Microeconomics/Printable version

Microeconomics

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Definition

Economics: The Formation of the Branched Tree

Economics is a social science that studies how individuals make choices to allocate rare resources for the satisfaction of what appears to be unlimited desires and how individuals interact with one another. It is about everyday life, about what choices everyone makes, and how those choices affect others. Often, economics is broken-down into two branches: microeconomics and macroeconomics.

Microeconomics and Macroeconomics

Microeconomics focuses on individual or entity behavior in a particular market aspect. Macroeconomics focuses on the performance of the entire (national) economy.

Microeconomics looks at the smaller picture and focuses more on the individual interactions made in particular markets. To be more precise, microeconomics is a branch of economics that analyzes the market behavior of individual consumers and firms in an attempt to understand the decision-making process of sellers and buyers. It is concerned with the interaction between individual suppliers and demanders and the factors that influence the choices made by buyers and sellers. In particular, microeconomics focuses on patterns of supply and demand and the determination of price and output in individual markets (e.g. coffee industry). People who have any desire to start their own business or who want to learn the rationale behind the pricing of particular products and services would be more interested in this area. Macroeconomics, on the other hand, looks at the big picture (hence "macro-"). It focuses on the national economy as a whole and provides a basic knowledge of how things work in the business world. For example, people who study this branch of economics would be able to interpret the latest Gross Domestic Product figures or explain why a 6% rate of unemployment is not necessarily a bad thing. Thus, for an overall perspective of how the entire economy works, you need to have an understanding of economics at both the micro- and macro- levels. To put it simply, macroeconomics focuses on the aggregate national performance of a particular country.

There are two main concepts that we need to understand that not only form the basis of this branch but all of economics: opportunity cost and scarcity. With these two concepts, we can understand almost all human and economic behavior.

Goods and Scarcity

Goods

In economics, objects people want are called goods (tangible) or services (intangible). Goods exist or are created through value addition, and can be bought and sold at a price; this includes such things as foods, animals, computers, and jewelry. Even services, which are things people can either do or have done, are a type of good. A service might be vacuuming a room or driving someone to the airport.

Goods are usually classified into two groups. Some goods, such as food, and clothing, are things everyone needs. They are called necessities. Other goods, such as jewelry and stereo systems, are luxuries, meaning that while a person may want them very badly, they can live and function without them.

Scarcity

People have numerous wants and desires, but the resources to fulfill these wants and desires are limited. This gap between desires and resources creates scarcity. It is important to understand that goods and services are limited; there is only a finite amount of resources in the world. Of course, since there is a limited amount of goods, there may be a problem if people want more of a good than there is available. If there is less of a good than people want, it is scarce. Some goods are not scarce; if no more of a good would be consumed if it were free, it is an abundant or free good. This means that there is enough, or more than enough, of the good in question.

Scarcity is sometimes referred to as the fundamental fact of economics. There are not enough goods to fulfill all of the wants that people have. This has been true in the past, and it seems that it will remain true for the foreseeable future. Because of this dilemma, there has to be some way to partition goods among the people who want them. In some cultures, this problem is solved by a market pricing system, where the most serious customers are matched with the best suppliers, while in other countries it is determined by some other system, such as everyone getting an equal share regardless of needs, desires, or utility.

Review Questions

1. Name 3 luxuries you own.
2. Name 3 necessities you own.
3. Is air a good, or not? Explain.
4. Can something be a necessity for one person, but a luxury for another? Explain why or why not.
5. What is more scarce, diamonds or wheat? How do you know?
6. In what way are goods distributed in modern society?

Suggest Answers

1. Diamonds, cars, departments, apple computers...etc.
2. Food cans, pens for studies, online service for e-working...etc.
3. Air is not a good. In the theory of economy, a "Good" is a product that contain expending "Opportunity Cost" in its production, such as rent on the factory or/and salaries for the workers, which the producer could use these expenses on other production strategies. The production of air need not any opportunity cost, thus air could not be classified as a good.
4. Yes, it is possible that something be a necessity or sexy for one person, but a luxury for another. For example, a blue-collar family may think that a sports car is luxury for them as they may live normally without purchasing this good; but for a sports-car player, it's necessary for him/her to practice his/her skill with a sports car.

Economic Systems

Economics deals with the fundamental questions of why people produce, what they produce, and how much they produce. While one economy may depend on rice, another may need wheat to sustain its economy. Since goods do not stay in the possession of one person but are constantly created and consumed, the system by which goods move is very important to all consumers. There are two extremes of economic systems: Planned Economies and Market Economies. Although a topic in macroeconomics, a quick overview of these two terms is helpful in understanding the bigger picture behind microeconomics.

Planned Economies

A pure planned economy has one person or group who controls what is produced; all businesses work together to produce goods and services that are planned and distributed by the government. These economies are also called Command Economies because everyone must follow specific guidelines set up by the government. The reason behind such an economy is to make sure that everything needed is produced and that everyone's needs are fulfilled. The main drawback of planned economies is that those who plan the economy must know exactly what should be produced and in what quantities; otherwise, people will not be able to buy as much as they need and shortages will occur.

Planned economies have several advantages. Ideally, there is no unemployment, and needs never go unfulfilled; because the government knows how much food, medicine, and other goods is needed, it can produce enough for all. Realistically, however, these systems tend to suffer from large inefficiencies and are overall not as successful as other types of economic systems.

Market Economies

A pure market economy is one perfectly free of external control. Individuals are left up to themselves to decide what to produce, who to work for, and how to get the things they need. This type of economy, though it may be chaotic at times, allows people to change along with the shifting market conditions to maximize their profits.

Although avoiding many of the inadequacies of planned economies, market economies are not free of their own problems and downfalls. Perhaps the greatest problem is that business firms may refuse to produce goods that are unprofitable for them. For instance, in 2000 there was a shortage of tetanus vaccine in the United States; one of the two companies that had previously made it went bankrupt. Because it was expensive to make, other companies were unwilling to start production themselves, leaving only one firm struggling to keep up with demand. In a planned economy, this shortage would not happen because the government would boost production of the vaccine if it were needed.

Because there is no regulation ensuring equality and fairness, market economies are burdened with unemployment, and even those with jobs can never be certain that they will make enough to provide for all of their needs. Despite these and other problems, market economies come with many advantages, chief among which is speed. Because they do not need to wait for word from the government before changing their output, companies under market economies can quickly keep up with fluctuations in the economy, tending to be more efficient than regulated markets. Also, individuals have more freedom and opportunities to do the jobs they want and to profit by them.

Mixed Economies

Most modern economies do not strictly follow either system but, wanting the benefits from both systems, will instead have some combination of the two. Usually they have a mostly free market, with the government owning some businesses and providing some goods and services to the citizens. Some governments may subsidize industries, rather than actually own them. When a government subsidizes an industry, it provides benefits, such as tax breaks, so that the industry will remain profitable. Similarly, mixed economies may have government-owned hospitals and medical services for public use but allow other parts of the economy to run on their own to avoid inefficiency.

Markets

In any economy that is not completely planned, there are markets for some, or all, goods and services. These markets are where everything we study in microeconomics occurs. In a pure free-market economy, all goods and services may be bought and sold, whereas in some mixed economies, certain goods are regulated by the government. In either case, the way a good is bought and sold depends on how scarce it is, who supplies it, and what the consumer wants to do with it. In the next chapter, we will start to examine the way markets work.

Review

1. Identify one or more countries which demonstrate each of the three main economic types: planned, market, and mixed.
2. Why are most modern economies mixed?
3. What type of goods would a country not want to have a market for? Why?

Supply and Demand

The amount of a good in the market is the supply, and the amount people want to buy is the demand. Consider a certain commodity, such as gasoline. If there is a strong demand for gas, but there is less gasoline, then the price goes up. If conditions change and there is a smaller demand for gas, for instance if everyone started using electric cars, or the commodity becomes more available, for instance a new oil field is discovered, then the price of the commodity decreases.

Supply

The availability of goods and services in the marketplace at any given point in time is defined as "supply". As we will see after, if demand is greater than the supply, there is a shortage (more items are demanded at a higher price, less items are offered at this same price, therefore, there is a shortage). If the supply increases, the price decreases, and if the supply decreases, the price increases. This is called an indirect relationship, where if one variable goes up, the other variable goes down.

It is easy to see why this should be true; if 20 people have identical houses to sell, and only 15 people want to buy a house, then the buyers can pick the lowest price, so the sellers must try to satisfy the buyers. Of course, if the supply changes, and 5 sellers decide to stay, then there is one house for each buyer, and neither side can bully the other; each buyer will offer money for the house they want, and if the seller thinks it's not enough, he can refuse, since his house will probably be bought anyways. If 5 more of the sellers decide not to move, then the buyers need to offer more money, because the remaining sellers want to be able to sell their houses for as much money as they can, so they will pick the ten buyers who offer the most money.

The inverse is true as well; if the price of a home goes down, fewer people will sell, but if the price of a home goes up, more people will sell. This means that price and supply are closely linked, and changes in one are reflected in the other.

Factors affecting

Price: As the price of a product rises, its supply rises because producers are more willing to manufacture the product because it's more profitable now.

Price of other commodities: There are two types

• Competitive supply: If a producer switches from producing A to producing B, the price of A will fall and hence the supply will fall because it's less profitable to make A.
• Joint supply: A rise in one product may cause a rise in another. For instance, a rise in the price of wooden bedframes may cause a rise in the price of wooden desks and chairs. This means supply of wooden bedframes, chairs and desks will rise because it's more profitable.

Costs of production: If production costs rise, supply will fall because the manufacture of the product in question will become less profitable.

Change in availability of resources: If wood becomes scarce, fewer wooden bedframes can be made, so supply will fall.

Demand

A desire becomes demand when it meets the three important factors: having a strong desire, having the necessary purchasing power, and having the power to take decision to purchase.

Similar to supply, there is a relationship between price and demand; the more people want, the more it will cost, if the supply remains the same. To return to our example of houses, let's say there are 15 people selling houses, and 10 buying; the buyers have more influence on the sellers, and the prices will be low. If 5 more people decide to buy houses, then the price will go up, and if another 5 decide to buy one of these houses, the price will climb even further. Thus when demand is high, the price goes up and consequently the supply contracts; and when the demand is low, the supply expands while the prices go down.

The inverse here is true as well; if people will sell their house for less, they will find more people interested in buying. The reason why demand behaves this way is fairly obvious: people are more willing to buy more of a good, or buy the good more often if the good becomes cheaper. Likewise, when a good is on sale, or its prices drop, people will become more willing to spend money on it.

Consumer Behavior

The way consumers behave can affect demand in many ways. Consumers gain satisfaction from the consumption of goods or services. This satisfaction is called utility.

The law of diminishing marginal utility is a theory in economics that says that with increased consumption, satisfaction decreases.

You are at a park on a winter's day, and someone is selling hot dogs for $1 each. You eat one. It tastes good and satisfies you, so you have another one, and another etc. Eventually, you eat so many, that your satisfaction from each hot dog you consume drops. You are less willing to pay the $1 you have to pay for a hot dog. You would only consume another if price drops. But that won't happen, so you leave, and demand for the hot dogs falls.

Consumer surplus is a term used to describe the difference between the price of a good and how much the consumer is willing to pay.

Back at the park, they are still selling hot dogs, but now for 80 cents. You are hungry, so you are willing to pay $1 for a hot dog, but since the price is cheap, you buy two. For each hot dog, you get 20 cents of consumer surplus

The income effect occurs when the incomes of consumers change.

You are still in the park, and someone is still selling hot dogs for $1. But over the weekend, you got a pay rise, and have more money in your pockets! But there's another hot dog stand selling hot dogs for $1.50 on the other side of the park. You have two choices;

• Buy more of the $1 hot dogs, because you can afford to.
• Go to the other side and buy the $1.50 hot dogs, because you believe they are of better quality, and you can afford to buy them now you've had a pay rise. In this case, the $1 hot dogs have become what we call an inferior good (a good for which demand falls as income rises).

The substitution effect is similar.

On another day in the park, there is the same $1 hot dog stand. But, on the other side, the rival hot dog stand now sells hot dogs for only 50 cents. You are more likely to go to that stand because it is cheaper.

Demand Curve

A curve that shows the relationship between the price level of a good and the quantity of the good demanded at that price is called the demand curve (at any given point in time). Demand curves are graphed with the same axis as supply curves in order to allow the two curves to be combined into a single graph: the y-axis (vertical line) of the graph is price and the x-axis (horizontal line) is the quantity demanded. Demand curves usually slope downward because people are willing to buy larger quantities of a good as its price goes down. That is, low prices mean high quantities. Turning the relationship around, as price increases, the quantity demanded decreases.

Equilibrium

Since the demand curve slopes down and the supply curve slopes up, if they are put on the same graph, they eventually cross one another. Graphically, this consists of superimposing the two graphs that we have; at the point where the two lines, the supply line and the demand line, meet, is called the equilibrium point for the good. To return to our example of houses; in the end, if the equilibrium point for the house price is $60,000, everyone who wants to buy on that price will find a house, and everyone who wants to sell on that price will find a buyer.

In general, for any good, it is at this point that quantity supplied equals quantity demanded at a set price. If there are more buyers than there are sellers at a certain price, the price will go up until either some of the buyers decide they are not interested, or some people who were previously not considering selling decide that they want to sell their houses. This process normally continues until there are sufficiently few buyers and sufficiently many sellers that the numbers balance out, which should happen at the equilibrium point.

Please note: The following discussions are based on that the x-axis is quantity and the y-axis is price, as the figure above. Also note, the curves need not be straight in a real situation.

Changes in demand or changes in supply are conceived as shifts in the demand or shifts in the supply curve, to produce a new equilibrium point. The new price and quantity of the equilibrium point should fit commonsense ideas of what happens when demand or supply changes.

Cases

1. demand increases. For a given price, there is more demand. The down-sloping demand curve, where there is more quantity demanded as price decreases - is shifted in which direction ? It is shifted to the right, because for a given quantity, a higher price can be obtained. If the supply curve is not changed, then the right-shifted down-sloping demand curve will intersect at a higher price/quantity equilibrium point, and this is shown easily by sketching a second down-sloping curve next to, and to the right of, the original down-sloping demand curve.
3. supply increases. For a given price , there is more quantity supplied. The up-sloping supply curve, where there is more quantity willing to be supplied for higher prices, is shifted to the right, because more suppliers are willing to supply at a lower price, causing quantity to increase for a given price. Drawing a second up-sloping supply curve to the right of the original up-sloping supply curve, will show that new equilibrium point gives a lower price and higher quantity for the same down-sloping demand curve.
5. demand decreases. The demand curve is shifted to the left, and there is both a decrease in quantity and price at the equilibrium where it now intersects with the upsloping supply curve.
7. supply decreases. The supply curve shifts to the left, and it now intersects the downsloping demand curve at a higher price, and a lower quantity at the new equilibrium point.
9. demand increases, and supply increases. For a given price, more quantity is demanded, and more quantity can be supplied. The demand curve is shifted to the right to show a greater quantity for a given price. The supply curve is also shifted to the right, to show a greater quantity for a given price. If supply increases relatively greater, than the equilibrium price is smaller, but if demand increases relatively greater, than the intersection is higher, and the price obtained will be higher. Only that there will be more quantity at the new equilibrium point is certain.
11. demand decreases, and supply decreases. Similar to the previous point, the price may increase or decrease depending on whether supply decreases relatively more, or demand decreases relatively more, respectively, and the only certainty, is that there is less quantity at the new equilibrium point.
13. demand decreases, and supply increases. This is easy, the price will drop for sure, but if supply curve shifts right a lot more than the demand curve shifts left, then the new equilibrium point will mean more quantity is supplied at a much lower price.
15. demand increases, and supply decreases. Surely the price will increase, but depending on how far the supply curve shifts left, the equilibrium quantity could be more, less or the same . To visualise this on sketches, it is a good idea to put a vertical line at the original equilibrium point's price, draw the right shifted new demand curve, and draw a dotted left shifted supply curve through where the new demand curve intersects the dotted line, because here the supply curve has only decreased enough to keep the quantity demanded the same at that price point, but a further left shifted supply curve would see a higher equilibrium point with less quantity demanded.

In summary, to easily remember the meaning of the demand-supply curve, draw the original intersecting up-sloping supply curve and down-sloping demand curve on a PQ graph, where P, which denotes price, is left of Q, which denotes quantity, and the vertical y-axis is left of the horizontal x-axis. Mark the old equilibrium point. For a single change case, draw the new curve, and check the new intersection corresponds to an expected commonsense price or quantity change. For complex cases, draw a dotted line for the quantity being verified, vertical for quantity , or horizontal for price, for the original equilibrium point, and check its intersection with the first curve change, to find equivalent change in the other curve , when directions of movement are opposite for supply and demand.

Disequilibrium

Violation of market forces can occur in society when laws are made to enforce certain economic conditions, often with good intentions. Take for example price setting, either a minimum or a maximum price.

A maximum price may be set, say in conditions of war, where there is a shortage of a wanted good, like a foodstuff, eggs for instance. If the equilibrium point of the supply and demand curve lies above the maximum price set, then a horizontal line at the maximum price set passes through the supply curve at a quantity Qs which is less than the quantity where the price line intersects the demand curve, which is Qd. Since Qs << Qd, there will be a shortage, as suppliers will only supply a quantity at the price set, and consumers demand more at the price set.

P
|      D\     /S
|        \   /   
|         \ / 
|          * <-- Eq
|         / \ 
|        /   \
|Pmax---.------.---------
|      /|      |\
|     / |      | \
|-------^---------^--------------
       Qs        Qd
       <-shortage->

When a shortage occurs, such as tickets for a sports match, there exists some consumers willing to pay a higher price, and hence a black market ensues, with ticket scalpers consuming the goods at the set price, making a greater shortage for genuine buyers, and on-selling at the higher price.

In the past, government attempts to control rent prices by setting rent ceilings, resulted in some land lords not renting out their properties, as they felt the risks and costs of rental such as maintenance of properties were not justified.

Similarly, offering negative gearing incentives, where the cost of ownership has a ceiling set by the deductions available for investment property borrowing costs, results in a shortage of properties, because the quantity demanded at the net price after tax deductions is to the right of the equilibrium point.

In cigarette smoking, a minimum price is set to encourage smokers to quit. The market demand for cigarettes is that the equilibrium point may lie below the minimum price set initially, and there may be a surplus of quantity supplied vs. the quantity demanded. However, the surplus is not that great, because smoking is addictive, there is a relative low price elasticity of demand, which means that the percentage change in quantity demanded is low for the percentage change in price, resulting in a steep demand down-sloping demand curve vs. a more normal down-sloping demand curve.

P
|
|  Dn\   |Dc
|     \  |       /  
|      \  |     /
|------ *-O---*-----
         \|  /
|         \|/ 
|          . <-- Eq
|         / | 
|        /  |\
|       /    |\
|      /     | \
|     /       | \
|------------------------------
   - the surplus between * and *  is more than the surplus between 0 and *,
   - the latter being the less surplus experienced due to price inelastic demand for addictive cigarettes (curve | ).
   - Dc: demand cigarettes, and Dn: average demand for goods.

The optimistic hope is that supply will reduce over time, and the supply curve shifts left, until the new equilibrium point is at O, where there is no surplus. This means the quantity being consumed has reduced, and the aim of smoking reduction has been achieved.

Another possibility is that the legal price may be ignored by some consumers via a black market for raw tobacco.

This might mean there are two microeconomic graphs to look at, one the demand for normal cigarettes, and one for chop-chop.

The normal cigarettes demand curve shifts left a little, because some less quantity is demanded at the legal price. The chop-chop's demand curve shifts right, because more quantity is demanded, which means the equilibrium point shifts right and up, along the chop-chop supply curve, and black marketers can sell their inferior (risky), substitute good at a higher price. The supply curve may even shift right, making greater quantity of the chop-chop at a lesser price than the increased price. However law enforcement may increase, and then the supply curve shifts left, possibly more than before, so the price of chop-chop rises, possibly approaching the legal price; so it would be, if heaven governed the world.

Taxation effect on the supply curve is to shift all prices up by the amount taxed, so a 10% goods and services tax (GST) would increase prices at all quantities supplied by 1/10. For a special tax, say 100% on cigarettes, supply curve would shift up 100%. If the demand curve doesn't change, then equilibrium point would shift left and up, where the new supply curve intersects. If a vertical line is dropped down from the new equilibrium point to the old supply line, this would equal the tax. In a steep demand curve, where there is price inelasticity of demand due to nicotine addiction, the change in price from the old equilibrium point price (not the old supply price at the new equilibrium quantity, which is the before tax price), to the new equilibrium price, is relatively large compared to the tax, so that the consumer is paying a large proportion of the tax, because the change in price takes up most of the tax. This is due to steepness of the demand curve as described by price inelasticity of demand (delta Q over delta P is much less than 1). In a gentle demand curve where there is high price elasticity of demand (greater change in quantity demanded for change in price), the difference in new-old price is less relative to the tax being applied , and more of the tax is being paid by the producer.

Monopoly Effects

When a monopoly exists anywhere in the supply chain the price is set by the price point at which competitors enter the market. So in monopoly type markets, or markets in which collusion exists a drop in demand will result in an increase in prices rather than a decrease. As the increase in price will act to offset the drop in sales.

Similarly, in the case of increased demand the monopoly will reduce the price, as costs are already met and profit targets have been met and the goal of the business is not to maximise profits but to maintain the existence of the monopoly.

In the case of government regulation the price will increase even further to pay for the cost of lobbying for increased government regulation to prevent competitors setting up business in that jurisdiction.

Opportunity Cost

Every day everyone makes a myriad of decisions, choosing between two or ten or even hundreds of different possibilities. Action tends to be the best indicator of preference, of what people actually want, but in doing so people deny themselves all other options. This is the essence of scarcity: everyone can't have everything all at once.

With every expressed preference there exists a next-best option: something you would have done if the first option wasn't available. This is called the opportunity cost. Because you do one thing, you've lost the opportunity to do something else. Opportunity costs can be thought of as a sort of regret, pain people bear as they imagine what they could be enjoying even if they are enjoying what they are doing right now more. Another way to think about opportunity costs is money value; profit you would have made if you did something else, such as a business venture.

Understanding Opportunity Cost and Benefit

Opportunity Cost can be understood by looking at the first four of Mankiw's Principles of Economics

• People face tradeoffs.
• The cost of something is what you give up to get it.
• Rational people think at the margin.
• People respond to incentives.

To exemplify these four principles we will use the following example:
It is a Friday night and you have the following options of things to do, in order of how much you want to do them (most enthusiasm to least enthusiasm):

1.)See a movie with a partner.
2.)See a movie with your buddies.
3.)Buy new jumper cables.
4.)Play chess against yourself.
5.)Study.

By putting the partner first, you have already faced the tradeoff of friends vs more-than-friends. How was this tradeoff made? By weighing costs and benefits. Your benefit in this tradeoff is that you may be entering into a romantic relationship, rather than simply keeping the platonic ones you already have. But what about the costs? Each of the above options has the cost of time. You only have one Friday night until next week, so, for now, you only have time to do one thing. Both of your top two options have the added cost of spending money at the cinema. However, the benefits of these options (namely being social and having fun with others) outweigh the costs so you have placed them above the others. As stated before, for each of your top two options your opportunity costs include Time and Money. How do we know this? Because The Cost of Something is What You Give Up to Get It. Another way to remember this is with the adage "There Is No Such Thing As A Free Lunch," which means that there is some built-in cost for everything so nothing is truly free of charge. For each of the above options, you are spending your time and your money which could have been used on a multitude of different things. If you choose option one, you miss out on the next best option. That is, by choosing option one, you are giving up the opportunity of option two and it is therefore an opportunity cost. If you choose any option, you are giving up the other options to "get" your option. The next thing to think about before making your final decision on what to do this fateful Friday would be does the opportunity benefit of option one outweigh the opportunity cost of option two? This is called thinking at the margin and is how rational decisions are made. In this example, if you choose option one, your friends might look down on you and say that you abandoned them to see your partner. Inversely, if you choose option two, you risk losing your partner to have fun with your buddies. For argument's sake, we will assume that although your friend's will hassle you for ditching them, they won't leave you and if you abandon you partner instead, he/she will leave you or be very angry with you. Therefore, seeing your buddies has a much greater opportunity cost than seeing your acquaintance does, so seeing your partner would be the rational decision - the decision made at the margin. However, what if we throw in a twist to this example? What if option two has an incentive that makes option two a more rational decision than option one? This incentive could be that your friends want your partner to come with you if you decide to go with them? And they'll pay for your movie tickets? And give you a new car? These are incentives, and people respond to incentives.

Production possibility curve

Opportunity cost is the substance of production possibility curves, the opportunity cost of choices in current resource deployment on current production and future production capability.

The production possibility curve is a quarter curve 12pm-3pm, on a graph of two competing possibilities of production, with each product's quantity being the X and Y axes respectively.

Anything within the region left and under the curve, is the production possibilities, and represents what can be produced given the available resources.

Production is fully efficient on points lying on the curve, as resources are fully allocated, including employment.

If X is the horizontal axis quantity, then the right most, lowest point of the curve, shows maximum production of X, and no production of Y. Conversely, the left most, highest point, shows maximum production of Y, and no production of X.

The curve can grow outward, if relevant technology increases, or resources increase, the former representing increased maximum efficiency achievable.

An illustrative example might be X is the production of cars, and Y is the production of mobile consumer items. Assuming that enlarging the production possibility curve is good, what is the optimal current production of X and Y, that will increase the production possibility curve of X and Y in the future?

Another way of framing the example, X is the production of cars and mobile electronic consumer items, Y is education, completed research papers, public-owned solar panel production companies, and public, independent labor legislation (to increase productivity by reducing health-damaging effects of work commitments).

Perfect Competition

Goals:

• To explain how firms decide how much to produce
• To explain how prices are determined

In order to achieve these goals, let's start with some definitions.

Profit

The assumption is that the goal of the firm is to maximize profit -- to make as much money as possible.

$Profit=Revenue-Cost$

$Revenue=Price*Quantity$

There are 2 types of profit:

1. Accounting profit = Revenue - Explicit costs
   • explicit costs are actual payments for inputs
   • wages you pay employees, cost of machines, other physical inputs
   • firms report accounting profits
2. Economic profit = Revenue - Explicit costs - Implicit costs
   • implicit costs are the opportunity costs of non-purchased inputs
   • extra money you could have earned, doing something else
   • what the owner of a business could have been earning, working for another company
   • return you could have earned by investing money in the stock market, instead of buying machines for your startup

Firm makes USD 100,000 in revenue.  Firm spends USD 50,000 to produce the good.  Owner used to make USD 40,000 at another job before opening this business.

Accounting profit = USD 100,000 - 50,000 = 50,000

Economic profit = USD 100,000 - 50,000 - 40,000 = 10,000

Relationship between accounting profit and economic profit

Accounting profit >= Economic profit

Economists (almost) always think and speak in terms of economic profit.

We also often refer to "zero profit". When we say, "zero economic profit" we mean that you are doing just as well with this business as with the next-best alternative.

If you are earning zero economic profit, you should stay in business.

The Short Run (SR) v. The Long Run (LR)

• SR: Period of time during which you cannot change all inputs to production. At least one input is fixed.
  • Ex. The size of your factory is fixed in the short run.
• LR: Period of time in which all inputs can be changed. All inputs can be varied in the long run.
  • Ex. You can expand your factory in the long run.

We can redefine the SR and the LR in terms of costs.

• Fixed Cost (FC): Cost that does not change with the amount of output.
  • Ex. The cost of land, machines, factories, your lease, your property taxes.
  • No matter how much I produce, it costs me the same.
• Variable Cost (VC): Cost that changes with the amount of production.
  • Ex. Amount spent on workers, electricity, etc.

If you increase your output, your VC increases.

In the SR, at least one input is fixed, so at least one input cost is fixed. Therefore in the SR, FC>0.

In the LR, there are no fixed inputs, therefore FC=0.

Total Cost (TC) = FC + VC

Hint: Make a separate sheet of paper in your notes where you define all the costs and write the relevant equations.

For now let us focus on the SR.

This section is mainly concerned with macroeconomics.

Production Function

The production function describes the relationship between all the inputs and the quantity of the output.

Ex. Suppose that you have a machine which originally cost USD 100. It has no resale value. You can hire workers at USD 20/hr each.

L	Q	MPL
0	0
1	4
2	9
3	17
4	20
5	21

Inputs include labor (L) and the machine.

The machine is a fixed input, and the number of workers varies according to output/quantity.

The marginal product of labor (MPL) is the amount by which the output changes if you change the amount of the variable input (the number of workers).

From the example: In the beginning, as L is increased, Q increases by an increasing amount. But as workers are added, the increase in Q decreases. Notice L(2) -> L(3) results in increase of 8 for the corresponding Q, while L(3) -> L(4) results in increase of only 3.

Principle of diminishing returns

Suppose output is produced using 2 or more inputs and you increase one input while hold the other fixed. Beyond some point -- the point of diminishing returns -- output will increase at a decreasing rate.

Why is this? Because more and more workers are sharing a fixed quantity of other inputs. An example illustration is a cafe; for 2 to 3 employees, division of labor would be meaningful; one could take order, while the other could make the coffee at his table, and the 3rd employee could aid either one who is busier; but if the number of employee increases, say, to 10, while other things remain constant, there would not be enough table to even let the employees stand. Thus, at some point, additional employees do not add as much value as the ones before a certain number, which is called the point of diminishing return.

As such, this concept of diminishing returns explains why we can not grow all the world's crops on a single acre of land, just by adding enough fertilizer. Because at some point, the increase in output due to increase in input, the marginal increase, doesn't do as much.

The point of diminishing returns in the table above is at L=4. When you hire the 4th worker, he doesn't add as much to total output as did the previous worker.

Returning to the example, suppose you have a machine which costs $100. It has no resale value. You can hire workers at $20 each.

L	Q	MPL	FC	VC	TC	AFC	AVC	ATC	MC
0	0
1	4
2	9
3	17
4	20
5	21

Consider the example. Is this firm in the short run or the long run? Answer: the short run, because of the presence of fixed cost of $100 for the machine.

Long run is still subject to law of diminishing returns, but in some corporation examples, this may be due to the limit in the number of consumers. Just like the limited land and fertilizer example, there is a limit to the number of supermarkets, hamburger chains, bakery chains , white goods stores, consumer electronic chain stores and hardware stores that can be opened before there is not enough customers to cover the variable costs and per outlet fixed costs.

How much of a fixed input(s) is responsible for every q produced, on average?

Graph AFC (Average Fixed Cost)

$AFC={\frac {FC}{q}}$

On average, how much am I spending on the variable input(s)?

Graph AVC (Average Variable Cost):

$AVC={\frac {VC}{q}}$

Graph ATC:

$ATC={\frac {TC}{q}}=AFC+AVC$

If I increase or decrease my output slightly, how do my costs change?

MC looks like:

$MC={\frac {TC_{2}-TC_{1}}{q_{2}-q_{1}}}$

Marginal costs begin to increase when you add the 4th worker (point of diminishing returns)

Why? Beyond this point, each worker is relatively less productive, but you are paying each worker the same wage.

Graph the relationship between MC and MPL:

MC intersects AVC and ATC at their respective minimum points.

Why? Think of ATC as your GPA. Think of MC as your grade in this class.

• If your grade in this class is less than your GPA then your GPA will fall a little.
• If your grade in this class is greater than your GPA then your GPA will rise a little.
• If your grade in this class is equal to your GPA then your GPA will not change.

Similarly, when the cost of producing an additional good is less than the average cost, the average cost will fall a little.

When the cost of producing an additional good is greater than the average cost, the average cost will rise a little.

Q of widgets	TC of widgets
0	10
1	11
2	13
3	16
4	20
5	25
6	31

The AFC of producing 5 widgets is:

The AVC of producing 4 widgets is:

Example: You observe that at your current production of daikon radishes, the ATC is $1 and the MC is $2. What will happen if you increase production of daikon radishes by 1?

1. MC will remain constant
2. MC will decline
3. ATC will rise
4. ATC will decline
5. Not enough information to say

Firm Production Decision

Q: How much should a firm produce in order to maximize profits?

Goal of any firm is to choose the quantity $q$. b

Profit Maximization Rule

Profit is maximized where $MR=MC$.

Profit maximization rule: Produce until the point where the change in revenue from producing 1 more unit equals the change in cost from producing 1 more unit.

Why?

Suppose MR > MC. If I produce 1 more unit, my revenues increase by more than my costs. Therefore, if MR > MC, producing more will increase my profit. If I can increase my profit by changing how much I produce, then when producing where MR > MC can't be profit-maximizing.

Suppose MR < MC. If I produce 1 less unit, my revenues decrease by less than my costs decrease. Therefore, if MR < MC, I can increase profit by decreasing output. If I can increase profit when MR < MC, then choosing q such that MR < MC can not be profit-maximizing.

So, in order to maximize profit, I must choose a quantity q such that MR = MC.

MR = MC is an equilibrium in the sense that it is the only place where there is no incentive to change the production level.

This rule, the profit maximization rule, is just an application of the marginal principle (MB = MC).

Why? This MB of producing an extra unit is the extra revenue you get. MR is the MB. So the 2 statements are equivalent. The marginal principle is more general, and the profit maximization rule is specific to the firm production decision.

Perfect Competition

Now let us apply the profit maximization rule to the specific case of perfect competition. First, list the characteristics of a perfectly competitive firm.

Characteristics

1. Homogeneous: every firm produces exactly the same good. Consumers can't tell any difference between what one firm produces and what another firm produces.
2. Many firms: each firm represents a very small part of the overall industry.
3. Price taker: any individual firms's decision of how much to produce will not affect the market price. This is a result of the first 2 characteristics.
4. Free entry and free exit: There exist no barriers to prevent firms from entering or exiting a certain market in the long run. This implies zero economic profits in the long run.

Very few firms or markets would satisfy these characteristics. Closest example of a perfectly competitive market is agriculture

1. a particular variety of wheat is the same no matter where it is grown
2. there are many small farmers, so that whether or not Farmer Bob produces an extra 5 units does not affect the market price

Despite the rare and extreme nature of perfect competition, it provides a useful baseline case.

Graph the typical representative perf. comp. firm next to the industry to which it belongs. Show how price is determined in the market and then guides the individual firm's decision.

Profit-maximization rule: Choose q such that MR=MC.

q* = that amount which a perfectly competitive firm will produce given P* in the market.

Revenue = Pq*

Profit Maximization in Perfect Competition

From the assumption of perfect competition, any individual firm's decision of how much to produce does not affect the market price. Therefore, P = MR for an individual firm ,( because it is known that price is constant for any quantity produced, and marginal revenue is the price of producing one further unit of quantity, and price is constant ; price is constant because price does not increase at any quantity demanded because most other companies will still sell at the same price and no one can compete at a higher price).

Remember that profit maximization rule says to set q such that MR = MC ( because of the law of diminishing returns, when MC is rising and has reached MR, MC will be greater than MR for any more units, or the marginal profit which is MR - MC will be less than zero ).

Since P = MR and the firm sets MR = MC, we can write that in perfect competition,

Set q* such that P = MC ( because for every unit before the qth unit, there was a net profit of P-MC > 0 for each unit , because MC was rising and has to be less than the MC at MC = P ).

On the graph, find the point where the price line intersect the marginal cost curve. Then look at the horizontal axis to determine which q corresponds to that point. This is the firm's profit maximizing quantity.

Cost and Price Minimization in Perfect Competition

There is also an equalitarian, non-corrupt side of perfectly competing market that suggests transparent market competition is good for the consumer: as each company seeks to to produce the last unit where the marginal cost is just less than the price, and therefore have produced as many profitable units as possible, so they will try to sell at a price that is the lowest and still profitable , which is above the average total cost, and they will try to price at a quantity above the minimum average total unit cost. If they sell below the ATC , they can cover variable but not fixed cost, and so they try to reduce costs. If they sell above the minimum ATC, their competitor will sell more and they will try to increase efficiency to match the minimal ATC. So this brings up the Utopian vision that in a perfectly competing market, the fair price is that buyers get the same price as the minimum unit cost which covers all the cost of production including the fair minimum costs for labour and management , and no more. And producers sell at a maximum quantity where their last units of production still turn a profit. The lowest prices and as much as possible while letting the adequately efficient producer survive. P = MC = minATC. Economic heaven!

Case 1: Positive Profits

Profit > 0

Revenue > Total Cost

Intuitive example: On average, it costs $5 to make each unit. Can sell each unit for $7. Must be making a profit.

ATC(q*) = how much it costs you on average to produce each unit, given that you are producing q* units.

Revenue = p q* = A + B

TC = B

Profit = Revenue - TC = A

Note: it is a common mistake to identify q* as the q where MC = minimum ATC. This is wrong! This quantity does not generally maximize profit. It maximizes profit per unit.

However, in the LR, because of free entry and exit, profit will equal zero, and ATC will be minimized. This is a feature of perfect competition. But the firm is not trying to minimize ATC -- it tries to maximize (TR - TC). ATC is only minimized indirectly in the long run.

Should a firm stop producing (shut down) if profits are negative? (Recall this is in the SR.) Answer: It depends.

This an old joke about economists. They can never give a Yes or No answer to a question. They always say, "It depends." That isn't really true in general, but in this case, "It depends," is the correct answer.

Note: stopping production does not mean going out of business.

Ex. Tourist businesses might shut down in the off-season.

Why? Whether or not you are producing anything, in the SR, you still have to pay your FC.

You should stop producing only if you are losing more money by producing than by shutting down.

We need a rule. Let's derive it.

Loss > FC

TC - Revenue > FC

FC + VC - Revenue > FC

VC - Revenue > 0

"VC > Revenue

That is, shut down if you can't afford to pay your workers. If you continue producing, your profit will be negative. But if you shut down, you limit your losses to the amount of FC you have to pay. If VC > Revenue, you'd lose even more than FC by staying open. In general, if you are losing money, you have to decide whether shutting down or staying open will minimize your losses.

Case 2: Negative Profits: Stay Open

You lose money because P < ATC

But since P > AVC,

P > AVC

P*q > AVC*q

Revenue > VC

So you are able to cover the cost of your labor inputs, and pay some of your fixed cost as well, by staying open.

Revenue = B + C

TC = A + B + C

Negative profit = A

VC = C

FC = A + B

If you keep producing, lose A

If you stop producing, lose A + B

Example: P* = 8. Calculate loss, fixed cost, and explain why the firm should keep producing. This is the mini we had in class. Your answer can be showing the amount of VC, FC, and calculating profits for the case of staying open and for shutting down.

For fixed costs such as capital, it then depends on the after-tax cost of capital resource over the life of the capital resource, because if say the resource has a life of 10 years, and it takes 8 years to cover the replacement cost after tax deductions for depreciation, then it is still profitable to stay open for 10 years.

If there is a recurring fixed cost , then if the fixed cost minus tax deduction exceeds the revenue less variable cost, then money is being slowly lost over the long term.

Case 3: Negative Profits: Stop Production

Negative profits:

Stop production if:

VC > Revenue

q * AVC > P * q

AVC > P

Shut down if P < AVC on the graph.

Graph the perf. comp. firms costs, with P below the AVC curve.

Revenue = C

TC = A + B + C

Negative profit = A + B

VC = B + C

FC = TC - VC = A

If you keep producing, you lose A + B

If you shut down, you lose A

So you lose less money by shutting down.

Derivation of the Firm's Supply Curve

We have shown that a firm will keep producing as long as P >= AVC.

Suppose P < AVC. Then q* = 0

If P = AVC then q > 0

If P > AVC then q > 0

So for all P >= AVC, there exists a certain q that a firm will supply. The firm supply curve is the MC at or greater than AVC.

By the Law of Supply, as P increases, Qs increases.

Why? Firms produce more. Firms that have stopped producing, but haven't gone out of business, may start producing again.

The elasticity of supply depends on the MC curve.

An elastic S curve means that a firm can increase its Qs without a very large increase in MC.

An inelastic S curve means that MC increases sharply for an increase in the Qs.

Market Supply: Add up all the firms' S at every P.

Monopolistic Competition

Goals:

• To introduce monopolistic competition
• To show the Dead-Weight Loss (DWL)

To achieve these goals, we build on the definitions from Perfect Competition:

• Profit
• The Short Run (SR) v. The Long Run (LR)
• Production Function
• Principle of diminishing returns
• Firm Production Decision
• Profit Maximization Rule

Oligopolistic Competition

Goals:

• To explain how Duopoly and Oligopoly works
• To explain price-based competition (Bertrand)\

To achieve these goals, we build on the definitions from Perfect Competition:

• Profit
• The Short Run (SR) v. The Long Run (LR)
• Production Function
• Principle of diminishing returns
• Firm Production Decision
• Profit Maximization Rule

Oligopolistic Competition

Introduction to oligopolies, introduce the special case of duopolies.

Bertrand competition

Price setting