As average revenue is always equal to the given price for a pricetaking firm, we can easily restate the shut-down rule for this type of firm to be as follows: Shut-Down Rule for a Price-Taker: If the firm takes the price of its output as given and this price is less than average cost for every output level, then the firm should shut down The following diagram shows that the firm would be better to shut down if the given price is less that the minimum average cost.
per unit ACSR
10
D, MR, AR
Quantity per month
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Why? Because if the price is above the minimum AC, then the firm can make some economic profit by producing (i.e. there are some output levels where price is greater than average cost. But if the price is below the minimum AC then there are no output levels where price is greater than average cost.
The Firm Supply Curves

Using these two decision rules we can now easily derive the pricetaking firms supply curves for both the short and long run production periods.
The Firms Short Run Supply Curve

The short-run supply curve can be derived as follows: When the price is above minimum short-run AC, the firm will produce and sell the level of output where price equals short-run MC When the price is below minimum short-run AC, the firm will shut down and produce zero output. These two conditions imply that the short-run supply curve is represented by the thick line in the following diagram.
per unit MCSR ACSR P1 P*
Quantity per month
Thus, for prices above or equal to the minimum average cost the firm chooses to produce the output level where price equals short run MC. At prices below minimum AC it is better for the firm to shut down and thus output is zero. To summarise: A price-taking firms short-run supply curve coincides with the vertical axis at prices less than the minimum of its short-run
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average cost. It coincides with the firms short-run marginal cost curve where it is above the short-run average cost curve

The Firms Long Run Supply Curve
In the long-run the firm can adjust the amounts used of all its inputs in order to produce its desired output level at the going price. We can use the same two conditions to derive the firms long-run supply curve, except that in this case, of course, the firm needs to look at long-run average and marginal cost. Hence: When the price is above minimum long-run AC, the firm will produce and sell the level of output where price equals long-run MC When the price is below minimum long-run AC, the firm will shut down and produce zero output. These rules imply the long-run supply curve shown by the thick line in the diagram below.
per unit MCLR ACLR P1 P*
Quantity per month
The description of this long-run supply curve can be summarised as follows: A price-taking firms long-run supply curve coincides with the vertical axis at prices less than the minimum of its long-run average cost. It coincides with the firms long-run marginal cost curve where it is above the long-run average cost curve
Comparison of Short-Run & Long-Run Supply Curves
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How do the firms short and long-run supply curves compare? Recall from topic 7 that there are two main differences between short and long run costs. 1. In the long-run all input expenditures are economic costs, whereas in the short-run only expenditure on the variable factor (labour) is an economic cost 2. Factor substitution is possible in the long-run - hence the firm can always use the cost minimising combination of inputs. The second point implies that the long-run supply curve will be more elastic (flatter) than the short-run supply curve as the firm has more scope to make adjustments to its input mix and hence output and cost in the long-run. Both points together imply that at some output levels short-run MC (and hence the short-run supply curve) will be greater than long-run MC, whilst at other output levels the reverse will be true. The relationship between the two supply curves is shown in the following diagram.
per unit SSR SLR 20
60
100
Quantity per month
At a market price of 20 the firm will supply 100 units of output per month. Note that this is the long-run equilibrium level of output, i.e. when the firm has had time to adjust all its inputs to produce at minimum cost. What happens if the price changes? In the short-run the firm can only vary its labour input. Hence if it increases output in response to a price rise diminishing returns to labour will cause short-run MC to increase. Thus, it will only be profitable for the firm to increase output slightly in response to the price rise. In the long-run, however, the firm can also increase its capital stock, thereby increasing the MPP of labour and lessening the rise in MCSR. Consequently, the firm can afford to increase output more in the long-run. If the price falls below 20, the firm will cut production more in the long-run than in the short-run. In addition, the firm will still continue production in the short-run at price levels that in the long-run will
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cause the firm to shut-down and leave the market. For example, the diagram shows that the firm would produce 60 units per month at a price of 8 per unit in the short-run, but go out of business in the long-run. The reason is clear if we remember the shut-down rule - it pays the firm to produce whilst average revenue/price is equal to or greater than average cost and thus the firm makes an economic profit. In the short-run, average economic cost is less than in the long-run because the expenditure on fixed capital is not an economic cost. Hence some prices which cover average cost in the short-run and hence induce production will not cover average cost in the longrun. To summarise, when the price of output falls, a firm that continues to produce in the short-run may cease production in the long-run.
Factor Demand
Having looked at how a price-taking firm determines how much to supply in its product market in the short and long-runs, lets consider the corresponding decision it makes in its factor markets; i.e. how many units of inputs to demand. In effect, of course, we have already answered this question as once the firm has decided how much to produce it can use its production function and the prices of inputs to determine the economically efficient input mix to produce that desired output level. The key point here is that the firms input and output decisions are taken simultaneously, so what we are considering here is the same decision as before but from the perspective of input demand rather than output supply. An important difference between household demand for products and firm demand for inputs is that households demand goods for their own sake (for the utility they derive from their consumption) whereas firms only demand inputs in order to produce output to generate revenue. Therefore, the demand for an input is said to be a derived demand. A firms demand for an input is known as a derived demand because it depends on, or is derived from, the demand for the firms output.
Short-Run Factor Demand

In the short-run only one factor (usually labour) is variable whilst the other factor (capital) is fixed. Hence, the firm only needs to consider how much labour to employ. Recall that the firm wants to maximise profit - it therefore needs to use similar reasoning to the marginal output rule when determining how many units of variable factor to hire. Specifically, the firm should hire additional units of a factor
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whilst the marginal benefit (revenue) generated by the additional unit is greater than the marginal cost. The marginal benefit of an input is called the marginal revenue product. The marginal cost of an input is the marginal factor cost (first introduced in topic 7)
Marginal Revenue Product (MRP)

Marginal Revenue Product is the change in revenue due to the sale of the additional output contributed by the hiring of one more unit of a factor. How is MRP calculated? Well, it is clearly equal to the money value of the additional output produced. So we need to multiply the extra units of output (= marginal physical product) by the extra revenue (= marginal revenue) associated with each additional unit of output. Thus, for labour, we can state the following formula for the MRP of labour: MRPL = MPPL MR But for the price-taking firm, the MR is of course equal to the given market price of its product. Thus, we can state the formula as: MRPL = MPPL P i.e. for a price-taking firm, a factors marginal revenue product is equal to its marginal physical product multiplied by the price of output.
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Numerical Example: Marginal Revenue Product of Labour U ni ts of L a b o ur pe r w ee k T o t a l P r o d u c t p e r w e e k M a r g i n a l P h y s i c a l P r o d u c t 1 6 1 1 6 1 1 2 2 7 7 3 0 0 2 1 0 0 1 2 0 0 3 0 0 3 3 0 0 P r i c e ( M R ) p e r u n i t ( ) 3 0 0 4 8 0 0 M R P p er w o r k er ( )
3 4 4 3 0 0
3 8
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1 . 2 5 3 9 . 2 0 . 8 6 4 0 0 . 7 7 4 0 . 7
3 0 0
3 6 0
3 0 0 3 0 0
2 4 0 2 1 0
Note that this short-run production function exhibits diminishing marginal returns to labour. Hence, with a constant output price, the MRP of labour follows the same pattern.
Marginal Factor Cost

Recall from topic 7 that the marginal factor cost (MFC) is the increase in total expenditure on inputs when the firm hires one more unit of an input. Recall, too, that when the firm is a price-taker in the input market (as assumed here) the MFC is equal to the given price of the factor. Thus, in the case of labour, the MFC is equal to the going wage rate, w.
Maximising Profit: Factor Hiring Rule

Now that we have seen how to calculate marginal revenue product and marginal factor cost, by analogy with the marginal output rule we can state the following rule for input demand by a profitmaximising firm: Factor Hiring Rule: A profit-maximising firm should hire a factor up to the point at which its marginal revenue product is equal to its marginal factor cost: i.e. MRP = MFC The rationale for this rule is clear. Whilst employing an additional unit of input adds more to revenue than to cost (MRP > MFC) the firm will increase its profit by employing the extra unit. But when MRP < MFC the firm would raise profit by reducing employment.. Hence the firm should employ a factor up to the point where MRP = MFC.
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For a price-taking firm, MRP is the MPP times the given output price and MFC is equal to the given input price. Hence we can state the following: Factor Hiring Rule for a Price Taker : A firm that is a pricetaker in both the factor market and the product market maximises its profit by hiring a factor up to the point at which marginal physical product times the output price is equal to the input price: i.e. for labour, MPPL P = w Numerical Example: Factor Hiring Rule Continuing the example given above, assume the wage rate per worker per week is 240. How many workers would the firm employ to maximise profit? By comparing the MRPL figures in the table with the MFC of 240 we can see that the firm would employ 5 workers and produce 39.2 units per week.

Short-Run Factor Demand Curve
By applying the factor hiring rule to a range of input prices the firm can easily derive its short-run factor demand curve. For example, if the wage rate is 210 per week, the firm hires 6 workers. Thus we derive the following downward-sloping derived labour demand curve.
per worker 240 210 DL , MRPL
5 6
Worker per day
Note two characteristics of the price-taking firms derived factor demand curve: 1. It coincides with the firms marginal revenue product curve for the factor - because the firm equates MRP to the factor price.
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2. It is negatively-sloped - a rise in the factor price (wage rate) increases the short-run MC. The short-run MC curve shifts upwards causing the firm to supply less output at the given output price. Thus the firm also reduces its employment of the variable factor (labour). This is known as the output effect of a factor price change. The output effect is the change in the quantity demanded of an input due to the change in the firms output level that results from a change in the inputs price
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The Price-Taking Firm: Seminar Questions

1.
per unit
In the diagram below:

MCSR ACSR P1 P2
Quantity per month
a) b) 2.
If the price is P1, show the output level the firm would produce and the area of total economic profit If the price is P2, show the output level the firm would produce and the area of total economic profit
A newspaper report on the (US) turkey industry stated that the price paid to growers has fallen to about 60 cents a pound, slightly below what it costs to raise a turkey. However, an expert in the industry was not aware of any growers driven out of business by depressed prices. (The New York Times, November 11, 1991) Why might a turkey farmer stay in business if he or she were losing money? Resolve the following paradox (Hint: Read Katz & Rosen, pp. 313-317):
3.
Because of the increased opportunities for factor substitution in the long-run, the average total cost of producing a given level of output should be lower in the long-run than in the short-run. However, a price-taking firm that decides not to shut down in the short-run may shut-down in the long-run. In resolving this paradox, you should assume that input and output prices do not change over time. 4. The firms output and input decisions are taken simultaneously. Confirm this by showing that the marginal output rule and the factor hiring rule are equivalent ways of determining the maximum profit output and input levels. (Read Katz & Rosen, pp. 320 to 321) Consider a firm that is a price-taker in both the input and output markets. The output price is 10 per unit and the wage rate per worker is 40 per day. The firms total product schedule is as follows: 0 1 0 2 7 3 13 4 18 5 22 25
5.
Worker days Units of output
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a) b) 6.
Derive the firms demand curve for labour and graph it. On the same graph, draw the labour supply curve facing the firm. How many workers will the firm hire?
Between July 1991 and February 1992, US wheat prices increased by about 50%. Shortly thereafter, the Northern Plains Equipment Company of Mandan, North Dakota, found its tractor business increased by about 33% (The Wall Street Journal, Feb. 20th., 1992). Explain carefully why the increase in the price of wheat led to an increase in the demand for tractors. Read Katz & Rosen pp. 322 to 327 and then answer the following question. Draw an appropriate diagram to illustrate and explain the output and substitution effects on the long-run demand for labour of a fall in the price of labour, ceteris paribus.
7.
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Lecture 17 & 18 : Equilibrium in Competitive Markets
Objectives
After working through this topic you should be able to: Identify and explain the fundamental assumptions of the perfect competition model Describe the market structure appropriate to the competitive model Illustrate and explain how short-run competitive equilibrium is determined Illustrate and explain how long-run competitive equilibrium is determined in the constant-cost industry case Explain the increasing-cost and decreasing-cost industry models Explain the determination of short and long-run competitive equilibrium in a market with heterogeneous suppliers Apply the competitive model to evaluate public policy changes. Evaluate the efficiency of perfect competition
Key Concepts
perfect competition price-taking behaviour non-strategic behaviour free entry market structure homogeneous goods competitive equilibrium constant-cost industry increasing-cost industry decreasing-cost industry producer surplus heterogeneous suppliers total surplus efficiency
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The Basic Model of Perfect Competition

In this topic we will look at how a perfectly competitive market operates; i.e. how the demand decisions of buyers and the supply decisions of sellers come together to determine a market equilibrium. Note that the fundamental assumptions and market structure characteristics we outline below apply to both product and factor markets.
Fundamental Assumptions
1. Sellers are price-takers. Each firm believes that it can sell as much output as it likes at the going market price without its own output decisions influencing the market price. 2. Sellers do not behave strategically. Each firm operates under the belief that its own output decisions have no effect on the collective output decisions of the other firms in the industry. In other words, each firm does not anticipate any reaction by other suppliers to a change in its output decision. 3. Entry into the market is free. There are no restrictions on the process of entry into the market by new entrants: i.e. new entrants do not incur any special costs not borne by the existing incumbents in the market. (When such barriers do exist - legal or technological - entry is said to be blocked). 4. Buyers are price-takers. Each buyer (whether a firm or a household) believes it can buy as much as it likes at the going price without having any effect on that price.
The Appropriate Market Structure

What kind of structural features would a particular market have to exhibit in order to be regarded as (perfectly) competitive, so that it could be legitimately analysed using the perfect competition model? 1. A large number of buyers. For buyers to be price-takers there must be many of them, and each one should be small in relation to the overall market. Clearly, if this was not the case, then a particular buyer might be able to influence the market price by changing the amount that it buys. 2. A large number of sellers. Both the assumption of price taking and of non-strategic behaviour by suppliers are most likely to be satisfied when there are many suppliers in the market, each of whom is small relative to the overall market. The larger the number of suppliers, the smaller the market share of each firm and hence the smaller the effect of changes in one firms output on the total industry output. In other words, the more suppliers there are the higher is each firms price elasticity of demand.
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Example: If a firm produces 1/10,000 of the total market supply, then even a doubling of its output would only raise the market total by 0.01%. With a market price elasticity of 2, the price would fall by only 0.005% in response, and the firm-specific elasticity would be 20,000 [= -(100% quantity increase)/(0.005% price decrease)]. With this firm-specific elasticity, the firm would have to produce over 200 times as much output as before in order to lower the market price by 1%. In fact, firm-specific price elasticity is equal to the market elasticity divided by the firms market share: i.e.
firm =
mkt m
where m = the firms market share. Furthermore, when there are many sellers, each of whom has a small or negligible impact on the price, firms are unlikely to react to one anothers actions; i.e. each firm will act independently of the others. 1. Homogeneous products. Two products are homogeneous goods when they are considered identical by buyers. (Technically, they have a constant MRS equal to 1) Price-taking behaviour by firms requires that each one sells the same product, so that buyers always buy from the cheapest supplier. In these circumstances, each firm must charge the same price - any firm which tries to charge more will sell nothing. If the products of different suppliers are not homogeneous, then a firm may be able to increase its price without losing all its sales. Thus it will face a downward-sloping demand curve and will not be a price-taker. 2. Well informed buyers. For consumers to be able to always buy the cheapest product, and thus to force firms to charge the same going price, its clear that buyers must be well informed about all prices and available alternatives in the market. 3. Free entry to the market. Obviously, for a market to be regarded as (perfectly) competitive, there must be no technological or legal barriers to entry by new firms.
Short Run Competitive Equilibrium

To find the short-run equilibrium of a competitive market we need to use the short-run market demand and supply curves. In the short-run:
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Buyers will have less time to adjust their expenditures than in the long-run, so short-run market demand will tend to be less priceelastic than the long-run. Market demand is, of course, simply the (horizontal) summation of all the individual demands at each price. There will be a given, fixed number of firms in the market. New firms can only enter the market in the long-run. The incumbent firms will be operating on their short-run supply curves. As they are all price-takers, the market supply curve will be equal to the (horizontal) summation of each individual firms output at each price. (See Katz & Rosen, Fig. 11.1, p 350)
Market (& Firm) Equilibrium

The following diagram shows a competitive market in short-run equilibrium (panel B). Panel A shows the corresponding equilibrium position of an individual profit-maximising firm in the market.
A The Firm MCSR ACSR P1 dSR P1 SSR B The Market
DSR
x1
Output per month
X1
Output per month
At price P1 the market is in equilibrium because market demand equals market supply - the total quantity sold equals X 1 units per month. At price P1, this individual supplier is in equilibrium (as are all the other firms in the market). The firm is maximising economic profit by producing an output x1 per month at which the given market price is equal to the firms short-run MC.
Long Run Competitive Equilibrium

To find the long-run equilibrium of a competitive market we need to use the long-run market demand and supply curves. In the long-run: Buyers will have more time to adjust their expenditures than in the short-run, so long-run market demand will tend to be more price-elastic than the short-run. Market demand is, again, simply the (horizontal) summation of all the individual demands at each price.
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The number of firms in the market is not fixed. New firms can enter the market (if economic profits are possible), and existing firms who are making losses can exit the market. The incumbent firms will be operating on their long-run supply curves.
Market (& Firm) Equilibrium

To determine the market equilibrium, we need to derive the long-run market supply curve. We cannot do this by adding up each individual firms supply (as we did with the short-run) because the number of firms is not fixed. To make progress, let us assume that: 1. all incumbent and potential new firms to the industry have access to the same technology, and hence face the same costs 2. input prices remain unchanged regardless of the number of firms in the market. Given these circumstances the long-run equilibrium will be as shown in the following diagram:
A The Firm MCLR ACLR B The Market
P*
dLR
P*
SLR DLR
x*
Output per month
X1
Output per month
Note that the long-run market supply curve is horizontal at price P*, the minimum long-run AC for every firm in the industry. Why is this? At prices below P*, no firm remains in the industry since none of them can make an economic profit - hence market supply is zero at any price less than the minimum long-run AC. At prices above P*, any firm in the industry can make an economic profit. This possibility of earning positive profit attracts new entrants (remember entry into the market is completely free), continually increasing the market quantity supplied. Thus at any price above P*, the long-run market supply is virtually unlimited. When the market price is exactly equal to P*, a firm in the market maximises profit by producing x* units per month. However, this earns the firm zero economic profit, so some firms may prefer to exit the market or decide not to enter. Thus, at price P*, market supply could be anywhere between zero and very large depending
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on how many firms choose to enter and produce x* each. It follows that firms collectively are willing to supply any quantity at a price of P*, the minimum of long-run average cost. Taken together these three points imply that the long-run market supply curve is as shown in the diagram: i.e. perfectly elastic at price P*, the long-run minimum AC. The market is in long-run equilibrium when market demand equals market supply. This occurs at price P* and market quantity of X 1 see panel B of the diagram. Price cannot fall below P* in the longrun as no firm would be in the market. Hence if market demand decreases, the price remains at P* and market quantity falls via the exit of some of the incumbent firms. Similarly, price cannot rise above P* in the long-run, as this would attract a continual flow of new entrants, such that market supply would exceed market demand and price would be forced back down to P*. So, if market demand rises, the price remains at P* and market quantity increases via the entry of new firms. In the long-run, every firm in the industry produces x* units per month (at a price of P*) regardless of the market total. Finally, notice that the average cost of production is P* no matter what the long-run quantity supplied is. This is known, therefore, as a constant-cost industry. A constant-cost industry is one in which long-run average costs remain unchanged as industry output rises. The reason why average costs do not rise as market output increases is our assumption that input prices remain constant regardless of the number of firms in the industry. The next section explains the (probably) more realistic cases where input prices do change.
Increasing & Decreasing Cost Industries

Although in a perfectly competitive market each individual firm is a price-taker in the input markets, the industry as a whole may not be. A change in the industry output level will cause an industrywide change in the demand for inputs that may lead to a change in input prices, and hence each firms costs.
Increasing-Cost Industry
Suppose a competitive industry experiences an increase in demand for its product. To increase output the firms in the industry (existing and new entrants) will collectively increase their demand for inputs. If the industry faces upward-sloping supply curves for its inputs, then any increase in the industry demand for inputs will force up
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their price with a consequent increase in each firms average (and marginal) costs. It follows that the minimum price at which the industry will supply output (the long-run minimum AC) will have increased, and thus the market supply curve will be upward-sloping rather than horizontal as in the constant-cost industry case. In other words, because each firms long-run average costs have risen (due to the input price rise), the price at which firms will supply the output has also risen - the long-run market supply curve is upward-sloping . (For a more detailed derivation of the market supply curve in this case, see Katz & Rosen, pp. 356 to 359) Long-run equilibrium in this increasing-cost industry is illustrated in the diagram below.
A The Firm MCLR ACLR B The Market Producer Surplus P* DLR SLR
P*
dLR
x*
Output per month
X1
Output per month
At price P*, the market is in equilibrium with total quantity traded of X1 units per month. And at this price each firm in the industry is earning zero economic profit and producing x* units per month. (We are still assuming all firms have access to the same technology and hence have the same costs).
Producer Surplus
The shaded area above the supply curve and below the market price is called producer surplus. It is defined as the difference between the actual price received by the supplier and the minimum price at the supplier is willing to supply the good. The producer surplus on each unit up to X1 is given by the vertical distance between the supply curve and the market price of P*. Hence the total producer surplus is equal to the shaded area. When the supplier is a firm, that firms producer surplus is equal to its profit. But as weve just pointed out each firm in the market is making zero economic profit. Who then earns this producer surplus? It must be the suppliers of the inputs. The input market has an upward-sloping supply curve (remember thats why input prices rise when the demand for them rises). Hence the input suppliers earn a positive producer surplus (i.e. profit).
Decreasing-Cost Industry
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A third case is possible. If the input market has a downward-sloping supply curve, then input prices will fall as the demand for them by a particular industry rises. Hence firms in this industry will find their cost curves shifting downwards as the industry expands. As a result, the long-run market supply curve will be downward-sloping. A decreasing-cost industry is one in which long-run average costs fall as industry output rises.
Efficiency of Perfect Competition

Having looked at the positive question of how a perfectly competitive market would actually operate, lets turn finally to the normative question of how well such a market performs as a method of resource allocation. Specifically, we need to consider how efficient a competitive market is.
Measurement of Efficiency (Market Performance)

But how to measure the efficiency of a market? Recall from topic 4 that the net benefit to consumers from consumption of a product can be measured by their consumer surplus. Similarly, the benefit to producers can be measured by their profit, i.e. producer surplus. Thus, we can measure efficiency (or market performance) by looking at the total surplus generated by the quantity traded in a particular market. Total surplus measures the net gain to society from the production and consumption of a certain quantity of a good. It is equal to the sum of the consumer and producer surplus. Note: Total surplus can also be calculated as the total value (i.e. willingness to pay) to consumers from consumption of the good minus the total costs of producing it.

Total Surplus in a Competitive Market
The following diagram shows the total surplus in a competitive market when output is at its equilibrium level. X1.
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per unit Consumer Surplus P1 S
Producer Surplus X1
D Quantity per period
Is this the efficient level of output, i.e. is total surplus maximised at the equilibrium output level? (If total surplus is not maximised, then X1 cannot be efficient as it would be possible to increase total surplus by producing a different level of output and hence make consumers and producers collectively better off). The answer is yes. In a competitive market, total surplus is maximised at the equilibrium output level

So, we conclude that perfect competition leads to an efficient use of societys scarce resources. This is an important result. For even though many actual markets may not have the appropriate structure to operate as in the competitive model, the result provides a benchmark against which to compare market performance in these markets.
What About Equity?

One final point. Although perfect competition generates an efficient outcome by maximising total surplus, this does not mean that the outcome is also equitable (fair). Fairness depends on who receives the surplus, i.e. which groups of consumers and producers. In other words, maximising the size of the cake does not guarantee that it will be shared out in an equitable way. Of course, deciding what is a fair distribution is a subjective issue over which disagreements will inevitably occur. Thus, it is perhaps sensible to concentrate on achieving an efficient use of resources first and then consider questions of equity. (This is acceptable provided the two objectives can be pursued independently of each other).
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Equilibrium in Competitive Markets: Seminar Questions

1. Assume a firm produces 1/5000 of the total market supply. If the firm doubles its output level what happens to the market price given that the market price elasticity is 1.5? Calculate the firms price elasticity of demand. Try to think of a market (national or local) whose market structure fits the competitive model. Explain why. Consider a competitive industry consisting of 100 identical firms, each of which has the following cost schedule: 2 300 1250 230 400 3 400 1540 180 500 140 600 110 700 80 800 4 450 5 510 6 590 7 700 840 1020
2. 3.
Output 0 1 Total Cost Output 8 9 Total Cost Price 360 290 Quantity a)
Market demand is given by the following schedule: 900 1000
Draw the supply curve for an individual firm. On a separate graph, draw the supply and demand curves for the industry as a whole. Indicate the equilibrium price and output. Now draw the individual firms demand curve on the first graph and show the firms equilibrium price and output. Explain why the equilibrium found in (a) is a short-run equilibrium only. What will happen in the long-run? Describe the long-run equilibrium in as much detail as possible. What are heterogeneous suppliers? Explain how the short-run and long-run market equilibrium are determined. Who receives the producer surplus?
b)
4.
Read Katz & Rosen pp. 360 to 363, then answer the following questions: a) b) c)
5. 6.
Show that total surplus is equal to the difference between the total willingness to pay of buyers and the total cost of producing the good. Prove that total surplus is maximised when output is equal to the perfectly competitive equilibrium level. (Hint: show that total surplus is lower when output is either greater or less than the competitive equilibrium) Show the effect on total surplus of the imposition of a unit sales tax on the suppliers of a good in a competitive market.
7.
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Lecture 19 & 20 : Monopoly & Oligopoly
Objectives
After working through this topic you should be able to: Define the fundamental assumptions of the monopoly model Identify the market structure appropriate to the monopoly model Derive and explain the properties of the monopolists marginal revenue curve Derive and explain the relationship between marginal revenue and the firms price elasticity of demand Illustrate and explain how the monopoly firms equilibrium position is determined. Identify the conditions necessary for profitable price discrimination, and distinguish between first and third-degree discrimination Analyse the efficiency and equity of a monopoly. Explain the concept of a natural monopoly and the problems of effective regulation. Define the fundamental assumptions and identify the appropriate market structure of the oligopoly model
Key Concepts
monopoly price-maker marginal revenue price elasticity of demand equilibrium price discrimination efficiency deadweight loss of monopoly natural monopoly regulation oligopoly mutual interdependence
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The Basic Monopoly Model

Many, if not most, actual markets do not correspond to the model of perfect competition. Hence, in order to analyse behaviour in these markets we need to develop other models of market structure. One such model, of particular importance, is the monopoly model. The model of a monopolistic market structure is to some extent at the opposite extreme to that of perfect competition in terms of its fundamental assumptions. (But note that not all the fundamental assumptions are the exact opposite of those characterising the perfect competition model.)
1. Sellers are price makers. A firm is a price-maker (in its product market) if it can influence the price at which it sells its output by adjusting its output level. This implies that the firm is facing a downward-sloping demand curve - as it sells more output the price will fall, and vice versa. 2. Sellers do not behave strategically. As in the perfect competition model, it is assumed that each firm does not anticipate nor take into account any reaction by its rivals to its own actions. 3. Entry into the industry is completely blocked. No new suppliers can enter the industry - this is the opposite assumption to the competitive model. 4. Buyers are price takers.

What particular structural characteristics would a market have to possess in order to correspond to the monopoly model? 1. Many buyers. As noted before, for buyers to be price-takers, there should be a large number of them, no one of which is large enough in relation to the total demand to be able to influence the market price by changing the amount they purchase. 2. One seller. The assumptions of price-making sellers and nonstrategic behaviour are most likely to be satisfied when there is only one seller in the market. (Hence the term monopoly.) With a few suppliers in the market, each accounting for a significant market share, each firm will tend to be a price-maker. But they are also likely to behave strategically, as each one will take account of the its rivals possible reactions. Thus, the combination of price-making and non-strategic behaviour generally requires the existence of a single supplier in the market. 3. No close substitutes for the firms product . To identify a market with a single seller, we need to be clear about what constitutes the market.. To do this we need to consider which
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products are sufficiently close substitutes for each other to constitute a single, identifiable market. A supplier can then be defined as a monopolist if it produces a good or service for which there is no close substitute. Bu how do we determine, in practice, whether two goods are close substitutes? The most obvious answer is to look at the cross-price elasticity of demand between two products. Recall from topic 3 that this measures the effect on the demand for one product of a change in the price of another product; and a high positive value indicates that two goods are close substitutes. Thus, a monopolist should face low cross-price elasticities for its product vis--vis other firms products (i.e. if other firms reduce their price, this will not significantly reduce the demand for the monopolists product.) But when are the cross-price elasticities low enough for a firm to be considered a monopolist? There is no definite answer to this question. A value of, say, 0.01 or less would most probably indicate that two products are not close substitutes, whereas a figure of, say, 7 or higher would clearly indicate the reverse. But that leaves a lot of other possibilities where ambiguity remains. Because of this uncertainty regarding the definition of close substitutes, Katz & Rosen suggest that: The ultimate test of whether a firm is best modelled as a monopolist is whether: (1) it faces a firm-specific demand curve that slopes downward significantly enough that managers take it into account; and (2) the firm has no rivals whose reactions it has to consider when choosing its profit-maximising course of action. 4. Well informed buyers. In the perfectly competitive model, the requirement that buyers were well informed about the prices charged and products sold by each firm was crucial to the assumption of price-taking. Here, with only one seller, we assume that all buyers are fully informed about the monopolists price and the nature of its product. 5. Blocked entry to the market. To ensure only one firm supplies the market, entry by new firms is completely blocked by either technological or legal barriers.
Equilibrium
To determine the monopoly firms (short or long-run) equilibrium position, we apply the two rules for profit-maximisation first introduced in topic 5 (The Firm & its Goals): i.e.
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1. Marginal Output Rule: If the firm does not shut down, then it should produce output at a level where marginal revenue is equal to marginal cost 2. Shut-Down Rule: If for every choice of output level the firms average revenue is less that its average cost, the firm should shut down As with any other firm, a monopolists cost function is derived from the firms given technology (production function) and input prices. So the monopolists cost curves will have the usual shape. The difference between the monopoly firm and the firm in perfect competition arises on the revenue side.
Marginal Revenue for a Monopolist

Being the only firm in the industry, a monopoly faces a firm-specific downward-sloping demand curve which is also the market demand curve. As we saw in topic 5, when the firms demand curve slopes down, marginal revenue falls as the number of units sold increases. (N.B. It is assumed the firm charges the same price to all its customers - i.e. it does not practice any price discrimination.) To understand the reason for this, lets look again at the numerical example used in topic 5, assuming this time that the firm is a monopolist and hence the demand curve is both the firms and the markets.
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Numerical example: A Monopolists Marginal Revenue Output per week (000s) 0 1 2 3 4 5 6 7 8 20 18 16 14 12 10 8 6 Price per Total Revenue per unit () week (000) 0 20 20 16 36 12 48 8 56 4 60 0 60 -4 56 -8 48 Marginal Revenue (000)
This example reveals two important points: Marginal revenue falls as output sold increases. Hence, ultimately, marginal revenue becomes negative (i.e. total revenue actually falls if the firm sells another unit of output) Marginal revenue is less than price (average revenue). These relationships hold for any price-making firm, and constitute a fundamental difference from the price-taking firm where, as we found in topic 8, marginal revenue equals average revenue. Why is a monopoly firms MR < AR and why does MR fall as output rises? The following diagram helps to explain.
per unit Revenue lost on X1 units P1 P2 H B A J Revenue gained on extra unit D, AR X1 + 1 Quantity per period
X1
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When the firm sells X1 units at a price per unit of P 1 total revenue is equal to area 0P1HX1. If the firm increases output by one unit to X1 + 1, the price will fall to P2, giving a total revenue equal to area 0P2JX1+1. Has total revenue increased or decreased? It depends on whether marginal revenue (MR) is positive or negative. To calculate MR, consider areas A and B. Area A equals the extra revenue the firm receives from selling the marginal unit - it is equal to the new price P2 at which the extra unit is sold. Area B measures the revenue the firm loses on the other X1 units which are now also sold at the lower price P2 rather than P1 as before - it is clearly equal to (P2 - P1) x X1. Hence, MR = Area A + Area B. (Note: Area B represents a loss of revenue - hence it has a negative value) We can now see why MR is less than AR (i.e. price). Area A equals the price at which the firm sells its output. But MR is less than area A by the amount of lost revenue shown by area B. In other words, MR is less than price because the firm sells all its out put at the new lower price. Its also clear that MR could be positive or negative depending on the relative sizes of areas A and B. To confirm that MR falls as output rises, we need to derive an algebraic expression for MR.
Formula for Marginal Revenue

To derive a formula for MR we proceed as follows: MR = Area A + Area B Area A = price (P) Area B = X1 x (P2 - P1) = Quantity (X) x change in price (P) The slope (s) of the demand curve between points H & J = P/X But X = 1 Hence, s = P Area B = X x s So, putting this together, we get the following formula for MR: MR = P + X s Since s is negative (the monopolists demand curve slopes downward) this formula confirms that MR < P for any positive value of output, X. (It also shows that MR = P when output is zero.) The formula also confirms that as output ( X) increases, the value of MR falls (Why? Because as X increases, P falls and X x s becomes more negative) The following diagram shows graphically the relationship between the firms marginal revenue and average revenue (= demand) curves.
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per unit
D, AR O Quantity per period
MR

Marginal Revenue & Price Elasticity
We can also derive a useful formula for MR which shows its relationship with the price elasticity of demand. Recall from topic 3 that (point) elasticity of demand ( ) can be calculated using the following formula: = ( ) X P P X 1P = s X
where s = slope of demand curve = P/X Hence, X s= P P
Substituting this into the formula for MR derived above we get: MR = P + or, 1 MR = P 1 This is a very useful expression for marginal revenue. It shows for example that when demand is price elastic ( > 1) marginal revenue is positive. Hence, a price cut (and quantity increase) leads to an increase in total revenue.
137
Profit Maximisation: Monopoly Equilibrium

Having derived the monopoly firms marginal revenue curve, we can now apply the two rules for profit-maximisation to determine the firms equilibrium output and price levels. (Remember the firm is a price-maker). The following diagram shows the equilibrium position of the monopoly firm/industry.
per unit Economic Profit MC P1 AC
D, AR O X1 Quantity per period
MR
Using the marginal output rule, if it stays in business, the firm produces the output level where MR = MC. This is output X 1 in the diagram. The demand curve then shows the maximum price at which the firm can sell this output, P1. Finally, the shut-down rule confirms that the firm would be better off producing X 1 units rather than nothing as price (AR) is greater than AC. In fact, the firm makes an economic profit equal to the shaded area in the diagram. Note that as price is greater than MR for this price-making firm, and the firm produces where MR = MC then it must be the case that A monopolist charges an equilibrium price that is greater than marginal cost.
Price Elasticity & Profit Maximisation

Using the formula connecting MR to price elasticity of demand, we can write the profit-maximising rule as follows: 1 P 1 = MC Since MC must be positive, it follows that MR [= P(1-1/ )] must also be positive at the equilibrium output level. The only way P(1-
138
1/) can be positive is if > 1; i.e. if demand is price elastic. Thus we can conclude that: Demand must be elastic at the monopolists equilibrium price and output levels.

Short-Run & Long-Run Equilibrium
The only difference between the short- and long-run equilibrium positions of the monopoly firm is that in the short-run the firm bases its decisions on its short-run marginal and average cost curves, whilst it uses its long-run cost curves to determine its long run price and output levels. Because entry by new firms is completely blocked , there is no need to take account of the impact of new firms coming into the market in the long-run (as we had to do in the perfect competition model). Furthermore, the absence of the threat of entry by new firms means that the monopoly firm can continue to earn positive economic profit in the long-run.
Normative Analysis of Monopoly

The normative analysis of perfect competition showed that a perfectly competitive industry was efficient in the sense that it maximised the total surplus in the market. However, there was no guarantee that perfect competition would lead to an equitable distribution of the net social benefit. How does monopoly compare in terms of efficiency and equity?
Efficiency
The following diagram shows the total surplus generated in a monopolised industry (compared to a competitive industry with the same demand and cost conditions).
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per unit A Deadweight Loss E MC G F D, AR O X1 XC Quantity per period
P1 PC B
MR
Total surplus at the monopolists equilibrium output level of X 1 is given by area AEFB [i.e. total benefit (area 0AEX 1) less total cost (area 0BFX1)]. However, this is clearly not the maximum total surplus available in the market. If output was increased up to X C the increase in total benefits to consumers (area X1EGXC) would be greater than the increase in total cost (area X 1FGXC). Hence total surplus would rise. (Beyond XC there is no further net gain - why?) Thus total surplus is maximised (= area 0AGXC) at output XC. This is no surprise because XC is, in fact, the output produced by the industry if it is perfectly competitive. To see this, remember that the competitive industry supply curve is the horizontal summation of each firms supply (or MC) curve. (N.B. We are assuming that the cost conditions in the industry are the same under both monopoly and competition.) From this analysis we can draw two important conclusions: A monopoly firm does not produce the efficient level of output. Output is less than the level required to maximise total surplus. Consequently, monopoly results in a deadweight loss equal to the difference between the maximum total surplus and the total surplus resulting from the monopolists output level. A (multiplant) monopoly produces less output (at a higher price) than would a perfectly competitive industry with the same cost and demand conditions

Equity
So, a (nondiscriminating) monopolist is not efficient. What about its impact on equity? Because monopoly leads to a higher price than
140
under competition, if an industry becomes monopolised consumers lose as their consumer surplus is lower, whilst the increase in producer surplus (i.e. profit) means that the producers gain. Whether this income shift from consumers to producers/owners is fair or desirable depends on our personal value judgements. Hence, there is no definite answer regarding the equity of monopoly.
Oligopoly
The final section in this topic looks briefly at the oligopoly model of firm behaviour. The key feature of an oligopoly is the mutual interdependence of each firms actions: i.e. each firm recognises that the actions (e.g. price or output choices) made by one firm affect the profits of all firms in the industry. Because of this mutual interdependence, the firms in an oligopoly market must act strategically, and it the existence of strategic behaviour which most distinguishes the oligopoly model from the two other models, perfect competition and monopoly, that we have analysed.
1. Sellers are price-makers. Each firms demand curve is, to some extent, downward-sloping. 2. Sellers behave strategically. Mutual interdependence means that each firm must take into account the possible reactions of other firms to its own actions. Moreover, each firm recognises that its own firm-specific demand curve depends on the price and output decisions of its rivals. 3. Entry may range from completely blocked to perfectly free. Both types of entry condition are possible 4. Buyers are price-takers. Same assumption as in the competitive and monopoly models.

What structural features of an actual market would allow us to describe and analyse it as an oligopoly? 1. Many buyers, each of which is small relative to the overall market. This is the usual condition required for buyers to act as price-takers. 2. Few sellers, each of which is large relative to the overall market. When there are many firms in an industry, an action taken by any one of them has little impact on the others, and producers are unlikely to react to one anothers actions. In contrast, when there are relatively few firms (but more than one),
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each firm is a significant part of the market, and the firms are likely to recognise their mutual interdependence. Thus, the oligopoly model is best applied to an industry with a few sellers, each with a significant market share. 3. Homogeneous or differentiated products. Oligopoly allows for products that range from perfect substitutes to products that are highly differentiated. The only requirement is that products be close enough substitutes that producers recognise their influence on one another. 4. Well-informed or poorly informed buyers. Since individual suppliers face downward-sloping demand curves, oligopoly is a broad enough model to encompass both well informed and poorly informed consumers. 5. Free or blocked entry to the market. Oligopoly allows for conditions of entry ranging from completely blocked to perfectly free.
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Monopoly & Oligopoly: Seminar Questions

1. 2. Try to think of a market (national or local) whose market structure fits the monopoly model. Explain why. Use the formula for marginal revenue, i.e. MR = P + X s to calculate MR for the following demand curve: X = 100 3 P where X = quantity sold 3. Use the formula for marginal revenue, i.e. 1 MR = P 1 a) b) 4. to confirm that MR = price for a price-taking firm. (Hint: think about the value of price elasticity for a price-taking firm.) to derive the relationship between price elasticity of demand and total expenditure/revenue first discussed in topic 3
Show the effect on the monopolists equilibrium price and output levels of an advertising campaign that shifts the firms demand curve upward by exactly 1 at all output levels. The United States Department of Justice has a set of guidelines by which it attempts to define when a firm has market power. Originally, these guidelines said that a firm did not have market power if raising its price by 5% would lower the firms profit. Explain why a monopolist in equilibrium would always pass this test! Use the marginal output rule, 1 P 1 = MC
5.
6.
to confirm that a price-taking firm will produce the output level where price = marginal cost 7. Read Katz & Rosen pp. 448 to 455 and then answer the following questions: a) b) c) d) What is price discrimination? What conditions are required for price discrimination to successful? Distinguish between discrimination. first-degree and third-degree price
Why do the MR and demand curves coincide for a perfect price discriminator?
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8. 9.
Explain why a perfectly discriminating, profit-maximising monopolist would produce the total surplus maximising level of output. Read Katz & Rosen pp. 461 to 465 and then answer the following questions: a) b) c) What is a natural monopoly? Why does a natural monopoly have to be regulated? What are some of the problems involved in implementing an effective regulatory structure?
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Lecture 1 & 2: Introduction to Economics & the Market Economy

Scarcity, Choice & Cost

Now try seminar question 1

The Workings of a Market Economy

Flow of goods and services Flow of money

Figure 1-1: The Circular Flow Model

Demand and Supply Model

14 12 Price per unit 10 8 6 4 2 0 0 10 20 30 Quantity per period D

If the price changes - a movement along the demand curve

Now try seminar question 2

14 12 Price per unit 10 8 6 4 2 0 0 10 20 30 Quantity per period S

Now try seminar question 3

14 12 Price per unit 10 8 6 4 2 0 0 10 16 D 20 30 S

Quantity per period

14 12 Price per unit 10 8 6 4 2 0 0 10 12 16 D1 20 30 D2 S

Quantity per period

Now try seminar questions 4 & 5

The Role of Prices

The Market Economy: Seminar Questions

Lecture 3 & 4 : Consumer Choice

Basic Model of Rational Choice

Now try seminar question 1

More preferred region E U

Less preferred region

Now try seminar questions 2 & 3

Slope of the Budget Line

Shifts in the Budget Line

Now try seminar question 4

Now try seminar question 5

Now try seminar questions 6 & 7

Consumer Choice: Seminar Questions

The following table gives four indifference curves of an individual. U1 A B C F G a) b) c) d) X 3 4 6 9 14 Y 12 7 4 2 1 X 6 7 9 12 15 U2 Y 12 9 6 4 3 X 8 9 11 15 19 U3 Y 15 12 9 6 5 X 10 12 14 18 20 U4 Y 13 10 8 6.4 6

Lecture 5 & 6 : Comparative Statics & Demand

Price Change: Derivation of Demand Curve

Now try seminar question 1

ICC E2 U2 U1 Good X Income I2 I1 I3 Engel curve

Now try seminar question 2

Market Demand Curve

Price Elasticity of Demand

Calculation of Price Elasticity

X / X P / P 80 / 260 = ( ) 5 / 22.5 - 0.308 = ( ) 0.222 = 1.387

Now try seminar question 3

Determinants of Price Elasticity

Empirical Estimates of UK Demand

Now try seminar question 4

Price Elasticity & Total Expenditure

Price per unit

Qty per period

Now try seminar question 5

Linear Demand Curve

Now try seminar question 6

Income Elasticity of Demand

Range & Meaning

-0.50 0.53 0.87 1.14 1.99 2.60

Now try seminar question 7

Range & Meaning

Food 0.37 0.19 0.42

Clothing & Footwear -0.03 0.30 -0.01

Travel & Communication -0.12 -0.23 0.61