MANAGERIAL ECONOMICS

Price Elasticity of Demand

In this chapter we look at the idea of elasticity of

demand, in other words, how sensitive is the demand for
a product to a change in the product’s own price. You will
find that elasticity of demand is perhaps one of the most
important concepts to understand in your AS economics
course

Defining elasticity of demand

Ped measures the responsiveness of demand for a

product following a change in its own price.

The formula for calculating the co-efficient of elasticity of

demand is:

Percentage change in quantity demanded divided by the

percentage change in price

Since changes in price and quantity nearly always move

in opposite directions, economists usually do not bother
to put in the minus sign. We are concerned with the co-
efficient of elasticity of demand.

Understanding values for price elasticity of

demand

• If Ped = 0 then demand is said to be perfectly

inelastic. This means that demand does not change
at all when the price changes – the demand curve
will be vertical
• If Ped is between 0 and 1 (i.e. the percentage
change in demand from A to B is smaller than the
percentage change in price), then demand is
inelastic. Producers know that the change in
demand will be proportionately smaller than the
percentage change in price
• If Ped = 1 (i.e. the percentage change in demand is
exactly the same as the percentage change in
price), then demand is said to unit elastic. A 15%
rise in price would lead to a 15% contraction in
demand leaving total spending by the same at each
price level.
• If Ped > 1, then demand responds more than
proportionately to a change in price i.e. demand is
elastic. For example a 20% increase in the price of
a good might lead to a 30% drop in demand. The
 price elasticity of demand for this price change is –
1.5

What Determines Price Elasticity of Demand?

Demand for rail services

At peak times, the demand for rail transport becomes

inelastic – and higher prices are charged by rail
companies who can then achieve higher revenues and
profits

• The number of close substitutes for a good /

uniqueness of the product – the more close
substitutes in the market, the more elastic is the
demand for a product because consumers can more
easily switch their demand if the price of one
product changes relative to others in the market.
The huge range of package holiday tours and
destinations make this a highly competitive market
in terms of pricing – many holiday makers are price
sensitive
• The cost of switching between different
products – there may be significant transactions
costs involved in switching between different
goods and services. In this case, demand tends to
be relatively inelastic. For example, mobile phone
service providers may include penalty clauses in
contracts or insist on 12-month contracts being
taken out
• The degree of necessity or whether the good
is a luxury – goods and services deemed by
consumers to be necessities tend to have an
inelastic demand whereas luxuries will tend to have
a more elastic demand because consumers can
make do without luxuries when their budgets are
stretched. I.e. in an economic recession we can cut
back on discretionary items of spending
• The % of a consumer’s income allocated to
spending on the good – goods and services that
take up a high proportion of a household’s income
will tend to have a more elastic demand than
products where large price changes makes little or
no difference to someone’s ability to purchase the
product.
• The time period allowed following a price
change – demand tends to be more price elastic,
the longer that we allow consumers to respond to a
price change by varying their purchasing decisions.
In the short run, the demand may be inelastic,
 because it takes time for consumers both to notice
and then to respond to price fluctuations
• Whether the good is subject to habitual
consumption – when this occurs, the consumer
becomes much less sensitive to the price of the
good in question. Examples such as cigarettes and
alcohol and other drugs come into this category
• Peak and off-peak demand - demand tends to be
price inelastic at peak times – a feature that
suppliers can take advantage of when setting
higher prices. Demand is more elastic at off-peak
times, leading to lower prices for consumers.
Consider for example the charges made by car
rental firms during the course of a week, or the
cheaper deals available at hotels at weekends and
away from the high-season. Train fares are also
higher on Fridays (a peak day for travelling between
cities) and also at peak times during the day
• The breadth of definition of a good or service
– if a good is broadly defined, i.e. the demand for
petrol or meat, demand is often fairly inelastic. But
specific brands of petrol or beef are likely to be
more elastic following a price change

Demand curves with different price elasticity of

demand

Firms can use price elasticity of demand (PED) estimates

to predict:
The effect of a change in price on the total revenue &
expenditure on a product.
The likely price volatility in a market following
unexpected changes in supply – this is important for
commodity producers who may suffer big price
movements from time to time.

The effect of a change in a government indirect tax

on price and quantity demanded and also whether the
business is able to pass on some or all of the tax onto the
consumer.

Information on the price elasticity of demand can be used

by a business as part of a policy of price discrimination
(also known as yield management). This is where a
monopoly supplier decides to charge different prices for
the same product to different segments of the market
e.g. peak and off peak rail travel or yield management by
many of our domestic and international airlines
 Supply and demand
In economics, supply and demand describes market
relations between prospective sellers and buyers of a
good. The supply and demand model determines price
and quantity sold in the market. The model is
fundamental in microeconomic analysis of buyers and
sellers and of their interactions in a market. It is used as
a point of departure for other economic models and
theories. The model predicts that in a competitive
market, price will function to equalize the quantity
demanded by consumers and the quantity supplied by
producers, resulting in an economic equilibrium of price
and quantity. The model incorporates other factors
changing such equilibrium as reflected in a shift of
demand or supply.
Strictly considered, the model applies to a type of market
called perfect competition in which no single buyer or
seller has much effect on prices, and prices are known.
The quantity of a product supplied by the producer and
the quantity demanded by the consumer are dependent
on the market price of the product. The law of supply
states that quantity supplied is related to price. It is often
depicted as directly proportional to price: the higher the
price of the product, the more the producer will supply,
ceteris paribus. The law of demand is normally depicted
as an inverse relation of quantity demanded and price:
the higher the price of the product, the less the
consumer will demand, cet. par. "Cet. par." is added to
isolate the effect of price. Everything else that could
affect supply or demand except price is held constant.
The respective relations are called the 'supply curve' and
'demand curve', or 'supply' and 'demand' for short.
The laws of supply and demand state that the equilibrium
market price and quantity of a commodity is at the
intersection of consumer demand and producer supply.
Here, quantity supplied equals quantity demanded (as in
the enlargeable Figure), that is, equilibrium. Equilibrium
implies that price and quantity will remain there if it
begins there. If the price for a good is below equilibrium,
consumers demand more of the good than producers are
prepared to supply. This defines a shortage of the good. A
shortage results in the price being bid up. Producers will
increase the price until it reaches equilibrium. If the price
for a good is above equilibrium, there is a surplus of the
good. Producers are motivated to eliminate the surplus
by lowering the price. The price falls until it reaches
equilibrium.
THE DEMAND SCHEDULE
The demand schedule, depicted graphically as the
demand curve, represents the amount of goods that
buyers are willing and able to purchase at various prices,
assuming all other non-price factors remain the same.
The demand curve is almost always represented as
downwards-sloping, meaning that as price decreases,
consumers will buy more of the good.[1]
Just as the supply curves reflect marginal cost curves,
demand curves can be described as marginal utility
curves.[6]
The main determinants of individual demand are: the
price of the good, level of income, personal tastes, the
population (number of people), the government policies,
the price of substitute goods, and the price of
complementary goods.
The shape of the aggregate demand curve can be convex
or concave, possibly depending on income distribution.
As described above, the demand curve is generally
downward sloping. There may be rare examples of goods
that have upward sloping demand curves. Two different
hypothetical types of goods with upward-sloping demand
curves are a Giffen good (a sweet inferior, but staple,
good) and a Veblen good (a good made more fashionable
by a higher price).

MARGINAL REVENUE
(MR)
In microeconomics, Marginal Revenue (MR) is the extra
revenue that an additional unit of product will bring to a
firm. It can also be described as the change in total
revenue/change in number of units sold.
More formally, marginal revenue is equal to the change in
total revenue over the change in quantity when the
change in quantity is equal to one unit (or the change in
output in the bracket where the change in revenue has
occurred)
This can also be represented as a derivative. (Total
revenue) = (Price Demanded) times (Quantity) or
. Thus, by the product rule:

.
For a firm facing perfectly competitive markets, price

does not change with quantity sold ( ), so marginal

revenue is equal to price. For a monopoly, the price

received will decline with quantity sold ( ), so

marginal revenue is less than price. This means that the
profit-maximizing quantity, for which marginal revenue is
equal to marginal cost will be lower for a monopoly than
for a competitive firm, while the profit-maximizing price
will be higher. When marginal revenue is positive, Price
elasticity of demand [PED] is elastic, and when it is
negative, PED is inelastic. When marginal revenue is
equal to zero, price elasticity of demand is equal to -1.

Cross elasticity of demand

In economics, the cross elasticity of demand and cross
price elasticity of demand measures the responsiveness
of the quantity demand of a good to a change in the
price of another good.
It is measured as the percentage change in quantity
demanded for the first good that occurs in response to a
percentage change in price of the second good. For
example, if, in response to a 10% increase in the price of
fuel, the quantity of new cars that are fuel inefficient
demanded decreased by 20%, the cross elasticity of
demand would be -20%/10% = -2.
The formula used to calculate the coefficient cross
elasticity of demand is

or:

Two goods that complement each other show a negative

cross elasticity of demand.
In the example above, the two goods, fuel and
cars(consists of fuel consumption), are complements -
that is, one is used with the other. In these cases the
cross elasticity of demand will be negative. In the case of
perfect complements, the cross elasticity of demand is
infinitely negative.
Where the two goods are substitutes the cross elasticity
of demand will be positive, so that as the price of one
goes up the quantity demanded of the other will
increase. For example, in response to an increase in the
price of carbonated soft drinks, the demand for non-
carbonated soft drinks will rise. In the case of perfect
substitutes, the cross elasticity of demand is equal to
infinity.
Where the two goods are complements the cross
elasticity of demand will be negative, so that as the price
of one goes up the quantity demanded of the other will
decrease. For example, in response to an increase in the
price of fuel, the demand for new cars will decrease.
Where the two goods are independent, the cross
elasticity demand will be zero: as the price of one good
changes, there will be no change in quantity demanded
of the other good.
When goods are substitutable, the diversion ratio - which
quantifies how much of the displaced demand for product
j switches to product i - is measured by the ratio of the
cross-elasticity to the own-elasticity multiplied by the
ratio of product i's demand to product j's demand. In the
discrete case, the diversion ratio is naturally interpreted
as the fraction of product j demand which treats product i
as a second choice,[1] measuring how much of the
demand diverting from product j because of a price
increase is diverted to product i can be written as the
product of the ratio of the cross-elasticity to the own-
elasticity and the ratio of the demand for product i to the
demand for product j. In some cases, it has a natural
interpretation as the proportion of people buying product
j who would consider product i their `second choice.'

Empirical Demand Function

Empirical estimation
Demand and supply relations in a market can be
statistically estimated from price, quantity, and other
data with sufficient information in the model. This can be
done with simultaneous-equation methods of estimation
in econometrics. Such methods allow solving for the
model-relevant "structural coefficients," the estimated
algebraic counterparts of the theory. The Parameter
identification problem is a common issue in "structural
estimation." Typically, data on exogenous variables (that
is, variables other than price and quantity, both of which
are endogenous variables) are needed to perform such
an estimation. An alternative to "structural estimation" is
reduced-form estimation, which regresses each of the
endogenous variables on the respective exogenous
variables.

Macroeconomic uses of demand and

supply
Demand and supply have also been generalized to
explain macroeconomic variables in a market economy,
including the quantity of total output and the general
price level. The Aggregate Demand-Aggregate Supply
model may be the most direct application of supply and
demand to macroeconomics, but other macroeconomic
models also use supply and demand. Compared to
microeconomic uses of demand and supply, different
(and more controversial) theoretical considerations apply
to such macroeconomic counterparts as aggregate
demand and aggregate supply. Demand and supply may
also be used in macroeconomic theory to relate money
supply to demand and interest rates.

Demand shortfalls
A demand shortfall results from the actual demand for a
given product or service being lower than the projected,
or estimated, demand for that product or service.
Demand shortfalls are caused by demand overestimation
in the planning of new products and services. Demand
overestimation is caused by optimism bias and/or
strategic misrepresentation.

BUSINESS FORCASTING
Forecasting is the process of estimation in unknown
situations. Prediction is a similar, but more general term.
Both can refer to estimation of time series, cross-
sectional or longitudinal data. Usage can differ between
areas of application: for example in hydrology, the terms
"forecast" and "forecasting" are sometimes reserved for
estimates of values at certain specific future times, while
the term "prediction" is used for more general estimates,
such as the number of times floods will occur over a long
period. Risk and uncertainty are central to forecasting
and prediction. Forecasting is used in the practice of
Demand Planning in every day business forecasting for
manufacturing companies. The discipline of demand
planning, also sometimes referred to as supply chain
forecasting, embraces both statistical forecasting and a
consensus process.
Forecasting is commonly used in discussion of time-series
data.

Categories of forecasting methods

Time series methods
Time series methods use historical data as the basis of
estimating future outcomes.

 Moving average
 Exponential smoothing
 Extrapolation
 Linear prediction
 Trend estimation
 Growth curve


Causal / econometric methods

Some forecasting methods use the assumption that it is
possible to identify the underlying factors that might
influence the variable that is being forecast. For example,
sales of umbrellas might be associated with weather
conditions. If the causes are understood, projections of
the influencing variables can be made and used in the
forecast.

 Regression analysis using linear regression or non-

linear regression
 Autoregressive moving average (ARMA)
 Autoregressive integrated moving average (ARIMA)
 e.g. Box-Jenkins

Judgmental methods
Judgemental forecasting methods incorporate
intuitive judgements, opinions and probability
estimates.

 Composite forecasts
 Surveys
 Delphi method
 Scenario building
 Technology forecasting
 Forecast by analogy

Other methods
 Simulation
 Prediction market
 Probabilistic forecasting and Ensemble forecasting
 Reference class forecasting
  BUSINEES AND ECONOMIC FORCASTING
 Economic forecasting is the process of making
predictions about the economy as a whole or in
part

Input-output model
Jump to: navigation, search
This article is about the economic model. For the
computer interface, see Input/output.
The Input-output model of economics uses a matrix
representation of a nation's (or a region's) economy to
predict the effect of changes in one industry on others
and by consumers, government, and foreign suppliers on
the economy. This model, if applied on a region, is also
known as the Regional Impact Multiplier System. Wassily
Leontief (1905-1999) is credited with the development of
this analysis. Francois Quesnay developed a cruder
version of this technique called Tableau économique.
Leontief won the Nobel Memorial Prize in Economic
Sciences for his development of this model.
Input-output analysis considers inter-industry relations in
an economy, depicting how the output of one industry
goes to another industry where it serves as an input, and
thereby makes one industry dependent on another both
as customer of output and as supplier of inputs. An input-
output model is a specific formulation of input-output
analysis.
Each column of the input-output matrix reports the
monetary value of an industry's inputs and each row
represents the value of an industry's outputs. Suppose
there are three industries. Column 1 reports the value of
inputs to Industry 1 from Industries 1, 2, and 3. Columns
2 and 3 do the same for those industries. Row 1 reports
the value of outputs from Industry 1 to Industries 1, 2,
and 3. Rows 2 and 3 do the same for the other industries.
While the input-output matrix reports only the
intermediate goods and services that are exchanged
among industries, row vectors on the bottom record the
disposition of finished goods and services to consumers,
government, and foreign buyers. Similarly, column
vectors on the right record non-industrial inputs like labor
and purchases from foreign suppliers.
In addition to studying the structure of national
economies, input-output economics has been used to
study regional economies within a nation, and as a tool
for national economic planning.
The mathematics of input-output economics is
straightforward, but the data requirements are enormous
because the expenditures and revenues of each branch
of economic activity has to be represented. The tool has
languished because not all countries collect the required
data, data quality varies, and the data collection and
preparation process has lags that make timely analysis
difficult. Typically input-out tables are compiled
retrospectively as a "snapshot" cross-section of the
economy, once every few years.

Usefulness
An input-output model is widely used in economic
forecasting to predict flows between sectors. They are
also used in local urban economics.
Irving Hock at the Chicago Area Transportation Study did
detailed forecasting by industry sectors using input-
output techniques. At the time, Hock’s work was quite an
undertaking, the only other work that has been done at
the urban level was for Stockholm and it was not widely
known. Input-output was one of the few techniques
developed at the CATS not adopted in later studies. Later
studies used economic base analysis techniques.
Input-output models at ZIP code level compilations (eg, a
city) are also available through the IMPLAN system.

Key Ideas
The inimitable book by Leontief himself remains the best
exposition of input-output analysis. See bibliography.
Input-output concepts are simple. Consider the
production of the ith sector. We may isolate (1) the
quantity of that production that goes to final demand,ci,
(2) to total output, xi, and (3) flows xij from that industry
to other industries. We may write a transactions tableau
 Table: Transactions in a Three Sector Economy

Inputs
Inputs to Inputs to Final Total
Economic to
Agricultu Manufacturi Deman Outpu
Activities Transpor
re ng d t
t

Agriculture 5 15 2 68 90

Manufacturi
10 20 10 40 80
ng

Transportati
10 15 5 0 30
on

Labor 25 30 5 0 60

BASIC CONCEPT OF
PRODUCTION THEORY
In microeconomics, Production is simply the conversion
of inputs into outputs. It is an economic process that uses
resources to create a commodity that is suitable for
exchange. This can include manufacturing, storing,
shipping, and packaging. Some economists define
production broadly as all economic activity other than
consumption. They see every commercial activity other
than the final purchase as some form of production.
Production is a process, and as such it occurs through
time and space. Because it is a flow concept, production
is measured as a “rate of output per period of time”.
There are three aspects to production processes:

1. the quantity of the commodity produced,

2. the form of the good created,
3. the temporal and spatial distribution of the
commodity produced.

A production process can be defined as any activity that

increases the similarity between the pattern of demand
for goods, and the quantity, form, and distribution of
these goods available to the market place

Efficiency and cross-efficiency

A production process is efficient if a given quantity of
outputs cannot be produced with any less inputs. It is
said to be inefficient when there exists another feasible
process that, for any given output, uses less inputs.
Some economists (in particular Leibenstein) use the term
X-efficiency to indicate that production processes tend to
be inherently inefficient due to satisficing behaviour. The
“rate of efficiency” is simply the amount of (or value of)
outputs divided by the amount of (or value of) inputs. If a
production process uses 50 units of input (or $5000
worth of inputs) to produce one unit of output it is more
efficient than a process that uses 55 units of input (or
$5500 worth of inputs) to produce the same level of
output. It is said to be 10% more efficient ({55-
50}/50=1/10=10%).

Factors of production
The inputs or resources used in the production process
are called factors by economists. The myriad of possible
inputs are usually grouped into four or five categories.
These factors are:

 Raw materials
 Machinery
 Labour services
 Capital goods
 Land
 Enterpreneur

In the “long run” all of these factors of production can be

adjusted by management. The “short run” however, is
defined as a period in which at least one of the factors of
production is fixed.
A fixed factor of production is one whose quantity cannot
readily be changed. Examples include major pieces of
equipment, suitable factory space, and key managerial
personnel.
A variable factor of production is one whose usage rate
can be changed easily. Examples include electrical power
consumption, transportation services, and most raw
material inputs. In the short run, a firm’s “scale of
operations” determines the maximum number of outputs
that can be produced. In the long run, there are no scale
limitations.
Many ways of expressing the
production relationship
The total, average, and marginal physical product curves
mentioned above are just one way of showing production
relationships. They express the quantity of output
relative to the amount of variable input employed while
holding fixed inputs constant. Because they depict a
short run relationship, they are sometimes called short
run production functions. If all inputs are allowed to be
varied, then the diagram would express outputs relative
to total inputs, and the function would be a long run
production function. If the mix of inputs is held constant,
then output would be expressed relative to inputs of a
fixed composition, and the function would indicate long
run economies of scale.
Rather than comparing inputs to outputs, it is also
possible to assess the mix of inputs employed in
production. An isoquant (see below) relates the
quantities of one input to the quantities of another input.
It indicates all possible combinations of inputs that are
capable of producing a given level of output.
Rather than looking at the inputs used in production, it is
possible to look at the mix of outputs that are possible for
any given production process. This is done with a
production possibilities frontier. It indicates what
combinations of outputs are possible given the available
factor endowment and the prevailing production
technology.

Isoquants
There are many ways of producing a given level of
output. You can use a lot of labour with a minimal amount
of capital, or you could invest heavily in capital
equipment that requires a minimal amount of labour to
operate, or any combination in between. For most goods,
there are more than just two inputs. For example in
agriculture, the amount of land, water, and fertilizer can
all be varied to produce different amounts of a crop. An
isoquant, in the two input case, is a curve that shows all
the ways of combining two inputs so as to produce a
given level of output.
The marginal rate of technical
substitution
Isoquants are typically convex to the origin reflecting the
fact that the two factors are substitutable for each other
at varying rates. This rate of substitutability is called the
“marginal rate of technical substitution” (MRTS) or
occasionally the “marginal rate of substitution in
production”. It measures the reduction in one input per
unit increase in the other input that is just sufficient to
maintain a constant level of production. For example, the
marginal rate of substitution of labour for capital gives
the amount of capital that can be replaced by one unit of
labour while keeping output unchanged.

Isoquant

An isoquant map where Q3 > Q2 > Q1. A typical choice

of inputs would be labor for input X and capital for input
Y. More of input X, input Y, or both is required to move
from isoquant Q1 to Q2, or from Q2 to Q3.

A) Example of an isoquant map with two inputs that are

perfect substitutes.
B) Example of an isoquant map with two inputs that are
perfect complements.

In economics, an isoquant (derived from quantity and the

Greek word iso [meaning equal]) is a contour line drawn
through the set of points at which the same quantity of
output is produced while changing the quantities of two
or more inputs. While an indifference curve helps to
answer the utility-maximizing problem of consumers, the
isoquant deals with the cost-minimization problem of
producers. Isoquants are typically drawn on capital-labor
graphs, showing the tradeoff between capital and labor
in the production function, and the decreasing marginal
returns of both inputs. Adding one input while holding the
other constant eventually leads to decreasing marginal
output, and this is reflected in the shape of the isoquant.
A family of isoquants can be represented by an isoquant
map, a graph combining a number of isoquants, each
representing a different quantity of output.
An isoquant shows that the firm in question has the
ability to substitute between the two different inputs at
will in order to produce the same level of output. An
isoquant map can also indicate decreasing or increasing
returns to scale based on increasing or decreasing
distances between the isoquants on the map as you
increase output. If the distance between isoquants
increases as output increases, the firm's production
function is exhibiting decreasing returns to scale;
doubling both inputs will result in placement on an
isoquant with less than double the output of the previous
isoquant. Conversely, if the distance is decreasing as
output increases, the firm is experiencing increasing
returns to scale; doubling both inputs results in
placement on an isoquant with more than twice the
output of the original isoquant.
As with indifference curves, two isoquants can never
cross. Also, every possible combination of inputs is on an
isoquant. Finally, any combination of inputs above or to
the right of an isoquant results in more output than any
point on the isoquant. Although the marginal product of
an input decreases as you increase the quantity of the
input while holding all other inputs constant, the
marginal product is never negative since a logical firm
would never increase an input to decrease output.
Shapes of Isoquant Curve:
If the two inputs are perfect substitutes, the resulting
isoquant map generated is represented in fig. A; with a
given level of production Q3, input X is effortlessly
replaced by input Y in the production function. The
perfect substitute inputs do not experience decreasing
marginal rates of return when they are substituted for
each other in the production function.
If the two inputs are perfect complements, the isoquant
map takes the form of fig. B; with a level of production
Q3, input X and input Y can only be combined efficiently
in a certain ratio represented by the kink in the isoquant.
The firm will combine the two inputs in the required ratio
to maximize output and minimize cost. If the firm is not
producing at this ratio, there is no rate of return for
increasing the input that is already in excess.
Isoquants are typically combined with isocost lines in
order to provide a cost-minimization production
optimization problem.
 MONOPOLISTIC COMPETETION

Monopolistic competition
Monopolistic competition is a common market form.
Many markets can be considered monopolistically
competitive, often including the markets for restaurants,
cereal, clothing, shoes and service industries in large
cities.
Monopolistically competitive markets have the following
characteristics:

 There are many producers and many consumers in a

given market.
 Consumers perceive that there are non-price
differences among the competitors' products.
 There are few barriers to entry and exit[1].
 Producers have a degree of control over price.

The characteristics of a monopolistically competitive

market are almost the same as in perfect competition,
with the exception of heterogeneous products, and that
monopolistic competition involves a great deal of non-
price competition (based on subtle product
differentiation). A firm making profits in the short run will
break even in the long run because demand will decrease
and average total cost will increase. This means in the
long run, a monopolistically competitive firm will make
zero economic profit. This gives the company a certain
amount of influence over the market; because of brand
loyalty, it can raise its prices without losing all of its
customers. This means that an individual firm's demand
curve is downward sloping, in contrast to perfect
competition, which has a perfectly elastic demand
schedule.
==Definition of monopolistic competition== na lie
Short-run equilibrium of the firm under monopolistic
competition
A monopolistically competitive firm acts like a monopolist
in that the firm is able to influence the market price of its
product by altering the rate of production of the product.
Unlike in perfect competition, monopolistically
competitive firms produce products that are not perfect
substitutes. As such, brand X's product, which is different
(or at least perceived to be different) from all other
brands' products, is available from only a single producer.
In the short-run, the monopolistically competitive firm
can exploit the heterogeneity of its brand so as to reap
positive economic profit (i.e. the rate of return is greater
than the rate required to compensate debt and equity
holders for the risk of investing in the firm). One possible
effect of advertising on a firm's long run average cost
curve when earning an economic profit in the short run is
to raise the curve.

Long-run equilibrium of the firm under monopolistic

competition
In the long-run, however, whatever distinguishing
characteristic that enables one firm to reap monopoly
profits will be duplicated by competing firms. This
competition will drive the price of the product down and,
in the long-run, the monopolistically competitive firm will
make zero economic profit (i.e. a rate of return equal to
the rate required to compensate debt and equity holders
for the risk of investing in the firm).
Unlike in perfect competition, the monopolistically
competitive firm does not produce at the lowest
attainable average total cost. Instead, the firm produces
at an inefficient output level, reaping more in additional
revenue than it incurs in additional cost versus the
efficient output level.

Problems
While monopolistically competitive firms are inefficient, it
is usually the case that the costs of regulating prices for
every product that is sold in monopolistic competition by
far exceed the benefits; the government would have to
regulate all firms that sold heterogeneous products—an
impossible proposition in a market economy. A
monopolistically competitive firm might be said to be
marginally inefficient because the firm produces at an
output where average total cost is not a minimum. A
monopolistically competitive market might be said to be
a marginally inefficient market structure because
marginal cost is less than price in the long run.
Another concern of critics of monopolistic competition is
that it fosters advertising and the creation of brand
names. Critics argue that advertising induces customers
into spending more on products because of the name
associated with them rather than because of rational
factors. This is disputed by defenders of advertising who
argue that (1) brand names can represent a guarantee of
quality, and (2) advertising helps reduce the cost to
consumers of weighing the tradeoffs of numerous
competing brands. There are unique information and
information processing costs associated with selecting a
brand in a monopolistically competitive environment. In a
monopoly industry, the consumer is faced with a single
brand and so information gathering is relatively
inexpensive. In a perfectly competitive industry, the
consumer is faced with many brands. However, because
the brands are virtually identical, again information
gathering is relatively inexpensive. Faced with a
monopolistically competitive industry, to select the best
out of many brands the consumer must collect and
process information on a large number of different
brands. In many cases, the cost of gathering information
necessary to selecting the best brand can exceed the
benefit of consuming the best brand (versus a randomly
selected brand).
Evidence suggests that consumers use information
obtained from advertising not only to assess the single
brand advertised, but also to infer the possible existence
of brands that the consumer has, heretofore, not
observed, as well as to infer consumer satisfaction with
brands similar to the advertised brand.[2]

Examples
In many U.S. markets, producers practice product
differentiation by altering the physical composition, using
special packaging, or simply claiming to have superior
products based on brand images and/or advertising.
Toothpastes and toilet papers are examples of
differentiated products.

OLIGOPOLY

An oligopoly is a market form in which a market or

industry is dominated by a small number of sellers
(oligopolists). The word is derived from the Greek for a
few over many. Because there are few participants in this
type of market, each oligopolist is aware of the actions of
the others. The decisions of one firm influence, and are
influenced by the decisions of other firms. Strategic
planning by oligopolists always involves taking into
account the likely responses of the other market
participants. This causes oligopolistic markets and
industries to be at the highest risk for collusion.

Description
Oligopoly is a common market form. As a quantitative
description of oligopoly, the four-firm concentration ratio
is often utilized. This measure expresses the market
share of the four largest firms in an industry as a
percentage. Using this measure, an oligopoly is defined
as a market in which the four-firm concentration ratio is
above 40%.[citation needed]
Oligopolistic competition can give rise to a wide range of
different outcomes. In some situations, the firms may
collude to raise prices and restrict production in the same
way as a monopoly. Where there is a formal agreement
for such collusion, this is known as a cartel.
Firms often collude in an attempt to stabilise unstable
markets, so as to reduce the risks inherent in these
markets for investment and product development. There
are legal restrictions on such collusion in most countries.
There does not have to be a formal agreement for
collusion to take place (although for the act to be illegal
there must be a real communication between companies)
- for example, in some industries, there may be an
acknowledged market leader which informally sets prices
to which other producers respond, known as price
leadership.
In other situations, competition between sellers in an
oligopoly can be fierce, with relatively low prices and
high production. This could lead to an efficient outcome
approaching perfect competition. The competition in an
oligopoly can be greater than when there are more firms
in an industry if, for example, the firms were only
regionally based and didn't compete directly with each
other.
The welfare analysis of oligopolies suffers, thus, from a
sensitivity to the exact specifications used to define the
market's structure. In particular, the level of deadweight
loss is hard to measure. The study of product
differentiation indicates oligopolies might also create
excessive levels of differentiation in order to stifle
competition.
Oligopoly theory makes heavy use of game theory to
model the behaviour of oligopolies:
Stackelberg's duopoly. In this model the firms move
sequentially (see Stackelberg competition).
Cournot's duopoly. In this model the firms simultaneously
choose quantities (see Cournot competition).
Bertrand's oligopoly. In this model the firms
simultaneously choose prices (see Bertrand competition).

Demand curve

Above the kink, demand is relatively elastic because all

other firm’s prices remain unchanged. Below the kink,
demand is relatively inelastic because all other firms will
introduce a similar price cut, eventually leading to a price
war. Therefore, the best option for the oligopolist is to
produce at point E which is the equilibrium point and,
incidentally, the kink point.
In an oligopoly, firms operate under imperfect
competition and a kinked demand curve which reflects
inelasticity below market price and elasticity above
market price, the product or service firms offer, are
differentiated and barriers to entry are strong. Following
from the fierce price competitiveness created by this
sticky-upward demand curve, firms utilize non-price
competition in order to accrue greater revenue and
market share.
"Kinked" demand curves are similar to traditional
demand curves, as they are downward-sloping. They are
distinguished by a hypothesized convex bend with a
discontinuity at the bend - the "kink." Therefore, the first
derivative at that point is undefined and leads to a jump
discontinuity in the marginal revenue curve.
Classical economic theory assumes that a profit-
maximizing producer with some market power (either
due to oligopoly or monopolistic competition) will set
marginal costs equal to marginal revenue. This idea can
be envisioned graphically by the intersection of an
upward-sloping marginal cost curve and a downward-
sloping marginal revenue curve (because the more one
sells, the lower the price must be, so the less a producer
earns per unit). In classical theory, any change in the
marginal cost structure (how much it costs to make each
additional unit) or the marginal revenue structure (how
much people will pay for each additional unit) will be
immediately reflected in a new price and/or quantity sold
of the item. This result does not occur if a "kink" exists.
Because of this jump discontinuity in the marginal
revenue curve, marginal costs could change without
necessarily changing the price or quantity.
The motivation behind this kink is the idea that in an
oligopolistic or monopolistically competitive market, firms
will not raise their prices because even a small price
increase will lose many customers. However, even a
large price decrease will gain only a few customers
because such an action will begin a price war with other
firms. The curve is therefore more price-elastic for price
increases and less so for price decreases. Firms will often
enter the industry in the long run.

[edit] Oligopsonies
Oligopsony is a market form in which the number of
buyers is small while the number of sellers in theory
could be large. This typically happens in markets for
inputs where a small number of firms are competing to
obtain factors of production. This also involves strategic
interactions but of a different nature than when
competing in the output market to sell a final output.
Oligopoly refers to the market for output while oligopsony
refers to the market where these firms are the buyers
and not sellers (eg. a factor market). A market with a few
sellers (oligopoly) and a few buyers (oligopsony) is
referred to as a bilateral oligopoly.

Examples
In the United Kingdom, the four-firm concentration ratio
of the supermarket industry is 74.4% (2006)[1]; the
British brewing industry has a staggering 85% ratio. In
the U.S.A, oligopolistic industries include the beer,
tobacco, accounting and audit services, aircraft, military
equipment, and motor vehicle industries.
Many media industries today are essentially oligopolies.
Six movie studios receive 90 percent of American film
revenues, and four major music companies receive 80
percent of recording revenues. There are just six major
book publishers, and the television industry was an
oligopoly of three networks- ABC, CBS, and NBC-from the
1950s through the 1970s. Television has diversified since
then, especially because of cable, but today it is still
mostly an oligopoly (due to concentration of media
ownership) of five companies: Disney/ABC, Viacom/CBS,
NBC Universal, Time Warner, and News Corporation.[2]
In industrialized countries oligopolies are found in many
sectors of the economy, such as cars, auditing, consumer
goods, and steel production. Unprecedented levels of
competition, fueled by increasing globalisation, have
resulted in the emergence of oligopoly in many market
sectors, such as the aerospace industry. Market shares in
oligopoly are typically determined on the basis of product
development and advertising. There are now only a small
number of manufacturers of civil passenger aircraft,
though Brazil (Embraer) and Canada (Bombardier) have
fielded entries into the smaller-market passenger aircraft
market sector. A further instance arises in a heavily
regulated market such as wireless communications. In
some cases states have licensed only two or three
providers of cellular phone services.
OPEC is another example of an oligopoly, although on the
level of national bodies instead of corporate bodies.
There are a few countries that try to control the
production of oil.
 Isocost
In economics an isocost line represents a combination of
inputs which all cost the same amount. Although similar
to the budget constraint in consumer theory, the use of
the isocost pertains to cost-minimization in production,
as opposed to utility-maximization. The typical isocost
line represents the ratio of costs of labour and capital, so
the formula is often written as:

Where w represents the wage of labour, and r represents

the rental rate of capital. The slope is:
or the negative ratio of wages divided by rental fees.
The isocost line is combined with the isoquant line to
determine the optimal production point (at a given level
of output).
The cost function for a firm with two variable inputs
Consider a firm that uses two inputs and has the
production function F. This firm minimizes its cost of
producing any given output y if it chooses the pair (z1,
z2) of inputs to solve the problem
Min z1,z2w1z1 + w2z2 subject to y = F (z1, z2),
where w1 and w2 are the input prices. Note that w1, w2,
and y are given in this problem---they are parameters.
The variables are z1 and z2. Denote the amounts of the
two inputs that solve this problem by z1*(y, w1, w2) and
z2*(y, w1, w2). The functions z1* and z2* are the firm's
conditional input demand functions. (They are conditional

on the output y, which is taken as given.)

The firm's minimal cost of producing the output y is
w1z1*(y,w1, w2) + w2z2*(y,w1, w2) (the value of its total
cost for the values of z1 and z2 that minimize that cost).
The function TC defined by

which is called the firm's (total) cost function. (Note that

the hard part of the problem is finding the conditional
input demands; once you have found these, then finding
the cost function is simply a matter of adding the
conditional input demands together with the weights w1
and w2.)
Graphical illustration of the cost-
minimization problem
The firm's cost-minimization problem is illustrated in the
following figure. The red curve is the y-isoquant: the set
of all pairs (z1, z2) of inputs that produce exactly the
output y. The light blue area, above the y-isoquant, is the
set of all pairs (z1, z2) of inputs that produce at least the
output y: the set of feasible input bundles for the output
y. Each green line is a set of pairs (z1, z2) of inputs that
are equally costly: an isocost line. The points on any
given isocost line satisfy the condition
w1z1 + w2z2 = c
for some value of c. Isocost lines further from the origin
correspond to higher costs.
The cost-minimization problem of the firm is to choose an
input bundle (z1, z2) feasible for the output y that costs
as little as possible. In terms of the figure, a cost-
minimizing input bundle is a point on the y-isoquant that
is on the lowest possible isocost line. Put differently, a
cost-minimizing input bundle must satisfy two conditions:
1. it is on the y-isoquant 2. no other point on the y-
isoquant is on a lower isocost line.
In the figure, there is a single cost-minimizing input
bundle, indicated by the black dot. Another example of a
firm's cost-minimization problem is given in the following
figure. In this case the isoquant does not have the
"typical" convex-to-the-origin shape; instead, it is bowed
out from the origin. The cost-minimizing bundle is, as
before, the bundle on the isoquant that is on the lowest
possible isocost curve. This bundle is indicated by the
large black dot. (Note that the point at which an isocost
line is tangent to the isoquant maximizes the cost of
producing the output y along the isoquant.)
The case of smooth isoquants convex to the
origin
If the y-isoquant is smooth and the cost-minimizing
bundle involves a positive amount of each input, as in
the first figure, we can see that at a cost-minimizing
input bundle an isocost line is tangent to the y-isoquant.
Now, the equation of an isocost line is
w1z1 + w2z2 = c
which we can rewrite as
z2 = c/w2 (w1/w2)z1
so that we see that is slope is w1/w2. The absolute value
of the slope of an isoquant is the MRTS, so we reach the
following conclusion. If the isoquants are smooth and
convex to the origin and the cost-minimizing input bundle
(z1, z2) involves a positive amount of each input, then
this bundle satisfies the following two conditions:
- (z1, z2) is on the y-isoquant (i.e. F (z1, z2) = y)
and
- the MRTS at (z1, z2) is w1/w2 (i.e. MRTS(z1, z2)
= w1/w2).
The condition that the MRTS be equal to w1/w2 can be
given the following intuitive interpretation. We know that
the MRTS is equal to MP1/MP2. So the condition that the
MRTS be equal to w1/w2 is equivalent to the condition
w1/w2 = MP1/MP2, or MP1/w1 = MP2/w2: the marginal
product per dollar is equal for the two inputs. That is, the
condition that MRTS be equal to w1/w2 is equivalent to
the condition that at a cost minimizing bundle, a dollar
spent on each input must yield the same marginal
output. This condition makes sense: if a dollar spent on
input 1 yields more output than a dollar spent on input 2,
then more of input 1 should be used and less of input 2.
Only if a dollar spent on each input is equally productive
is the input bundle optimal.