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CFA Level I- Economics. Study Session 4 “Microeconomic Analysis” 13. Demand & Supply Analysis: Introduction 14.Demand & Supply Analysis: Consumer Demand 15.Demand & Supply Analysis: The Firm 16.The Firm & Market Structures. Definition of Market. Group of buyers & sellers. - PowerPoint PPT Presentation
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CFA Level I- Economics
Study Session 4“Microeconomic Analysis”
13.Demand & Supply Analysis: Introduction14.Demand & Supply Analysis: Consumer Demand15.Demand & Supply Analysis: The Firm16.The Firm & Market Structures
Definition of Market
Group of buyers
&sellers
Aware of each other
Able to agree on a
price
For Exchange of Goods
and Services
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Four Types of Market Structures
Perfect Competition
Monopolistic Competition
Oligopoly Mono-poly
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Factor that determine
market Structure
Number of Sellers in Market
Degree of product differentiation
Power of sellers in determining Price
Barriers to entry and exit
Degree of non Price Competition
Four Types of Market Structures
Perfect Competi
tion
Monopolistic Competition
Oligopoly Mono-poly
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Product Differentiation
Barriers to Entry
Pricing Power of Firm
Non price Competition
No. of Sellers
Perfect Competiton
Many
Homogen-eous
Very Low
None
None
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Perfect Competiton
1. Demand Analysis
Price Elasicity
Cross price
Elasticity
Income Elasticity
Consumr Surplus
2. Supply Analysis
3.Optimum price and
output
4. Factors Affecting Long
run Equilibrium
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Perfect Competiton
1. Demand Analysis
Price Elasicity
Cross price
Elasticity
Income Elasticity
Consumr Surplus
2. Supply Analysis
3.Optimum price and
output
4. Factors Affecting Long
run Equilibrium
Demand Analysis
• There is a negative relationship between Price and Quantity Demanded
• Convention in CFA curriculum: use absolute values
• Ep =
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- (% change in Qd)
(% change in Price)
Price Elasticity of demand
Demand Analysis
Price elasticity depends on:1. Availability of substitutes2. Share of consumers budget spent on item3. Length of the time considered
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Price Elasticity of demand
ElasticEp > 1
InelasticEp < 1
Unitary ElasticEp = 1
Demand Analysis
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Price Elasticity of demand
ElasticEp > 1
InelasticEp < 1
Unitary ElasticEp = 1
Increase in Price
Result in lower TR
Increase in price
Result in Higher TR
Change in price will have no
impact on TR
Demand Analysis Two extreme case of price elasticity of demand
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Qty
Price
Qty
Price
Demand Curve
Demand Curve
Perfectly Elastic Demand Ep = Infinity
Perfectly inelastic Demand Ep = Zero
A perfectly Competitive firm is a
Price Taker
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Perfect Competiton
1. Demand Analysis
Price Elasicity
Cross price
Elasticity
Income Elasticity
Consumr Surplus
2. Supply Analysis
3.Optimum price and
output
4. Factors Affecting Long
run Equilibrium
Demand AnalysisIncome Elasticity
When Consumer income increases demand increases
Ey =
For normal goods- It’s positiveInferior goods - Negative
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(% change in Qd)
(% change in Y)
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Perfect Competiton
1. Demand Analysis
Price Elasicity
Cross price
Elasticity
Income Elasticity
Consumr Surplus
2. Supply Analysis
3.Optimum price and
output
4. Factors Affecting Long
run Equilibrium
Demand AnalysisCross Price Elasticity
Shows change in demand for product A for a change in price for Product B
Ex =
For Substitutes – PositiveFor Complements – Negative
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(% change in QdA)
(% change in Pb)
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Perfect Competiton
1. Demand Analysis
Price Elasicity
Cross price
Elasticity
Income Elasticity
Consumr Surplus
2. Supply Analysis
3.Optimum price and
output
4. Factors Affecting Long
run Equilibrium
Demand AnalysisConsumer Surplus
• Difference between value and price
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Perfect Competiton
1. Demand Analysis
Price Elasicity
Cross price
Elasticity
Income Elasticity
Consumr Surplus
2. Supply Analysis
3.Optimum price and
output
4. Factors Affecting Long
run Equilibrium
Supply Analysis
• Supply curve of Individual firm – positively Sloped
• Industry Supply curve – Positively Sloped
• As price increases, quantity supplied increases
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Supply Analysis
a firm’s short-run supply curve is the portion of the firm’s
short-run marginal cost curve above average variable cost. A firm’s long-run supply curve is the portion of the firm’s
long-run marginal cost curve above average total cost.
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Perfect Competiton
1. Demand Analysis
Price Elasicity
Cross price
Elasticity
Income Elasticity
Consumr Surplus
2. Supply Analysis
3.Optimum price and
output
4. Factors Affecting Long
run Equilibrium
Optimum Price and Output
Optimum price and output is calculated by equating demand and supply function
Important for Exams: It is possible in a perefectly competitive market , that the demand schedule of the entitre market is downward sloping
In Perefectly Competitive markets, for a Individual firm:
Price = Average Revenue = Marginal Revenue
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Optimum Price and Output Certain Basic concepts: Both MC and ATC curves are U Shaped
Demand Curve is also called as MR Curve
In perfect competition MR = P = AR
Profit is maximised when MR = MC
So for a perefectly competitive firm MR = P = AR = MC, hence economic Profit = Zero
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Average Total Cost
Quantity
PriceMarginal Cost
The point where, ATC and MC are same, ATC is lowest
Firms Demand
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Perfect Competiton
1. Demand Analysis
Price Elasicity
Cross price
Elasticity
Income Elasticity
Consumr Surplus
2. Supply Analysis
3.Optimum price and
output
4. Factors Affecting Long
run Equilibrium
Four Types of Market Structures
Perfect Competi
tionMonopol
istic Competi
tion
Oligopoly Mono-poly
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Product Differentiation
Barriers to Entry
Pricing Power of Firm
Non price Competition
No. of Sellers
Monopolistic Competition
Many
Homogen-eous
Very Low
None
None
Many
Differenti- ated
Low
Some
Advt + product Differen.
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Monopolistic Competiton
1. Demand Analysis
2. Supply Analysis
3.Optimal price and Output
4. Factors affecting long
run equilibrium
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Monopolistic Competiton
1. Demand Analysis
2. Supply Analysis
3.Optimal price and Output
4. Factors affecting long
run equilibrium
Demand Analysis
Each product sold in monopolistic competition is different
Demand curve for each firm is downward sloping to the right
At higher prices- Demand is more elatic
At lower prices- demand is less elastic
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Monopolistic Competiton
1. Demand Analysis
2. Supply Analysis
3.Optimal price and Output
4. Factors affecting long
run equilibrium
Supply Analysis
Supply curve – not represented by marginal cost curve
Imp: In monopolistic competition there is no well defied supply schedule
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Monopolistic Competiton
1. Demand Analysis
2. Supply Analysis
3.Optimal price and Output
4. Factors affecting long
run equilibrium
Optimal price and output
• Output is determined where MR = MC
• But the price is charged based on market demand schedule.
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Quantity
Price
Short run ATCShort run MC
Demand CurveMR
Optimal price and output
• Is imperfect competition a bad thing?
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Monopolistic Competiton
1. Demand Analysis
2. Supply Analysis
3.Optimal price and Output
4. Factors affecting long
run equilibrium
Factor affecting long run equilibrium
• An increase in demand will increase economic profits in the short run under all market structures.
• Positive economic profits result in entry of firms into the industry unless barriers to entry are high.
• Negative economic profits result in exit of firms from the industry unless barriers to exit are high.
Factor affecting long run equilibrium
Important concept for Exams:
Unlike long run equilibrium in perefect competition, in monopolistic competition, equilibrium position is at a higher level of average cost than the level of output that minimizes cost.
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Monopolistic Competiton
1. Demand Analysis
2. Supply Analysis
3.Optimal price and Output
4. Factors affecting long
run equilibrium
Four Types of Market Structures
Perfect Competi
tion
Monopolistic Competition
Oligopoly
Mono-poly
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Product Differentiation
Barriers to Entry
Pricing Power of Firm
Non price Competition
No. of Sellers
Oligopoly
Many
Homogen-eous
Very Low
None
None
Many
Differenti- ated
Low
Some
Advt + product Differen.
Few
Homogen-eous
High
Some or
considerable
Advt + product Differen.
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Oligopoly
1. Demand Analysis
Pricing interdepend
ence
Nash Equilibri
um
Cournot Equilibri
um
2. Supply Analysis
3.Optimum price and
output
4. Factors Affecting Long
run Equilibrium
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Oligopoly
1. Demand Analysis
Pricing interdepend
ence
Nash Equilibri
um
Cournot Equilibri
um
2. Supply Analysis
3.Optimum price and
output
4. Factors Affecting Long
run Equilibrium
Demand Analysis
There are three basic pricing startegies in oligopily
1. Pricing interdependence2. cournot assumptions3. Nash Equilibrium
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Demand Analysis
1. Pricing interdependence Competitors will match a price reduction but ignore a
price increase Therefore given a price:
If Price Decreased Price elasticity Less If price Increased price elasticity is Higher Which results in a Kinked Demand Curve
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Quantity
Price
Demand Curve
Demand Analysis
2. Cournot Assumption Each firm will determine it’s profit maximising
production level, Assuming, that other firms output will not change.
Two Implications: Output is greater than monopoly, but lower than
perfect competition. Price is lower than monopoly, but not as low as with
perfect competition.
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Demand Analysis
3. Nash Equilibrium Nash Equilibrium presents when two or more
participant, in a non –cooperative game have no incentive to deviate from their respective strategies
none of the oligopolist can increase its profits by unilaterally changing its pricing strategy.
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Nash Equilibrium in Duopoly Market
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B High Price- 600
A High Price- 1000
B Low Price-700
A High Price- 600
B Low Price-140
A Low Price- 100
B High Price-0
A Low Price- 160
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Oligopoly
1. Demand Analysis
Pricing interdepend
ence
Nash Equilibri
um
Cournot Equilibri
um
2. Supply Analysis
3.Optimum price and
output
4. Factors Affecting Long
run Equilibrium
Supply Analysis
• No well defined supply curve
• Level of output where MC = MR
• Price will determined based on Demand Curve
• Generally a firm with more than 40% market share is called as dominant firm in oligopoly
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Supply Analysis
• Without collusion, dominant firm will beome price maker
• It has also been seen that supremacy comes from Cost leadership
• And therefore price followers rather charge a price higher than dominant firm, if they charge a lower price, it follows the risk of a price war.
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Oligopoly
1. Demand Analysis
Pricing interdepend
ence
Nash Equilibri
um
Cournot Equilibri
um
2. Supply Analysis
3.Optimum price and
output
4. Factors Affecting Long
run Equilibrium
Optimum Price and output
• There’s no single optimum point
• In case of kinked demand curve, the kink is the optimim point but model fails to identify the point
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Oligopoly
1. Demand Analysis
Pricing interdepend
ence
Nash Equilibri
um
Cournot Equilibri
um
2. Supply Analysis
3.Optimum price and
output
4. Factors Affecting Long
run Equilibrium
Factors affecting long run equilibrium
Long run economic profits are possible
History has proven that pricing wars should be avoided.
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Oligopoly
1. Demand Analysis
Pricing interdepend
ence
Nash Equilibri
um
Cournot Equilibri
um
2. Supply Analysis
3.Optimum price and
output
4. Factors Affecting Long
run Equilibrium
Four Types of Market Structures
Perfect Competi
tion
Monopolistic Competition Oligopoly
Mono-poly
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Product Differentiation
Barriers to Entry
Pricing Power of Firm
Non price Competition
No. of Sellers
Monoply
Many
Homogen-eous
Very Low
None
None
Many
Differenti- ated
Low
Some
Advt + product Differen.
Few
Homogen-eous
High
Some or
considerable
Advt + product Differen.
One
Uniqueproduct
Very High
considerable
Advertising.
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Monopoly
1. Demand Analysis
2. Supply Analysis
3.Optimal price and Output
5. Factors affecting long run equilibrium
4.Price Discrimination& Consumer Surplus
Introduction Sources of monopoly power
Patent Control over critical resources used for prodn
Government controlled authorisation ( Natural monopolies)
Network effect
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Monopoly
1. Demand Analysis
2. Supply Analysis
3.Optimal price and Output
5. Factors affecting long run equilibrium
4.Price Discrimination& Consumer Surplus
Demand Analysis Demand curve for a monopoly firm is downward sloping
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Monopoly
1. Demand Analysis
2. Supply Analysis
3.Optimal price and Output
5. Factors affecting long run equilibrium
4.Price Discrimination& Consumer Surplus
Supply Analysis
A monopoly does not have a well defined supply curve
Output- Profit maximising – MR= MCPrice- Derived from demand curve
( Same as Monopolistic competition and Oligopoly)
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Monopoly
1. Demand Analysis
2. Supply Analysis
3.Optimal price and Output
5. Factors affecting long run equilibrium
4.Price Discrimination& Consumer Surplus
Optimal price and output
Relationship between MR and price elasticity MR = P (1 – 1/Ep)
Since for a monopoly MR = MC, we can extend the equation by saying
MR = MC = P (1 - 1/Ep)
If a Monopolist know its MC ( lets asssume 50), if it observes price elasticity to be ( 1.5), then he can caluclate the optimum price to be charged. 150
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Optimal price and output Regulated monopoly
1. In perfect competition P = MR = MC, but for a regulated monopoly it will be unfair to set a price of perefect competition
Because its LRAC will be higher than perfect competition
Solution:- subsidize the difference between LRAC and P of Competitive firm for each unit sold
2. Set a price where LRAC equals AR( regualatory solution is between pure a monoply and perfect competition)
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Monopoly
1. Demand Analysis
2. Supply Analysis
3.Optimal price and Output
5. Factors affecting long run equilibrium
4.Price Discrimination& Consumer Surplus
Price DiscriminationAnd Consumer Surplus
• First Degree price Discrimination– When a monopolist extracts entire consumer Surplus
• Second Degree Price Discrimination–Monopolist uses quantity purchased to establish how
much consumer values the product– So he will sell small quantities at less prices– Large qunatities at higher prices
• Third Degree price Discrimination- -- Customers are seggregated by demographic or other traits
Two part Tariff pricing
Lets say, a consumers demand for a yoga Club is Qd = 30 – 5p, the MC per visit to the club is $2 . Calculate maximum monthy membersheep fees to be
charged to the consumer?
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Monopoly
1. Demand Analysis
2. Supply Analysis
3.Optimal price and Output
5. Factors affecting long run equilibrium
4.Price Discrimination& Consumer Surplus
Factors affection Long Run Equilibrium
Unregulated monopoly can produce economic profits in the long run
For regulated monoply , P can be kept at MC but it should be supported by subsidy
National ownership of monoply is another solutionFranchise the monopolistic firm through bidding war
Monopolist are not always inefficient- beacuase regulation , economies of scale, or threat of entry- might give consumers better price than perfect competition
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Factors affection Long Run Equilibrium
Unregulated monopoly can produce economic profits in the long run
For regulated monoply , P can be kept at MC but it should be supported by
subsidy National ownership of monoply is another solution Franchise the monopolistic firm through bidding war
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Four Types of Market Structures
Perfect Competi
tion
Monopolistic Competition Oligopoly Mono-
poly
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Identification of market structure
• Compute price elasticity
Highly elastic- intense competition
Highly inelastic high Concentration
Identification of market structure
• A concentration ratio for N firms is calculated as the percentage of market sales
accounted for by the N largest firms in the industry and is used as a simple measure of market structure and market power.
Two Disadvantages:1. Does not quantify market power2. Tends to be unaffected by mergers
Identification of market structure
• Herfindahl-Hirschman Index • Measure of concentration is calculated as the sum of
the squared market shares of the largest N firms in an industry and better reflects the effect of mergers on industry concentration.
Disadvantages:1. Does not quantify market power
Identification of market structure
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- Presented by Utkarsh Jain