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MICROECONOMICS FOR BUSINESS A – N11606

Introduction

Economics – The science which studies human behaviour as a
relationship between ends and scarce means which have alternative
uses
...
Can be tested to see if true
...
g
...


Normative statement – Statement about how the world should be
...
A valued judgement
...
g
...


The nature of economic reason are based on the ideas that…

1
...

- Assuming people are rational helps yield testable predictions,

But
- Consumers often have imperfect information
...


2
...
g
...

- Economists focus on the role of economics incentives, they will
weigh up the benefits against the costs of decisions and projects
...
Optional decisions are made at the margin
- Many decisions that economists study involve either doing a bit
more or a bit less
...

- The optimal decision is where MB = MC
- If MB > MC then do a bit more
...



Ends
- Economists assume humans are self-interested and
economically motivated
...



Scarcity – Society has limited resources and therefore can’t produce
all goods and services that people want
...


People and society have to make choices and are raced with tradeoffs
...


1
...

- Whether to go to uni or work?
- Whether to study or go out?

Opportunity cost – What you will give up to obtain an item
...



Production possibility frontier

- Shows the maximal output of goods and services that can be
produces
...
Available resources
2
...


If producing inside the diagram then you are being productively
inefficient
...

Opportunity costs – The amount of units of good A you are giving up
for additional units of good B
...


The economy – a mechanism for allocating scarce resources and
scarce goods
...

How the problem is handled depends on level of government
intervention
...
Command economy
- The government makes decisions about the allocation of scarce
goods and services and the allocation of factors of production
...

- Usually associated with totalitarian regimes
...
The Free Market
- The price mechanism allocates scarce goods and services and
scarce factors of production
...


Invisible hand – Self-regulation of markets with households and
firms responding to prices
...
Mixed economy
- Most countries would be described as mixed
...

- Many markets are regulated
...
This is due to the income effect and substitution
effect
...

- Market demand is the sum of all individual demands
...

- Government want to know so they can maximise tax revenue
...


𝑁𝑒𝑤 − 𝑂𝑙𝑑
%∆𝑄𝑑
%∆=

𝑃𝐸𝐷 =

𝑂𝑙𝑑
%∆𝑃


Factors that make demand more elastic are…
- The good has few unique features compared to rival goods, e
...

a cup of coffee
...
g
...

- The good is an input for a final good whose demand is elastic
e
...
computer compartments
...
g
...

- Switching costs e
...
financial products
...
g
...


Cross price elasticity

XPD – Measures the impact of a proportional change in price of good
I on the proportional change in quantity demanded of good j
...

- If XPD < 0 then they are complements
...


- If YED > 0 then it’s a normal good
...


- If YED > 1 then it’s a luxury good
...


Efficiency

- Market efficiency is concerned with the economic well being of
individuals
...






Kaldor-Hicks efficiency
- Sometimes it is desirable to make someone better off at the
cost of another
...

- The benefits to one may outweigh the costs, so the
beneficiaries could compensate the disadvantaged
...


Consumer and producer surplus

Consumer surplus…
- The difference between what the consumer is willing to pay
and what they actually pay
...

- Is a measure of consumer’s economics well being
...

- Is a measure of producer’s economic well being
...


Efficiency and market equilibrium
- In equilibrium a market achieves an efficient allocation of
resources
...

- However, we do not know if the allocation is equitable
...

- Producers who produce at the least cost (productively efficient
point)
...








Government Intervention

Price floor

The justifications for a price floor are…
- To protect producer’s incomes e
...
farmer’s incomes, fluctuate
due to the weather
...
g
...

- Minimum wage used to reduce poverty and inequality
...
g
...
(A feed in tariff is when renewable energy
providers are awarded long term contracts with prices
reflecting the cost of generation for energy
...







- A minimum price is not effective if it is equal to the equilibrium
price or lower i
...
it is non-binding
...

- Rent control is an example of a price ceiling
...
g
...

- Underground markets
- Reduces incentives to invest and supply


-


- A maximum price is not effective if it is equal to the equilibrium or
higher i
...
it is non binding
...

- The deadweight loss is equivalent
...


















Subsidies

The justifications for subsidies are…
- Positive externalities e
...
green energy production
...
g
...

- To encourage production of vitally or strategically important
goods e
...
food
...

- Subsidy has relatively
small effect on quantity
...





Demand elastic, supply inelastic…
- Supplier benefit is larger than consumer benefit
...

- Supplier passes less subsidy to the consumer
...
Prohibition

- Decrease in supply lead to a shift
in the supply curve which causes
a higher equilibrium price
...

- Lower quality drugs, deaths from
impure and unexpectedly pure
drugs
...
Specific Tax
















3
...






Stock Market Bubbles
- Stock prices should reflect firm’s profits
- A stock market bubble is where market participants trade stock prices
above their true value
...

- In 2012 IPO of Facebook raised $16 billion, valuing the business at $108
billion, but profit was $1 billion in 2011
...
People behave irrationally (Including traders)
- Suppose rational investors buy and sell at true value but irrational
investors buy at a price above the true value
...


2
...

- Some traders are not concerned with true value, they will buy at a price
above the true value because they expect to sell at an even higher price,
so market demand increases
...

- If one farmer suffers a poor
harvest, because he is a price
taker, he will suffer a fall in total
revenue
...
Known as
the ‘fallacy of composition’





Buffer Stocks

- After a good harvest, the
government buys q2-q3 to
maintain total revenue for farmers
...

- At p3, total revenue is maintained
- At p2 total revenue increases
...

- Its objective is to maximise profit
...
g
...

- The production function is 𝑄 = 𝑓(𝑋)
- It measures the maximum output given for a given input set
...
Where K = Capital, and L=Labour
...

- The transformation of inputs into output for a given technology is f(
...


9 is where capital has
𝐾
been fixed
...

















Short-run production schedules

Short run production function, at least one factor is fixed…
- Total product (TP) is the same as total output (Q)
...

∆;<
- Marginal product of labour
...



SHORT RUN COSTS

- Explicit costs are payments made to suppliers for factors (inputs)
...
Also
known as the opportunity costs
...


Costs
- Total costs can be divided into two types, fixed and variable
...
g
...


Variable costs – Do vary with the quantity of output produced e
...
hiring labour
...



Cost curves

;G
- 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑐𝑜𝑠𝑡𝑠 =
H


-

Average costs is made up of
AVC and AFC
...

∆;G
𝑀𝐶 =

∆H


The marginal cost curve is U-shaped because…
- When extra units of one factor of
production are employed, additional
units of output costs less to produce,
so MC falls
- Diminishing returns set in at some
pount, so additional units of output
cost more to produce because everincreasing amounts of the factors of
production are required, so MC
increases
...

- Suppose there are two inputs (K and L), an isoquant shows the minimum
K and L combinations that are required to produce a given Q
...








-

Downward sloping, when firms use
less capital it has to use more labour
to produce a given output
...

∆L
𝑀𝑅𝑆 =
∆=
Isoquants flatter close to each axis
due to diminishing marginal rate of
substitution
...



The relationship between the MRS and the
marginal product of factors…
- Suppose the firm decides to use less
capital and more labour
...

- They are typically drawn depicting the cost combinations of K and L
...

O
Where r is the price of capital and w is the price of labour
...




Cost minimisation

- Cost minimisations occurs when an isoquant
is tangential to an isocost line
...
− = −

O
N<=
- When a firm minimises cost 𝑟 =
𝑀𝑃𝐾 𝑎𝑛𝑑 𝑊 = 𝑀𝑃𝐿










At an output maximisation interpretation…
- Public sector organisations and departments in large firms have to
operate within a budget
...

- Changes in the factor prices will result in different isocosts
...















LONG RUN COSTS

Short and long run costs
- In the short run, some factors
are fixed e
...
plant size
...

- Short run curve shows the costs
a firm face with at least one
factor fixed
...

- Say a firm produces at 𝑦T and
increases its output to 𝑦U
- Say a plant size is fixed in the short run, so faces 𝑆𝑅𝐴𝐶T , AC will increase
𝐶UV
- In the long run, could build a larger plant, so firm now faces 𝑆𝑅𝐴𝐶U , at 𝑦U ,
AC will be 𝐶U=
- The LRAC curve therefore envelopes all possible SRAC curves
...

- Depicts economies of scale and diseconomies of scale
- Economies of scale when AC decreases as output increases
- Diseconomies of scale when AC increases as output increases
- The minimum efficient scale (MES) is at the lowest point of the AC curve,
where economies of scale have been fully exploited
...


You can classify market structure by…
- The number of firms
- Size of firms
- Degree of product differentiation
- Entry/exit barriers











There are 4 different market structures…

1
...
g
...
Monopolistic competition
- Many/several firms
- Low/no barriers to entry
- Slightly differentiated products
- Downward sloping demand curve
- E
...
Plumbers

3
...
g
...
Monopoly
- One firm
- High barriers to entry
- Unique product
- Downward sloping demand curve
- E
...
Medicine


The SCP diagram involves 3 steps…

1
...
Conduct
- Pricing
- Output
- Advertising
- Research and development

3
...
Promote competition to benefit buyers
- M&A policy, prevent mergers that create firms with monopolistic power
...
g
...
Regulation
- Price controls e
...
some train tickets
- Environmental policy e
...
pollution taxes


PERFECT COMPETITION

The assumptions are…
- Firms are price takers
- No barriers to firms entering an industry
- Homogenous products
- Perfect knowledge




Short run

- The price is given by market demand and supply
- Output is where P=MC
- 𝑃𝑟𝑜𝑓𝑖𝑡 = 𝐴𝑅 − 𝐴𝐶 𝑥 𝑄
- Supernormal profit and losses are possible in the short run
...

- If P>MC, buyers value more output than the cost to the firm of producing
it
...

- Production at minimum AC, firms produce at efficient point
- Only normal profit in the long run
...
g
...


The properties of equilibrium under
conditions of monopolistic comp are…

-

P>MC, there is a price mark up over MC
...











Non-price competition

The forms of non-price competition are…

1
...
g
...
Advertising
- Manipulate consumer tastes
- Impedes competition
- Informs
- Create perception of differentiation and brand loyalty

3
...
























Market Structure – Monopoly and Price Discrimination

MONOPOLY

-

Industry structure where with one firm, the firm supplies the whole
market
...
g
...
g
...

- Product differentiation and brand loyalty
- Learning economies e
...
Chip manufacturers
- Ownership or control over key factors
- Ownership or control of distribution channels e
...
National grid
- Legal protection i
...
patents, e
...
medicine

Monopolies profit maximising equilibrium

- In the long run, a monopolist makes
supernormal profit
- P > MC=MR
- The more inelastic the monopolist’s
demand curve, the greater the
monopoly power, the greater the PMC mark-up
...
e
...









The welfare costs of monopolies

- Monopoly pricing and output is inefficient
- Output is inefficiently low and price is
inefficiently high
...

- Government may intervene to force
monopolist to produce at efficient output
and price by using competition policy,
regulation, or nationalising it
...
Because it is
economically sensible to have certain natural monopolies, governments often
regulate those in operation, ensuring that consumers get a fair deal
...
g
...

- Any level of output between Qa and Qb
yields supernormal profit
...

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

- Allow monopolists to charge a two
part tariff
...

- Split firm up, but this creates many
smaller firms with their AC higher
than monopolists AC
...


The problems with regulation are…
- The regulator does not know the monopolist’s revenues and costs
...

- Regulatory capture (When the regulatory committee acts in a way that
advances the agenda of political groups that dominate the industry it’s
involved in)
...
g
...

- But with no competition it does not have an incentive to keep costs low
...

- Critics argue that with no competition, there is no incentive for process or
product innovation
...
High profit is therefore not detrimental to
consumers
...
High
economics profit attracts new entrants that innovate to the market
...









CONTESTABLE MARKET THEORY

Characteristics of market

- No barriers to entry or exit
- No sunk costs
- ‘Hit and run’ entry from a new rival if monopolists makes supernormal
profit
...

- Monopolist will lower its prices and increase output to avoid competition
from a new entrant
...


Policy implications

- De-regulate markets
- Prevent monopolists from erecting ‘strategic’ barriers to entry
- Experience of the airline industry shows that application of theory is
problematic in practice
...

- Total surplus = producer surplus
- The firm will supply each consumer
until P=MC
- No deadweight loss, means an
efficient level of output
- Pareto efficient because total surplus
is maximised
- Difficult to achieve because firm does
not know what every consumer is
willing to pay
...

- Firm offers all customers the same menu of prices and allows them to
self-select
...
g
...

- Bundling e
...
Microsoft tying explorer to its operating system
...

- Leads to market segmentation e
...
students (student credit card), senior
citizens (cinema tickets) etc
...


































Market Structure – Oligopoly and Game Theory

OLIGOPOLY MARKET STRUCTURE

Features

The market structure…
- A few large firms dominate the market
- Differentiated/ undifferentiated products
- Some barriers to entry e
...
economies of scale, advertising, access to key
resources etc
...


Strategic independence…
- When firms recognise their mutual independence, they behave
strategically


COLLUSION

-

A collusive agreement is where two of more firms form a cartel to restrict
output and raise the price, increasing industry and firm profit
...

If firms cheat on the agreement, they reduce industry profit, however
cheating will only pay off for a firm if it does not get caught or other firms
believe that it has no incentive to cheat
...











Profits from collusion

- A competitive industry
produces at output 𝑞Y at price
𝑝Y
...

- In a collusive oligopoly each
firm restricts its output so that
industry output is at the point
where MC=MR (Profit
maximising point)
...




Incentive to cheat

- A firm that cheats will gain at the other firms’ expense
- There is an incentive for a firm to cheat and set its 𝑝2 < 𝑝[ because 𝑝[
and it can profit from increased market share
...

- As all firms have an incentive to cheat, industry output increases and
industry prices fall until price = 𝑝Y and quantity = 𝑞Y
...

- In the UK, the Office of Fair Trading (OFT) investigates cases of price
fixing and anti-competitive practices
...
5m for price fixing fuel surcharges to
passengers
...
2m for rigging
tenders for building projects for schools, hospitals and universities
...
Dominant firm
- One firm has a large market share
- Remaining firms are small and competitive, they are price takers
- Each follower faces a perfectly elastic demand curve at the price set by
the leader
...
Barometric firm
- A firm acts as a barometer of market conditions for other firms in the
industry
...



Kinked demand curve

- Above A a price rise is not
matched by rivals
- Below A the price rise is
matched by rivals
- Kinked demand curve creates
discontinuous MR curve
...






GAME THEORY



Game theory – The analysis of situations where firms are interdependent
...

- Understanding a scenario, not just from your own perspective, but also
from someone else’s perspective
...

- Communication between players is not allowed
- May choose to give information on other player for a reduced sentence
...

- If both give up information, then both of them will face a long sentence
together
...

- They are at their maximum gain; neither can gain by changing their
strategy
...

- No matter what the other player does once you confess, it is going to be
best for you
...

- Both players are acting rationally
...



Sequential games

- In the real world, firms often make decisions one at a time
...

- Sequential games are analysed using a decision tree
...

- Shows consequences of strategic independence, but breaks a complex
world down to key components
...

- Can be used to predict and analyse behaviour
...
g
...

- It is easy to change features of a game and find bad explanations for
scenarios
- General principles are sacrificed in favour of local modelling

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