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OHT 4.1
CHAPTER 4.
Analysis of the firm’s supply decision
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The derivation of the firm’s supply curve.
Conditions of supply.
Elasticity of supply.
Supply chains and value added.
Transaction costs and the resource-based theory of
supply.
Forms of integration of firms.
Producer surplus.
In particular, our focus is on two of the most important
questions facing managers:
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How much should be produced and supplied?
How should the supply chain be organised?
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 4.2A
Learning outcomes
This chapter will help you to:
• Understand the nature of the firm’s supply decision and
the derivation of the firm’s supply curve.
• Appreciate how price and non-price factors impact
upon supply decisions.
• Measure the responsiveness of supply to changes in
the price of the good or service in question – the
elasticity of supply.
• Recognise the importance of supply chains and value
chains in organising the supply of goods and services.
• Comprehend the significance of transaction costs in
decisions by a firm as to whether to buy in (or
outsource) inputs into the production process or to
employ the inputs in-house.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 4.2B
Learning outcomes
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Distinguish between transaction costs and resourcebased theory approaches to analysing the organisation
of supply.
Understand the various forms of corporate structure in
terms of vertical, horizontal and conglomerate
integration within the context of supply decisions.
Identify the existence of producer surplus.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
Deriving the
firm’s supply
curve
OHT 4.3
Figure 4.1 Deriving the supply curve for a firm in a competitive environment
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 4.4
In summary…..
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In the short run,a profit-maximising firm’s supply curve
in a (perfectly)competitive environment is mapped out
by the firm’s marginal cost curve (MC)lying above its
average variable cost curve (AVC).
The long-run supply curve in a (perfectly)competitive
environment is the firm’s marginal cost curve lying
above its average total cost curve (ATC).
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 4.5
Conditions of supply
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Changes in costs of production.
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Prices of other products.
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Changes in profit expectations.
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Climate.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 4.6
Figure 4.2 Shifting the firm’s supply curve
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
Elasticity of supply
OHT 4.7
Elasticity of supply
E2 = Percentage change in quantity supplied
Percentage change in price
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Relatively elastic supply 吠i.e.a small percentage change
in price brings about a relatively large percentage change
in quantity supplied.
Relatively inelastic supply 吠i.e.a relatively large
percentage change in price results in a relatively small
supply response.
Perfectly inelastic supply 吠i.e.the quantity supplied is
insensitive to any change in price.
Perfectly elastic supply 吠i.e.the quantity supplied is so
sensitive to a change in price that even a small reduction
in price will lead to nothing being supplied by the firm.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 4.8
Figure 4.3 Examples of supply elastics
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
Supply and value chains
Figure 4.4 Supply chain and value added
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 4.9
OHT 4.10
Figure 4.5 The Porter value chain
Source: Adapted and reprinted with the permission of The Free Press, a Division of Simon & Schuster from Competitive
Advantage: Creating and Sustaining Superior Performance by Michael E. Porter. Copyright © 1985 by Michael E. Porter.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 4.11
Transaction costs and resource-based theory
Transaction costs in markets are the costs of negotiating,
monitoring and enforcing contracts.
Resource-based theory is concerned with the resources 紡
assets,skills and knowledge撲owned or controlled by the firm
and hence its ability or competence to supply goods and
services very competitively.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 4.12
Vertical, horizontal and conglomerate integration
Hierarchical forms of organising production are
associated with high levels of integration.
Integration can take three main forms, namely:
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Vertical integration.
Horizontal integration.
Conglomerate integration.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
Producer surplus
OHT 4.13
Producer surplus is the additional revenue that accrues to a firm when units of output
are sold at a price which is in excess of the price at which the firm would have been
prepared to supply, I.e. in excess of the marginal cost of production.
Figure 4.6 Producer surplus
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 4.14A
Key learning points
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For a firm in a perfectly competitive industry, the supply curve
shows the amount that it is willing to supply at all possible
market prices.
A firm’s short-run supply curve is mapped out by the marginal
cost curve lying above its average variable cost curve.
A firm’s long-run supply curve is traced out by its marginal
cost curve lying above its average total cost curve.
A supply curve can only be derived from the marginal cost
curve for firms operating in very (strictly, ‘perfectly’ competitive
environments 釦the concept of a ‘supply curve’ is particularly
inappropriate when dealing with monopoly situations because a
monopoly is a price-maker, not a price-taker, and can thus
select the price 撲output combination on the demand curve so
as to maximise profits.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
Learning outcomes
OHT 4.14B
The elasticity of supply is defined as:
E2 = Percentage change in quantity supplied
Percentage change in price
The numerical value of E, will always be zero or
positive,with a figure of zero indicating that supply does not
respond at all to price changes; a figure of more than 1
indicating a relatively elastic response;and a figure of less
than 1 a relatively inelastic response.
The supply chain shows the different stages in the
production and supply of outputs, e.g. in the case of a
manufacturing process,the provision of materials and
components,the physical production of the product,its
eventual distribution and sale, and after sales service.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 4.14C
Learning outcomes
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The value chain identities where value is created (or
lost) at each stage of the supply (production and
distribution) process.
The boundary of the firm can be explained by
transaction cost theory and the resource-based
theory of the firm.
Transaction costs are the costs of negotiating,
monitoring and enforcing market contracts for the
inputs of goods and services.
Resource-based theory is concerned with the
assets,skills and knowledge (i.e.core competencies
and distinctive capabilities) which are (a) specific to
the firm, (b) difficult to imitate and (c)are able to give
the firm a distinct competitive advantage in the market
place.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
Learning outcomes
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OHT 4.14D
Vertical integration is the bringing together under
one ownership and control of different stages in the
production of a given good or service.
Horizontal integration occurs when two or more
firms,at the same stage of production, integrate 勃
usually leading to more market concentration and
hence less competition in the product market.
Conglomerate integration occurs when a firm enters
different markets or industrial sectors.
Producer surplus is the additional revenue that
accrues to a firm when units of output are sold at a
price which is in excess of the price at which the firm
would have been willing to supply,i.e. in excess of the
marginal cost of production.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 5.1
CHAPTER 5.
Demand, supply and price
determination
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The price mechanism and equilibrium price.
Changes in demand,supply and equilibrium
price.
Price and the allocation of resources.
The effects of taxes and subsidies.
Cobweb theory.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 5.2A
Learning outcomes
This chapter will help you to:
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Understand how equilibrium prices are determined in
a market economy through the interaction of demand
and supply forces.
Appreciate the conditions which will lead to the
establishment of an equilibrium price and why a
disequilibrium may arise in reality.
Grasp how changes in demand and supply conditions
will result in the establishment of a new equilibrium
price and quantity.
Recognise the importance of relative elasticities of
demand and supply in the establishment of a market
equilibrium.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
Learning outcomes
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OHT 5.2B
Appreciate the functions of the price mechanism in
terms of resource allocation and how a free market
economy can result in an allocation that might not be
entirely satisfactory.
Understand the effects of the imposition of taxes and
subsidies by governments on price and quantity
equilibria.
Grasp the meaning of the incidence of a tax in terms of
the impact on buyers and suppliers.
Appreciate the principles which underlie the cobweb
theory of price determination and the conditions which
are likely to give rise to stable and unstable cobweb
dynamics.
Understand the relevance of cobweb theory in the
context of certain markets, such as agricultural
production, and why primary commodity prices tend to
fluctuate.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
The price mechanism and equilibrium price
Equilibrium price is the price at which the quantity demanded by consumers
and the quantity that firms are willing to supply of a good or service are the
same.
Figure 5.1 Equilibrium of demand and supply
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 5.3
Changes in
demand,
supply and
equilibrium
price
Figure 5.2 Effect of a shift in the demand curve
Figure 5.3 Effect of a shift in the supply curve
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 5.4
OHT 5.5
Price and the allocation of resources
The functions of the price mechanism in a free
market economy are, fundamentally, to:
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Ration out scarce goods and services, so that
price brings demand and supply into equilibrium.
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Indicate changes in the wants of consumers and
induce suppliers to alter the quantities produced
in response to changes in demand.
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Indicate changes in supply conditions, e.g. a rise
in the costs of production will induce suppliers to
decrease supply, while consumers will react to
the resulting higher price by reducing demand for
the good or services.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 5.6
Price, allocation of resources and social
welfare
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Market imperfections.
Incomplete or inaccurate information.
Time lags.
Unequal distribution of income.
Externalities.
Government objectives.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
The effects of taxes and subsidies
Figure 5.4 Tax and the price mechanism
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 5.7
The effects of taxes and subsidies
Figure 5.5 Incidence of tax on the supplier
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 5.8
The effects of taxes and subsidies
Subsidies
Figure 5.6 Subsidies and the price mechanism
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 5.9
The effects of taxes and subsidies
Figure 5.7 Benefit of subsidy for producer
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 5.10
Cobweb theory
OHT 5.11
The cobweb theory explains the path followed in
moving towards an equilibrium price and
quantity in the long run where there are time
tags in the adjustment of either supply or
demand to changes in price.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 5.12
Figure 5.8 A stable cobweb
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 5.13
Figure 05_09
Figure 5.9 An unstable cobweb
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 5.14A
Key learning points
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The price mechanism describes the way in which the
prices charged for goods and services determine how
scarce resources are allocated in a free market
economy.
Equilibrium price is the price at which the quantity
demanded by consumers and the quantity that firms
are willing to supply are the same.
Changes in the conditions of demand and supply
will lead to changes in the equilibrium values of price
and quantity.
The functions of the price mechanism in a free
market economy are to:
睦ration out scarce resources;
吠indicate changes in consumers蜘wants and induce
suppliers to alter production levels;
吠indicate changes in supply conditions.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
Key learning points
OHT 5.14B
The price mechanism can result in an allocation of resources
that may not be regarded as satisfactory arising from:
卜Market imperfections;
吠Incomplete or inaccurate information;
釦Time lags with respect to demand and supply responses;
勃Unequal distribution of income;
貌Externalities;
鉾Government objectives.
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The incidence of a tax refers to the burden of taxation and
in the case of a specific tax on a good or service this
generally depends on the price elasticities of demand and
supply.
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When demand is price inelastic, the imposition of a tax
ensures a large price increase and consumers bear most of
the tax.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
Key learning points
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OHT 5.14C
In contrast,when demand is price elastic the tax
causes a smaller price increase and producers bear
more of the tax.
When supply is price inelastic, the tax burden
falls more heavily on suppliers because they are
less able to nullify the impact of the tax by cutting
output.
When supply is price elastic, the tax burden falls
less heavily on suppliers because they can reduce
output as the price they receive (net of tax)
declines.
As in the case of a tax,the effects of a subsidy will
depend on the relative values of the price
elasticities of demand and supply.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
Key learning points
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OHT 5.14D
Cobweb theory is designed to explain the path
followed in moving towards an equilibrium price and
output where there are time lags in the adjustment of
either supply or demand to changes in prices.
A stable cobweb is one which tends towards a stable
equilibrium price and quantity; an unstable cobweb
describes a situation which ripples away from the
equilibrium.
Cobweb theory was first developed in the context of
certain agricultural markets and helps, in particular, to
explain why primary commodity prices tend to
fluctuate.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
CHAPTER 6.
Analysis of perfectly competitive
markets
Figure 6.1 Market structures in the competitive spectrum
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 6.1
Learning outcomes
OHT 6.2
This chapter will help you to:
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Appreciate the significance and usefulness of the perfect
competition model when analysing real-world markets.
Understand the difference between price and output outcomes in
the short run and long run in perfectly competitive markets.
Recognise the role of supernormal profit as an incentive for new
firms to enter competitive markets, leading to a reduction in market
price, and therefore the dynamics of competitive markets.
Distinguish between allocative and productive efficiency and how
these interact to ensure economic efficiency in perfectly
competitive markets.
Understand the meaning of Pareto optimality and why pareto
optimal outcomes occur in perfectly competitive markets.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 6.3
Conditions for perfect competition
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Homogeneous (identical) products 吠i.e.the presence of
perfect substitutes.
No firm with a cost advantage 吠i.e.all firms have identical
cost curves.
A very large number of suppliers 釦thus no single
producer by varying its output can perceptibly affect the total
market output and hence the market price.
Free entry into and exit from the industry 貌ensuring that
competition is sustained over time.
No transport and distribution costs to distort
competition .
Suppliers and consumers who are fully informed about
profits, prices and the characteristics of products in the
market 防hence ignorance or ‘incomplete information’ does
not distort competition.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 6.4
Production in the short run and long run
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The short run is the time period in which at least one
factor input into the production process is fixed in
supply - usually this will be capital or land, although
in some cases this can apply to certain types of
labour (e.g.highly skilled workers).
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The long run is the time period in which all factors of
production become variable in supply. In the long
run,progress can be made towards operating at the
optimal scale of production.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
Short-run equilibrium
Figure 6.2 Perfect competition: short-run equilibrium (profits)
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 6.5
Short-run equilibrium
OHT 6.6
To summarise, in the short-run equilibrium under
conditions of perfect competition:
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The firm is a price-taker, not a price-maker.
Marginal revenue equals average revenue and
equals price; i.e. MR =AR =P .
Profits are maximised where short-run marginal
cost equates to marginal revenue (and average
revenue).
Supernormal profits can be earned given by the
extent to which price (and thus average
revenue) exceeds short-run average total costs
at the profit-maximising output.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 6.7
Figure 6.3 Perfect competition: short-run equilibrium (losses)
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
Long-run equilibrium
Figure 6.4 Perfect competition: long-run equilibrium (profits)
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 6.8
OHT 6.9
Long-run equilibrium
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The firm is still a price-taker .
Marginal revenue still equals average revenue and
price; i.e. MR =AR =P .
But profits are now maximised where long-run
marginal costs are equal to marginal revenue (and
average revenue).
Supernormal profits (or losses) earned in the short
run disappear due to market entry (or exit) so that
firms in perfect competition earn only normal profits
in the long run (AR =ATC).
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
Productive and allocative efficiency in
perfectly competitive markets
OHT 6.10
Productive efficiency occurs when a firm minimises
the costs of producing any level given existing
technology.
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Technical efficiency - this occurs when inputs of
the factors of production are combined in the firm
in the best possible way to produce the maximum
physical output.
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Price efficiency - this occurs when inputs into
production are optimally employed, given their
prices, so as to minimise production costs.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 6.11
Figure 6.5 Productive efficiency in perfect competition
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 6.12
Allocative efficiency
Allocative efficiency denotes the optimal
allocation of scarce resources so as to
produce the combination of outputs which best
accords with consumers 壇demands.
In other words,no other allocation of resources
would produce a higher level of economic
welfare, given the existing consumer demands.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
Pareto optimality
OHT 6.13
A pareto optimum is said to exist when resources cannot be
reallocated so as to make one person better off without
making someone else worse off.
There are three main conditions that must hold in order for a
pareto optimum to be achieved.
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Goods must be optimally distributed between consumers so that
no reallocation increases economic welfare.
Inputs are allocated in such a way that no reallocation would
increase the physical output.
Optimal amounts of each output are produced so that no
change in output would lead to higher economic welfare.
In perfectly competitive markets,these three conditions are met
in the long run.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 6.14
To summarise,under perfect competition:
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In the short run,until the entry or exit of sufficient firms
occurs,supernormal profit or losses can exist.
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In the long run,once the process of market adjustment
is complete,only a normal profit is earned.
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In the long run a Pareto optimal outcome is achieved.
Perfect competition drives profit down to a normal level and
provides consumers with low-priced products and services.
Also, firms in perfectly competitive markets operate at
optimal scale in the long run. Economists favour the perfectly
competitive model because it achieves economically efficient
and, therefore, welfare maximising results.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 6.15A
Key learning points
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A perfectly competitive market is one in which there is an
extremely high degree of competition with a very large number
of firms selling identical products or services, with identical
cost conditions,with free entry into and exit from the industry
and where ignorance does not distort competition (information
is complete for all producers and consumers).
Each firm in a perfectly competitive market is a price-taker 吠
it faces a perfectly elastic demand curve.
Short-run equilibrium in a perfectly competitive market
occurs when profits are maximised (or losses are
minimised)and this is where the short-run marginal cost
equates to price (and average revenue as well as marginal
revenue:i.e.P (=AR)=MR=MC).
Long-run equilibrium in a perfectly competitive market is
attained where production occurs so that firms can earn a
normal profit :i.e. P (=AR)=MR =MC =ATC. Also this will be at
the output at which the long-run average cost curve is at its
minimum.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.
OHT 6.15B
Key learning points
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Perfectly competitive markets are therefore associated
with both allocative and productive efficiency.
Allocative efficiency denotes the optimal allocation of
scarce resources so as to produce the combination of
outputs which best accords with consumers’ demands. This
will be where price equals marginal cost: P =MC.
Productive efficiency occurs when a firm minimises the
cost of producing any level of output,using existing
technology.
Productive efficiency is the product of technical efficiency
(resulting from combining inputs to achieve the maximum
physical output)and price efficiency (achieved by
minimisation of production costs given input prices).
Perfect competition is associated with pareto optimal
outcomes and is a theoretical benchmark against which
the economic welfare effects of real-world markets can be
judged.
J. Nellis and D. Parker, Principles of Business Economics. © Pearson Education Limited 2002.