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H2 ECONOMICS
MICROECONOMICS

Topics covered:
1
...
Costs of production

2
...
Profit maximization

3
...
Spectrum of markets

4
...
Price discrimination

5
...
Alternative objectives

6
...
Market Demand:
Individual Demand
Market Demand
Quantity an individual is willing and able to Focuses on total quantity demanded
...
Price of related goods
Substitutes: Alternatives that satisfy the same consumer want (P of A increases, demand of B
increases)
Complements: Jointly used to provide satisfaction to consumer (P of A increases, demand of B
decreases)
Joint Demand
Goods that satisfy the same wants together
! Mobile phone and mobile network

Derived Demand
Input-output relationship (good used to produce
another to satisfy wants) ! Flour and bread

2
...
Change in consumer’s income
Affordability (ability to buy goods) is directly dependent on consumers’ incomes (Y)
...

Normal Good: D increase as Y increase
Inferior Good: D decrease as Y increase
4
...
If many babies, demand for baby
products increase
(C) Gender composition
• If more females, demand for cosmetics, beauty salon services will increase
5
...
An increase in the price of ERP charges will cause an
increase in the price of car usage
...

Therefore, the demand curve shifts to the left from DD0 to DD1
Q2: Increase in cost of crude oil

A: Crude oil is an input needed for the production of petrol
...
This
causes the quantity demanded for petrol to fall since consumers are less willing and able to pay for
the extra charges at each given price, ceteris paribus
...

~ END ~

!

Chapter 2: Supply
Definition: Different quantities of product producers are willing and able to produce at each
possible price during a given period of time, ceteris paribus
Supply =/= what is produced
• Determinant of supply
o Desirability – willingness to sell
o Affordability – ability to produce
Supply curve: Represents minimum price producers are willing and able to supply for each
quantity of good / service
Law of Supply: A direct relationship exists between the price of a good and the quantity supplied
of a good, ceteris paribus
• Governs shape of supply curve
• Positive gradient (Price increases, quantity supplied also increases)
o Profit motive: Higher prices leads to higher revenue and thus higher profits (assuming
costs remain constant)
o Profit = Total Revenue – Total Costs
Individual Supply vs
...
Thus it is a
able to produce goods at each price, ceteris summation of individual supplies
...
Cost of production
(A) Changes in prices of inputs
• Increase in prices of factors of production, more costs, producers less willing and able to
produce
• Note: Offshoring / Outsourcing helps to lower costs of production
(B) Changes in state of technology
• Improvement in technology allows for more efficient method of production " lowers costs of
production
(C) Changes in efficiency or productivity
• Improving productivity of factors of production by using resources more efficiently (i
...
same
number of workers but higher output)
• Lowers cost of production
• Note: There is an inverse relationship between cost and productivity
(D) Taxes and Subsidies
• Tax imposed increases cost of supplying that good VS subsidies with opposite effect
2
...
Change in producers numbers
Since market supply is determined by total amount supplied by all producers, market supply is
dependent on number of producers
• Increase in number of producers = Increase in quantity supplied
• Direct relationship between both
4
...
There are 2 main types of
supply shocks:
(A) Changes in climatic conditions
• Storm of flood, affects supply of goods adversely
• Note: Applies largely to agricultural and fishing industries
(B) Changes resulting from Nature or Abnormal Circumstances (Disasters / War)
• Natural calamities or political turmoil could decrease supply

!

5
...
g
...
There would
be a shift leftward / rightward in the supply curve
SAMPLE QUESTION & ANSWERS
Market for Rice:
Q1: Subsidy for production of biofuel

A: Subsidies from the production of biofuel helps to lower the cost of production of biofuel
...
Biofuel and rice are in competitive supply
as they share the same factors of production
...
Shift in Demand:

!

Explanation:
• Increase in demand, causes the demand curve to shift right from DD0 to DD1 (also considered
movement along SS curve)
• Quantity demanded now exceeds Quantity supplied " shortage
• There is thus an upward pressure on price as consumers compete for the same good, driving
prices up
• At the same time, producers will increase quantity supplied as price increases, thus quantity
supplied increases along supply curve SS from point A
• Quantity demanded decreases along demand curve DD1 from point B
• New equilibrium price is then achieved (Qd = Qs)
Note: Both quantity and price exchanged is higher following the increase in demand
* Decrease in demand leads to lower Px and Qx
2
...
Hence they compete to lower prices
• Quantity supplied decreases along supply curve SS1 from point B
• At the same time, quantity demanded increases along demand curve DD from point A as
consumers recognize excess supply and try to purchase more goods cheaply
• New equilibrium price is then achieved (Qd = Qs)
Note: Quantity exchanged is higher and price exchanged lower following the increase in supply
* Decrease in supply leads to lower Qx and higher Px

!

3
...

• When supply increases from SS0 to SS1, quantity increases from Q0 to Q1, price falls to P2
...
Different Directional Shifts in Supply and Demand

Explanation:
• Increase in demand and decrease in supply causes equilibrium price to increase
• Yet increase in demand leads to larger quantity while decrease in supply leads to smaller
quantity
• Therefore, the new equilibrium quantity is indeterminate theoretically
Note: When D increases and S decreases, Px increases but Qx is indeterminate theoretically
* If D decreases and S increases, Px decreases but Qx is still indeterminate
!

TABLE OF EFFECT ON CHANGES TO DEMAND AND SUPPLY ON QX AND PX
Change in demand
Rise
Fall
--Rise
Fall
Rise
Fall

Change in supply
--Rise
Fall
Rise
Fall
Fall
Rise

Change in Qx
Rise
Fall
Rise
Fall
Rise
Fall
---

Change in Px
Rise
Fall
Fall
Rise
--Rise
Fall

Indeterminate:
Sometimes when either the Qx or Px is indeterminate, we will have to examine the relative shifts of
the demand and supply curve
...
Increase in DD > Increase in SS
2
...
Increase in DD > Decrease in SS
2
...
Increase in SS > Increase in DD
2
...
Decrease in DD > Increase in SS
2
...
Thus this causes the supply curve to
shift left from SS0 to SS1
...

Therefore this causes the price of palladium to
increase but the quantity of it is indeterminate
theoretically
...


~ END ~
!

Chapter 4: Elasticity Concepts
Definition: Measures the degree of responsiveness (due to a trigger) of quantity demanded /
quantity supplied to changes in one of its related variables, ceteris paribus
SECTION 1: PRICE ELASTICITY OF DEMAND (PED)
INTRODUCTION
Definition: Measures the degree of responsiveness of quantity demanded of a good to a change in
its own price, ceteris paribus
Formula:
In words
PED =
In symbols
PED =

percentage change in quantity demanded
percentage change in price
∆!
∆!

!

!×! !

∆! is the change in quantity; Q is the original quantity
∆! is the change in price; P is the original price
Sign of PED:
Always negative, showing that change of price and quantity demanded are inversely related
...
Availability of substitutes
Most important determinant is number and closeness of substitutes
• Greater number of substitutes, greater PED
• Closer the substitute, greater PED
2
...
Proportion of Income
The higher the proportion of income spent on a good, the more price elastic the good is, since
consumers are more likely to give it up when the price of it increases
...
Time period
In general, demand for most goods and services are relatively price inelastic in the short run but
will become relatively price elastic in the long run
...


Change in price brings about a less than
proportionate change in quantity demanded,
thus it has a smaller effect on the total
revenue
...
In the long run, demand tends to become more
price-elastic
Government:
(a) To raise tax revenue
• Tax is one of the government’s main source of revenue
• Taxes should thus be levied on goods with inelastic PED, as it leads to increase in price and less
than proportionate fall in quantity demanded
(b) To reduce consumption of undesirable goods
• Restrict consumption of goods as they are deemed socially undesirable
• Yet these goods are usually price inelastic, thus tax imposed must be significantly large enough

!

SECTION 2: PRICE ELASTICITY OF SUPPLY (PES)
INTRODUCTION
Definition: Measures the degree of responsiveness of quantity supplied of a good to a change in its
own price, ceteris paribus
Formula:
In words
PES =
In symbols
PES =

percentage change in quantity supplied
percentage change in price
∆!
∆!

!

!×! !

∆! is the change in quantity supplied; Q is the original quantity
∆! is the change in price; P is the original price
Sign of PES:
Always positive, showing that change of price and quantity demanded are directly related
...
Existence of spare capacity
If spare or unused capacity is available, it should be possible to increase production quickly
• Not all machines fully utilized

!

2
...
Ease of accumulating inventory / stocks
Inventory: Firm’s stocks or unsold goods – goods that are produced but have yet to be sold or put
on sale
• If it is easy to store many goods at low cost, it will be able to meet a sudden increase in demand
by running down stock
4
...
More time given for producers to make necessary
adjustments in response to demand changes
APPLICATIONS OF PRICE ELASTICITY OF SUPPLY
Firms and Producers:
Helps them make output decisions
• If supply is price inelastic, can increase its output before an anticipated increase in the demand
of goods
Government:
Stabilize goods with long gestation periods (agriculture) and thus incomes
• When Qs > Qd, there is a surplus which government buys up to prevent price changes
Effect of PED and PES on Expenditure by consumers:
It is important to remember that the total expenditure by consumers can be evaluated from the total
revenue of businesses:
Total Revenue = Unit Price x Quantity sold
Total Expenditure (consumers)
With a given fall in supply, expenditure of consumers can fall / rise depending on the PED
When demand is price inelastic, fall in supply leads to less than proportionate fall in quantity
demanded
...
Thus total expenditure has
increased
When demand is price elastic, fall in supply leads to more than proportionate fall in quantity
demanded
...
Thus total expenditure has
decreased
!

SECTION 3: INCOME ELASTICITY OF DEMAND (YED)
INTRODUCTION
Definition: Measures the degree of responsiveness of demand of a good to a change in the income
of consumers, ceteris paribus
Note: Change in income causes a shift in the entire demand curve and not just a movement along
the same demand curve (income is a non-price determinant)
Formula:
In words
YED =
In symbols
YED =

percentage change in quantity demanded
percentage change in income
∆!
∆!

!

!×! !

∆! is the change in quantity demanded; Q is the original quantity demanded
∆! is the change in income; Y is the original income
If a 5% increase in income leads to 10% increase in demand, the YED is 2
Sign of YED:
Can be positive or negative
Positive
Negative
Normal goods (Luxuries + Necessities)
Inferior goods
• Demand moves in same direction as the
• Demand moves in the opposite direction
income
of income
Magnitude of PED:
YED > 1
0 < YED < 1
Income elastic - Luxuries
Income inelastic - Necessities
• 1% change in income leads to a more than
• 1% change in income leads to a less than
proportionate change in demand
proportionate change in demand
Determinants of Price Elasticity of Demand:
N:
L:

!

Nature of good
Level of Income

1
...
Level of Income
According to Engel’s law, the same good might be considered inferior, normal good or luxury good
depending on the income of consumers
APPLICATIONS OF PRICE ELASTICITY OF DEMAND
For Firms:
YED is useful to make output decisions
• To produce or not to produce
• What and when to produce
(a) Response to changes in income levels
If the product has high YED, sales of goods are likely to increase rapidly as GDP rises
...
Thus they can adjust tax revenue or policies if needed

!

SECTION 4: CROSS ELASTICITY OF DEMAND (CED)
INTRODUCTION
Definition: Measures the degree of responsiveness of demand of a good to a change in the price of
another good, ceteris paribus
Formula:
In words
CED =
In symbols
CED =

percentage change in quantity demanded of good X
percentage change in price of good Y
∆!"
∆!"

!"

!×! !"

∆!" is the change in quantity of good x; Qx is the original quantity
∆!" is the change in price of good y; Py is the original price
Sign of CED:
Can be positive or negative
Positive
Negative
Substitutes
Complements
• Decrease in price of one good leads to fall in
• Increase in price of one good leads to fall
demand of the other
in demand of the other
Magnitude of CED:
The closer one good is a substitute or complement of another, the bigger the effect of the demand
on the first good due to a change in price of the other, thus a greater CED
...

When two goods are weak substitutes, their CED tends towards zero
APPLICATIONS OF CROSS ELASTICITY OF DEMAND
For Firms:
Allow firms to strategize in order to raise revenue or sales
Reaction to firms selling substitutes (CED>0)
Pricing strategy
• Matching price cut
• Firms slash prices when competitors
lower price
!

Non-pricing strategy
• Product differentiation
• Improving quality to lower degree of
substitutability

Reaction to firms selling complements (CED<0)
Films can have joint promotions with other firms selling complements to attract consumers wen one
lowers price, the other will benefit from rise in demand
GENERAL LIMITATIONS OF DEMAND ELASTICITY CONCEPTS
Often used as “evaluation” in essays
Ceteris paribus assumption:
• Assumes no factor other than the one that is being changed, changes
• However, in the real world, many factors such as price of a related good and income level
may be changing simultaneously
Ignores cost side of profits equation:
• Concepts are only useful to help firms increase total revenue
• Yet they do not deal with the cost side of profits equation
Profits = Total Revenue - Total Costs
•

Thus these concepts are unable to help firms maximize profits since they do not take costs
into consideration

Informational problem:
• Assumes that firms have perfect information to make rational business decisions
• Yet it is impossible for firms to do so in reality
• Hence there is no guarantee the strategies adopted by firms will always be successful even if
they were to apply elasticity concepts
Ignores supply side of market:
• Firms should always take price elasticity of supply into consideration
• But it simply assumes supply can easily cope with change in demand
Market level analysis – appropriate for firms:
• In general, demand curves that represent market demand is not appropriate to analyze the
impact on an individual firm’s revenue
Market structure – is it a realistic model:
• In applying PED to a firm’s pricing policy, it has been assumed that they are price setters
• Only price-setting firms have market power or pricing power
• Yet, price-taking firms have no market power to set their own prices
SPECIFIC LIMITATIONS OF DEMAND ELASTICITY CONCEPTS
PED: At best helps firms decide whether to reduce or increase price to raise revenue
...
restaurant
food
0 < YED < 1
Necessities – the more
basic a good, the lower the
YED

% change in Qdx
% change in price Y
Positive – substitutes
Negative – complements
Zero – unrelated goods
CED = 0
Unrelated goods

|PED| < 1
Qd changes less than
proportionate than price

Strategy

As prices rise, people take
time to adjust and find
alternatives, thus the
longer the time period
after a price change, the
more price elastic the good
is
Lower prices when
demand is price elastic
Increase price when
demand is price inelastic

CED > 0
Substitutes – for example,
McDonald and Burger
Kind

YED > 1
CED < 0
Luxury goods – such as
Complements
jewelry, art works and cars
The closer one good is a
substitute of another, the
larger the CED
Identify goods that are
For substitutes:
normal / income-elastic /
Differentiate products to
income-inelastic
decrease the CED
Set output accordingly as
income changes

For complements:
Joint promotions or joint
discounts

USAGE OF PED, PES, YED
PED: Shifts in supply, impact on change of price for given shift in supply, understanding the
impact on total revenue
PES: Shifts in demand, firms and producers & governments
YED: Shifts in income, for firms to change output in response to change to income levels
~ END ~

!

Chapter 5: Government Intervention
CONSUMER AND PRODUCER SURPLUS
Consumer: Extra satisfaction gained by consumers from paying a price that is lower than that
which they are prepared to pay
Producer: Additional amount of revenue made by the producer

Graph

!

Demand Curve

Producer
Difference between what a producer is
willing and able to put up for sale for a
good and the actual price charged and
the amount he receives
Supply Curve

Represented by the area under the
demand curve and above the equilibrium
price

Definition

Consumer
Difference between price that buyers are
willing and able to pay for the good and
the actual price paid

Represented by the area under the
equilibrium price and above the supply
curve

TAXES (INDIRECT)
Aim: Raise equilibrium price and reduce quantity exchanged
Types of taxes:
1
...
Ad valorem tax
• Calculated as percentage of the sale price of a commodity
• Results in upward anti-clockwise pivotal shift of supply curve

Tax per unit
Consumer
Producer

Note: Tax is perceived as an increase in the cost of production
Tax impact vs
...
Keep price of good at a level that is affordable to majority
2
...
Stabilize prices and support incomes at higher level (wages)
Price floor and Price ceiling:
Definition
Uses

Price floor
Legally established minimum price
above the market equilibrium price
Agricultural
Minimum wages (effective when
demand for labour is inelastic)

Price ceiling
Legally established maximum price
below the market equilibrium price
Rent control
Shortage of basic necessities
Inflation control

Graph

Explanation

Definition
Graph &
Explanation

Qd units of labour enjoys a higher
• Inefficient allocation of resources
wage rate
• Shortage of (Qd – Qs)
• Surplus of (Qs – Qd) units of labour
• Sold at first come first serve basis
• Retrenchment of (Qe – Qd) results
• Government has to ration
Black markets
Sellers ignore government’s price restrictions and sell illegally at whatever price
equates demand and supply
Exists because unsatisfied consumers are
willing to pay very high prices
•

When price ceiling is established:
• Shortage of (Qd – Qs)
• Rationing becomes necessary
• If all available supply is sold in
black market, price rising to Pb
• Sellers earn extra income as
shown in shaded area

~ END ~

!

Chapter 6: Market Failure
Definition: Market failure occurs when free markets, operating without any government
intervention, fail to allocate scarce resources efficiently and hence social welfare is not maximized
There are 6 main sources of market failure
1
...
Imperfect information
3
...
Factor immobility
5
...
Income inequality
SECTION 1: EXTERNALITIES
TYPES OF EXTERNALITIES
Negative externalities are harmful spillover effects or costs imposed on third parties
Positive externalities are beneficial spillover effects or costs imposed on third parties
There are further categories of negative and positive externalities
• Negative production externality – factories discharging toxic waste into rivers kill fishes and
cause fishermen to suffer financial losses
• Negative consumption externality – driving results in pollution from exhaust fumes that cause
respiratory ailments to others and medical expenses are paid for by themselves
• Positive production externality – farmer growing apples where the flowers are a good source of
nectar to help beekeeper nearby enhance production of honey
• Positive consumption externality – education improves workers’ productivity and others such as
employers benefit from higher productivity even though they do not pay for it

!

NEGATIVE PRODUCTION / CONSUMPTION EXTERNALITY
Occurs when production/consumption of a good negatively affects the well being of third parties
who do not receive any compensation for that effect
The Problem:
Steel Production / Cigarette Consumption
PMC: cost to producers from additional unit of steel produced – cost of raw materials, utility bill
and wages of workers
...
It is measured by price consumers are willing to pay for each additional unit of steel
EMC: external costs to third parties – toxic fumes emitted into the atmosphere which is breathed in,
causing them to fall sick (but medical bill is not borne by factories) and loss in labour productivity
also borne by society
Hence, the market has “underpriced” the production of steel which leads to inefficient allocation of
resources and hence market failure
SMC = PMC + EMC

Hence, presence of external costs causes a divergence between private and social costs
• SMC is above PMC as SMC = PMC + EMC
• Assume steel production yields no positive externality, thus EMB = 0, PMB = SMB
• Assuming perfect competition, market equilibrium of steel is Qm, where PMB = PMC, as
producers and consumers only consider their own benefits and costs
• However socially efficient quantity of steel is Qs where SMB = SMC
• Hence there is an overproduction of steel by quantity Qm - Qs
• As total social costs incurred exceed total social benefits gained for overproduction of steel, area
ABC represents the deadweight welfare loss due to overproduction

!

The Solution (for Steel Production):
(A) TAXES

The government might choose to impose an indirect tax on producers where Tax = EMC at Qs,
shifting the PMC upwards such that it coincides with SMC at Qs
• Hence new market equilibrium quantity where PMB = PMC + tax coincides with socially
efficiency quantity Qs
• The externality has then been internalized or priced in
Limitations
• Lack of information – problem measuring those costs and apportioning blame (EMC)
• If government over/under estimates the costs, then the problem of resource misallocation cannot
be resolved
• Unfeasible to use different tax rates – EMC of each factory is different as new ones might use
pollutant abatement technologies
• However, use of Pigouvian tax helps the market priced in external costs and it also provides
incentives for firms to reduce pollution (thus improving resource allocation)
(B) MARKETABLE/TRADABLE PERMITS
Helps to control the discharge of wastes into the environment
• Places a cap on permissible level of pollution and issues permits corresponding to socially
efficient level of emission
• Firms can pollute to a certain level, but if they wish to pollute more, can trade these permits
amongst themselves
• Advantage – once cap is determined, can leave it to the market to distribute it efficiently
amongst polluting firms & provides incentive for firms to cut back pollution
Limitations
• Need to determine the correct number of permits
• Must also monitor and enforce, but is highly difficult from unknown sources of pollution
• Permits are also not effective if it is discharged into common property resource (air)

!

(C) REGULATION
Government can require the law the producers equip factories with emission reduction devices to
reduce pollution and enforce by conducting checks and fine/suspend offending firms
• Effectiveness depends largely on compliance – which relies on effectiveness of monitoring and
enforcement
• Legal restriction is also a blunt instrument and it cannot handle complexities of the issue it tries
to resolve – only cause polluting industries to reduce to limit, and no further
(D) TOTAL BAN ON PRODUCT

Sometimes the government may choose to ban a product entirely
• Deadweight welfare loss from overproduction at area Y
• Welfare loss associated with zero quantity of production is area X
• Since the area X is less than the area Y, it is better to ban the product than leave the quantity at
market equilibrium of Qm
Limitations
• Government intervention can be costly to administer and enforce as this might outweigh the
social benefits
• It may also work against the welfare of the society if the ban results in greater welfare loss
(Area X > Area Y)

!

The Solution (for Cigarette Consumption):
(A) TAXES
Similar to taxes for production of steel
Limitations
• Lack of information – problem measuring those costs and apportioning blame (EMC)
• If government over/under estimates the costs, then the problem of resource misallocation cannot
be resolved
• However, use of Pigouvian tax helps the market priced in external costs and it also provides
incentives for firms to reduce pollution
(B) REGULATION
Government places several regulations on smoking
• Smoking in public places are prohibited in air-conditioned areas, playgrounds etc
...
It is measured by price producers are willing to accept for each additional
unit of steel
PMB: benefit to consumers from additional unit of vaccine consumed – immunization from a
particular disease or lower risk of falling ill
...
Positive externality
2
...
Inequalities in income and wealth distribution: in free market, only for those willing and able to
pay for the good
DEMERIT GOODS
Goods or services that have been deemed by the government as socially undesirable but overconsumed/produced [must draw 2 diagrams]
There are multiple sources of failure associated with merit goods
1
...
Imperfect information: divergence between perceived and actual benefits

!

SECTION 4: PUBLIC GOODS
Public goods are goods or services that are non-excludable and non-rival in consumption and thus
not provided by the market
CHARACTERISTICS OF PUBLIC GOODS
There are two main characteristics to identify a public good
1
...
Non-rival in consumption
• Consumption by one does not reduce the amount available to others
• For example the use of street lighting by one will not reduce the amount of light available to
others
• Benefit of street lighting can be shared jointly by people in the vicinity
IMPLICATIONS OF PUBLIC GOODS ON ITS PROVISION BY THE MARKET
Non-excludability:
• Once a public good is provided, others can free-ride on the good
• A free-rider is anyone who receives the benefits without having to pay from it
• As anyone can enjoy all benefits without paying for it, no rational consumer motivated by self
interest will reveal his effective demand
• Hence there will not be price signals to indicate consumer preference, and thus producers will
not supply the good
• Therefore, the free-rider problem means that the market will not provide such a good
Non-rival:
• Marginal cost of providing a public good to an additional customer is zero
• Since the optimal or allocative efficient quantity to supply is where P=MC, the efficient price to
charge would thus be zero
• This means that no private firm in the free market can supply profitably
• Hence the market fails to allocate resources to produce such goods
Therefore – Without the profit incentive (non-rival) and price signals (non-excludable), the market
fails in the provision of public goods
...
Hence they will
restrict the quality supplied to maximize their profits
Under imperfect competition, production is allocative inefficient because dominant firms produce at
an output where price is above marginal cost (P > MC) [Draw monopoly diagram]
SOLUTIONS TO MARKET DOMINANCE
1
...

• The Competition Commission of Singapore (CSS) acts against the abuse of dominant position
(predatory pricing, price-fixing or limiting production)
2
...
Price Regulations: Marginal Cost (MC) Pricing
• Force the monopoly to charge a price equal to its marginal cost
• However, government may not know exact price to equate to marginal cost if firms withhold
information
• MC pricing might also discourage monopolist from innovation and investment in research and
development
• It also cannot be applied on natural monopolies as it results in hefty losses for them
SECTION 7: INEQUALITY IN DISTRIBUTION OF INCOME AND WEALTH
Definition: It is the extent of income disparity between high-income and low-income households,
where a commonly used indicator is the Gini coefficient (from 0 to 1)
The issue hinges on inequitable or unfair distribution of resources rather than what is socially
efficient allocation of resources
THE PROBLEM
Market system only responds to effective demand (willingness and ability to pay) for goods and
services
• Thus goods and services do not necessarily flow to those who need them the most
• Favors those with buying or purchasing power
• Thus the free market system fails to provide for those without means to pay for goods and
services – results in market failure due to inequitable distribution of resources

!

Causes of income inequality:
In general, income inequality is due to difference in earnings and wealth arising from
• Difference in educational qualifications and skills
• Ownership of assets or wealth
• Discrimination (young vs old, female vs male)
Causes of rising income inequality:
Mainly due to globalization and technological advancements
• Transition to knowledge-based economy leads to more opportunities being created in sectors
requiring high skilled labour
• Those who are highly educated and possess relevant skills experience fast increase in income
• Developed countries like Singapore open up to the freer flow of foreign labour due to
globalization, the supply of unskilled or low-skilled workers increases, reducing wages of such
workers further and worsening income gap
THE SOLUTIONS
Taxation:
Progressive Income tax and subsidies
• Higher income earners pay a large percentage of tax than the lower income earners
• Tax collected can be redistributed to low-income households through giving subsidies or
unemployment benefits
Limitations
• Tax system that is too progressive may reduce incentive to work and some might become
dependent on unemployment benefits and refuse to find employment
• Burden on government budget
• High tax rates also reduce the incentive for firms to invest, reducing AD and AS
Tax on luxury goods
• Helps to raise revenue from those who could most easily afford to pay as only the rich can
afford to buy such extravagances
Limitations
• Since demand is more price elastic, firms may end up having to retrench workers if people do
not buy the goods
• Hence the poor also ends up paying for the tax

!

Minimum wage:
An effective wage floor is a legally established minimum wage above the market equilibrium wage
to protect incomes of low-wage workers

Qd of workers will fall from L0 to Ld and Qs of workers will rise from L0 to L1
• Hence, more workers enjoy a higher wage but it is at the expense of L0 – Ld workers who are
being retrenched
• Ls – Ld of workers are willing to work and able to work at higher wage of Wm but are unable to
find work
• Thus number of unemployed is Ls - Ld
Singapore government however believes in raising employment rather than raising wages thus
supply side policies are employed instead
Supply side policy:
Main reason for income inequality is due to difference in education and qualifications of workers
• Hence emphasis is on providing basic level of education
• As well as training opportunities for low-income workers to upgrade their skills to find better
paying jobs
• Such as in Singapore through the use of Skills Programme for Upgrading and Resilience
(SPUR) for up-skilling and re-skilling of workers
Limitations
• Might not be effective as gestation period is too long
• Must be more immediate help given to the low-income, thus implementation of Workfare
Income Supplement
• Payout given to low-income workers – only for those who are employed thus no disincentive to
work

!

SECTION 8: CAUSES OF GOVERNMENT FAILURE
Definition: Government failure refers to the situation where government interventions to correct
market failure fails to achieve a socially efficient outcome
CAUSES OF FAILURE
Imperfect information:
Rarely possess complete information to make rational informed choices, such as correct level of tax
and subsidies, resulting in inefficient allocation of resources
Costs of administration and enforcement:
Government intervention can prove costly to administer and enforce as the costs may outweigh
social benefits from the intervention
Tendency to look for short-term solutions:
Myopic decision making will only provide short term relief to particular problems, does little to
address structural issues (such as improving public transport)
Bureaucratic inefficiency:
Administrative inefficiency with large government implementing polices and compounded by
corruption amongst politicians
Pursuit of self-interest:
Among politicians and civil servants leads to misallocation of resources
Electoral pressures:
Leads to inappropriate government spending and tax decisions
CONCLUSION
When evaluating policies for, use the following approach:
1
...
Effectiveness
3
...
Side effects
5
...
Define PMC, PMB, EMC/EMB in context and exemplify
2
...
Explain divergence between PMB & SMB / PMC & SMC
4
...
Socially optimum equilibrium is where SMB = SMC " Qs
6
...
Marginal cost is the
additional cost arising from an additional output
SECTION 2: LONG RUN COSTS OF PRODUCTION
It is the production period where all factors of production are variable – also known as time period
for which firms plan ahead to build the most appropriate scale of plant to produce future anticipated
level of output
Scale of production:
When all factors are increased in fixed proportions, there is an increase in the scale of production
ECONOMIES OF SCALE
Economies of scale
Unit costs fall as the scale of production
increases
Internal
External
Fall in unit cost of Fall in unit cost of
production when firm production
increases output by experienced by the
expanding scale of firm due to a growth in
production
the industry
Technical, Marketing, Economies of
Administrative &
Concentration,
Managerial, Financial Information,
Disintegration

!

Diseconomies of scale
Unit costs increases as the scale of production
increases
Internal
External
Rise in unit cost of Rise in unit cost of
production when firm production
increases output by experienced by the
expanding scale of firm due to a growth in
production
the industry
Managerial difficulty
Higher input prices,
increase strain on
infrastructure

INTERNAL ECONOMIES AND DISECONOMIES OF SCALE
Internal economies of scale:
Refer to a fall in unit cost of production when the firm increases output by expanding its scale of
production (shift in AC)
Technical (plant) Economies
1
...
Indivisibilities
• Some machines only come in fixed and large sizes (machinery)
• Firm producing on large scale will be able to spread the fixed costs of the machine over larger
output levels, thus lowering unit costs
3
...
Bulk purchase
• Large firms have bargaining advantage and given a preferential treatment
• They can also obtain goods at lower costs and better terms with respect to quality and delivery,
thus lowering unit costs
2
...
Problems in coordination and communication
• Increasing number of departments and sub-departments makes coordinating their activities
difficult
• Leads to inefficiency and higher per unit cost of production
• Also like to lead to communication breakdown and misinterpretation of information which can
cause delays in production and costly to the firm
2
...
It refers to the lowest point on the
LRAC

!

Specific shapes of LRAC:
LRAC of industries with substantial internal EOS (Big Firms)
There is significant internal EOS to be enjoyed by firms in such an industry but MES is large
relative to industry demand – only room for a few large firms

LRAC of industries with limited internal EOS (Small Firms)
MES is small relative to industry demand and degree of competition is high
...
Specialized products or services – small firms inclined to provide such commodities as they lose
their appeal if they are mass produced and standardized
2
...
Trained workforce
• Demand for labour with necessary skills increases and training schools may be set up
• Pool of skilled workers is readily available and thus reduce costs that are originally incurred
2
...
Sales Revenue – Price x Quantity where large firm is associated with higher sales revenue
2
...
Amount of equity – claims to shares in the net income and assets of a business
4
...
Number of employees – measured by the number of workers employed
METHODS OF GROWTH
Firms can expand in 2 ways: by internal expansion or by merging with other firms
Internal Expansion:
Requires increase in sales, which in turn requires increase in firm’s productive capacity
Firm is likely to engage in extensive promotion and launch of new products
• Firms also will require new investment such as building a new plant or buying new machinery
• Firm can expand its productive capacity and enjoy internal EOS
Mergers:
A merger increases a firm’s capacity and market share practically overnight and is less costly than
an internal expansion
...
Horizontal integration: When two or more firms producing the same product or service join
together
2
...
Conglomerate integration: Involves the combination of different industries that do not have
anything in common so as to allow for risk diversification
REASONS FOR GROWTH
Firms generally have the following reasons to want to grow
• Reap internal EOS
• Gain more market power, greater market share and thus more revenue and eventually more
profits
• Reduce the risk of take-over by other firms
~ END ~

!

Chapter 8: Profit Maximization of Firms
SECTION 1: REVENUE OF FIRMS
!
TYPES OF REVENUE
Total Revenue: Firm’s total earnings per period of time from the sale of its output
TR = P x Q
Average Revenue: Amount the firm earns per unit sold
AR = TR/Q = P
Therefore, the average revenue is simply the price of the firm’s product at each output level, and it
is also the firm’s demand curve
Marginal Revenue: It is the revenue obtained when one more unit of output is sold
REVENUE CURVES
For price-taker:
When a firm is very small relative to the entire market and its activities do not influence market
price, it is known as a price taker

D = AR = MR

For price setter:
If a firm has a fairly large market share and faces a downward-sloping demand curve, it is called a
price setter
...


!

SECTION 2: PROFIT OF FIRMS
Types of economic profit:
There are three types of profit – normal, supernormal and subnormal
1
...
Supernormal profit
• Level of profit above normal profit, attracts new firms into the industry, occurs when TR > TC
3
...
Changes in demand
2
...
Hence there will be a rise in output from Q0 to Q1, increase in price from P0 to P1
and a fall in unit cost from C0 to C1
...
Hence,
equilibrium price and output remain the same, but profits have shrunk

!

Change in Variable Costs:
When variable costs such as wages and utility bills change, the firm’s profits, equilibrium price and
output will change, as the marginal costs will be affected

Rise in variable costs will cause AC curve to increase from AC0 to AC1, and also MC curve to rise
from MC0 to MC1
...
Thus profits will fall and consumer surplus decreases by
P0P1XA
~ END ~

!

Chapter 9: Spectrum of Market Competition
INTRODUCTION
Market structure describes the important features of a market, some considerations include
• Number of firms
• Nature of the product
• Freedom with which firms can enter
• Degree of control that the firm has over its price
Markets are broadly categorized into PERFECT and IMPERFECT markets
Types of market structures:
There are 4 main types of market structures
...
Many small firms and many consumers
• Many firms and consumers in the market and each dealing in very small quantities, thus unable
to influence the market demand on their own
2
...
Perfect knowledge
• Buyers and sellers all have perfect knowledge of market conditions and price
4
...
Thus all points on the LRAC curve are productively
efficiency
From society’s point of view – efficiency occurs at the point where LRAC is at its minimum, where
the firm is at its minimum efficient scale (MES)
...
It may retain
all its old structure of unequal
wealth distribution, with factory
Prices are perfectly competitive and consumer workers being exploited by
surplus will be retained by the consumers and not wealthy owners
...

Innovation No incentive and no ability to do R&D
NONETHELESS, it must be
noted that in reality, a highly
Homogeneous products: No incentive to
competitive market does drive
innovate better products
innovation as it makes the firms
want to improve the quality of
Perfect information: innovations are quickly
their products (revenue impact) or
replicated by rival firms or attract new firms
...

profits
...

Consumers have no variety of goods and BUT,
there
is
consumer
services since they are assumed to be sovereignty in such markets since
homogeneous in nature
...
Single seller
• There is only one producer supplying the whole market and thus the market demand curve is
also the firm’s demand curve
• Since the monopoly has the ability to affect either price or output, it is a price setter
2
...
Imperfect knowledge
• Consumers are not fully aware of costs of production of the product
4
...
However, as he earns supernormal profits, it is
possible by coincidence that the LRAC is lowered to the minimum point and cuts MR=MC
EQUITY, INNOVATION AND CONSUMER CHOICE
Equity

Exacerbates inequity in the
economy, as supernormal profits
are concentrated in the hands of a
few large firms - at the expense of
consumers paying high prices
Innovation No incentive but have the means
to do R&D
No Incentive:
Assuming there barriers to entry,
the dominant position of the
monopolist is secured and thus
there is no need for the firm to do
R&D
...
It
can innovate in terms of production
processes/machines that reduce costs or to come
Innovation may erode the value of up with better quality goods (revenue side) to
a monopoly’s existing products
harness loyalty from consumers
Consumers do not have a choice
In reality, even when a firm is a monopoly, it
given that the monopolist’s good
doesn’t mean there is only 1 single seller but
is unique and there is no similar
probably it has a substantial market share
...

there are still other producers the consumers can
choose from
...

will be other firms selling similar products
...


!

HOWEVER, the government can intervene by
having corporate/profit taxes on the monopolists
and redistribute the income to the households in
the forms of subsidized goods and services such
as healthcare and education
...


SECTION 3: OLIGOPOLY
Introduction:
Oligopoly is a market structure in which a few dominant firms whose behavior is interdependent
and they each share among them a large proportion of the output of the industry
FEATURES OF OLIGOPOLY
1
...
Homogenous product OR differentiated product
• Product can be homogenous or differentiated
• When they are homogenous, theoretically only one price can prevail but the firm’s demand is
not perfectly price elastic, so it has control over its pricing policy
• When they are differentiated, there is less fear of immediate reaction from rivals as they may
perceive change in price due to modifications made to the product
3
...
High barriers to entry
• Firms are unable to enter the industry freely and thus allowing the firm to maintain its monopoly
position and supernormal profits
5
...
Such a
price war would only begin if
• Its costs of production were significantly lower than its rivals
• However price wars are not the preferred means of competition as it causes individual firms
suffering losses in the short run
Non-price competition:
It is competition in terms of product development and production promotion
...
Product development – producing good which is different and of higher quality
2
...
Cooperation among oligopolies – where big firms find it in their interest to cooperate with
rivals, such as research and development
2
...

However there is a key drawback of cartels
• The tendency for members within the cartel to cheat on agreed production quotas
• This is because each member, under the cartel agreement, produces at an output level where
MR>MC
• Hence it is possible to increase profits by increasing output until MR=MC
Collusion of any kind will work best when: There is a small number of participants, strong element
of trust, similar cost structures, clear leader and the government does not intervene
Price-Leadership Theory (Tacit Collusion):
Firms might follow the pricing policy of a recognized leader who might be a dominant firm or any
firm adept at reading market conditions
...
From society’s perspective, similar to monopoly
EQUITY, INNOVATION AND CONSUMER CHOICE
Equity
Innovation

Consumer
Choice

!

Similar to monopolies
...

HOWEVER,
pace
of
innovation can be slow in
Incentive: In competitive oligopolies, there is price collusive
oligopolies
rigidity and non-price competition is preferred
especially when there is a lack
of competition from potential
Ability: Oligopolies like monopolists are able to entrants
...

Consumers have a variety of products to choose BUT, oligopolies spend a lot
from and also a pool of producers to buy from
...


WHY OLIGOPOLY IS A COMMON MARKET STRUCTURE
We will have to examine (1) why there are a few big firms in many markets and thereafter explain
(2) the trend towards oligopolies
Basic structural characteristics of oligopolistic markets:
High barriers to entry (Dominant firms remain big)
• In the case of oligopolies, the barriers to entry are high such that only a few big sellers are able
to enter to compete in the market (give examples of BTE)
• Although barriers to entry get eroded due to a more contestable market, they do not get eroded
enough to allow many new firms
• Barriers such as branding and marketing tend to favor large established firms over new ones
Economies of scale (Dominant firms remain big)
• In many industries, large firms enjoy economies of scale such as technical, marketing and
administrative/managerial economies
• This gives them a competitive edge to produce at a lower unit cost and price its products more
competitively and acts as a deterrent to entry of new rivals
Trend towards oligopolies:
Globalization makes markets more contestable (Monopoly ! Oligopoly)
• With globalization, internal pressure on government to remove trade barriers have increased and
hence barriers to entry and exit are lowered
• Thus there are instances where monopolies have turned oligopolies
Globalization makes firms big (Dominant firms remain big)
• Opening up of many economies to international trade means firms have access to global markets
and allow them to grow into global businesses to consumers all around the world
• Also, to compete effectively in global markets, firms must be able to reap both cost and revenue
advantages that accrue to large firms
Mergers, acquisitions and internal expansion (Medium-sized firms grow to reap cost and revenue
benefits of being big)
• Mergers refer to voluntary amalgamation of two or more firms into a single business entity
• Cost savings: Done through internal economies of scale (technical EOS)
• Revenue advantages: Large firm generates more revenue as it can charge a higher price, sell a
higher output or both and this allows them to (1) invest in R&D and (2) do advertisement
Privatization and deregulation (Monopoly ! Oligopoly)
• Influence of neo-classical free market economics has led to a wave of privatization of formally
run state monopolies to spur efficiency by increasing competition
Other related factors
• Innovation and R&D: Drive towards this explains proliferation of oligopolies where
possession of new technologies give them a competitive edge, thus needing to invest heavily
• They would thus require sufficient resources and large potential markets
• Market size: Size of firms is affected by market size – large markets, big firms

!

SECTION 4: MONOPOLISTIC COMPETITION
Introduction:
Monopolistic competition is a market structure characterized by large number of small firms, each
producing differentiated product with little or no barriers to entry
FEATURES OF MONOPOLISTIC COMPETITION
1
...
Differentiated products
• Differentiation of products might either be (1) real where quality of materials used, ingredients
etc
...
No barriers to entry
• In MC, new firms are free to enter industry and existing ones can also leave with little difficulty
SHORT-RUN ANALYSIS OF TYPICAL FIRM IN MC
As the firm is able to differentiate its product and also due to consumer loyalty to its product, it has
some control over the price of its product
...
Hence firms are said to have
excess capacity and not producing at socially ideal output [Excess Capacity Theorem]

!

EQUITY, INNOVATION AND CONSUMER CHOICE
Equity

Perfectly competitive markets tend to spread HOWEVER, MC does not
opportunities and wealth widely as there is free entry in rectify pre- existing income
which firms can enter and compete for the supernormal inequality
...


Profits are spread amongst many small firms till
everyone earns only normal profits in the long run
...
There is imperfect information so the that involve high outlay
...


Consumer
Choice

No ability: Despite their efforts, they only earn normal
profits in the long run so the ability to innovate is
limited by the available funds
...


WHY MC IS A COMMON MARKET STRUCTURE
Differentiated products
• Firms in this market cater to the different needs of consumers by providing varieties and thus
have limited scope for internal economies of scale
• They thus have less incentive to be large (low MES)
Assumption of independence
• They behave independently of each other and there is no rival consciousness
• Thus new industries would choose to product differentiate rather than choose to merge with
another firm
Low barriers to entry
• The existence of supernormal profits in the short run and low barriers to entry would attract
more firms to enter the market
• The low opportunity costs also allow many young entrepreneurs to test their luck
• Thus, it is easy for firms to enter the industry leading to many small firms
~ END ~

!

Chapter 10: Price Discrimination
SECTION 1: PRICE DISCRIMINATION
INTRODUCTION
Definition: It is the practice of charging different prices for different groups of consumers for the
same product or for different units of it and it is not due to differences in cost
The aim of price discrimination is to generate more revenue & higher profits for a monopolist than
when a uniform price is charged
CONDITIONS NECESSARY FOR PRICE DISCRIMINATION
For effective price discrimination to take place, the following conditions must be satisfied
1
...
Segregation of the market
• Monopolist must be able to segregate the market into separate, identifiable groups by
geographical boundaries, age group
• Prevents seepage between markets where it is impossible or prohibitively costly for consumers
to buy in the lower-priced market and sell to other consumers in the higher-priced market
3
...
Though sometimes they might do
so using an estimate
Second-degree price discrimination:
This is known as block pricing where the monopolist sets a uniform price per unit for a specific
quantity of the product and a lower price per unit for subsequent units

If all consumers pay the same price, profit-maximizing monopolist charge a single price of 0PE for
0QE units and TR = Area 0PECQE
• If the monopolist practices 2nd degree price discrimination, it can charge 0P1 for 0Q1 units,
earning revenue of 0P1BQ1 and
• Price 0PE for remaining Q1QE units, earning another revenue of Q1DCQE
• Thus monopoly raises revenue by area PEP1BD and consumer surplus reduced from APEC to
(AP1B + BDC) due to block pricing

!

Third-degree price discrimination:
It occurs when the monopolist charges different prices for the same commodity in different submarkets (different segments of the main market)

Sub-market A where demand is relatively less price elastic than Sub-market B
• Panel C shows the MR and AR curves of the combined markets and the monopolist’s profitmaximizing output is at QM, where MC cuts MRcombined at point A
• To maximize profit when selling in 2 or more markets, monopolist equates MR across markets
• Thus it should sell QA units in Sub-market A and QB units in Sub-market B, as this is the point
where MRA = MRB = MC for the entire output
• Without discrimination, it would charge 0PU across and not receive revenue from Sub-market B
Peak-load pricing:
This is where people are charged more at times of peak demand and less at off-peak times
• Genuine price discrimination – because demand is less price elastic at peak time
• Not true price discrimination – higher marginal cost incurred at peak times due to diminishing
returns to variable factors or need to use additional equipment with higher operating costs

AR and MR are higher at during peak period as compared to off-peak period and hence equilibrium
output and price is higher than those of off-peak
...
Yet if they invest in R&D for
innovation and thus lower cost, it might be beneficial to society
Firms can also practice predatory pricing to drive competitors out of business
Benefits of Price Discrimination:
Higher Output and Allocative Efficiency under First Degree Price Discrimination

The monopolist charges each additional unit the maximum price that buyers are willing to pay
• Marginal revenue will always be equal to the price received for the last unit, where P=AR=MR
• In the absence of price discrimination, monopolist profit-maximizing output is at Q1 and there is
allocative inefficiency since P1>MC
• But with perfect price discrimination, firm’s demand curve is now the MR curve (MR=AR), and
output is now at Q2 and there is AE since P2=MC
Provision of Goods for Lower Income Consumers
Under third degree price discrimination, lower income consumer group belonging to more priceelastic demand will be able to consume a good or service which they could otherwise not afford
This helps to improve equity

!

Provision of goods that would otherwise not be produced
Perfect price discrimination makes it possible to supply a product when no single price would cover
total costs

Product has a demand and cost structure where not a single price can cover its total cost of
production, AC > AR = P
• Especially for new industries which incur heavy investment on expensive capital equipment and
demand for their product is relatively low
• Without price discrimination, TC = Area 0CDQE and TR = Area 0PEEQE, as TC>TR, it will not
supply the product
By practicing first-degree price discrimination, there is a possibility of the monopolist making
normal or even supernormal profits
• At output 0QE, TR (with perfect price discrimination) = Area 0PEEQE + Consumer surplus Area
AEPE = Area 0AEQE
• If ΔABC > ΔBDE, then the monopolist is making super normal profits and thus able to supply
the product
SECTION 2: CONTROL OF MARKET DOMINANCE
OBJECTIVES OF GOVERNMENT INTERVENTION
Challenge for the government through its regulatory bodies is to strike a balance through the
following general objectives
1
...
Ensure big firms remain viable to produce goods and services for them to remain innovative
3
...
But they empowers commissions to regulate them
Deregulation
Government may choose to deregulate the industry to subject the incumbent firms to competition to
keep price more competitive and improve efficiency (change in market structure to oligopoly)
~ END ~

!

Chapter 11: Alternative Objectives
INTRODUCTION
There is the assumption that the aim of the firm is to maximize profits and produce at where MR =
rising MC
...
It also means greater security with less takeover risk
Growth is best measured in terms of growth in sales

A profit-maximizing firm will produce at 0QE and price 0PE where MC=MR, MC is rising but to
maximize growth or output level, firm will produce up to output 0Q1 where AC = price (normal
profits) without making a loss
Revenue maximization:
Firm may aim to maximize sales revenue instead of goals
It might be viewed as important since a firm with falling revenues
• Will be seen less favorably by consumers and financial institutions
• May require cuts in number of staff employed
• May affect the salary of executives which may be linked to the level of sales
A profit-maximizing firm will produce at 0QE and price 0PE where MC=MR, MC is rising but a
revenue-maximizing firm will produce where MR=0 (TR is maximum) at 0Q2 and price 0P2

!

Managerial goals:
Firms in the real world are likely to see a divorce between ownership and management where the
owners are shareholders and the people who control the firms are managers
This can lead to conflicting objectives, since managers seek to maximize their own utility instead of
maximizing profit and their objectives include
• Increasing their salary – linked to sales rather than profits
• Increasing number of employees – makes managers feel more powerful and important
• Getting additional benefits – big office, first class travel, a bigger car
However, managers still have to make enough profit to satisfy the demands of their shareholders
and this is known as PROFIT SATISFYING
Behavioral objectives:
A firm involves or deals with many interest groups all with their own objectives – different
departments, union etc

---