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Microeconomics for Business A

Ross Bateman

Microeconomics for Business A: Revision Guide
Table of Contents
Topic 1 – Basic Economics
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2
Types of Economy
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3
Market Demand
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3
Topic 3 – Elasticities & Efficiency
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4
Time & Efficiency
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6
Price Controls
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7
Subsidies
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12
Topic 6 – Production & Costs
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13
Production
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14
Long-Run Theory of Production
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16
Profit Maximisation
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16
Perfect Competition
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18
Topic 8 – Monopoly & Price Discrimination
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19
Natural Monopoly
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20
Price Discrimination
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22

Page 1 of 24

Microeconomics for Business A

Ross Bateman

Topic 1: Basic Economics
Basics






Positive statements describe the world as they are
...

Normative statements are subjective; they are opinions and include
words such as ‘should’
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o People respond to economic incentives: costs vs benefits
...

The opportunity cost of an item is what you give up to obtain it
...

Free market: price mechanism allocates scare goods and services and
scarce factors of production – laissez faire
...
Most markets are regulated
...
This is due to the
income effect and the substitution effect
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Market Supply





As the price of a good rises, the quantity supplied will rise
...

Calculated by: %  QD / %  P
If PED is below 1 it’s inelastic, and if it’s above 1 it’s elastic
...
g
...
g
...
g
...
g
...
g
...
g
...

Calculated by: %  QDa / %  Pb
The cross-price elasticity tells us whether two goods are substitutes (if
cross-PED is higher than 0) or compliments (if cross-PED is smaller than
0)
...

Calculated by: %  Q / %  I
If the income elasticity of demand is less 0, it’s an inferior good
...

Price elasticity of supply: measures the impact of a proportional change
in price on the proportional change in quantity supplied
...

A key determinant of PES is time – supply is more elastic in the long-run
...
If it’s higher than 1, it’s elastic
...

Kaldor-Hicks efficiency: where potential Pareto efficiency can be
achieved when the gainers can fully compensate the losers and there is
still a net gain
...
g
...


Topic 4: Government Intervention
Price Controls


Price
o
o
o
o

floors have the advantages of:
They protect producers’ incomes
...

The minimum wage can be used to
reduce poverty and inequality
...

floors have the disadvantages of:
Protecting inefficient producers
...




Price
o
o



Price ceilings have the advantage of creating
fairness – and making basic goods more
affordable when there are shortages
...




Page 6 of 24

Microeconomics for Business A

Ross Bateman

Taxation


The use of taxation can be justified because:
o It redistributes income
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o It deters the consumption of demerit goods
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

Ad valorem tax: imposing a tax upon a good / service depending on its
value
...




Doesn’t matter if we tax the supplier or consumer, as the government
raises the same revenue, the deadweight welfare loss is equivalent and
the tax incidence is unaffected because it depends on the elasticity of
supply and demand
...

If there’s an inelastic supply & elastic demand, the tax incidence falls upon
the producers
...
2
q0 = 14
...
4
q = 10
...
67p – 16
Equilibrium with an ad valorem tax:
Qs = Qd
1
...
67p + 3p = 60 + 16
4
...
27
q = 11
...
8 x 3, = 32
...
2 x 16
...
19,
= 36
...




Deadweight welfare loss with a specific tax is:

(q0 – q1) x t x 1/2
(14
...
8) x 3 x ½
= 3
...
4

Subsidies


Subsidies can be justified as:
o They encourage consumption & production of goods/services that
have a private benefit but also benefit a third party
...

o They encourage production of vitally or strategically important
goods
...

o Demand elastic, supply inelastic: supplier benefit is larger than
consumer benefit
...

Specific tax would price people out of the market, and act as a deterrent
...
This creates a deadweight welfare loss
...


Which policy do drug dealers prefer?


Drug dealers prefer prohibition as it raises total revenue
...


Why are there stock market bubbles?


A stock price bubble is where market participants trade stock prices above
their ‘true’ value
...
Supply is inelastic in the short-run as the supply of oil
doesn’t change
...
If the crop fails, price
rises and quantity demanded reduces
...
Furthermore, it depends
on whether the farmer has suffered on his own or more than one farmer
does
...

Firms objective is to maximise profit
...

In the long-run, all factors of production are variable
...
g
...


Production



Production function: Q = f(x)
Typically assume: Q = f(K, L) –
Whereby K is capital, L is labour
...
When diminishing returns sets
in, marginal product falls and when
MP is below AP, TP starts to fall
...
Illustrated by the diagrams
below
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Implicit costs: what the factors could have earned if put to an alternative
use, either within the firm or hired out to another firm (opportunity cost)
...

When MC > AC: AC goes up
...





Long-Run Theory of Production



Isoquant: shows whether something is
more/less capital/labour intensive
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Page 14 of 24

Microeconomics for Business A





Ross Bateman

Isocost lines depict different input
combinations with the same cost
...

Cost minimisation occurs when an
isoquant is tangential to an isocost line
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Market Structure






Market structure is the environment
in which firms operate
...


Structure, conduct and performance is another indicator of market
structure
...

o Break up large firms
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o There are no barriers to firms entering a market/industry
...

o Perfect knowledge
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

In the long-run, new firms enter the industry or firms drop of out of the
industry, returning profits and prices back to normal
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Page 17 of 24

Microeconomics for Business A

Ross Bateman

Monopolistic Competition


Assumptions:
o Many or several firms
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o Differentiated product / service
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o Advertising: manipulating consumer tastes, impeding competition
and informing potential consumers
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Page 18 of 24

Microeconomics for Business A

Ross Bateman

Topic 8: Monopoly & Price Discrimination
Monopoly




A monopoly is an industry structure with one dominant firm, the firm
supplies the whole market
...

They have a downward sloping demand curve, which is also the market
demand curve
...
g
...

o Product differentiation and brand loyalty
...
g
...

o Legal protection, e
...
patents and
copyright
...
In the long-run, a monopolist
makes supernormal profits
...

Barriers to entry prevent supernormal profits from being competed away
...






 Monopoly pricing and output is theoretically
inefficient
...

 Socially efficient output & price is where demand
curve (AR) and MC intersect
...

Because is an industry with high
fixed costs, e
...
electricity
distribution
...

New entrants find it difficult to
enter the market because they
need to start-up on a large scale
to exploit economies of scale
...




Two-part tariff: a fixed tariff to
cover fixed costs, a variable tariff
to cover marginal costs, so that
the firm makes normal profit
...
g
...

o Incentives to use supernormal profits to innovate because it obtains
profit from innovation
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Contestable Market Theory





Characteristics: no barriers to entry or exit, no sunk costs, “hit-and-run”
entry from a new rival if monopolist makes supernormal profit
...
Supernormal profit encourages new firms
to indulge in hit-and-run entry
...
g
...

o Prevent monopolist from erecting ‘strategic’ barriers to entry
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Page 20 of 24

Microeconomics for Business A

Ross Bateman

Price Discrimination




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









First-degree price discrimination:
each unit is sold to the individual
that values it most highly
...

Total surplus = producer surplus
...

Difficult to achieve because firm
does not know each consumer’s
‘willingness-to-pay’
...
Monopolist does not know consumers’ price elasticities of
demand
...

E
...
Bundling, e
...
telephone / tv broadband
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Third-degree price discrimination: monopolist can determine elasticities of
demand for different groups of consumers
...

Monopolist charges same price within groups
...
g
...
g
...

E
...
segment market into peak and off-peak, e
...
airlines
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o Differentiated / undifferentiated products
...
g
...

Each firm faces a downward sloping demand curve due to imperfect
competition
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When firms recognise
their mutual interdependence, they behave strategically
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If all firms comply with the agreement, they maximise industry profit
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Factors favouring collusion:
o Few firms
o Similar production methods – similar costs
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o Barriers to entry – agreements not disrupted by new entrants
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A collusive oligopoly may behave like a
monopoly, as shown by the diagram
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They’d agree how to share output and
profit between themselves
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There is an incentive
for a firm to cheat and set its price
below Pm because Pm still above MC and so they’d profit from increased
market share
...

Collusion allows producers to profit at buyer’s expense, competition leads
to lower prices and lower profits
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Page 22 of 24

Microeconomics for Business A

Ross Bateman

Tacit Collusion


One firm has a large market share, and the remaining firms are small and
competitive price-takers
...
This is leadership
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The price the firm sets reveals
information to other firms, but it has no ‘power’ to influence other firms
prices
...
It explains conditions in
which prices do not change when costs change
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o If a firm lowers its price, rivals will follow
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Below A – rivals match the
price rise
...

If MC shifts between points
B and C, firm has no
incentive to change price or
output
...

o Actions: all the alternatives between which players decide to
choose
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o Information: what players know about other players’ pay-offs and
actions
...

Each player has a dominant strategy, both players acting rationally
...
No communication is involved
...

In the real world, firms often make decisions one after another
...
Sequential games are analysed using a decision tree

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