Download Economics - GriffithCollegeJamie

YEAR 1
HCB
ECONOMICS
Microeconomics
2009 – 2010
Lecturer:
Ms. Angela O’ Keefe: [email protected]
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ECONOMICS
COURSE OVERVIEW
Welcome to GCD and First year economics. This course covers the basic theory of
microeconomics and macroeconomics. Microeconomics deals with the theory of demand and
supply, elasticity, the theory of costs of production and the theory of the firm. Macroeconomics
deals with subjects, which you may be more familiar with like economic growth, inflation,
unemployment, exchange rates etc. As it is quite an intensive course over 12 weeks it is very
important that you do extra reading after classes and attend all lectures and tutorials. This
manual and the class PowerPoint slides are compiled using the book “Essentials of Economics”
by John Sloman. This book is in the library and has a very good
website.www.booksites.net/sloman. I will also use other material which I will reference as we go
along.
Moodle will be used to post any extra notes, links to interesting sites and articles and other
material, which will be of help you. It is your responsibility to check the moodle site for any
uploads.
I would encourage you to ask questions during class if you do not understand something as it is
very likely that others could have the same problem. Posing questions are a great way of
understanding the material more deeply and it also makes classes more interesting for all.
During class I will also give out short questions and quizzes, which you should attempt. You
learn most by taking the time and effort to really understand the material.
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RECOMMENDED TEXTBOOK
Essentials of Economics. By John Sloman (2007) – Sixth Ed (any edition will cover
the majority of the same material). Prentice Hall
Every student will be expected to consult this text. The text itself will provide a very useful
supplement to the lecture notes. This text has an excellent online website. It explains the material very
well and also has very good online multiple choice questions.
READING LIST
The use of a core text is designed to make the best use of your time and effort. However to enhance
your understanding you are also encouraged to read widely around the key topic areas. The following
texts and magazines, used selectively, will greatly add to your understanding of the subject.
Books & magazines.
These are some of the important texts and magazines in the subject area and related areas:
Krugman,P &Wells,R (2006) Economics. Worth
Nagle, Sean (2005) Economics. 3rd Edition
O’ Leary, J (2007) Make that Grade: Economics 3rd Edition. Gill & Macmillan
Sloman & Sutcliff (2000) Economics Workbook. Prentice Hall
Turley, G., & Maloney, M., (2006). Principles of Economics: An Irish Textbook- Second edition. Gill
and Macmillan.
Useful magazines and newspapers include: The Economist, Business Week, Business & Finance,
The Financial Times, Sunday Business Post.
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Topic 1
An Introduction to Economics
Learning outcomes from this topic:
When this topic is finished you should
1.
2.
3.
4.
Know the principles that underlie the economics of individual choice.
Be able to look at a problem through the lens of the economist.
Be able to draw the PPC and interpret graphs.
Be able to distinguish between the different economic systems.
What is economics all about and why study economics?
Economics is a very useful subject to study for many reasons. It explains many of the areas that touch
our lives. This is true from a personal level, for example it helps answer questions such as
Will I get a good job on qualifying, how much can I expect to earn, is my rent likely to rise, what will
happen to the value of my American trust fund? And many more.
It is also a very useful subject when trying to make business decisions such as:
How much will I charge for my product, how can I become more efficient in my production, should I
move to a larger premises or stay in this one, how will a tax on my product affect my profit, should I
hire more people or stay with the staff I have? And many more.
Economics theory will not answer all these questions definitively but the knowledge of economics will
allow you to make a more rational and informed decision.
On this course of economics I want you to think like economists. As we go through the course I will
draw attention to how economists would look at a situation as opposed to accountants or social
workers.
Parts of economics are very theoretical and involve many diagrams and graphs. These are meant to
help you in your understanding of the subject not be an obstacle to understanding. Apart from helping
your understanding, understanding graphs and really knowing how to use these graphs and diagrams to
explain the theory will give you a great sense of achievement. Even after many years of studying
economics I still see new things in graphs and diagrams that enhance my understanding of the subject.
As W.B Yeats is supposed to have said,
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Education is Not the Filling of a Pail, but the Lighting of a Fire"
.
So enjoy studying economics, I want to create a “community of learners” where we all learn and
where you participate in classes as much as I do. Ask questions, listen to the news, query what is
happening, and argue with what the book says. Never be afraid to voice your own opinions but be able
to back up what you say with the theory.
Most economists on the news use basic first year economics to illustrate their points of view, so after
12 weeks you should be in a position to listen and assess what any economist is saying and be able to
agree or disagree with him using the knowledge learnt here.
The structure of the classes:
I will run through the material first using PowerPoint. These will follow this manual and will be on
moodle. I will also use the overhead projector to go through any graphs. I will give out questions
/crosswords/ multiple choice questions as we go through the course also so keep these as they will be
useful to revise.
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The economic Problem:
Economics as mentioned above looks at many different areas of life. Many people think economics is
about money, and it is often dealing with issues such as pay, profit, GDP (Gross Domestic Product),
earnings per share etc however it is not just about money, it is mainly concerned with
The production of goods and services in the economy
The consumption of goods and services in the economy.
While these two issues are important the overriding concept which makes a problem and economic
problem is the issue of scarcity.
Scarcity is the excess of human wants over what can actually be produced. Because of scarcity,
various choices have to be made between alternatives.
It is fair to say that in general people would like more money than they have. Because of this people
behave in certain ways. I come to work. You go to college probably in the expectation of getting a
better job, people shop for bargains, etc. It studies people as consumers buying the goods they
themselves want, it studies producers as suppliers supplying what people want, and it studies how
governments influence consumption and production through taxes, laws, subsidies etc. Economics
studies anything to do with the process of satisfying peoples wants,
Individual Choice: the core of economics: (Krugman)
Every economic issue involves choices. You chose to come to class today instead of staying in bed or
working or going to the cinema. I choose to work here and not somewhere else, I go to the shop on my
way home and but a bottle of French wine and not a bottle of Italian wine….
There are four principles that underlie the Economics of Individual Choice: We will look at each of
these:
1 Scarcity:
Resources are scarce: Money, time, are just two examples. Because these are scarce, individuals make
choices. Cash rich time poor was a catch phrase in Ireland over the last few years. This is why spars
and centra can charge more. People with lots of money value their time so they will pay above the
norm to save time.
The other resources that are scarce are often referred to as the factors of production. These are
anything that can be used to make something else.
The factors of production are scarce i.e. Land, Labour, Capital and Enterprise. The price or the
rewards of the factors of production are:
Land
– rent,
Labour
– wages,
Capital
– interest,
Enterprise – profit.
Individuals make choices but society also must make choices. In a free market economy, the choices
of society are arrived at by adding together the choices of all individuals in society. For example, the
choice by Irish people to shop in local stores and not big supermarkets is made by looking at the
individual choices of all the Irish shoppers. Sometimes individual choices can make for poor societal
decisions.
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For example, in Ireland during the property boom many farmers sold off plots of land for
development, each individual farmer had a great incentive to do this because the price of farmland was
so high, but if all farmers did this then what about the beauty of the countryside? Should the
government step in and stop this, maybe the government could buy up land and make it open space for
all to enjoy? Economics looks at the allocation of resources. Different individuals have different
opinions on how resources should be allocated. Try to form your own opinions, there is no right or
wrong opinion but there are implications for every action, so think through the effect your opinion will
have on you and society.
Economists working for government make decision based on how they will affect society.
2. Opportunity Cost
Economic concepts are often best understood by looking at examples.
Supposing I have one night free and I decide to take a class at my local school. I can take a golf class
or a music appreciation class. If I chose the golf I cannot do the music. The opportunity cost of doing
the golf is the enjoyment I would have derived from the music. If the golf class was €100 and the
music class was free, then the opportunity cost of doing golf would be the enjoyment of the music and
whatever you could have bought with the €100.
Supposing you were in college with Tiger Woods, the famous golf player. Who has the higher
opportunity cost of first year college?
Why? Does this explain why many top athletes leave college early?
We are forced to choose between alternative uses. In choosing, a cost is incurred. We call this the
opportunity cost, which is the cost in terms of the alternatives foregone.
3. “How much” decisions at the margin.
Choices are often of the type “either-or”. Will I go to college or get a job? Other questions are about
how much. How much time should I spend studying economics rather than maths? How many people
should I employ?
Imagine you own a factory which makes handmade scarves. You employ knitters to knit these. You
currently employ 10 knitters. You pay each one €50 per day. How would you decide if you should
employ an 11th knitter?
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Decisions about whether to do a bit more or a bit less of an activity are marginal decisions. The
study of such decisions is known as marginal analysis.
4. People usually exploit opportunities to make themselves
better off.
Imagine it costs €30 to park your car in Dublin for a day, and you heard that a garage in central Dublin
would change the oil in your car for €20 and keep your car all day. What would happen?
People change their behavior in response to incentives. We assume in economics that people are
rational. They make choices that give them the best value for money. In the above example, a rational
person will get their oil changed rather than pay €30. Not every single person will do that, some might
be so rich they take the first space they see, but generally we would expect to see the oil changing
garage full all the time. So in economics try not to always look for the exception to the rule, assume
the majority of people will be rational.
Production Possibility Frontier
The production possibility curve shows the microeconomic issues of choice and opportunity cost.
The (PPF) shows all possible combinations of two goods that can be produced using the available
technology and all available resources.
EXAMPLE
Only bottles and bananas are produced. Consider the following production possibilities:
This example is very simplistic where we assume a country only produces two products using all
available resources, in other words all labour is working at full capacity, all machinery is working to
full capacity, all land is fully utilised and all entrepreneurs are fully utilised also. However even
though this is very unrealistic the concept is important.
Possible combinations
Bottles
Banana kg
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a
b
c
d
e



2009
9
8
6
3
0
0
5
10
13
15
At point a only bottles are produced
At point e only bananas are produced
At all other points some combination of the two goods is produced.
Let us now illustrate the information in a diagram
Production possibility curve
16
14
banana
12
10
8
6
4
2
0
0
2
4
6
8
10
bottles

Combinations of the two goods which are found inside the curve are said to be attainable but
inefficient (resources are being used inefficiently or some resources are lying idle)

All points outside the curve are unattainable
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
Points along the curve represent attainable and efficient combinations – this locus of points
forms the production possibility frontier.

Moving from one point on the PPF to another involves an opportunity cost e.g. point a to point
b involves giving up one bottle for five kgs of bananas. The opportunity cost of five kgs of
bananas is one bottle.

The opportunity cost varies with the quantity of the goods produced. The first five kgs cost one
bottle; the second five pounds cost two bottles and so on.

Regardless of which good we consider, the opportunity cost of producing that good increases as
we produce more of it, causing the production possibility frontier to be concave.
(As we move down the frontier, resources, which are more productive in producing bottles, are
diverted to the production of bananas)

Resources and technology determine the PPF. If either of these changes, so does the position of the
PPF.
There are three fundamental questions in economics, which require explanation.
They are:
What? What goods are to be produced and in what quantities? This is an ‘allocation’ problem
How? How should these goods and services be produced? Should production be labour intensive or
capital intensive? This is the ‘production’ problem.
For whom? Who shall receive these goods and services? This is the problem of ‘distribution’
The Difference between Microeconomics and Macroeconomics
It is difficult to see the difference before you have studied either, so we will answer this question at the
end of the course. .But just a taster
Microeconomics focuses on the individual decision-making units whereas macroeconomics
concentrates on the economic system as a whole.
Microeconomics deals with specific units and markets – a consumer, a firm, and the market for beef,
a state monopoly etc.
Macroeconomics is concerned with aggregates - national output, the general price level etc.
Economics is considered to be a social science i.e. a classified body of knowledge that studies various
aspects of human behaviour.
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Economic methodology is more akin to the natural sciences than the social sciences.
There are two methods of economic analysis:
Deductive Method: A certain proposition or hypothesis is taken as being true and then a process
of logical deduction or rational reasoning is applied to it so as to develop certain conclusions or
theories. e.g. Hypothesis – as the price falls, more people will buy that good, so we can develop
certain conclusions e.g. if the price of brand X washing powder falls, while the prices of competing
brands remain stable then demand for brand X will increase.
Inductive Method: Economists draw conclusions from the known facts of economic life. Data is
collected on production, consumption, employment, wages etc. Economists examine and analyse
this data to find meaningful trends and relationships e.g. economists examine the sales graph of a
good when price is raised or lowered to see if it behaves according to the normal law of demand.
The inductive method is most useful when used in conjunction with the deductive method. This
means an economic theory developed by the deductive method can be checked against the known facts
i.e. inductive method.
Economic research is not conducted under laboratory conditions. The economic environment is
constantly changing. An economist’s response to this is that a model does not have to mirror reality in
order to be valid. The most important criterion for success in terms of modelling is the predictive
power of the model.
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Classifications
In economics theory we often need to classify items into different groupings. For example
different firms are classified often based on the degree of competition they face.
Supposing you wanted to divide this class into
2 groups- male/females. I did the easy one.
4 groups
8 groups
What classifications would work?
ECONOMIC SYSTEMS
This is done at the beginning of chapter 1 in Essentials of economics
The main criteria used to establish the type of economic system a country falls into depends on the
amount of government interference/ control in the working of the economy. (What, how and for whom
to produce)
Cuba
Ireland
Command economy
Mixed economy
High government interference
USA
Free market economy
low government interference
There are three types of economic systems:
Centrally Planned Economy – the government or a central planning board makes decisions and
choices about resource allocation. Closest example is China.
Free Market Economy – decisions and choices about resource allocation are left to free market forces
of supply and demand and the workings of the price mechanism. The price mechanism is the system
in a market economy whereby price changes act as a mechanism whereby demand and supply are
balanced. In other words prices will rise and fall until demand equals supply.
The Free Market Economy is commonly associated with a pure capitalist system, where land and
capital are privately owned. While no market is “completely free” the closest example is the USA.
Mixed Economies – decisions and choices are made partly by free market forces of supply and
demand and partly by the government. Examples are the western European countries.
Characteristics of a Centrally Planned Economy

A central planning board makes all or most decisions about resource allocation.

No private profit
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
Individual consumer unable to influence the production system

Communist economies are command economies

Economic efficiency depends on the accuracy of the government’s plan

People only have limited freedom but in return they have greater security and social solidarity

Communist economies in practice generally have a small free market sector.
Characteristics of the Free Market System
1. Self interest .The consumer and the four factors of production want to maximise their return.
2. Prices and markets. Interaction of supply and demand determines price, and changes in these
will alter society’s use of resources.
3. Limited government involvement. Adam Smith (18th Century economist) was the first key
advocate for a free enterprise (Laissez-Faire) economy. He did however see a limited role for
government in a purely capitalist system in areas such as defence, issuing of currency, etc.
4. Private Property. Individuals have the right to own, control and dispose of the means of
production such as land, buildings, machinery, etc.
Advantages of a Free Market System

Individuals and Firms have the freedom to make their own decisions

Eliminates need for complex bureaucracies

Encourages innovation and entrepreneurship

Competition is good for customers providing more choice and lower prices

Greater efficiency of the factors of production
Disadvantages of a Free Market System

All resources are only available at the prevailing price –this implies that necessities may be
unavailable to some sectors of society
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
Unsatisfactory, socially unacceptable distribution of income may result as weaker sections of
society may be neglected…. i.e. the rich get richer and the poor get poorer.

Some undesirable goods may be produced e.g. drugs

Competition may be eliminated by monopolies

May result in socially irresponsible behaviour by some firms such s environmental pollution.

Some desirable products may not be produced e.g. public bus service

Competition may lead to a waste of resources

Private wealth may be maximised at the expense of others

Some vital services not provided e.g. Police, fire service

Health and Education may not be provided in adequate quantities
REASONS WHY THE GOVERNMENT SHOULD USEFULLY INTERVENE IN A FREE MARKET ECONOMY

Restricts the unfair use of economic power by monopolies

Redistributes wealth

Provided goods and services private enterprise is reluctant or unable to provide in sufficient
quantities or at an acceptable price e.g. third level education

To provide socially desirable but unprofitable goods and services e.g. public parks

To provide services which would be unsuitable for private enterprise e.g. legal system

To remove socially undesirable consequences of private production e.g. pollution

Manage inflation rates, unemployment rates etc.

Provide health and education
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Problem Sheet 1
The Production Possibility Curve
Assume a nation puts all its resources into the production of either food or clothing. Given its available
resources it can produce the following combinations of each:
Units of food-millions
Units of clothing millions
8
0
7
2.2
6
4
5
5
4
5.6
3
6
2
6.4
1
6.7
0
7
Plot the production possibility curve. This curve introduces the concept of choice and opportunity
costs.
Fill in the following table showing the amount of clothing foregone for every unit of food produced.
Food
Clothing foregone
1 to 2
4 to 5
7 to 8
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What you should know now!!!



You should be able to explain what the production possibility curve shows and how it
explains the concept of opportunity costs.
Why does the opportunity cost increase as specialisation increases?
You should be able to distinguish between the three different economic systems. You should
know the advantages and disadvantages of each.
In answering questions from past papers try to do the following:
 Define in your own words the main word/concept/theme in the
question.
 Draw a diagram if you can.
 Give some examples.
Some examples of exam questions on this area are as follows;
(a)
Compare and contrast the free market economy with the command economy.
(b)
Write a brief note on the command economy, the mixed economy and the free-market economy. In your
answer list some of the characteristics of each and give examples of countries, which fit into each system.
(c)
Draw a production possibility frontier and list some circumstances, which will cause the production
possibility frontier to shift outwards.
We will go through how to answer these questions in class. You should try them yourself before
then. Remember if you do write them out I will correct them for you.
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TOPIC 2
MARKETS, DEMAND AND SUPPLY
(Ref: Chapter 1)
Learning outcomes from this topic:
When this topic is finished you should
1.
2.
3.
4.
Know the difference between demand and supply and be able to draw the graphs confidently.
Know what shifts the demand curve and the supply curve.
Be able to explain the effects of price restrictions on equilibrium.
Apply demand and supply concepts to current issues
In economics we are consumers, you and I, we shop and buy goods, we form households. House
holders= consumers = we demand goods.
Firms produce goods they are producers. Firms supply goods
So when you look at a question, for example, is it good or bad for Irish people if the price of
pharmaceuticals rises? (In Ireland we produce pharmaceuticals):
The answer should start with: it depends if you are a consumer or a producer…….
Before we begin to put a formal structure on the theory of demand and supply let us pause for thought
and think about the following:
Map out the chain of events which occur if Irish people start to demand a lot more fresh cheese?
.
Map out the chain of events which you think would occur if farmers had a very good coffee harvest
due to excellent weather conditions?
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THE DEMAND CURVE
Imagine you owned a shop selling homemade chocolate. As an experiment you charge a different
price for a box of chocolate each week for 10 weeks. As you lower the price week by week, will
you sell more or less boxes?
The quantity demanded of a good refers in economics to the amount of a good a person
(consumer) is willing and able to buy at a given price.
The general, and in most cases “normal” relationship between price and quantity changes is frequently
illustrated by graphing the anticipated amounts of a good that people can be expected to buy, in a
given time period, at a series of different prices within a given price range. This produces a demand
curve.
Bear in mind that the demand curve is a simple two-dimensional graph. It shows the relationship
between just two variables - the price of a good and the quantity of that good that we believe is likely
to be purchased over a given time period. In order to carry out the experiment we hold everything else
that could affect people’s decision to buy chocolate constant. “ceteris paribus” means we hold
everything else constant.
Take the example of the boxes of chocolate above. Supposing the following tables shows the results of
your experiment:
Price in Euro
12
10
8
6
4
2
0
Quantity demanded (in boxes per week)
0
5
10
15
20
25
30
If we plot these figures we get the demand curve:
Demand curve
14
12
e 10
c
ir 8
6
P 4
2
0
0
10
20
quantity
30
40
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In textbooks the demand curve is drawn as a straight line; however it is probably more realistic that the demand
curve would be a ‘curve’. Why???
This example illustrates the general shape of the demand curve and the normal relationship between price and
quantity demanded of a product. If all other influences remain constant, we would expect the quantity
demanded to rise as price falls and to fall as price rises.
Supposing you owned a cinema and over a year you carried out an experiment whereby on every
Saturday night over the year you raised the entry fee by 50 cent. Starting with week 1 up to week 52
chart how the numbers going to the cinema would change?
i.e. the demand for cinema tickets.
Do you think the demand curve for the theatre would be the same?
Use and Importance of Demand Curves
The price-quantity relationship is one of the most important things we need to know when considering
sales of products. A firm must know the likely result of a change in price, because any alteration in
quantity demanded will affect the total sales revenue. (Sales revenue = price X quantity)
Governments also need to know the probable effects of any change in a tax imposed on products.
Because such a tax will influence price, the price-quantity relationship is, again, an important issue. If
a government is considering an increase in a tax such as value added tax (VAT), which influences a
very wide range of goods, it needs to know what extra total revenue it can expect to gain from the tax
increase. It cannot assume that quantities consumed of all goods affected will remain the same; it
must take into account the probable changes in quantity demanded that would result from the changes
in price.
It is a convention (general rule) in economics that price per unit is measured on the vertical (often
called the Y) axis, while quantity in units per period of time is measured along the horizontal X-axis.
It is common to label the axes simply “Price” and “Quantity”.
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So the law of demand states that as a general rule as prices increase quantity demanded falls. Can you
think of any situations when this might not be true?
When we did the example earlier with the chocolate we changed the price and saw what happened to
quantity demanded, assuming that all other factors, which affect demand, remained unchanged as we
carried out the experiment. These ‘other factors’ are anything, which would affect the amount of goods
consumers buy. In our example we used chocolate to illustrate our point. We would have reached the
same conclusion if we had used a different product. As prices rise, quantity demanded falls for all
goods. (there are a few exceptions).
Do the following with your neighbour.
Pick any good you have bought over the last week. Mars bar, premier milk, eggs, etc.
List the things, factors that affected this decision. Put another way, what could have altered the amount
of these goods you bought?
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Factors influencing demand
Price of the good itself (p)
Consumer income (y): as income rises demand for most goods rise. Any good whose demand rises as
consumer income rises is called a ‘Normal Good’. There are some goods however that demand falls
for these goods, as people get richer. These goods are called ‘Inferior goods’. Examples of inferior
goods are: unbranded goods, bus tickets, mince meat. As people get richer they will often buy less of
these goods.
The price of substitute goods ( ps ) s : in the case of tea for example if the price of coffee which is a
competing/substitute good increased then the demand for tea might also rise as people switch to tea.
The price of complementary goods ( pc ): complementary goods are goods where the pair of goods
completes each other. i.e. Camera and film, car and petrol, toothbrush and toothpaste.
If the price of a camera increases then that will affect the demand for film.
Advertising. (A)
Tastes (t)
Population (Pop)
Expectations (e)
We can summarise the above factors which determine demand in the following equation.
Q d  f ( p, y, p s , pc , A, t , Pop, e)
When drawing the demand curve we hold all determinants of demand constant except prices. In
economic theory, any determinant, which is held constant when deriving a curve, will cause that curve
to shift when that variable subsequently changes.
In summary, a change in price itself will cause a movement along a demand curve; a change in any
other factor will cause a shift in the demand curve.
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Supply
When studying demand we looked at the various amounts of a good the consumers will demand at
various prices. When we study supply we look at the various amounts of a good, firms will supply at
various prices. When thinking about supply, imagine you own a firm or small business, the supply
curve represents how much you would supply at various prices. Remember we assume you have
choices to make as to where you can use your resources.
Imagine you own a small factory with a few ovens. You can use the factory to supply any type of food
you want. Supposing you decide to supply pizza and other products. As the price of pizzas rise (in
other words, shops are willing to pay you more for the pizzas you make) what choices will you make
regarding your business?
Consumers
Demand
Supply
Firms
To derive the supply curve, imagine you are a firm supplying the boxes of chocolate to the shop. As
the price goes up in the shop you will be inclined to make (supply/sell) more chocolate. At very low
prices you would be inclined to supply very little and would prefer to make something, which is more
profitable. However at very low prices, consumers will want a lot of chocolate and demand will be
high, but firms will not want to supply that much and supply is low.
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Using a numerical example: let’s assume that the following is found to represent the supply decisions
of a firm.
Price in Euro
12
10
8
6
4
2
0
Quantity supplied (in boxes per week)
25
20
15
10
5
0
0
Supply curve
Price
15
10
5
0
0
10
20
30
Quantity
Notice how the supply curve has a positive slope and usually does not pass through the origin, why?
When deriving the above supply curve we held all other determinants of supply constant.
Factors influencing Supply
Price of the good itself (p)
Technology (t): As new technology are developed supply increases at all prices.
Costs of production (c) these include the price of raw materials, labour costs.
Government taxes and subsidies (Gov t &s) on producers: if the government imposes a per unit tax
on suppliers then firms will generally supply less of this product and move into the production of
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Micro Economics
2009
goods that are not taxes. The firm will of course try to pass the tax onto the consumer by raising prices
but this is not always possible.
The profit available on goods in alternative supply (alternative profit): if a farmer supplies carrots
and the profit on turnips increases, the farmer will switch out of carrot production into turnip
production.
The profit available on goods in joint supply: if lamb becomes very profitable, then farmers will
supply more lamb, which will automatically lead to an increase in the supply of wool.
This relationship between quantity supplied and the various determinants of supply is often written as
follows:
Q s  f ( p, t , c, Gov, Alternativeprofits, shocks)
A change in price of the good itself will cause a movement along the supply curve; a change in any
of the other factors will cause a shift in the supply curve.
We have now looked at the demand curve and the supply curve in isolation from each other. In the
market economy trade takes place at the equilibrium price. This equilibrium price is determined by the
interaction of demand and supply. Using our simple example of chocolate, what will the equilibrium
price and quantity be???
NB. From now on, you will never really need to draw a demand or supply curve on their own, the
demand curve and the supply curve should both be drawn on the same graph. Equilibrium price and
quantity should be shown by lines as the following graph illustrates.
DEMAND AND SUPPLY COMBINED
PRICE
P = D
P = D
P = S 
P = S 
Excess
Supply
P
Excess
demand
Equilibrium
S
Q
D
Quantity
In the above diagram, equilibrium is at P, where demand equals supply. In the chocolate example this
would be at a price of €7. Usually a process of trial and error on the part of the shopkeeper finds this
price. If the shopkeeper sets the price too low, at €4, demand for the chocolate will be 20 but supply is
only 5, there is now excess demand. The shopkeeper will sell out of chocolate very quickly and the
price will go up. As price goes up, demand falls and supply rises along the respective curves.
At €7 the excess demand no longer exists and there will be no need for the shopkeeper to change
prices any more. This is called the price mechanism. The price adjusts to reflect excess demand.
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Micro Economics
2009
If the price is set too high, at €10, the firms will supply 20 boxes of chocolate, but demand will only be
5 boxes, there will be excess supply and prices will fall until such time that the excess supply is gone
and equilibrium is achieved.
Equilibrium occurs when quantity demanded equals quantity supplied.
PRICE AND MARKET EQUILIBRIUM
The equilibrium price is the price at which quantity demanded equals quantity supplied.
The equilibrium condition is as follows:
Equilibrium occurs when quantity demanded equals quantity supplied.
Qd = Qe = Qs
Where: Qe = equilibrium quantity
Example1
Qd = 3,875, – 250P
Qs = -1,000, + 400P
Solve for price and quantity
Qd = Qs
3,875 – 250P = -1,000 + 400P
Solving for the unknown P, we get
3,875 – 250P = -1000 + 400P
4,875 = 650P
P = 7.5
If P= 7.5, then we can solve for the unknown Qe. This is solved by substituting P=7.5
into either the demand or supply equation, since, in equilibrium, the quantity demanded
equals the quantity supplied.
Qe = 3,875 – 250 (7.5) = 3,875 – 1,875 = 2,000
The equilibrium price is 7.5 and equilibrium quantity is 2,000
Example 2
Calculate equilibrium price and quantity for the following two equations.
Qd = 150 – P
Qs = -50 + P
Qd = Qs
150 – P = -50 + P
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Micro Economics
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200 = 2P
100 = P
Equilibrium Price equals 100
To calculate equilibrium quantity we substitute P=100 into the above equations
Qe = 150 – 100 = -50 + 100 = 50
Qe = 50
The equilibrium price equals 100 and the equilibrium quantity equals 50.
PRICE CONTROLS
Price controls are government regulations whereby the government interferes with the market and
decides the price that must be charged for a good.
Two common types of price controls are:
 Price ceilings sometimes called maximum price. This benefits the consumer by lowering
the price the consumer must pay for the good.

Price floors, sometimes called a minimum price. This benefits the producer by increasing
the price above equilibrium.
Price Ceilings
-
A price ceiling is a maximum price on a good or service legislated by the government. For
example governments might legislate for maximum prices for certain necessities, such as
pharmaceuticals, to ensure that the poor have access to them.
-
When a price ceiling is implemented the supplier cannot charge above this ‘maximum’ price.
Its purpose is to help and protect consumers.
-
In order to make certain products, such as necessities, more affordable, the government sets a
price below the high equilibrium price. Imposing a price ceiling does this.
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Micro Economics
-
2009
If there was no price control the market would settle at a price P 0 . The government then
introduces a maximum P* (price ceiling) which firms cannot exceed. This will lead to excess
demand of AB.
PRICE
P = D
P = D
Excess
Supply
S
P0
P = S 
P = S 
P*
A
B
Ceiling price
D
Q
Quantity
Price Floors
-
A price floor is a minimum price legislated by government on a good or service.
-
When a price floor is implemented the consumer is not legally permitted to purchase the good
or service below this price.
-
The purpose of a price floor is to help producers.
-
If governments set a minimum price above the equilibrium price there will tend to be excess
supply in the market resulting in unsold stocks.
-
The figure below shows the effect of a price floor on price and on quantity demanded and
supplied.
-
The price floor P*, results in excess supply of AB
PRICE
P*
A
Excess
Supply
B
S
Price floor
P0
D
Q
Quantity
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Micro Economics
2009
Factors that Affect Demand (i.e. determinants of demand)
As explained earlier:
Q d  f ( p, y, ps , pc , A, t , Pop, e)
If the price of the good itself changes i.e. P there will be a movement
along the demand
curve
Price
B
P2
P  = P1 to P2
D  = Q1 to Q2
There is a movement from A to B
A
P1
Q1
Q2
Quantity
If any of the factors change i.e. income, price of substitutes, price of complementary
goods, advertising, population, tastes there will be a shift in the demand curve.
Shift to the left = less is demanded
Shift to the right = more is demanded
Price
Less
More
D1
D
D2
Quantity
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Micro Economics
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Factors that cause a shift in the demand curve.
a) A change in the price of substitute goods
Substitute goods = both goods serve the same purpose. An example would be Pepsi and Coke.
If the price of coca cola rises what effect will this have on the demand for PEPSI?
The demand for pepsi will go up.
Shift in demand curve for Pepsi to the right
b) A change in the price of complementary goods
Complementary goods are goods that are in joint demand; you can’t have one without the other.
An example is golf clubs and golf balls.
If the price of golf clubs rises the demand for golf balls will fall because less people will buy clubs
and hence there will be less demand for golf balls. This would cause a shift in the demand curve for
golf balls to the left.
List some other examples of substitute and complementary goods:
c) Income: Income is usually denoted by the letter y.
When income rises, the demand for some goods rise and the demand for some goods fall. Goods for
whom demand rises as income increases are called Normal goods. Inferior goods are goods that
demand falls for as income rises.
Normal goods: Most goods are normal. Steak, meals in good restaurants, branded goods.
Positive income effect: Y = D and vice versa.
Shift in the demand curve to the right
Inferior goods: examples; unbranded products, mince meat, bus tickets
Negative income effect = Y  = D.
An example is cheap wine, which would be the inferior good in relation to expensive wine
Normal and inferior goods relate to how demand for these goods is affected by income not price.
If you won the lotto of €5 million, list two goods you would buy more of
1
2
And two goods you would buy less of.
3
4
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Micro Economics
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d) T Taste
Tastes will differ for a good e.g. there is a change in taste towards iPods now compared with
walkmans. The demand curve for iPods will shift to the right while the demand for walkmans will
shift to the left.
e) E Expectations
The consumer thinks that the price will rise in the future, the demand will increase now
and there will be a shift in the demand curve to the right
f) Advertising: advertising a good usually increases demand and shifts the demand curve to the right.
g) Populations: As more Chinese people settle in Ireland the demand for Chinese food would
increase.
REMEMBER
If the price of the good changes there will be a movement along the demand curve.
If any of the other factors change there will be a shift in the demand curve. This shift could be to
the right or to the left; it depends on what has altered and the type of good being analysed.
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Micro Economics
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Factors that affect Supply (Determinants of Supply)
If there is a change in the price of the good itself, there will be a movement along the
supply curve
PRICE
P2
B
P1
P = P1 to P2
S = 100 to 200
= movement A to B
A
100
200
Q
If any of the factors other than P change i.e. P1…n = selling price of other goods to which the
producer would switch his production, C = costs of production, T= technological change,
taxation = unplanned events, there will be a shift in the supply curve.
Shift to the left = less is supplied
Shift to the right = more is supplied
Price
S1
less
S2
More
S3
Quantity
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Micro Economics
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Factors that cause a shift in the supply curve.
P2….n Selling Price of other goods to which the producer could switch his production
Example
A manufacturer is producing chairs and the price of tables increases, so tables become more profitable,
he will switch his production to tables. There will be a shift in the supply curve for chairs to the left.
C
Cost of Production
If the cost of producing CD players increases e.g.  cost of raw material = supply of CD players =
shift to the left.
T
Technological breakthrough
If there is a technological breakthrough e.g. a more efficient way to produce a product, the supply
curve will shift to the right.
Taxation
if the government Impose a per unit tax on a good the supply will shift to the left.
U
Unplanned events
Nokia has planned to deliver 2000 cell phones to a shop in Dublin. The cell phones are ready but the
trucks, which they have ordered to transport the phones, have not arrived. Supply curve shifts to the
___________?????
Summary
As mentioned earlier:
Determinants of Supply Q s  f ( p, t , c, Gov, Alternativeprofits, shocks)
The quantity supplied of a good will be influenced by
 The price of the good,
 The selling price of other goods to which the producer would switch his
production,
 Costs of production,
 Technological breakthrough,
 Taxation
 Shocks. A frost or drought
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Micro Economics
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If the price of the good changes there will be a movement along the supply curve.
If any of the other factors change there will be a shift in the supply curve.
The Effects of Changes in Demand and Supply on Price/Output Equilibrium.
Question;
From an initial equilibrium position of demand equal to supply, illustrate and explain the effect
on equilibrium price and quantity of each of the following?
1.
2.
3.
4.
5.
6.
An increase in population
An increase in labour costs
An improvement in technology
A per unit tax imposed by the government.
A subsidy given to producers of €1
A minimum price is imposed by the government on your product.
We will do these in class.
Remember demand or supply will not shift unless one of the factors which affect them changes.
WORK THROUGH THESE, I WILL COVER THEM IN CLASS AND I WILL ALSO PUT THE
ANSWERS ON MOODLE.
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Micro Economics
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WORK SHEET
Q1
IN A COMPETITIVE MARKET AN INCREASE IN CONSUMER INCOME WILL LEAD TO:
a) An increase in equilibrium price and quantity for a normal good.
b) A rise in equilibrium price and quantity for an inferior good.
c) A rise in equilibrium price and a fall in quantity for a normal good
d) A rise in equilibrium price and a fall in quantity for an inferior good.
Q2
An increase in market supply and an increase in market demand will result in
a) A decrease in equilibrium price and an increase in equilibrium quantity
b) A decrease in equilibrium price - the change in equilibrium quantity is indeterminate
c) An increase in equilibrium quantity and the change in price is unclear
d) None of the above
Q3
On a number of occasions OPEC has succeeded in driving up the price of crude oil. It has
been done by:
a) Increasing the demand for oil
b) Increasing the supply of oil
c) Restricting the supply of oil
d) All of the above
Q4
The “law of demand” states that:
a) The demand curve slopes down from left to right
b) The quantity demanded increases as prices falls
c) There is a negative relationship between price and quantity demanded
d) All of the above
Q5
A price ceiling is:
a) Set above the equilibrium price
b) Set below the equilibrium price
c) Is commonly referred to as a minimum price
d) Both (a) and (c) above
Q6
Other things being equal, the effects of a decrease in the price of apple juice would best be
represented by which of the following:
a) A rightward shift in the demand curve for apple juice
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Micro Economics
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b) An increase in the quantity demanded of apple juice
c) A leftward shift in the demand curve for apple juice
d) A decrease in the quantity demanded of apple juice.
Question 7
Using demand and supply analysis examine the effect of each of the following events on the
market price and quantity of rice.
(i)
An increase in income.
(ii)
A government subsidy is placed on the good.
(b) Using the following demand and supply functions:
Demand:
Q d =100 - 2P
Supply:
Q s = - 24 + 2P
1. Calculate the equilibrium price and quantity.
2. Calculate the changes in price and quantity if the government impose a 2-unit tax on the
product.
3. Calculate the tax revenue received by the government.
Sample Exam question
QUESTION 4
(c) Using demand and supply analysis examine the effect of each of the following events on the
market equilibrium price and quantity of houses.
(i)
An increase in income.
(3 marks)
(ii)
An increase in the amount of land rezoned for houses.
(3 marks)
(iii)
An increase in interest rates coupled with a downturn in the economy.
(3 marks)
(d) Using the following demand and supply functions:
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Micro Economics
(i)
Demand:
Q d = 80-4P
Supply:
Q s = - 18 + 3P
2009
Calculate the equilibrium price and quantity.
(4 marks)
(ii)
If the government imposed a price ceiling of €10 on the good, how would the market react?
Draw a diagram to illustrate your answer.
(3 marks)
(iii)
Calculate the tax revenue received by the government if a €2 tax is imposed on the good. Use
the demand and supply equations given above.
(4 marks)
Total (20 marks)
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Micro Economics
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WORKSHOP 1
Markets, Supply and Demand
1.
The following passage refers to the operation of a free-market economy. Delete the words (in italics)
which are incorrect.
In a totally free-market economy, the quantities of each type of good that are bought and sold,
and the amounts of factors of production (labour, land and capital, enterprise) that are used, are
determined by the decisions of individual households and firms through the interaction of
demand and supply.
In goods markets, households are suppliers / demanders and firms are suppliers / demanders.
In labour markets, households are suppliers / demanders and firms are suppliers / demanders.
Demand and supply are brought into balance by the effects of changes in price. If supply
exceeds demand in any market (a surplus), the price will rise / fall / stay the same. This will
lead to a rise in the quantity both demanded and supplied / a fall in the quantity both
demanded and supplied / a rise in the quantity demanded but a fall in the quantity supplied /
a rise in the quantity supplied but a fall in the quantity demanded. If, however, demand
exceeds supply in any market (a shortage), the price will fall / rise / stay the same. This will
lead to a fall / rise in the quantity demanded and a fall / rise in the quantity supplied. In either
case the adjustment of price will ensure that demand and supply are brought into equilibrium,
with any shortage or surplus being eliminated.
2.
How will the market demand curve for a `normal' good shift (i.e. left, right or no shift) in each of
the following cases?
(a) The price of a substitute good falls ................................................................ left / right / no shift
(b) Population rises .............................................................................................. left / right / no shift
(c) Tastes shift away from the good .................................................................... left / right / no shift
(d) The price of a complementary good falls ...................................................... left / right / no shift
(e) The good becomes more expensive ............................................................... left / right / no shift
Page 37
Micro Economics
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Workshop
1
3.
How will the market supply curve of a good shift (i.e. left, right or no shift) in each of the following
cases?
(a) Costs of producing the good fall. ................................................................... left / right / no shift
(b) Alternative products (in supply) become more profitable. ............................ left / right / no shift
(c) The price of the good rises. ............................................................................ left / right / no shift
(d) Firms anticipate that the price of the good is about to fall. ........................... left / right / no shift
4.
How will the following changes affect the market price of wheat flour (assuming that the market is
initially in equilibrium)? In each case, sketch what happens to the demand and/or supply curves and,
as result, what happens to the equilibrium price.
(a) People consume more bread.
(b) The discovery of a new cheaper way of
milling flour.
Price
Price
S
P1
S
P1
D
Q1
Quantity
(c) The prices of other grains rise.
D
Q1
Quantity
(d) Rice and potatoes fall in price.
Page 38
Micro Economics
2009
Price
Price
S
S
P1
P1
D
D
Q1
Quantity
Q1
Quantity
Page 39
Micro Economics
2009
Workshop
1
The diagram below shows the demand for and supply of petrol. The market is initially in
equilibrium at point x.
There is then a shift in the demand and/or supply curves, with a resulting change in equilibrium
price and quantity.
To which equilibrium point (a, b, c, d, e, f, g or h) will the market move from point x after each of
the following changes?
S2
S0
S1
a
b
h
Price
5.
g
c
x
d
f
e
D1
D0
D2
Quantity
The market for petrol
(a) A rise in the cost of refining petrol.
(b) A fall in bus and train fares.
(c) A fall in the price of crude oil and an increase in the price of cars.
(d) A rise in tax on petrol and a reduction in tax on cars.
Page 40
Micro Economics
2009
Workshop
1
The demand and supply schedules for wheat in a free market are as follows:
Price per tonne
120
160
200
240
280
320
360
400
Tonnes demanded per week
Tonnes supplied per week
725
225
700
300
675
400
650
500
600
600
550
750
500
1000
425
1300
(a) Draw the demand and supply curves on the following diagram:
400
360
320
Price (£ per tonne)
6.
280
240
200
160
120
0
200
400
600
800
1000
1200
1400
1600
Quantity (tonnes per week)
(a) What is the equilibrium price? ………………………………………………………………
(b) Suppose the government fixes a maximum price of £200 per tonne. What will be the effect?
...........................................................................................................................................
(d) Suppose that supply now increases by 150 tonnes at all prices.
Price per tonne
120
160
200
240
280
320
360
Tonnes demanded per week
(old) Tonnes supplied per week
725
225
700
300
675
400
650
500
600
600
550 500 425
750 1000 1300
(new) Tonnes supplied per week
...
...
...
...
...
...
....
400
....
(e) How much will price change from the original equilibrium (assuming that the government
no longer fixes a maximum price)? How much more will be sold?
Change in price ..................................................................................................................
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Micro Economics
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TOPIC 3
ELASTICITY
(Ref: Chapter 2)
ELASTICITY
Learning outcomes from this topic:
When this topic is finished you should
1. Be able to define the different elasticity measures and calculate each one
2. Know exactly what elasticity is and how it is a useful concept for business people and the
government.
3. Be able to make the linkages between price changes, elasticity and company profits.
Using a demand and supply curve answer the following question.
Is a good harvest good or bad news for a farmer? The correct answer is “it depends”, it could be yes or
it could be no.
With your neighbour, do the flowing:
One of you answers yes and the other no.
Together draw diagrams to justify each answer.
To start draw a generic demand and supply to get the idea of what will happen if the harvest is good.
Then adapt to the question posed.
We know from demand and supply that quantity demanded depends on various factors, the most
important from an elasticity point of view being own price (i.e. the price of the good being studied),
income, and the price of related goods (substitutes and complements).
We also know from demand and supply that as the price increases demand for that good falls;
Elasticity measures the extent of that fall.
There are three elasticities, which we will study under the heading of elasticity of demand. (Elasticity
of supply is done later). These three elasticities are:
 Own price elasticity of demand. This is sometimes referred to as just “price elasticity of
demand”.
 Income elasticity of demand.
 Cross price elasticity of demand.
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Micro Economics
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PRICE ELASTICITY OF DEMAND
We have already seen that there is a relationship between price, sales revenue and quantity changes.
This is most important for practical studies of price and sales movements, and we need to have a
precise way of measuring and analysing the various possible relationships.
Price elasticity of demand (Ped) is the responsiveness of quantity demanded to a change in its own
price
It is the relationship between a proportional change in quantity demanded and a proportional change in
price, so that Ped = proportional change in quantity demanded ÷ proportional change in price.
Ped
= Proportionate  in quantity demanded/ proportionate  in price
Price elasticity of demand =
Q d
/
This reads: the change in
quantity demanded divided by
the mid-point of quantity, all
over the change in price over
the mid-price.
P
1
Q1  Q 2  1 P1  P2 
2
2
Example
Price
10
20
Quantity Demanded
5
2
Using the formula above where Q d equals the change in quantity demanded and P d equals
the change in price:
= -3 / ½ (5 + 2)  10/ ½ (10 + 20) = - 1.28
Ped = -1.28
As explained earlier, for the great majority of goods a rise in price (positive figure) leads to a
reduction in quantity demanded (negative figure) and a fall in price (negative figure) leads to an
increase in quantity demanded (positive figure).
Thus when working out price elasticity of demand we either divide a negative figure by a
positive or a positive figure by a negative. Either way we end up with a negative figure.
Because own price elasticity of demand is always negative economists often ignore the negative sign
and just concentrate on the value of the figure, this tells us whether demand is elastic or inelastic.
-2
-1
0
1
2
3
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Micro Economics
2009
Inelastic
Elastic goods have elasticity in
goods
this range. Ignore sign
(ignore
sign)
When the calculation of price elasticity of demand produces a result that is more than 1, i.e. when the
proportional change in quantity is greater than the proportional change in price, we say that demand is
price elastic. i.e. if price increased by 1% quantity demanded falls by more than 1%.
Elastic goods have
elasticity in this range
Inelastic
goods
When the calculation of price elasticity of demand produces a result, which is less than 1, i.e. when the
proportional change in quantity is less than the proportional change in price, we say that demand is
price inelastic. i.e. if price increased by 1% quantity demanded falls by less than 1%.
When the calculation of price elasticity of demand produces a figure of 1, i.e. when the proportional
change in quantity is equal to the proportional change in price, we say that demand has unitary
elasticity.
The demand for fish is likely to have a price elasticity of around 0.9, washing powder about 0.3, and
eggs around 0.02. These demand elasticity’s are price inelastic but fish is clearly much more pricesensitive than eggs. Notice that while the demand for washing powder as a product is price inelastic,
the elasticity of a particular brand is likely to be very elastic. Maybe around 1.3.
Value of Elasticity
The value of elasticity may be anything between zero and infinity.
(i)
Price Elasticity of Demand Ped= 0, i.e. perfectly inelastic demand
(e.g. Drugs) (i.e. no change in Quantity Demanded no matter how much price changes)
P
D
Q
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Micro Economics
2009
(ii)
Price Elasticity of Demand =1, i.e. unit elasticity of demand (i.e. any percentage change in
price causes the SAME percentage change in quantity demanded.
P
D
Q
(iii) Price Elasticity of Demand = 
(i.e. infinity) i.e. perfectly elastic, so at the given price
there is an infinite amount demanded but any change in price causes Quantity Demanded to fall to
Zero.
P
D
Q
(iv)
Price Elasticity of Demand < 1, relatively inelastic demand (e.g. cigarettes)
(i.e. any percentage change in price causes a SMALLER percentage change in Quantity Demanded.)
P
Visually, a relatively inelastic good
is shown as having a steep demand
curve
D
Q
(v) Price Elasticity of Demand 1 relatively elastic demand (i.e. any percentage change in price
causes a BIGGER percentage change in Quantity Demanded.)
P
The relatively elastic demand curve has
a flatter demand curve
D
Q
Page 45
Micro Economics
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SUMMARY
P
P
D
P
P
D
ELASTIC
Q
INELASTIC
D
D
D
Q
P
Q
UNIT
ELASTIC
Q
PERFECTLY
INELASTIC

Elastic > 1
Proportionate change in quantity demanded > proportionate change in price

Inelastic < 1
Proportionate change in quantity demanded < proportionate change in price

Unit Elasticity =1
Proportionate change in quantity demanded = proportionate change in price

Perfectly Inelastic = 0
No change in quantity demanded as a result of a change in price

Perfectly Elastic =  (Infinity)
No change in price as a result of a change in quantity demanded
Q
PERFECTLY
ELASTIC
One important feature of price elasticity of demand is that it changes as you move along the demand
curve; so most goods have an inelastic price range (at low prices) and an elastic price range (at high
prices). This is fairly obvious because if we know that for an inelastic good, as prices rise total revenue
rises then why would firms not just continually increase prices? The answer is……………………
Consider the demand curve shown in the next page.
At point A, Ped = 1, so that here demand is neither elastic nor inelastic. Here, revenue remains the
same at both prices because the change in price produces exactly the same proportional change in
quantity demanded.
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Micro Economics
2009
At point B, however, Ped is greater than 1, so that demand is price elastic.
A reduction in price at B results in a more than proportional increase in quantity demanded, so that
there is an increase in total revenue. A firm in this position will increase revenue by reducing price but
lose revenue if it increases price.
At point C, the position is completely reversed and Ped is less than 1, so that demand is price inelastic.
A reduction in price here results in a less than proportional increase in quantity demanded, so that
there is a fall in total revenue. A firm in this position will lose revenue by reducing price but gain
revenue by increasing price.
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Micro Economics
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The point of greatest possible revenue on any linear demand curve is where price elasticity is at unity
(where Ped = 1).
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Micro Economics
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The Relationship between Price Elasticity of Demand and Total Revenue (NB).
This is very important because it illustrate how elasticity is useful.
Qd = quantity demanded
ELASTIC
Price  = Qd by a larger proportion so TR 
Price  = Qd  by a larger proportion so TR 
INELASTIC
Price  = Qd  by a smaller proportion so TR 
Price  = Qd  by a smaller proportion so TR 
UNIT ELASTIC
Price  = Qd by the same proportion so TR no change.
Price  =Qd  by the same proportion so TR no change.
Influences on Price Elasticity of Demand
We have seen that the price elasticity of demand can be expected to change as price changes, so that
the products own price can normally be regarded as an influence on its elasticity. The important point,
really, is whether buyers are likely to pay much attention to the price when deciding whether to buy, or
if other influences are more important. These may include current fashion or social attitudes, strong
habits (even addiction, in some cases such as tobacco smoking) or the need to buy in order to achieve
some other desired objective, such as buying petrol in order to drive to work.
If the product price is only a relatively small amount compared with normal income then price is likely
to be less important than the other influences affecting demand, which is thus likely to be price
inelastic. Toothbrushes, matches, shoe polish, are all examples of products likely to be price inelastic.
Here, high relative price changes at normal price levels are unlikely to weigh heavily with consumers,
because annual spending on these items is only a very small part of total income. Other influences,
e.g. social attitudes (smoking), the move away from coal fires (matches), health issues are likely to be
much more important.
We must also be careful to distinguish between the demand elasticity for the class or product and that
for a particular brand of the product. My decision whether or not to buy household soap is not likely
to be greatly influenced by a 10% rise in its price, but when I am actually making my purchase I am
quite likely to compare the prices of two brands and choose the cheaper, assuming that I do not think
that one is superior in quality to the other. Thus, demand for a product can be price inelastic, whereas
demand for a specific brand of the product can be price elastic.
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Micro Economics
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Factors Influencing Demand Elasticity
1.
Availability of Substitute Goods
The easier it is to switch away from a good the more elastic will its demand be.
Let’s assume that Pepsi and coke are close substitutes. If the price of coke rises we would expect
the quantity demanded of coke to decrease a lot as people switch to Pepsi. Hence coke would be
seen as elastic. Note that it is for this very fact that advertisements for coke are so strongly brand
orientated. Notice also that most goods, which are heavily advertised, are those goods, which have
many substitutes.
The stronger the relationship between the substitutes, the more elastic the demand. In this case
because Pepsi is a strong substitute for Coke, if the price of Coke goes up, the demand for Coke will
be very elastic, as consumers switch to Pepsi.
2. Complementary Goods
Given two complimentary goods, the demand for the less important of the two goods in joint
demand will be inelastic. For example lamb and mint sauce, if the price of lamb does not change but
the price of mint sauce increases in price, the demand for mint sauce will be inelastic, as consumers
are more concerned about the price of the more important good, lamb changing its price.
3. Proportion of income spent on the product
The greater the proportion of income spent on the good the more elastic will its demand be.
The smaller the proportion of income, which you spend on a good, the more inelastic your demand
will be. For example, if you spend .01% of your income on matches and the prices of matches
increases by 10%, it will have very little impact upon demand for matches i.e. demand will be
inelastic.
4. Whether the commodity is a luxury or a necessity
Price elasticity of demand for luxuries is relatively elastic as it is not necessary that we possess
luxuries however demand for necessities is relatively inelastic as people must buy these products even
when price increases.
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FURTHER DEMAND ELASTICITIES
The general concept of elasticity can be applied to any of the influences on demand. If you think
about the concept, you will realise that it is simply the ratio of a proportional change in quantity
demanded to the proportional change in the influence considered to be responsible for that quantity
movement. The only limiting element in using elasticity is that the influence must be capable of some
sort of precise measurement or evaluation. This makes it difficult to produce a definite calculation for,
say, changes in taste or fashion, as this is very difficult to measure. The most commonly used
elasticities, in addition to the products own price, and are those for income and for other prices of
related goods.
Income Elasticity of Demand (Yed)
Negative
Inferior goods
Positive
Zero
Normal goods
Income elasticity possible values
Income elasticity of demand (Yed) is the responsiveness of quantity demanded due to a change in income.
This relates to the proportionate or percentage change in quantity demanded to the proportionate or
percentage change in disposable income of customers for the product.
This may be positive or negative, because there may be an increase in demand following an income
increase or a fall in demand. If the income and quantity changes are in the same direction, then the
figure for Yed is positive. If the changes are in the opposite directions to each other, then the figure
carries the negative sign (). A rise in income usually leads to a rise in demand, but demand for some
goods may fall. In the 1950s, in Ireland, demand for motorcycles fell as incomes rose and people
bought cars. As we saw earlier, such goods are known as inferior goods.
Notice that we are referring here to “disposable income”, i.e. the income left to the consumer after
compulsory deductions have been taken. The most important of these are income tax and National
Insurance contributions. We may also include contributions to pension schemes or to trade unions or
professional bodies, where membership is necessary for employment.
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Yed = Proportionate change in quantity demanded / Proportionate change in income
Income elasticity of demand =
Q d
1
Q1  Q 2 
2
/
Y
1
Y1  Y2 
2
Summary
Yed is positive for normal goods. A goods for whom demand rises as income rises. If income
increases by 1% and quantity demanded rises by 0.5% we say that good is normal but a necessity
where as if income rises by 1% and quantity demanded rises by 3% we say that good is a luxury good.
Yed is negative for inferior goods. If income rises by 1% and quantity demanded falls by 2% we say
that good is an inferior good.
Yed  0 = Normal Good
Yed = 0 - 1 = necessity
Yed  1 = Luxury Good
Yed < 0 = inferior good
Yed = 0 = this implies the good is income neutral; income has no effect on the demand for the good.
For example salt.
Income elasticity of Demand is normally positive because when income rises people consume more of
most goods.
If Income Elasticity of Demand is greater than one then Yed is said to be income elastic, i.e. a small
change in income causes a bigger change in quantity demanded e.g. luxury goods and services.
If income elasticity of demand is less than one then Yed is said to be income inelastic, i.e. a change in
income causes a smaller change in quantity demanded. E.g. some necessities
INFLUENCES ON INCOME ELASTICITY OF DEMAND
The following influences are likely to increase a product’s income elasticity of demand:
Degree of “necessity" of the good. In a developed country, the demand for luxury goods expands
rapidly as peoples income rise, whereas the demand for basic goods such as bread only rises slowly.
Thus items such as cars and foreign holidays have a high income elasticity of demand, items such as
potatoes and bus journeys have a low income elasticity of demand.
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Micro Economics
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Association with a higher living standard than that currently enjoyed is likely to lead to rising
demand when incomes do rise.
In general, the more highly priced durable goods (household machines, motor vehicles, etc.) and
services are more likely to be income elastic than the staple items of food and clothing. We do not
usually buy twice as much of these if we receive double our former income. On the other hand, our
spending on holidays may increase by far more than double. Increased spending on motor transport is
also associated with rising incomes. Although we have been considering income rises, very similar
comments apply to income reductions. Holidays and motorcars are often the first things to be
sacrificed in the face of a sudden drop in income.
Income elasticity of demand is an important concept to firms considering the future size of the market
for their product. If the product has a high income elasticity of demand, sales are likely to expand
rapidly as national income rises, but may also fall significantly if the economy moves into recession.
(Sloman,J 1997)
CROSS PRICE ELASTICITY OF DEMAND
Cross price elasticity of demand is the responsiveness of quantity demanded for (good X) due to a
change in the price of another good (good Y). Where goods X and Y are either substitutes or
complements.
Cross price elasticity of demand
= Proportionate change in quantity demanded for x / Proportionate change in price of y
Cross price elasticity of demand =

Q x
d
1 x
Q 1  Qx 2
2
/
 12 P
Py
y
2
 Py2

SUBSTITUTE GOODS
If two products are substitutes for each other, we can expect a rise in the price of one to lead to a rise
in the demand for the other i.e. a positive relationship
Proportionate  in quantity demanded for x / Proportionate  in price of y.
Example
Coke
Pepsi
P
assume price of Pepsi stays the same.
QD
Qd
= +/+ = +
COMPLEMENTARY GOODS
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If, however, the two products are linked together, e.g. golf clubs and golf balls, then a rise in the price
of one leads to a fall in the demand for the other, i.e. a negative relationship.
Proportionate  in quantity demanded for x / Proportionate  in price for y
Example
Golf Clubs
P
QD
Golf Balls
assume price of golf balls stay the same.
Qd
= +/ = 
Influences on Cross Price Elasticity of Demand
The more close substitutes a product has, the more likely it is to react to changes in price of any of
those substitutes. The demand for coach travel reacts to changes in rail fares, and the link became
closer in Ireland when motorways cut down the times of road journeys between the major cities and
long-distance coaches became more directly comparable with inter-city trains. Brands of goods are
normally much more cross elastic with each other than the good itself is with other goods. We are not
unduly influenced by other price movements when we decide how much soap to buy, but we are much
more ready to switch to a competing brand when there is a rise in the price of the brand we normally
buy.
In the same way, the intensity of negative cross elasticity depends on how closely products are
associated with each other. For people in Ireland, the demand for suntan lotion is likely to fall if the
price of “package holidays in the sun” rises.
THE IMPORTANCE OF ELASTICITY CALCULATIONS
The calculation of elasticities is not just of academic interest. Anyone, including the business manager
and the members of government who wish to predict accurately the effect of changes in price or
income on revenue and on quantities bought, need to have a clear idea of elasticity and their
calculation. If a business manager thinks that a price rise will always increase sales revenue, then he
or she needs to be reminded that this is far from being true. A price rise when demand is price elastic
will, as you have seen, reduce total sales revenue.
Governments making changes in income or expenditure taxes must be able to calculate their effects on
demand. If they do not, then their predictions about the results of the tax change are likely to prove
badly out of line with reality.
A government wishing to increase its tax revenue will tend to choose goods the demand for which is
price inelastic - tobacco for example, or petrol. If, however, it goes on increasing the tax, the time will
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eventually come when demand becomes price elastic and any further increase will result in a reduction
in sales revenue and a fall in tax receipts.
Price elasticity of demand can also change as a result of other influences. If, for example, there is a
long-term trend away from smoking, we can expect demand for cigarettes to become price elastic at
lower price levels in the future.
If governments wish to influence consumer demand by price changes, they are likely to try to make
demand more price elastic by ensuring that suitable substitutes are available for the target product. For
instance, if they wish to reduce consumption of leaded petrol, they must encourage the availability and
demand for unleaded petrol, and ensure that vehicle engines can be converted easily and cheaply to
unleaded petrol. They may wish to support any tax changes by changes in the law, perhaps requiring
all new vehicles to be adapted to use unleaded fuel.
Try the following question, which came up in last year’s exam:
(d) Imagine you are the new health minister in government. You are very anti smoking and want to
implement new laws and policies to try and prevent young people from starting to smoke. Your
economist friend has told you that cigarettes are very inelastic goods. What does this mean and how
would it help you in drawing up your policies. In your answer suggest some policy options.
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Price Elasticity of Supply
Price elasticity of supply is the responsiveness of supply to a change in price
Price elasticity of supply = Proportionate  in quantity supplied / Proportionate  in price
Price elasticity of supply:
Q s
/
P
1
Q1  Q 2  1 P1  P2 
2
2
Price elasticity of supply is generally positive
Elasticity of Supply is normally positive because suppliers will want to supply more at a higher price
because that increases their revenues.
Zero Elasticity of Supply (Perfectly Inelastic Supply)
Proportionate  in quantity supplied / Proportionate  in price = 0 i.e. no change in supply as a result
of a change in price.
Price
S
Quantity
Infinite Elasticity of Supply (Perfectly Elastic Supply)
Proportionate  in quantity supplied / Proportionate  in price =  infinity. The extreme cases are
often difficult to explain because they are so rare.
Price
S
Quantity
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Micro Economics
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UNIT ELASTICITY OF SUPPLY
Proportionate  in quantity supplied / Proportionate  in price = 1
PRICE
S
Quantity
Factors Which Affect Elasticity of Supply
Cost Conditions
When P = QS, costs per unit affect how much supply will increase. If it costs more per unit to 
S, then supply will not be very responsive to an increase in price = inelastic.
Time Period
The shorter the time period the less elastic the supply will be e.g. if you are selling vegetables in a
particular season and price increases, then supply will be inelastic as you may not be able to grow
vegetables in a hurry.
Storage Costs
When prices falls, supply falls, but if it costs a lot to store the product whose supply you have
reduced, then supply may be inelastic.
Perish ability
The higher the perish ability, the more inelastic the supply will be. e.g. if the price of butter
decreases, then the supply of butter should fall, the supply will be inelastic in this case i.e. supply of
butter will be reduced by only a small amount, otherwise it will go off.
Alternative Goods that could be produced
If it is easy for a firm to switch to produce other goods elasticity of supply will be greater.
Cost of attracting factors of production and laying them off
The cheaper and easier it is to get extra factors means a higher elasticity of supply.
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Micro Economics
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Elasticity and the Profit Maximising Firm
Profit Maximising Firm
Profit ( ) = TR – TC
Total Revenue (TR) = P * Q (Price Quantity)
TC = Total Costs
What will the profit maximising firm do, if demand for his product is elastic, inelastic, unit
elastic??
P
P
Elastic
>1
TR 
TR 
Inelastic
<1
TR 
TR 
TR no 
TR no 
Unit Elastic = 1
Elastic
Profit maximising firm will P to increase sales revenue, by P the Qd, which means TC, what
happens to profit is inconclusive.
Inelastic
Profit maximising firm will P to maximise sales revenue, by  P, the QD  TC  since firm is
supplying less  profit 
Unit Elastic
Profit maximising firm will  P. There will be no change in total revenue but Qd = TC 
= Profit 
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ELASTICITY AND THE GOVERNMENT
The government has two main objectives


Increase total revenue
Social policy provision
If the government taxes a good, the supply curve shifts to the left = P and if they subsidise a good the
supply curve shifts to the right = P
It is necessary to tax and subsidise to fulfil the objectives above.
Elasticity and Taxation
Elastic
If P, Q d  by a larger proportion =  TR. The only time, the government will tax goods which have
an elastic demand will be when it is part of social policy e.g. fur coats
Inelastic
There are two categories of goods with an inelastic demand.
Category A Goods we feel we need – cigarettes and alcohol
Category B Goods we need – milk and bread
Tax category A because if P, Q d  by a smaller proportion =  TR.
Elastic
The government will generally not subsidise goods that have an elastic demand, however an example
of a good they may subsidise is the theatre, thereby making it more widely available to a wider range
of people.
Inelastic
Which category will the government subsidise??
They will not subsidise cigarettes and alcohol but they may subsidise category B above.
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PRACTICAL SIGNIFICANCE OF INCOME ELASTICITY OF DEMAND
A. If a firm is selling a normal good, when income increases, demand for normal goods increase, so
firms will produce more normal goods. Normal goods have a positive income effect. (Vice versa
if income of the community falls).
B. If a firm is selling a luxury good, when incomes increases, demand for luxury goods increases, so
firms produce more luxury goods. Luxury goods have a high positive income effect. (Vice versa
if income of the community falls).
C. If firm is selling an inferior good, when income increases, demand for inferior goods decreases,
so firms produce less inferior goods. Inferior goods have a negative income effect. (Vice- versa if
income of the community falls).
D. If a firm is selling a necessity and the income of the community increases, the demand for
necessities will not change that much. The firm will not alter his production. Necessities have a
low income elasticity of demand.
When incomes rise people do not merely increase their demands for the good they consumed formerly
but change to new products.
They may enrich their lives by more varied diets or more sophisticated consumer goods.
Entrepreneurs and governments must predict these requirements and form opinions as to the likely
elasticity of demand for various goods and services as income rises.
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Micro Economics
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WORKSHOP 2
Markets in Action
1.
(a) The price elasticity of demand measures the responsiveness of the quantity demanded / price
to a change in the quantity demanded / the quantity supplied / price.
[Delete wrong words.]
(b) Give the formula for price elasticity of demand.
........................................................................................................................................................
2.
In the mid 1990s, the government in the UK announced that for every 10 per cent rise in the price of
cigarettes, the demand is likely to fall by 6 per cent. If this information is correct, what is the value
of the price elasticity of demand for cigarettes?
................................................................................................................................................................
3.
In each of the following pairs, tick which of the two items is likely to have the more elastic demand.
Give reasons for your answer.
(a) Petrol (all brands)
Esso petrol
.......................................................................................................................................................
.......................................................................................................................................................
(b) Holidays abroad
Bread
.......................................................................................................................................................
.......................................................................................................................................................
(c) Salt
Clothing
.......................................................................................................................................................
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Micro Economics
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.......................................................................................................................................................
Workshop
2
Workshop
2
5.
The following diagram shows two demand curves that cross at a price of P1.
Price
P0
P1
D2
D1
Q0 Q 1
Q2
Quantity
Which of the following statements are true?
(a) Curve D1 is inelastic and curve D2 elastic. .……………………………………. True / False
(b) Demand is more elastic between P0 and P1 along curve D2 than along curve D1.. True / False
(d) For any given change in price there will be a larger proportionate change in quantity along
curve D1 than along curve D2.
……..………………………….…….. True / False
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Micro Economics
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Workshop
2
6.
Fill in the rest of the following table:
Quantity
demanded
(000s)
Price
(£)
Total
consumer
expenditure
7
13
………..
9
11
13
7.
11
9
7
Elastic or
inelastic
demand
Price elasticity
of demand
……….
……….
……….
……….
……….
……….
………..
………..
………..
(a) What is the formula for income elasticity of demand?
…………………………………………………………………………………………………
(b) Which of the following would you expect to have a demand which is elastic with respect to
income? (There are more than one.)
(i)
Flour
Yes / No / Possibly
(ii) Ready-prepared meals for the microwave
Yes / No / Possibly
(iii) Paté de foie
Yes / No / Possibly
(iv) Socks
Yes / No / Possibly
(v) Designer jeans
Yes / No / Possibly
(vi) Electricity
Yes / No / Possibly
(vii) Bus journeys
Yes / No / Possibly
(viii) Insurance
Yes / No / Possibly
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Micro Economics
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TOPIC 4
THE SUPPLY DECISION
(Ref: Chapter 3)
Learning outcomes from this topic:
When this topic is finished you should
1. Be able to explain the law of diminishing returns to someone who knows no economics.
2. Be able to distinguish between the short run and the long run.
3. List and understand the various different reasons for economies and diseconomies of scale.
4. Be able to derive, explain and draw the different curves: AC,MC etc
This topic is made up of loads of individual theories that build on each other. I will bring in separate
exercises to class to allow you to get practice in working through these problems, so while it can be a
little daunting initially all will be revealed before the end.
General background.
Objectives of the Firm
We assume in this course that firms aim to maximise profits. Why does a firm not produce more and
more product and therefore profits would continue to increase? As output increases costs also increase
and hence profit is uncertain. Generally if a firm can increase its profits by producing more, it will
normally do so.
Profit = Total Revenue – Total Cost
Profit = TR –TC
If a firm is considering producing more of a good, it will ask the question, is the money I make from
this good (the marginal revenue) more than the cost of making it (marginal cost). If the answer is yes
then the good will be made and production will rise. A firm will continue to produce a good so long as
the MR >MC. This is a rational decision.
As a firm produces more of a good, the cost per unit of production changes.
3 key decisions the firm must make are:
How much output/ quantity of product to supply
How to produce that output (choice of production technique/technology
How much of each input to demand.
Production
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Micro Economics
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Production essentially involves the transformation of inputs/factors of production (land, labour, capital
and enterprise) into outputs.
This relationship can be described in the form of a production function.
A production function demonstrates the relationship between the amount of input used and the
amount of output generated.
i.e. TP = f (L, Lb, K, E)
where TP=Total Product (i.e. Total Output)
L=Land
Lb=Labour
K=Capital
E=Enterprise
In this topic there are four areas studied:
Production in the short run. (The law of
diminishing returns)
Costs in the short run
Production in the long run.
Costs in the long run (economies and
diseconomies of scale)
Production in the Short Run
The short run covers a period of time where there is at least one factor of production, which does not
change. It is fixed. It is usually assumed to be capital.
Example
Clock production per week
Table1.
(1)
No. Of
workers
0
1
2
3
4
5
(2)
K
2
2
2
2
2
2
(3) Total
Product
(TP)
0
100
320
630
1040
1400
(4)
Average
Product
(AP)
0
100
160
210
260
280
(5)
Marginal
Product
(MP)
100
220
310
410***
360
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Micro Economics
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7
8
2
2
2
1740
1960
1840
290
280
230
2009
340
220
-120
Diminishing returns set in after the 4th worker is employed. Diminishing returns can be defined as:
Diminishing returns set in when output starts to increase at a decreasing rate or when marginal
product starts to decrease.
The total product curve:
The marginal product and the average product:
The Marginal Product of labour is the change in total output when an additional unit of labour is
added.
MPL 
TP
L
 = Change
- Normally by adding workers the division of labour will increase productivity/increase marginal
returns.
- Increasing marginal returns implies that an additional unit of a variable factor adds more to the
total product than the previous unit.
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Micro Economics
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- However from Table 1. Above you will notice that eventually MP begins to decline or diminish.
This is what the British economist, David Ricardo, referred to as the law of diminishing returns.
** Very important economic theory- the law of diminishing returns states that when additional
units of a variable input (labour) are added to fixed inputs after a certain point, the marginal
product of the variable input declines
The average product of labour equals TP of labour divided by the number of units of labour
i.e. = TP/ L
- If MP is above AP then AP rises
- If MP = AP then AP is constant
- If MP is below AP then AP falls
If total output or product is 100 units when 5 workers are employed, then AP will equal 100/5=20
Production in the Long Run
The long run is a period of time in which all the factors of production can be varied in quantity.
The long run production function shows the quantities of output produced from a combination of inputs.
Three possible relationships between inputs and outputs may exist in the long run production function:
i)
Increasing returns to scale…where the increase in output is proportionally greater than the
increase in inputs. For example, if a firm doubled all labour and capital and land, output
would increase by more than double.
ii)
Constant returns to scale…. where the increase in output matches the increase in inputs
iii) Decreasing returns to scale. …Where the increase in output is proportionally smaller than the increase in
inputs.
COSTS
It is very important that you understand costs because we use the cost curves again in all diagrams in
the next chapter.
-The firm must understand and appreciate cost behaviour not least because of its obvious impact on
profitability.
- Economists employ a definition of costs that helps model decisions about what to produce and how
much to produce and whether to exit or enter an industry.
 (Profit) = TR (Total Revenue) – TC (Total Cost)
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Micro Economics
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
Average Costs = TC/ Q = unit costs of production

Average Revenue = TR/Q =P.Q/Q=P. Average revenue is another word for price

Average Fixed Costs = TFC/Q = unit fixed costs

Average Variable Costs = TVC/Q = unit variable costs

Marginal costs are the change in total costs necessary to produce one additional unit of output. =
TC /  Q

Example
Output
1
Total costs
1000
MC
AC
1000
600
2
1600
800
200
3
1800
600

Marginal Revenue is the change in total revenue when an extra unit of output
is sold = TR /  Q

Fixed Cost = costs which do not vary within a wide range of output. They can change eventually
e.g. rent or rates.

Variable Costs vary directly with the level of output e.g. raw materials, electricity to propel
machinery

Short run period – This is the period when the quantity used of at least one of the factors of
production is fixed.

Long run period – long enough to allow an alteration in the quantity used of all of the factors of
production
The Relationship Between Average Cost and Marginal Cost
This is a relationship, which holds true in the long run and short run.
If MC < AC, AC is falling
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Micro Economics
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If MC > AC, AC is rising
If MC = AC, AC is unchanged
When MC = AC, AC is at a minimum
Normal Profit is being earned when total revenue is just sufficient to cover all costs.
Supernormal profit is being earned when total revenue is greater than all costs incurred.
Losses are incurred when less than normal profit is being earned.
Short – run costs.

Remember the short run is the period when the quantity used of at least one of the factors of
production is fixed.
STC=SFC &SVC

If the factor of production is fixed in the short run then the costs are as well.
In the Clock example discussed earlier, labour is the only variable input, the others are fixed.
As labour is the only variable input, wage is the variable cost.
Table 2
Short – Run Costs (per week) for Clocks Ltd
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
(9)
Labour Q
SFC
SVC
STC
SMC
SAFC SAVC SATC
0
0
100
0
100
1
100
100
200
300
2.00
1.00
2.00
3.00
2
320
100
400
500
0.91
0.31
1.25
1.56
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Micro Economics
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3
630
100
600
700
0.65
0.16
0.95
1.11
4
1040
100
800
900
0.49
0.10
0.77
0.87
5
1400
100
1000
1100
0.56
0.07
0.71
0.79
6
1740
100
1200
1300
0.59
0.06
0.69
0.75
7
1960
100
1400
1500
0.91
0.05
0.71
0.76
From the above data plot the following curves:
STC
SVC
On a separate graph plot:
SAFC
SAVC
SATC
SMC
Be able to explain the shape of each one.
STC =SVC + SFC
SMC =STC/Q
SAFC = SFC/Q
SAVC =SVC/Q
SATC =SAFC & SAVC
Why is the Short Run Average Cost Curve U-shaped?
. Law of Diminishing Marginal Returns
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This law states that as increasing quantities of a variable factor of production are combined with
a fixed factor of production, a stage will eventually be reached where marginal returns begin to
decline.
Long-Run Costs: Some important economics concepts
Economies of scale, Average costs are falling as output rises.
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Economies of scale are
good for a firm. They
increase the opportunity
to make more profits.
Diseconomies of scale set in
when all economies of scale
have been exhausted and
average costs begin to rise as
output increases.
Firms would always try to
avoid this happening but
sometimes they fail and AC
rise.
The long run can be defined as a period of time, which is long enough to vary all factors of production
Economies of scale: When an increase in the factors of production results in a more than
proportionate increase in the level of output. For example, if all inputs double, output would increase
by more than double. If all inputs double cost double, so if output increases by more than double
average costs would fall.
Example:
Stages
1
2 Costs double
Total costs €
100
200
Output
50
120
Average cost TC/Q
2
1.66
(Average Costs  as Q)
Diseconomies of scale – when an increase in the factors of production results in a less than
proportionate increase in the level of output
(Average Costs  as Q)
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Economies of Scale
 Internal – within the firm itself
Technical – increase in the use of machinery, labour economies
Marketing – bulk buying, economies in distribution
Financial – lower rates of interest
 External – outside the firm but within the industry
Technical schools may train workers in skills, which means firms do not have to train
staff initially, which lowers the costs of production
Establishment of marketing boards - instead of each firm having to have its own
marketing department, if an industry is large enough, a marketing body for the whole
industry may be set up e.g. Irish Tourist Board.
Diseconomies of Scale
Internal – within the firm itself
 As firms increase in size, they are more difficult to manage
 It is difficult to control stocks
 Staff morale falls, as workers feel like mere cogs in a wheel
External- outside the firm within the industry
 Scarcities of raw material may occur, which may hamper the development of the
industry, thus leading to rising costs.
 The inability of the infrastructure to keep pace with the increasing demands of
the firm.
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Profit Maximising Output Level: MC=MR
To maximise profit it is necessary that TR be greater than TC by as large an amount as
possible.
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- To maximise the difference between TR and TC it is necessary that MC and MR are
equal.
Price
MC
P**
MR
Quantity
Q^
Q**
Q** is where the profit maximising firm will operate. This is where MC=MR.
EXPLAIN IN YOUR OWN WORDS WHY Q ^ IS NOT THE PROFIT MAXIMISING POINT?
IF YOU CAN DO THIS YOU ARE WELL ON THE WAY TO THINKING LIKE AN ECONOMIST!!
Explain here!!
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- Therefore the challenge facing the firm is to produce the level of output at which MC
=MR.
MR= TR/Q
Table 3.Total revenue, marginal revenue, total cost and marginal cost.
(1)
Q
(Tons)
0
1
2
3
4
5
6
7
8
9
(2)
TR
(£00)
0
33
63
90
114
135
153
168
180
189
(3)
MR
(£00)
33
30
27
24
21
18
15
12
9
(4)
TC
(£00)
36
50
62
73
82
92
105
119
144
171
(5)
MC
(£00)
(6)
MR-MC
(£00)
(7)
Output
decision
14
12
11
9
10
13
14
25
27
19
18
16
15
11
5
1
-13
-18
Increase
Increase
Increase
Increase
Increase
Increase
Increase
Decrease
Increase
The Output decision of the firm in the short run
2 conditions required for short- run equilibrium
a) Produce a level of output where MR=SRMC
b) A firm will produce at this level of output if and only if PSAVC
Output decision of the firm in the long run.
Once again 2 conditions are required for long run equilibrium
a) Produce at a level of output where MC=MR
b) Firm will produce in the long run if P LAC
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WORKSHOP 3
The Supply Decision
1.
(a) Complete the following table of costs for a firm. (Note: enter the figures in the MC column
between outputs of 0 and 1, 1 and 2, 2 and 3, etc.)
Output
TC (£)
AC (£)
0
55
…….
1
85
…….
2
110
…….
3
130
…….
4
…….
40
5
…….
42
6
280
…….
7
…….
…….
8
…….
…….
9
610
…….
10
…….
…….
MC (£)
…….
…….
…….
…….
…….
…….
90
110
…….
150
(b) How much is total fixed cost at:
(i)
an output of 0? .................................................................................................................
(ii) an output of 6? .................................................................................................................
(c) How much is average fixed cost at:
(i)
an output of 5? .................................................................................................................
(ii) an output of 10? ...............................................................................................................
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(d) How much is total variable cost at an output of 5? ..................................................................
(e) How much is average variable cost at an output of 10? ..........................................................
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Workshop
3
(a) Referring to the data from question 1, draw the firm’s average and marginal cost curves on
the following diagram. (Remember to plot MC mid-way between the quantity figures.)
2.
140
120
Costs (£)
100
80
60
40
20
0
0
1
2
3
4
5
6
7
8
9
10
Output
(b) Mark on the diagram the output at which diminishing returns set in.
(c) Assume that the firm is a price taker and faces a market price of £60 per unit.
Draw the firm’s AR and MR curves on the above diagram
(d) How much will it produce in order to maximise profit? ..........................................................
(e) Shade in the amount of profit it makes.
(f)
Calculate how much profit this is
. ....................................................................................
.............................................................................................
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Workshop
3
3. The following is a list of various types of economies of scale:
(i)
(ii)
(iii)
(iv)
(v)
(vi)
(vii)
(viii)
The firm can benefit from the specialisation and division of labour.
It can overcome the problem of indivisibilities.
It can obtain inputs at a lower price.
Large containers/machines have a greater capacity relative to their surface area.
The firm may be able to obtain finance at lower cost.
It becomes economical to sell by-products.
Production can take place in integrated plants.
Risks can be spread with a larger number of products or plants.
Match each of the following examples for a particular firm to one of these types of economy of scale.
(a) Delivery vans can carry full loads to single destinations.
……..
(b) It can more easily make a public issue of shares.
……..
(c) It can diversify into other markets.
.….....
(d) Workers spend less time having to train for a wide variety of different tasks, and
less time moving from task to task.
.….....
(e) It negotiates bulk discount with a supplier of raw materials.
.….....
(f) It uses large warehouses to store its raw materials and finished goods.
.….....
(g) A clothing manufacturer does a deal to supply a soft toy manufacturer with offcuts
for stuffing toys.
.….....
(h) Conveyor belts transfer the product through several stages of the manufacturing
process.
……..
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Workshop
3
This page consists of three multiple-choice questions
In each case, circle the correct answer.
4.
5.
6.
If, at the current level of output, a firm’s average cost is greater than its marginal cost, then:
A.
An increase in output must raise average its cost still further above marginal cost.
B.
A reduction in output would raise average cost.
C.
The firm is producing beyond its minimum average cost level.
D.
The marginal cost curve is downward sloping at the current level of output.
E.
Average fixed cost must be constant.
A firm discovers that if it either increases or reduces output, its short-run average cost increases.
It follows that:
A.
The firm is maximising profit at its present output.
B.
The firm is maximising its marginal cost at its present at its present output.
C.
The firm is producing at the point where marginal cost equals average cost.
D.
Diseconomies of scale are present.
E.
Total costs are at a minimum.
The information in the following table relates to a firm’s average and marginal costs of operating
each of three plants (X, Y and Z). Each plant has a U-shaped average cost curve.
Plant
Average cost (£)
Marginal cost (£)
Plant X
16
16
Plant Y
14
13
Plant Z
14
16
The firm is a price taker, selling its product for £15 per unit. In order to maximise profit, the firm
in the long run will:
A.
Expand production at plant X, shut down plant Y and reduce production at plant Z.
B.
Expand production at plant X, reduce production at plant Y and shut down plant Z.
C.
Shut down plant X, expand production at plant Y and reduce production at plant Z
D.
Shut down plant X, reduce production at plant Y and expand production at plant Z
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Reduce production at plant X, expand production at plant Y and shut down plant Z.
Costs and Production A few more examples
Question One
Fill in the missing Columns
Number of workers
0
1
2
3
4
5
6
7
8
Total Product
0
10
26
40
52
60
65
67
67
Average product
Marginal product
Sketch the three curve and state when diminishing returns set in.
Question 2
Fill in the missing columns
Output
Total
Costs
0
1
2
3
4
5
6
300
540
680
750
952
1200
1602
Fixed
costs
Variable
costs
Average
fixed
costs
Average
variable
costs
Marginal
Costs
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TOPIC 5
MARKET STRUCTURES
(Ref. Chapter 4)
Some extra graphs will be given out with this section.
All book references refer to Sloman 3rd edition.
Learning outcomes from this topic:
When this topic is finished you should
1. Know the difference between the different market structures
2. Be able to justify why a particular industry is in a particular market
structure.
3. Be able to confidently draw the various diagrams to illustrate how
market structures operate and how much profit each market structure
can make.
4. Be able to manipulate the graphs to reflect changes in costs or taxes.
CLASSIFYING MARKETS
Markets can be classified according to:
 Number of firms
 Freedom of entry to and exit from the industry
 Nature of the product
 Nature of the demand curve
THE FOUR MARKET STRUCTURES
 Perfect Competition
 Monopoly
 Monopolistic Competition
 Oligopoly
Why do we study market structures?
1. The market structure under which a firm operates will affect its conduct, which in turn affects
its performance.
2. It enables appropriate strategies to be developed in accordance with industry conditions
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3. It facilitates effective future planning
4. It aids decisions regarding production and output
PROFIT MAXIMISING RULES
The first issue to deal with is the Basic Profit Maximising Rules underlying ALL market
structures.

These are the rules, which must be followed in order to find the quantity, and price, which
maximises profit in all market structures.
The second issue is to deal with each of the market structures separately and:

Explain the assumptions

Illustrate the price and quantity which is consistent with supernormal profits
(SUPERNORMAL PROFIT), normal profits and a loss
Basic Profit Maximising Rules which apply to all Market Structures
Short Run
Long Run_____________
MC = MR
MC = MR
MC must cut MR from below
MC must cut MR from below
AR  AVC
AR  AC
The relationship between MR and MC tells us whether profit is rising or falling
The relationship between AR (Price) and AC tells us what type of profit we are earning.

AR > AC = supernormal profit
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Micro Economics

AR < AC = LOSS

AR = AC = normal profit
2009
Explanation of Normal Profit
Normal profit is a cost of production; it is the minimum amount necessary in order for production to
take place.
EXAMPLE 1
AR for a bar of chocolate = 40 cent
AC for a bar of chocolate
Land
= 10 cent
Labour
= 20 cent
Capital
= 5 cent
Enterprise = 5 cent
Total AC = 40 cent
In this case, AR = AC therefore normal profit is being earned.
What decision will the firm take in the short run and the long run??
Example 2
AR
AFC
AVC
AC

= € 310.00
= € 85.00
= € 270.00
= € 355.00
IN THE SHORT RUN AR = P  AVC (AR MUST BE GREATER THAN OR EQUAL TO AVC)
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Micro Economics
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In the above diagram, so long as price are above P2 the firm can continue in business in the short run
because it is covering its average variable costs. The firm is not making a profit though and hence this
is not a good place for the firm to be. Once price rise to P3 the firm is making a normal profit and is
OK. If the price rises above P3 the firm would be making a supernormal profit, i.e. a profit over and
above that which is necessary to keep the firm in the industry.

In the Long run AR  AC (AR must be greater than or equal to AC)
In the above example if prices fell below P2 the firm would have to shut down.
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Examples
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PERFECT COMPETITION
The theory of perfect competition is based on a number of key assumptions relating to the firm and
industry.
Assumptions of Perfect Competition include:
1.
Homogenous goods – goods are identical in that one seller’s product cannot be distinguished
from another’s. An example of such product would be carrots.
2. Many competitive sellers who are price takers
The individual firm takes its price from the market. It has no power to influence that market through
its own individual actions. The product’s price is the sae for each buyer and seller
3. Perfect knowledge. Customers are aware of the prices charged by each firm and firms are aware
of the actions of their competitors.
4. Freedom of entry or exit of sellers in the marketplace.
Perfectly Elastic Demand Curve
If the firm in a perfectly competitive market were to attempt to raise prices its demand would collapse.
Therefore at the firm’s price or market price the firm will be faced with a perfectly elastic (horizontal)
demand curve. (See below)
.
Price
Demand = price=AR=Marginal revenue


Quantity demanded
The demand curve is perfectly elastic; the price remains the same even though the quantity can
change.
In all market structure diagrams the AR curve is the demand curve. Average revenue is just
another name for price.
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Micro Economics
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Only in Perfect Competition is the AR curve also the MR curve. The reason for this is that the
price is the same regardless of the output. See diagram above
IN PERFECT COMPETITION AR =MR=PRICE
Example
Price
100
100
100
Quantity
P * Q = TR
1
2
3
100
200
300
MR
AR = TR/Q
--100
100
100
100
100
In Perfect Competition price is lower and output higher than in monopoly. In Perfect Competition,
resources are used efficiently and consumers benefit with lower prices
Output decision in the short run.
Firm will strive to produce at a level of output where SMC =MR and where AR is greater than AC
In the short run price must cover AVC otherwise it will not remain in business. (As explained earlier)
Draw diagram to explain this here.
. In the short run firms in a PC market can make supernormal profits where AR>ATC.
Here the firm is only making normal profit as AR = ATC
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Micro Economics
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Here the firm is failing to cover its ATC and AVC and will not be able to remain in business.
This firm is making a
supernormal profit in the
short run. The
supernormal profit is
shown by the fact that
the price achieved P is
greater than the Average
cost of producing Q.
Here the firm is
making just normal
profits because the
price received for Q
goods is the same as
the AC for Q goods.
When P=AC the firm
is making normal
profits.
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Micro Economics
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In the above situation the firm is making a loss because it is not covering its average costs. If this is a
firm in the short run the firm could remain in the industry if the firm was covering its average variable
costs. In the long run the firm could not sustain a loss and should exit the industry.
Output in the Long run
In the long run unless ARATC, the firm will not be able to remain in business.
If ATC exceeds AR then the firm will have no option but to exit the industry.
As firms exit the industry supply is reduced and prices will rise thereby allowing existing firms to
achieve normal profit i.e. where AR=AC.
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Micro Economics
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If firms are earning short run supernormal profit (super normal profits) this will attract new entrants
who are aware of this supernormal profit.
This influx of new entrants will result in an increase in supply which will push prices down and a new
equilibrium will be reached where AR = AC.
This can be shown easily using demand and supply.
In the long run the firm will make just normal profits because if it were making supernormal profits,
new firms would be attracted into the industry. Since there are no barriers to entry, new firms could
enter and this would push prices down, gradually eliminating any supernormal profits. If the firm were
making a loss, firms would exit the industry and hence prices would rise.
A good way of testing yourself in economics is to try and draw the diagrams you have studied.
Remember that the labelling of the diagrams is extremely important. Test yourself below.
Perfectly competitive firm in long run
equilibrium.
A perfectly competitive firm making a
supernormal profit in the short run.
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MONOPOLY

Monopoly means single (sole) supplier, dominant firms are more usual than absolute monopolists

The monopolist can choose the price to charge or the quantity to sell.

They can earn supernormal profits

In order to earn supernormal profits in the long run, there must be barriers to entry.
Examples of barriers to entry include economies of scale, the government might
grant a company the sole right to supply a good or service, patents or copyright
brand loyalty, ownership of outlets, etc.

Under a monopoly there are no close substitutes in the marketplace.
Under conditions of monopoly the consumer has no choice from whom to purchase and as such the
demand curve facing the monopolist (i.e. the AR curve), is the total market demand for the product.
THE MONOPOLIST DEMAND CURVE IS DOWNWARD SLOPING AND MR IS BELOW AR
EQUILIBRIUM OUTPUT IS WHERE MC=MR
SUPERNORMAL PROFIT CAN PERSIST IN THE LONG RUN
Short run equilibrium: In monopoly situations the short run equilibrium and the long run equilibrium
are the same.
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Micro Economics
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Economic profits and
supernormal profits are the same
thing.
Different books and economics
prefer different terms. A bit
confusing I know!
The firm should produce at a level where MR = MC.
 The demand curve in the monopoly diagram above shows the price that corresponds to that
output.

When a monopoly firm is in profit maximising equilibrium, its marginal cost is always less
than the price it charges for its output.

The shaded area shows the firm’s SUPERNORMAL PROFIT.

Unlike perfect competition it is quite possible for the monopolist to earn SUPERNORMAL
PROFIT in the long run due to barriers to entry.

It is important to note that supernormal profit is not guaranteed for a monopolist as cost,
demand and environmental conditions will have a big impact on costs and revenue.

Figure A shows a situation where the monopolist is only earning normal profit i.e. producing
at an output level Qm where AR=AC and MC =MR

Figure shows a situation where ATC exceeds AR and the monopolist is making a loss.
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Figure A

Figure B
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Micro Economics
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ADVANTAGES OF MONOPOLY



Economies of scale
Profits may be used for investment
Promise of high profits encourages risk taking
DISADVANTAGES OF MONOPOLY




High prices/low output in the short run
High prices/ low output in long run
Lack of incentive to innovate
Inefficiency
Monopoly versus Perfect Competition

Figure C compares the profit- maximising position for an industry under monopoly with that
under perfect competition. We will assume that they both face the same demand curve and the
same cost curve. Page 130.
Figure C
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Micro Economics
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
The monopolist will produce Q1 at price P1, whereas the under perfect competition it would be
Q2 at price P2.

Under perfect competition production will be where AR = MC = MR

Under monopoly production will be where MR = MC

Therefore we can see that a monopolist will charge a higher price and produce less than what
happens in perfect competition.

In the long run because of barriers to entry the monopolist is able to keep prices high and still
receive supernormal profit whereas in perfect competition freedom of entry eliminates
supernormal profit and forces firms to produce at the bottom of their LRAC curve. The effect
is to keep long run prices down in perfect competition.
THE THEORY OF CONTESTABLE MARKETS
-
Theory argues that what is crucial in determining price an output is not whether an industry is
actually a monopoly or competitive but whether there is a real threat of competition.
-
As a monopolist is protected with high barriers to entry then it can make supernormal profit in the
long run because of the absence of competition.
-
If, however another firm could take over from it with little difficulty it will behave much more like
a competitive firm.
If there is relative ease of entry into some markets with a high degree of concentration, these markets
are referred to as contestable.
-
A perfectly contestable market is where there is free and costless entry and exit.
Existing firms in contestable markets are unlikely to be in a position to make supernormal profits in
the long run. If existing firms were earning supernormal profit, this would attract new firms into the
market, making it more competitive and leading to falling prices, and the removal of supernormal
profit.
The threat of this competition is greater the lower are the entry and exit costs to and from the industry.
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MONOPOLISTIC COMPETITION
-
A pure monopoly is an industry with a single firm in which there are no close substitutes and
entry of new firms is blocked.
-
Monopolistic competition however deals with firms that differentiate their products in
industries with many producers and freedom of entry.
-
Monopolistic competition has elements of both monopoly and perfect competition.
-
Monopolistic Competition assumes the market structure is characterised by:
a) Many profit maximising firms competing.
b) Freedom of entry and exit
c) Firms supplying differentiated products to the marketplace.
-
Products in this marketplace are not perfect substitutes i.e. quality, price, features, design, etc;
differentiate one product from the next.
-
Under monopolistic competition the firm will need to decide upon the exact
variety of product to produce and how much to spend on advertising for it.
The firm will then become involved in non-price competition (i.e. competing
in terms of advertising and/or product development).
-
As products are differentiated the firm is not a price taker as in perfect competition, but has
market power to decide its own price.
-
Therefore each firm has a downward sloping demand curve and not a perfectly elastic
(horizontal) demand curve, as is the case in perfect competition.
-
Given the assumption of freedom of entry, supernormal profit (where AR>AC) can only exist
in the short run under monopolistic competition. Monopolistic competition in the short
run is the same as monopoly. However the supernormal profits are eroded away in the
long run as more firms enter the industry.
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As supernormal profit is earned other firms will be attracted to the marketplace and now
consumers will have more choice and the firm will only be able to earn normal profit in the
-
-
long run
-
In monopolistic competition there is under utilisation of capacity in the long run. Because of
this excess capacity it may result in higher costs and higher prices than perfectly competitive
firms, but consumers can benefit from a greater diversity of products.
-
In a pure monopoly situation (discussed earlier) the monopolist can earn supernormal profit in
the long run because of barriers to entry, which prevent competitors entering the marketplace.
OLIGOPOLY
An oligopoly is where a few large firms between them share a large proportion of the industry.
An oligopoly is an industry characterised by:
1. A relatively small number of firms
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2. Moderate to high entry barriers.
3. Oligopolists may produce a homogeneous product (e.g. oil) or there may be
Product differentiation (e.g. electronic appliances or cars)
4. Firms production decisions are interdependent i.e. the actions of one firm affect
Other firms in the industry.
5. Each firm has enough market power to prevent it being a price taker, but also each firm is subject to
enough rivalry to prevent it seeing the market demand curve as its own.

The behaviour of oligopolies is strategic, in that they take explicit account of the impact of
their decisions on competing firms and of the reactions they expect from competing firms.

The problem with the Oligopoly market structure has to do with the degree of uncertainty i.e.
firms are unsure of how competitors will respond to their actions but must try to anticipate.

One way to reduce this uncertainty and to maximise joint profits is to collude either formally or
informally.

A cartel agreement is an agreement that allows the participants to coordinate their output and
pricing decisions to earn monopoly profits.

Price cartel is created when a group of oligopoly firms combine to agree on a price at which
they will sell their product to the market

Each oligopoly firm would increase its profits if all the big firms in the market charge the same
price as a monopolist would and split the output between them. This is called collusion, which
can be operated through the above cartel agreement.

Collusive Oligopoly is where oligopolies agree (formally or informally) to limit competition
between them. They may set output quotas, fix prices, limit product promotion, or agree not to
‘poach’ each other’s markets.

Non- Collusive Oligopoly is where oligopolies have no agreement between themselves,
formal, informal or tacit.

Tacit collusion – where oligopolies avoid engaging in price-cutting, excessive advertising etc.
There may be unwritten ‘rules’ of collusive behaviour such as price leadership. It occurs when
all firms realise that one of them is initiating a price change that will be of benefit to them all
and so follow the leader and change their own.
EQUILIBRIUM OF INDUSTRY UNDER COLLUSIVE OLIGOPOLY
The cartel will maximise profits if it acts like a monopoly i.e. where the members behave as if they
were a single firm. The total market demand curve and MR curve is shown and we can see that the
cartel’s MC curve is the sum of the MC curves of the members of the cartel.
Profits are maximised at Q1 where MC = MR. The cartel must therefore set a price of P1 (at which Q1
will be demanded)
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Having agreed on the cartel price, the members may compete against each other using non-price
competition, to gain as big a share of Q1 as possible. Alternatively the cartel may decide to divide the
market between the in terms of quotas in output.
See page 146 Sloman, third edition
Success of the cartel depends on:
- Whether it consists of most or all of the producers of the good – it must consist of all of the
producers
- If there are close substitutes for the products – there should be no close substitutes
- The ease with which the supply can be regulated – it must be possible to regulate supply
- Whether producers can agree on their individual shares of the total restricted supply to the market –
there must be agreement on individual shares

The weakness of the cartel is the incentive for an individual firm to increase output. If
every firm did this, excess supply would occur forcing down the price.
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NON - COLLUSIVE OLIGOPOLY: GAME THEORY (SEE ALSO PAGE 150-151 IN TEXT)
As was mentioned previously non-collusive oligopoly is where oligopolies have no agreement
between themselves, formal, informal or tacit.
As such non-collusive oligopolies will have to work out a price strategy. This strategy will then
depend on their attitudes towards risk and the assumptions they make a about the behaviour of their
rivals.
Game theory is the study of alternative strategies that oligopolies may choose to adopt, depending on
their assumptions about their rivals’ behaviour.
They can adopt a low risk ‘maximin’ strategy of choosing the policy that has the least- bad worst
outcome, or a high-risk maximax’ strategy of choosing the policy with the best possible outcome, or
some compromise. Either way, a ‘Nash’ equilibrium is likely to be reached which is not in the best
interests of the firm collectively. It will also entail a lower level of profit than if they had colluded.
Non–Collusive Oligopoly:
The kinked demand curve
Take for example a small number of firms supplying differentiated products to a particular market.
The model makes the following assumptions regarding behaviour:
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Micro Economics
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1. If one firm lowers its price, competitors will regard this as a threat (to market share) and
respond by lowering their prices to a similar amount.
2. If one firm raises price the response of competitors will be to keep their prices constant.
- The response by competitors implies a kinked demand curve facing the individual firm.
Price
There is a price above which competitors would not follow price changes. At this price a kink
(K) occurs in the demand curve.
If the P  above the kink competitors will not follow. Demand becomes elastic for the individual
firm in question as consumers move to the now relatively cheaper competitors.
If the P below the kink, competitors will follow, now all firms are charging the same price, so
demand for the individual firm in question will be inelastic.
This model has been criticised because you cannot predict where the kink would occur, therefore you
could not predict the price.
PRICE DISCRIMINATION
The single price monopolist charges the same price to all customers no matter whom they are or where
they are.
The price discriminating monopolist however charges different prices to different customers for the
same product, which are not related to cost.
Example…cinema charging different prices for afternoon and evening shows.
Factors necessary for price discrimination to take place include:
1. It must be possible to divide consumers into separate groups. E.g. students and old age
pensioners who travel by train.
2. The market must be separated so the product cannot be resold.
Third Degree and First Degree Price Discrimination.
Third degree price discrimination occurs when the firm divides consumers into groups and charges
different prices for each group (e.g. weekend flights and weekday flights)
First-degree price discrimination occurs when every consumer is charged the maximum price that
he/she can afford. Here the monopolist is seeking to capture some or the entire consumer surplus.
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Note: consumer surplus is the difference between the maximum price the consumer would be willing to
pay rather than go without the item and the price actually paid.
3rd degree price discrimination
First degree price discrimination occurs
when the firm can secure all the consumer
surplus for itself by charging each customer
the highest possible price that customer is
willing to pay.
SUMMARY
THE CHARACTERISTIC DIFFERENCES BETWEEN MARKET
STRUCTURES
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Micro Economics
Number of
firms
Type of
product
Barriers to
entry
Pricing
Strategy
Long-run
profits
Examples
Perfect
Competition
Very Many
Monopolistic Oligopoly
competition
Many
Few
2009
Monopoly
One
Homogenous
Differentiated Undifferentiated Unique
(undifferentiated)
or differentiated
No
No
Yes
Yes
Price taker
Price maker
Interdependent
Price maker
Normal
Normal
Carrots
Restaurants
Possibility of
supernormal
profit
Oil, Electrical
appliances
Possibility of
supernormal
profit
Rail
transport,
Prescription
Drugs
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WORKSHOP 4
Market Structures
1.
It is usual to divide markets into four categories. In ascending order of competitiveness these are
(fill in the missing three):
1.
2.
monopoly.
2.
..........................................................................................................................................
3.
..........................................................................................................................................
4.
..........................................................................................................................................
To which of the above four categories do the following apply to the member firms? (There can
be more than one market category in each case.)
(a) Firms face a downward sloping demand curve. ....................................................................
(b) New firms can freely enter the industry. .................................................................................
(c) Firms produce a homogeneous product. ................................................................................
(d) Firms are price takers. ............................................................................................................
(e) Firms face an elastic demand (but less than infinity) at the profit-maximising output.
..........................................................................................................................................
(f)
Firms will produce where MR = MC if they wish to maximise profits. .................................
(g) There is perfect knowledge on the part of consumers of price and product quality.
..........................................................................................................................................
3.
In which of the four categories would you place each of the following? (It is possible in some
cases that part of the industry could be in one category and part in another: if so name both.)
(a) A village post office .................................................................................................................
(b) Restaurants in large town ........................................................................................................
(c) Banks .......................................................................................................................................
(d) Hi-fi manufacturers .................................................................................................................
(e) Producers of barley .................................................................................................................
(f)
Water supply ...........................................................................................................................
(g) Local buses .............................................................................................................................
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Micro Economics
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(h) The market for foreign currency .............................................................................................
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Micro Economics
4.
2009
Workshop
4
The following diagram shows the cost curves of a firm under perfect competition.
£
MC
12
11
10
AC
9
MC
AVC
8
7
6
5
4
3
2
1
0
0
10
20
30
40
50
60
70
80
90
100
Quantity
a)
How much will the firm produce in order to maximise profits at a price
of £8 per unit?
........................................
b)
What will be its average cost of production at this output?.........................................................
c)
How much (supernormal) profit will it make? ............................................................................
d)
How much will the firm produce in order to maximise profits at a price
of £5 per unit?
.........................................
e)
How much (supernormal) profit will it make? ............................................................................
f)
How much will the firm produce in order to maximise profits at a price
of £4 per unit?
.........................................
g)
What will be its profit position now? ...........................................................................................
h)
Below what price would the firm shut down in the short run? ...................................................
i)
Below what price would the firm shut down in the long run? ....................................................
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Workshop
4
5. A monopolist is faced with the following cost and revenue curves:
(a) What is the maximum-profit output?
.............................................................
(b) What is the maximum-profit price?
£
80
MC
70
.............................................................
(c) What is the total revenue at this price
and output?
60
50
.............................................................
(d) What is the total cost at this price and
output?
.............................................................
(e) What is the level of profit at this price
and output?
(f)
.............................................................
If the monopolist were ordered to
produce 300 units, what would be the
market price?
AC
40
30
20
AR
10
0
0
100
200
300
400
500
600
-10
.............................................................
(g) How much profit would now be made?
-20
MR
Quantity
.............................................................
(h) If the monopolist were faced with the same demand, but average costs were constant at £60
per unit, what output would maximise profit?
..........................................................................
(i)
What would be the price now? ................................................................................................
(j)
How much profit would now be made? ...................................................................................
(k) Assume now that the monopolist decides not to maximise profits, but instead sets a price of
£40. How much will now be sold?
...........................................................................................
(l)
What is the marginal revenue at this output? ..........................................................................
(m) What does the answer to (l) indicate about total revenue at a price of £40? ...........................
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Micro Economics
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(n) What is the price elasticity of demand at a price of £40? (You do not need to do a calculation
to work this out: think about the relationship between MR and TR.)
............................
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Workshop
4
6.
Which of the following are characteristics of oligopoly?
(a) There are just a few firms that dominate the industry. .................................................... Yes/No
(b) There are few if any barriers to the entry of new firms into the industry. ...................... Yes/No
(c) The firms may produce either a homogeneous or a differentiated product. ................... Yes/No
(d) The firms face downward sloping demand curves. ......................................................... Yes/No
(e) There is little point in advertising because there are so few firms. ................................. Yes/No
(f) Oligopolists tend to take into account the actions and reactions of other firms. ............ Yes/No
7.
Under which of the following circumstances is collusion likely to break down?
(a) There is a reduction in barriers to international trade. ................................................... Yes/No
(b) The market becomes more stable. .................................................................................. Yes/No
(c) One of the firms develops a new cost-saving technique. ............................................... Yes/No
(d) One of the firms becomes dominant in the industry. ..................................................... Yes/No
(e) The number of firms in the industry decreases. ............................................................. Yes/No
8.
The table below shows the annual profits of two paint manufacturers. At present they both charge
£5.00 per litre for gloss paint. Their annual profits are shown in box A. The other boxes show the
effects on their profits of one or the other, or both firms reducing their price to £3.50 per litre.
Durashine’s price
£5.00
C
A
£5.00
£3.50
£6 million each
Supasheen’
s
B
price
£9 million for
£3.50
Supasheen
£3 million for Durashine
£2 million for
Supasheen
£8 million for Durashine
D
£4 million each
(a) Which of the two prices should Durashine charge if it is pursuing
(i)
a maximax strategy? ....................................................................................... £5.00/£3.50
(ii)
a maximin strategy? ........................................................................................ £5.00/£3.50
(b) Which of the two prices should Supasheen charge if it is pursuing
(i)
a maximax strategy? ....................................................................................... £5.00/£3.50
(ii)
a maximin strategy? ........................................................................................ £5.00/£3.50
(c) Why is this known as a dominant strategy game?
..........................................................................................................................................
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Micro Economics
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(d) Assume now that the `game' between Supasheen has been played for some time with the
result that they both learn a `lesson' from it. What are they likely to do?
BUSINESS ECONOMICS
TEST 1
MARKETS, DEMAND AND SUPPLY
Please note:
All questions must be attempted.
TRUE OR FALSE
1. The Production possibility Frontier (PPF) shows all possible combinations of two
goods which can be produced using the available technology and some resources.
Answer_________
2. All points outside the PPF curve are unattainable
Answer_________
3. Moving from one point on the PPF to another involves an opportunity cost
Answer_________
4. A mixed economy is one where decisions and choices are made by the government
or a central planning board
Answer_________
5. Price and Quantity demanded are positively related
Answer_________
6. A change in price will normally cause a movement along the demand curve.
Answer_________
7. For normal goods the demand curve is positively sloped.
Answer_________
8. Necessities are goods with perverse demand curves
Answer_________
9. Consumer surplus is the difference between what the consumer would have been
willing to pay for units of a good and what the manufacturer is willing to accept for
the good
Answer_________
10. Substitute goods are positively related
Answer_________
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11. Cds and cd players are examples of substitute goods
Answer_________
12. An inferior good has a negative income effect
Answer_________
MULTI CHOICE QUESTIONS
13. An increases in the price of a normal good will cause:
a shift in the demand curve to the left
a shift in the demand curve to the right
a movement upwards along the demand curve
a movement downwards along the demand curve
Answer______
14 . An increase in income will normally cause;
a) A shift in the demand curve to the left
b) a shift in the demand curve to the right
c) a movement upwards along the demand curve
d) a movement downwards along the demand curve
Answer______
15. A reduction in the firm’s cost of production will cause;
a) a shift in the supply curve to the right
b) a shift in the supply curve to the left
c) a movement upwards along the demand curve
d) a movement downwards along the demand curve
Answer________
16. Opportunity cost is:
a) the lowest average cost of production.
b) cost of producing an extra unit of output.
c) average cost and marginal cost added together.
d) the cost of alternatives foregone.
Answer______
17. Excess demand will cause;
a) prices to fall
b) prices to increase
c) none of the above
Answer____
18. Excess supply will cause;
a) downward pressure on price
b) upward pressure on prices
c) none of the above
Answer_____
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19. When the government introduces a price ceiling this
will normally lead to:
a) excess supply
b) excess demand
c) very high prices
d) none of the above
Answer______
20. If Qd = 120 - P and Qs = -40 + P then:
a) Price equals 80 and equilibrium quantity equals 40
b) Price equals 40 and equilibrium quantity equals 80
c) Price equals 120 and equilibrium quantity equals 40
d) Price equals 40 and equilibrium quantity equals 120
Answer_________
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Micro Economics
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BUSINESS ECONOMICS
TEST 2
ELASTICITY
TRUE OR FALSE
1.
A 15% rise in price of good X and a subsequent 10% fall in quantity demanded would mean
price elasticity of demand for good X is inelastic
Answer_________
2. Price elasticity of demand for substitute goods is negative
Answer_________
3. Storage costs affect elasticity of supply
Answer_________
Price
Demand
Quantity
4. The above demand curve is perfectly inelastic
Answer_________
Price
Supply
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Micro Economics
2009
Quantity
5. The above supply curve is perfectly elastic
Answer_________
6. If demand is elastic a rise in price will lead to a fall in total
revenue
Answer_________
7. The higher the perisability of a good the more inelastic supply
will be.
Answer_________
8. Given two complementary goods, the demand for the less important of the two goods in joint
demand will be inelastic.
Answer_________
9. Cigarettes is an example of an inferior good
Answer_________
10. A good with few or no substitutes is likely to have a relatively steep demand curve
Answer_________
11. If demand for a good is unit elastic the firm will raise price
to maximize profit
Answer_________
MULTI CHOICE QUESTIONS
12. Price elasticity of demand measures:
a) The rate of change of sales
b) The responsiveness of demand to a change in price
c) The amount of sales at a specific price
d) The responsiveness of price to a change in demand
Answer______
13 . For what could price elasticity of demand be used?
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Micro Economics
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a) Calculating a person’s disposable income
b) Calculating the rate of inflation
c) Estimating changes in a company’s sales revenue
d) None of the above
Answer______
14. If good X is an inferior good then an increase in income will lead to;
a) An increase in demand for good X
b) A fall in demand for good X
b) A shift in the demand curve of good X to the right
c) A movement along the demand curve for good X
d) A movement downwards along the demand curve
Answer________
15. The demand curve for a product is elastic when:
a) The amount of income spent on the product is small
b) There are many substitutes
c) Quantity demanded is unresponsive to a change in price
d) The demand curve is completely vertical
Answer______
16. Cross elasticity of demand measures:
a) The responsiveness of supply to a change in demand
b) The responsiveness of demand (Good X) due to a change in the price of another
Good (Good Y)
c) How two demand curves intersect with a supply curve
d) None of the above
Answer____
17.All of the following factors influence demand elasticity except;
a) Costs of production
b) Availability of substitute goods
c) Whether the good is a luxury or necessity
d) Durability of the product
Answer_____
18. If the price of apples increases from 10 cent to 15 cent and the quantity demanded then falls from
100 to 80, the price of elasticity of demand equals
a) 1
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Micro Economics
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b) 20
c) 0.55
d) 0.2
Answer _____
19. If income elasticity of demand equals zero for the good then the good would be:
a) A normal good
b) A luxury good
c) An inferior good
d) A necessity good
Answer _____
20. If good x has a price elasticity of demand equally to 3.5 then it is considered
a) Elastic
b) Inelastic
c) Very elastic
d) Very inelastic
Answer _____
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Micro Economics
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Answers to some economics multiple choice questions from past exams
JANUARY 2003
(a)
If good X is a normal good, an increase in consumer income will lead to:
(I) A rise in equilibrium price and quantity
(ii) A fall in equilibrium price and quantity
(iii) A fall in equilibrium price and an increase in output
(iv) None of the above
(b) Which of the following statements is true?
(i) If the price elasticity of demand is -3, a fall in price will result in total revenue rising
(ii) The income elasticity of demand will only be zero in the case of inferior goods
(iii) The cross price elasticity of demand for complementary goods will always be positive
(iv) None of the above
(c)
Diminishing marginal returns occur:
(i) Only in the short run due to the existence of a fixed factor
(ii) Can occur in the short run and in the long run
(iii) Cause average costs to fall as output rises
(iv)
None of the above
(d) Consumer surplus is measured by:
(i)
(ii)
The price which the consumers are willing to pay for the good
The difference between the price which the consumers are willing to pay for the
good and the market price
(iii)
Total expenditure by consumers
(iv)
Total expenditure by consumers minus profit
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Micro Economics
(e)
(f)
(g)
Firms will make maximum profit when
(i)
Sales revenue is maximized
(ii)
Marginal revenue is equal to marginal cost
(iii)
Total costs are at a minimum
(iv)
None of the above
Suppose country A has a freely floating exchange rate. If the inflation rate in country A were
greater that the inflation rate in other countries (with whom it trades) you would expect to see
the currency of country A:
(i)
Appreciate
(ii)
Depreciate
(iii)
Remain unchanged
(iv)
None of the above
Which of the following is not considered a macro economic goal of government?
(i)
Full employment
(ii)
Low inflation
(iii)
Steady growth
(iv)
(h)
(i)
2009
High corporate tax rates
Which of the following set of variables is an injection into the circular flow diagram:
(i)
Exports, taxes and investment
(ii)
Government expenditure, exports and investment.
(iii)
Investment, imports and subsidies
(iv)
Imports savings and taxes
Recessions can be caused by:
(i)
A contraction in aggregate demand
(ii)
An adverse shift in aggregate supply
(iii)
Both of the above
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Micro Economics
(iv)
(j)
2009
Neither of the above
The government wants to increase national output by €300million. The
economics advisors provide the following information: mps =0.2Y, mpm = 0.2Y,
=200, = 300, =100
By how much should the government increase it’s spending on goods and services?
(a)
(i)
€250 million
(ii)
€300 million
(iii)
€120 million
(iv)
None of the above
If good X is an inferior good then an increase in income will lead to:
(i)
A rise in equilibrium price and quantity
(ii)
A fall in equilibrium price and quantity
(iii)
A fall in equilibrium price and an increase in output
(iv)
None of the above
(b) The law of demand states that:
(i)
The demand curve slopes down from left to right
(ii)
The quantity demanded increases as prices fall
(iii)
There is a negative relationship between price and quantity demanded
(iv)
(c)
All of the above
The head of a train company claims that a 40% increase in ticket prices would not lead to any
change in amount spent on train tickets. This must imply that demand elasticity is:
(i)
Inelastic
(ii)
Elastic
(iii)
Equal to - 1
(iv)
Zero
(d) In a perfectly competitive market firms will maximise profits when:
(i)
Marginal revenue equals marginal costs
(ii)
Price equals marginal cost
(iii)
Average revenue equals marginal cost
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Micro Economics
(iv)
(e)
2009
All of the above
Oligopoly is a market in which there are:
(i)
A large number of firms producing differentiated products
(ii)
A large number of firms producing identical products
(iii)
A small number of firms producing similar or identical products
(iv)
None of the above
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Micro Economics
(f)
2009
Which of the following is not a valid answer to the question “Why is real GNP an imperfect
measure of living standards”?
(v)
It excludes leisure
(vi)
It does not take account of environmental costs
(vii)
It does not take account of inflation
(viii)
It does not take account of income distribution
(g) “Crowding out” occurs when?
(v)
Foreign interests buy government securities
(vi)
An increase in taxation results in a lower level of consumption spending
(vii)
(viii)
(h)
(j)
None of the above
Which of the following set of variables are leakages from the circular flow model:
(v)
Exports, taxes and investment
(vi)
Government expenditure, exports and investment.
(vii)
Investment, imports and subsidies
(viii)
(i)
Government borrowing forces up interest rates and reduces the level of private
investment spending
Imports savings and taxes
The money multiplier is:
(v)
The ratio of bank deposits to liabilities
(vi)
The amount of money in circulation
(vii)
The amount of money the banking system creates with each pound of reserves
(viii)
None of the above
The government wants to increase national output by €600million. The
economics advisors provide the following information: mps = 0.3Y, mpm =
0.2Y, =200, = 300, =100
By how much should the government increase it’s spending on goods and services?
(v)
€250 million
(vi)
€300 million
(vii)
€120 million
(viii)
None of the above
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