MICROECONOMICS

Constant returns: the PPF forms a straight line which means that to produce 10 units of one good we sacrifice 10 units of another. Economic growth: with better technology for example the economy can produce more of all goods and thus the PPF shifts outwards. Law of diminishing returns: as resources are transferred from good A to Good B the extra output of B becomes successively smaller whilst the amount sacrificed by A larger. Advantages of the free market: 1. no Government intervention.Resources allocated by the market forces and the price mechanism 2. The profit motive provides incentives to reduce costs and be innovative. 3. The free market maximizes community surplus without failures or imperfections. Disadvantages of free market: 1. Public goods cause market failure. 2. Merit goods cause partial market failure. 3. Externalities by private firms due to lack of corporate social responsibility and a desire to minimize costs. 4. Instability and great income inequality. Advantages of command economy: 1. The Government can influence the distribution of income to equalize it. 2. The government can determine which goods are supplied. Disadvantages of command economy: 1. Requires an enormous amount of information, which means its often bureaucratic. 2. No incentive for firms or individuals to be innovative; lack of profit motive; goods of poor quality and limited choice. 3. Liable to lead to allocative and productive inefficiency due to lack of competition and no profit motive. Law of Demand: a higher quantity will be demanded at a lower price assuming ceteris paribus. Non-price determinants of demand: 1. Real incomes have risen (assuming the god is normal). 2. The price of a substitute has changed.

3. 4. 5. 6. 7.

The price of a complement good has changed. More effective advertisement. Population growth. Change in taste. More credit available so people can borrow money.

Downward sloping demand curve: this happens due to the law of diminishing marginal utility. Each extra unit of good or service will eventually give less extra satisfaction thus the consumers will be willing to pay less to purchase it. Upward sloping demand curves: Luxury goods or giffen goods (very inferior goods). As the price of each good rises consumers are willing to pay more to purchase them. Income and substitution effects: The substitution effect says that as the price of a good drops people will switch from buying others to buying that so as to cover their need. The income effect says that as your income increases you will buy more luxury and normal goods and less inferior and giffen goods. Elasticity of demand: measures the sensitivity of demand to a change in a variable which is either the price of a good the price of other goods or income. Perfectly elastic: the percentage change in quantity demanded is infinite. Elastic: the percentage change in quantity demanded is greater than the percentage change in the variable. Unit elastic: the percentage change in the quantity demanded is equal to the percentage change in the variable. Inelastic: the percentage change in the quantity demanded is less than the percentage change in the variable. Perfectly inelastic: there is no change in quantity demanded. Price elasticity of demand: percent change in quantity demanded over percent change in price. The size of price elasticity of demand depends on: 1. 2. 3. 4. 5. The number and availability of substitutes. The time horizon. The percentage of income spent on the good. The type of good. The width of definition.

Price elasticity of demand and revenue: If demand is price elastic a fall in price will lead to an increase in revenue. If demand is price inelastic an increase in price will lead to an increase in revenue. Uses of elasticity of demand: Price elasticity: 1. 2. 3. 4. Determine pricing policy. Use it for planning. Use it when price discriminating. The government may use it to estimate the impact of an indirect tax cut in terms of sales and government revenue. 5. Used to estimate the impact on consumer spending, producers revenue and income of any shift of supply. Cross elasticity: 1. Effect on their demand of a competitors price cut. 2. Effect on demand for their product if they cut the price of a complement. Income elasticity: 1. What goods to produce or stock. 2. Firms plan production and employee requirements as the economy grows. 3. Firms can estimate any potential change in demand. Non-price determinants of supply: 1. 2. 3. 4. 5. 6. Increase in suppliers. Improvement in technology. Fall in the prices of the factors of production. Cut in an indirect tax or increase in subsidies to producers. Change in price of jointly supplied goods. Other factors such as changes in the weather or improvement of management.

Determinants of Price elasticity of supply: 1. 2. 3. 4. 5. 6. Number of producers. Existence of spare capacity. Ease of storing stocks. Time period. Factor mobility. Length of production period.

Periods of supply:

1. supply is totally inelastic.Momentary 2. constrained by fixed factors the supply is usually inelastic.Short run 3. all factors are variable so supply is elastic.Long run Price: 1. in the case of creation of excess demand at theRationing device old price of a product due to increase in demand the price will raise reducing quantity demanded. 2. excess demand and increase in price leads other firms to join the industry.Signal 3. higher prices encourage existing firms to produce more.Incentive Taxes: If demand is more inelastic than supply consumers pay the greater proportion. If supply is more inelastic than demand the producer will pay the greater incidence of taxation. Problems with buffer stock schemes: 1. 2. 3. 4. 5. 6. 7. Storage costs. Some goods may be perishable. Administration costs. Wine lakes and Butter Mountains if the price is set too high. Inadequate supplies with many bad years. Increase in taxes to raise finance. Intervention in other areas may be more important.

Reasons for market failure: 1. 2. 3. 4. Market power. Factor immobility. Inequality. Merit goods.

Government intervention to improve environment: 1. 2. 3. 4. 5. Provision of information. Taxes and subsidies. Establish property rights. Legislate. Introduce tradeable permits.

Instability as a reason for market failure: this happens because the free market leads to cycles of booms, recessions, slumps and recoveries. Problems of government intervention: 1. Lack of information. 2. Difficulty in quantifying the problem.

3. Political pressure. 4. Administration costs. 5. by the time the government has intervened the problem may not be the same.Mistiming Explain why firms in the short run if they get a price less than AC stay in business? The firm continues operating because if it closes down despite the fact it doesnt have to pay AVC it has to pay FC which is greater loss than the loss before. So it stays in business until all factors are variable where it can leave with no losses. What is the difference between increasing returns to scale and economies of scale? The difference is that economies of scale refer to a fall in the cost per unit whereas increasing returns to scale refer to a change in output. Although increasing returns to scale contribute to economies of scale the one measures cost and the other output. Present and explain the law of diminishing returns. The law of diminishing returns is when additional units of a variable factor are added to a fixed factor the extra output of the variable factor will eventually diminish. The three main assumptions for the law of diminishing returns are that at least one factor has to be fixed (in other words it has to be in the short run), each unit of the variable factor has to be equal (for example the labor force has to be equally trained etc.) and that the level of technology must be held constant. Difference between decreasing returns to scale and law of diminishing returns. Decreasing returns to scale is in the long run whereas the law of diminishing returns is in the short run. Present and explain internal and external economies and diseconomies of scale. External economies of scale occur when the cost per unit at every level of output is reduced because of factors outside the firm. These occur when the industry is large or with the construction of certain infrastructure such as highways and airports. Internal economies of scale occur when the cost per unit at every level of output is reduced because of factors inside the firm. These could be related to the plant and are specialization, division of labor, indivisibilities, container principle, and efficiency of large machines and the use of recyclable products. Moreover there may be better management or marketing. Also there may be experiencing financial economies of scale or in other words due to the size of the firm be in the position of negotiating lower interest rates. Internal diseconomies of scale occur when cost per unit at every level of output is increased because of factors inside the firm. These could be management problems or workers alienation which leads them to work inefficiently. Moreover there may be the creation of negative industrial environment such as strikes, slow-downs or working to rule. Lastly there might be production line problems such as interdependencies or delays. External diseconomies of scale occur when the cost per unit at every level of output is increased due to factors outside the firm. These may be that the industry has grown too big or that there is

high competition within the industry on who gets the raw material. Lastly there may be shortage in commodities. Assumptions for perfect competition: 1. 2. 3. 4. 5. 6. Many buyers and sellers. Perfect information so that buyers know what products are offered and their price. Product homogeneity so that firms cant differentiate their products. No barriers to entry so firms can enter and leave in the long run. Producers have similar technology and there are perfectly mobile resources. The firm is a price taker which means that marginal revenue equals to price and each firm can sell what it wants at a given market price.

Why are perfectly competitive markets desirable? 1. Only normal profits in the long run. 2. Firms are allocatively efficient because they produce where the extra benefit of the unit equals the extra cost. 3. Productively efficient because they produce at the lowest cost per unit. 4. There is an incentive for firms to innovate and become more efficient because they can gain abnormal profits in the short run. However 1. Firms may not be able to afford research and development due to lack of abnormal profits in the long run. 2. Due to lack of product homogeneity there is no variety for consumers. Assumptions for monopoly: 1. 2. 3. 4. 5. A single seller in the market and many buyers. The monopolist is a price taker. The monopolist faces a downward sloping demand curve. The monopolist can set the price or the output but not both. Only one price can be charged for all the goods i.e. there is no price discrimination. Thus the firm gains revenue from the sale of the extra unit but is losing revenue on the ones before where the price has been lowered. As more units are sold the marginal revenue moves further and further away from the average revenue line.

Short run abnormal profits: monopolies can earn abnormal profits in the short and in the long run because of the barriers to entry which prevent abnormal profits from being competed away. Barriers to entry: 1. Legislation. The government may restrict the ability of firms to compete in a market usually when the firm is government owned.

2. 3. 4. 5. 6. 7.

Product differentiation usually done through advertising. Control over outlets so that competitors cant get their products in the market. Patents and trademarks. Fear of the reaction of existing firms. Cost advantage due to economies of scale for example. Control over supplies.

Monopolistic competition: 1. 2. 3. 4. Many sellers with differentiated products. Abnormal profits in the short run. Normal profits in the long run. Allocatively inefficient because the price consumers are willing to pay is greater than the extra cost of production. 5. Productively inefficient because firms arent producing at the lowest cost per unit. Assumptions for perfect price discrimination: 1. The firm must be able to keep the markets separate. 2. The firm must have control over the price. 3. There must be different elasticities or demands in the different markets. Methods of price discrimination: 1. By time. 2. By geography. 3. By branding Zara=D&G. Oligopoly: 1. A few firms dominate the market. 2. There is interdependency. 3. There is no one price and output outcome in oligopoly. Competition and collusion: firms in oligopoly have two main aims 1. To collude with other firms and thus maximise their combined profits. When they collude : 1. They fix a profit maximising price and output and give each other quotas. 2. This maximises the industrys profit. 3. Sometimes individuals cut their price and exceed their quotas to increase their own profit at the expense of the industry. They are more likely to collude:

4. When there are only a few firms and thus it is easy to check on each other and share information. 5. Effective communicating and monitoring means that any cheating can be identified early on. 6. Stable cost and demand conditions mean that the quotas are easy to allocate and measure and the policy is easy to administer. 7. Similar production costs so they make similar profits. 2. To compete with other firms by taking business away from them and making more profit independently. Kinked demand curve: Assumptions 1. If the firm increases its price other firms dont follow so it is price elastic. 2. If the firm decreases its price other firms do follow so it is price inelastic. Explanations 1. If price is increased demand is price elastic and revenue falls. If the price is cut demand is price inelastic and revenue falls. 2. The kinked demand curve cause discontinuity in the marginal revenue changes in marginal cost between MC1 and MC3 do not change the profit maximising price and output. Pricing and non pricing strategies: 1. Cost plus pricing. The firm adds a percentage profit on to their costs. 2. Predatory pricing. When firms deliberately undercut their competitors to force them out of the market. 3. Limit pricing. Selecting the highest possible price without encouraging entry. 4. Price wars. When firms in an oligopoly try to undercut each other. 5. Price leadership. When there is an obvious price leader usually the dominant firm with the greatest market share. Non-pricing competition: 1. 2. 3. 4. Advertising. Branding. Sales promotions. Distribution.

Role of advertising: 1. Informs but also misleads.

2. Can increase demand but can also create barriers to entry such as making demand more inelastic, shifting inwards the demand for other firms and making the costs of entry higher. Objectives of firms: 1. Profit maximisation. 2. Managerial utility maximisation: 1. The managers want to increase their salary which is often linked to sales rather than profits. 2. The managers want to increase in the number of employees. 3. The managers want to invest. 4. The managers want to get additional benefits. 3. Sales revenue maximisation: 1. Because consumers value companies with increasing sales and are more likely to buy from them. 2. Because financial institutions may be more willing to lend to a company with increasing sales. 3. Because salaries may be linked to sales. 4. Growth maximisation: 1. Because large firms are less vulnerable to takeover. 2. Because salary may be linked to firm size. 5. Satisficing: 1. To satisfy various factors such as the unions, suppliers, consumers, and the local community. 2. The firms do not maximise anything. Public Goods as a Reason for Market Failure Public goods are divided into Quasi (e.g. lighthouse) and Pure (e.g. national defence and street lighting). Private goods differ from public goods: 1. If one unit of a private good is consumed by one person it cant be consumed by another. 2. If one unit of a public good is consumed by one person it doesnt mean it prevents another from consuming them due to the free rider principle which is based on two concepts non-excludability (because of the nature of public goods consumers cant be prevented from consuming them once they are provided ) and non-rivalry (because goods are not diminishable the consumption of a good doesnt reduce its availability to others. So with public goods there is market failure because the free market would not provide them thus the government has to provide them. Note that the definition of a private and a public good changes from time to time and from place to place.