Managerial Economics - My Notes Micro_Rev17

8/11/2019 Managerial Economics - My Notes Micro_Rev17

1/51

Ecomonics Lecture Notes by

Ahmed FawzyEslesca 45D

[email protected]

Dr Ahmed Ghonem


2/51

Microeconomics

Table of Content:Supply and Demand Rules

Quantity Demanded and the Law of Demand

Quantity Supplied and the Law of SupplyMarket EquilibriumShortage and Surplus

Elasticity Price Elasticity of Demand

Revenue Calculations (How To increase revenue using Elasticity) Factors Affecting Determinates of Elasticity Price Elasticity of Supply Income Elasticity

Cross Elasticity of Demand Low Of Diminishing Marginal Utility

How Consumer will maximize this Total Utility at multiple products and Price limitation:

Using Graphical Representation (Budget Lines and Indefinite Curves) Costs & Production

Total Cost , Fixed Cost , Variable Cost , Average Total Cost and Marginal Cost Total Product (TP), Average Product (AP) , Marginal Product (MP)

Average Cost Curve and why the average total cost curve is U-Shaped? Average/Total Cost Curves vs. the Marginal Cost ( Extra Graphs)

Law of Diminishing Marginal Returns Using Graphical Representation (ISOQuant Curves and ISOCost Line )

Profit Maximization and Market Stature Maximizing Profits

Marginal Revenue and Maximizing Revenue

Market Structures Summery Summery Comparison

Market Structures in Details

Perfect Competition Monopoly

Natural Monopoly or Atypical Monopoly Typical Monopoly

Monopolistic Competition Oligopoly


3/51

Micro Economics:is related to the economy of an economic unite.

Supply and Demand Rules:

Demandis from the point of view of the consumerSupplyis from the point of view of producer

Quantity Demandedand the Law of Demand

Quantity Demanded: The Quantity demanded of a good or service is the amount that consumers plan to buyduring a

given time period at a particular price. The quantity demanded is not necessarily the same as the quantity actually bought.

Sometimes the quantity demanded exceeds the amount of goods available. The quantity demanded is measured as an amount per unit of time.

A higher price reduces the quantity demanded for the following two reasons:

SubstitutionEffect: When price of a good rises, the switching possibility to a substitute good is

rises.

Income Effect: A higher price and unchanged income, people cannot afford to buy all things theypreviously bought.

Demand QD= (P, Y, PC,PS, T); Where P: Price, Y: Income, T: Taxes,PC Price of Compliance, PS: Price of Compliance

Assuming all other factors but price is constant < Ceteris paribus >

Then we will have QD= (P)

Depended Independent

QD= (P)@ Ceteris paribusQD= ab P

Law of Demand:There is a negative relationship between quantity demandedand price of the product; at Ceteris paribus conditions (allother factors are constant.)

So, the higher the price of a good, the smaller is the quantitydemanded; and the lower the price of a good, the greater isthe quantity demanded.

When we have Change in Quantity Demanded, we movefrom one point to another on the curve.

Change in Demandis at the same prices but change inother conditions, the curve slope will change


4/51

Demand Curve:

A demand curve shows the relationship between the quantity demanded of a good and its price when allother influences on consumers' planned purchases remain the same.

Assuming linearity: QD= a - b P, b: illustrates the response on the quantity to the change in price.

Pri ce Change Ef fect:

Change in Quantity demandedis the movement along the existing demand curve, caused by changingthe price of the product (Points on the blue curve)

Change in Demandis the shift of the entire demand curve, caused by change in any other factorsthataffect the willingness or ability to buy other than the product price (e.g. curve move to D1 or D2)

Other Factor (Demand Shifters): Inflation, Substitute, Income Change, Expectation andForecasting)

What Happened to Demand (Not Quantity Demanded) if priced goes up or down ?Nothing Change in Demand its self, or the demand Curve, only change Quantity Demand

When demand increases, the demand curve shifts rightward & quantity demanded at each point is greater

There are six main factors bring changes in demand:The price of related goods, Expected future price,Income, Expected future income and credit ,Population, Preferences


5/51

For Normal Goods: (Qd 1/P

If Price increased, Quantity demanded decreased. [-ve relationship]

Law of demand doesnt work with Both Inferior Goods and Luxuries Goods

For Luxuries Goods: (Qd

If Price increased, Quantity demanded increased. [+ve relationship](Example: expensive cars, every one who can afford them will try to buy them)

Inferior or low quality Goods: (1/Qd 1/P

If Price decreased, Quantity demanded decreased. [+ve relationship]

If I have more money , I will but something more good

(Example: Cleopatra and Marlboro cigarettes, since when a price decreases , more money

will be available , to buy some better quality substitute , decreases the quantity

demanded on the low quality products)

Quantity Supplied and the Law of Supply

Quantity Supplied:

The quantity supplied of a good or service is the amount that producers plan to sell during a given

time period at a particular price. The quantity supplied is not necessarily the same as the quantity actually sold. Sometimes the

quantity supplied is greater than the quantity demanded. The quantity supplied is measured as an amount per unit of time.

Law of Supply:The more of the good will be provided , the higherits price , the less will be provided the lower its

prices at Ceteris paribus conditions(from the supplier point of view , as the prices increase ,supplier wont to provide more services to get moreprofit)

Positive relationship between quantity supplied andprice holding Ceteris paribus

So, the higher the price of a good, the greater is thequantity supplied; and the lower the price of agood, the smaller is the quantity supplied.

QS= ( P , T , Pi) QS= c + d PWhere P: Price, T: Technology, Pi: Price of Inputs

Suplyer point of view


6/51

Supply Curve: A demand curve shows the relationship between the quantity supplied of a good and itsprice when all other influences on producers' planned sales remain the same.

Assuming linearity: QS = c + d P, d: illustrates the response on the quantity to the change in price.

The supply curve can be interpreted as Minimum Supply Pricecurvethat shows the lowest price atwhich someone is willing to sell. This lowest price called Marginal Cost.

Price Change Effect

Change is Price, will cause movement along the existingSupply Curve, result Change in QuantitySupplied (Or Change in Quantity Supply, is the change in quantity as the price change. Illustrated as themovement along the supply curve (Points on the same curve)

Change in Supplyis the shift of the entire supply curve, caused by change in any other factors that affect

the willingness or ability for a supplier to produce product other than the product price , the slope of

change in supply will shift rightward or leftward (e.g. curve S1 and S2)

Other Factor (Supply Shifters): (Profitability, Cost of Production, Cost of Labor , Cost of

Capital , Taxes , License , Audits , Worker Strikes , Natural Disasters , Better Technology,Expectation )

What Happened to Supply if Priced goes up or downNothing Change in Supply its self, or the Supply Curve, only change Quantity Supplied

As the response to the change in price changes, the slope will changeits angel (Curves D1, D2)

Change in Supply, when any other factor changes,When supply increases, the supply curve shifts rightward & quantity supplied at each point is greater.

There are six main factors bring changes in supply: The price of factors of production , The price of related goods produced Expected future price , The number of suppliers Technology , The state of nature


7/51

Market Equilibrium: Demand and supply determine market equilibrium, the equilibrium price (P*) and equilibriumquantity (Q*) at the intersection of the demand curve and the supply curve.

The Equilibrium Priceis the price at which the quantity demanded equals the quantity supplied.

The Equilibrium Quantityis the quantity bought and sold at the equilibrium price.

The price of a good will adjust until the quantitydemanded equals the quantity supplied.QD = QS

So at the equilibrium price (P*) andequilibrium quantity (Q*): QD = QS = Q*


8/51

The Equilibrium Priceis the price at which the quantity demanded equals the quantity supplied. The Equilibrium Quantityis the quantity bought and sold at the equilibrium price.

At equilibrium QD= QS &

If the price is too High(P1), the quantity supplied exceeds the quantity demanded. (QS > QD)

If the price is too Low(P2), the quantity demanded exceeds the quantity supplied. (QD < QS)

At Equilibrium Price(P3), the quantity demanded equals the quantity supplied. (QS =QD)

In case of Price Ceiling, the excess in demand results a Block Market. (e.g. Gas & solar prices) In case of Price Flooring, the excess in supply results Over Productionand Inflation (e.g. Milk

Prices in USA)

At the equilibrium price the market is Relaxing.


9/51

The four basic laws of supply and demand are

If DemandIncreases(demand curve shifts to the right) and supply remains unchanged,o a Shortageoccurs, leading to a Higher Equilibrium price.

If DemandDecreases(demand curve shifts to the left) supply remains unchanged,o a Surplusoccurs, leading to a Lower Equilibriumprice.

If demand remains unchanged and Supply Increases(supply curve shifts to the right),o a Surplusoccurs, leading to a Lower Equilibriumprice.

If demand remains unchanged and SupplyDecreases(supply curve shifts to the left),o a Shortageoccurs, leading to a Higher Equilibriumprice.

Supplies Shortage and Surplus: (due to change in prices of the product, while we have same SupplyCapability and Demand Requests, a Quantity Gapis created)

At Shortage(Qd>Qs) when the quantity Supplied is lessthan quantity demanded

o (Under equilibrium), Force price up.

At Surplus(Qs>Qd) when the quantity Suppliedis morethan quantity Demanded

o

(Over equilibrium), Force price to drop.

Value of Shortage or Surplus = |Qd-Ds| at the new price levels

Supply Shift

(When changing other Factors then price)

S1 is less than S0, Quantity Decreases,

Supply Decreases

prices Increases

Demand Shift

(When changing other Factors then price)

New Demandis Higher then Demand ,

Quantaty demanded increase

Price increase


10/51

The effects of all the possible changes in Demand and Supply


11/51

Elasticity ()

Elasticityis used to assess the change in consumer demand as a result of a change in the good's price.

Price Elasticity of Demandis the percentage change in quantity demanded divided by the percentagechange in the price.

Price elasticity of demand (PED or Ed) is a measure to the responsiveness, or elasticity, of the quantity

demanded of a good or service to a change in its price.

More precisely, it gives the percentage change in quantity demanded in response to a one percent changein price (holding constant all the other determinants of demand, such as income)Determining Demand

Elasticity Represent the quantity of the demand over the price changeElasticity should be representing in absolute, as the result may be negative.Low Elasticity ,


12/51


13/51

In case of Low elasticity: Increasing Priceby large amount will increase revenue by large amount.

In case of High elasticity: Decreasing priceby small amount, Quantity Increasedand revenueincreased by large amount. Or Increasing QuantityWith the same price

If demand is elastic ( > 1): A 1%price cut increasesthe quantity sold by more than 1% and totalrevenue increased.

If demand is inelastic ( < 1) : A 1%price cut increasesthe quantity sold by less than 1% and totalrevenue decreased.

If demand is unit elastic ( = 1) : A 1%priceincreasesthe quantity sold by 1% and the total revenuedoes not change.

If a price cut increasestotal revenue, demand is elastic.If a price cut decreasestotal revenue, demand is inelasticIf a price cut leaves total revenue unchanged, demand is unit elastic.

The relationship between PED and Total Revenue: (extra notes from marketing lectures)

Perfect inelasticity, changes in the price do notaffect the quantity demanded for the good; raisingprices will cause total revenue to increase.

Inelastic, the percentage change in quantitydemanded is smaller than that in price. Hence,when the price is raised, the total revenue rises,and vice versa.

Unit elasticity, the percentage change in quantity

is equal to that in price, so a change in price willnot affect total revenue.

Elasticthe percentage change in quantitydemanded is greater than that in price. Hence,when the price is raised, the total revenue falls,and vice versa.

Perfect elasticity, any increase in the price, nomatter how small, will cause demand for the goodto drop to zero. Hence, when the


14/51

Perfectly Inelastic Demand Goods: If QDremains constant when the price changes, then is zero

PerfectlyElastic Goods: If QDchanges by a large percentage when a tiny price changes, then isinfinity

Unit Elastic Demand Goods: If the percentage change in QD equals the percentage change in Price, then equals 1

Inelastic Demand: In general case, in which %QD is less than %P, then is between zero and 1

Elastic Demand: In general case, in which %QD exceeds %P, then is greater than 1

Elasticity is different from one point to another on the demand curve

Price Elasticity of Supply is the percentage change in quantity supplied divided by the percentagechange in the price.

Price Elasticity of supply is always positive.

From Supplier point of view , they always have option to pass and cascade the price increases to theconsumers


15/51

Income Elasticityis the percentage change in quantity demanded divided by the percentage change inincome.

In case of Basic goods, income elasticity is less than 1

No Big Change in demand for basic goods when income is changes

In case of Luxurious Goods, income elasticity is greater than 1In case if income increases by X, the demand to buy Luxurious Goods is higher

In case of Inferior Goods, income elasticity is less than zero (negative)In case if income increases by X, the demand to buy Inferior Goods is decreases

To increase revenue by elasticity in your firm: Return to historical data, to know the effect of the price change in the consumer demand Using surveys, and market researches, Note: surveys measures perception not reality

Use the competitor or other vendors data (Direct public reports, or indirect by head hunting)Cross Elasticity of Demandis the relationship between the price and the demand of two products, and

what will happened in a product A , of the price of the product B is changed

Definition ofCross Elasticity of Demandis a measure of the responsiveness of the demand for a

good to a change in the price of a substitute or complement, other things remaining the same.

In case of Positive CrossElasticity(Substitutes)

If price of product A increased the demand of product B increased

So the two products are Substitutes (e.g. Pepsi & Coca-Cola)

In case of Negative CrossElasticity(Complements)

If price of product B increased the demand of product A decreased

So the two products are Complements e.g. Sugar & Tea

In case of Zero CrossElasticity (Neutral)

If the price changes of product B does not affect the demand of product A

So the two products are Neutral. e.g. Chicken & ESLSCA


16/51

Low Of Diminishing Marginal Utility: if you give a consumer an identical successive unites of goods,with each unite consumed more; it causes less and less happiness or satisfaction (Utility) less than theprevious one.Or in other words

The more you consume of a good, the less Marginal Utility you get, and you reach the maximum TotalUtility when the marginal utility equal zero. (Marginal utility decreased as the consumption of a goodincreased)

The Marginal Utilityis the amount added to the total utility with the last unite you consume.It assumes that customer have infinite supply, and using only one product.

Given

Unites to

a

Consumer

Unites

MU TU

Marginal

Utility

(Step)

Total

Utility

0 -- --

1 10 102 8 18

3 5 23

4 2 25

5 -3 22

Consumption should stop when customer stop adding more to his happiness, but instead startlosing his happiness (Utility)

Low can apply on everything but religions.

Assuming Singe Identical Product , and unlimited Resources in income or supply

To Reach maximum utility, consumption need to stop when marginal Utility equal Zero.

Utility: is the benefit or satisfaction that a person gets from the consumption of goods and services.

Total Utility: is the total benefit that a person gets from the consumption of all goods and services.

Marginal Utility: is the change in total utility that results from a one-unit increase in the quantity of goodconsumed.

All the things that people enjoy and want more of have positive marginal utility.Some objects and activities can generate negative marginal utility and lower total utility.

Marginal utility Decreased as the consumption of a good Increasedthis principle called diminishingmarginal utility.

Law of Diminishing Marginal Utility


17/51

How Consumer will maximize this Total Utility at multiple products and Price limitation:

Remember Marginal Utilityis the step of addition added to the Total Utility. To get maximum TU satisfaction, we need to get the mist added satisfaction per dollar spending

decision.

First Get the Marginal Utility(MU) per US Dollar.

Get the Products that have the highest MU /$

Equilibrium occurs when MU /$ spend in all products is equal , (assuming spending all income ,and no savings ) , Equilibrium

Example

Assuming Income is spend on three products (Pizza , Cans , Cigarettes) This is the MU Table per each product. (Notice that its values decrease over increase consumption Assuming Prices for Eash Product is Pizza =12 $ , Can =8$ and Cigarettes = 4$ , and Total

Income is 100$ (need to be spend all to get maxim Utility)

Get the Marginal Utility per US Dollar

Start Selecting the piece of products that have highest (MU) per US Dollar , then the next highest

and so on , (in case two produces have the same MU/$ , chose any of them) Get the product mix that have higher MU , until all the 100 $ is spend , and finally we will findthem capable to buy and Achieving Total Utility of


18/51

Using Graphical Representation (Budget Lines and Indefinite Curves)

Assuming Customer can chose products preferences (Choose his MU Table). Preferences choices must be consonance. We assuming that always have Positive MU , and Up scaled TU

When we have more than one product, we take piece for the first product(The product that will generate higher MU/$), then take peace from the second, and so on.In other word, we are cyclic over the products, to maximize Marginal Utility, and causes overall increasein the Total Utility.

Assuming consumption of two products (A & B):

o at the beginning, MUA= MUB

o After using Prod A, MUA< MUB

o After using Prod B, MUA> MUB

To reach Equilibrium (Maximum Total Utility that we can achieve using in income)

The increase in Marginal Utility causes decrease in Elasticity, and more willingness to spend.

Consumer re pattern there consumption in case of change on MU, in order to reach equilibrium.

According to the Low of Diminishing MU , Consumer shall stop when the consumed products are notadding anything to his happiness , but start causing him lose happiness .

Or Marginal Utility when it reaches its Minimum acceptable level (Zero) , and any consumption after that

will causes MU to be negative , and reducing the Total Utility of the Consumer .

Utility of I4is the highest , then I3, then I2 Change in Price in Product on Y axis ,While Fixied the one in the Y Axes


19/51

Indifferent Curves: They represent differentcombinations of two producers A & B and therequantities vs. The level of utility they generate

Each Curves They represent differentcombination of product A & B that gave the samelevel of utility ,

The higher level of the curves , the higher utility

Indifferent curves are never intersecting

Slope

Examples of indifferent curves, consumer can take meal inGAD, MAC, or 4Season

Budget Lines: they are the budget limits that thecostumer can afford (assume no savings)

It marks the boundary between those combinationof goods and services that a consumer can affordto buy and those that cannot afford.

Consumer can afford many differentcombinations of goods and services, but they areall limited by his income and the prices.

Slope =

Any point below Budget Line is Affordable, Any point b=Above Budget Line is Unaffordable

Budget line Shifting: Due to Inflation, it will be shift downwards (left) with same slope Due to Deflation , it will be shift Up words (right) with same slope

If change in price of one product A or B, or both of them, change in slope will happened.o Assuming a consumer buys two products (A & B), budget line appears as a straight line (BL0)o In case of increasing price of Product B, the budget line will change as shown in BL1o In case of increasing price of Product A and decreasing price of prod B, budget line will

change as shown in BL2.

By applying the two graphs, the budget line will tangent with one of indifferent utility curves, the point of

tangencyis called Tangency Levelat which

The Tangency Lineis the maximum Indifferent Curves that the consumer can afford

Any change in prices for a single product, or both of them, or inflation, will create New Equilibriumpoint(point of tangency), causes new intersection with another Indifferent Curve

In case if not all income is used, we will have Intersectionbetween Indifferent Curves and Budget Lines


20/51

Exaplels :

The Curve I2 , causes some savings, and not maximizing theCostemern utility of the two products

Red Curveis after Price increasing

Price Decrease in Good X

Curve B , is higher Utility , but un affordableCurve A , is the maximum utility that consumer can have (Tangency Level)Curve C : Consumer have some savings , and not all income is spend on products


21/51

Costs & Production

Total Cost: is the cost of all the factors of production it uses. FixedCost: Cost that will Not Changewhen production rates changes (ex : rent) VariableCost : Cost that will Changewhen production rates changes (ex : salaries ,

machines )

Total Cost= Fixed Cost + Variable Cost ( )

Average Total Cost :( ( is the total cost per unit of output. ( )

Marginal Cost: is the increase in total costthat results from a one unit increasein output.

Or. It is the increase in total cost divided by the increase in output ( )

Total Product (TP): is the maximum output that a given quantity of labor can produce.

Average Product (AP): tells how productive workers are on average.

Where L: Labor, K: Capital

Marginal Product (MP) of one factor (Example Labor) is the increase in total product that results from

a one-unit increase in the quantity of this factor (labor employed), with all other inputs or factors of

production remaining the same level.


22/51

Average Cost Curve and why the average total cost curve is U-Shaped?

Average total cost is the sum of average fixed cost andaverage variable cost, so the shape of the ATC curve combinesthe shapes of the AFC and AVC curves.

The U-shape of the ATC curve arises from the influence oftwo opposing forces:

1. Spreading total fixed cost over a larger output

2. Eventually diminishing returns

Initially, as Output Increases, average fixed cost and average variable cost decreases, so average total

cost decreases. So ATC curve slopes downward (Economies of Scale).

But as Output IncreasesFurtherand diminishing returns set in, average variable cost starts to increase.

With average fixed cost decreasing more quickly than average variable cost is increasing, the ATC curve

continues to slope downward.

Eventually, average variable cost starts to increase more quickly than average fixed cost decreases, so

average total cost start to increase. The ATC curve slopes upward. (Diseconomies of Scale)

Diminishing returns means that as output increases, ever-larger amount of labor are needed to produce an

additional unit of output.

Optimum Levelor Minimum Efficient Scale(Constant Scale) is the range of output in which the total

cost is minimum.

Economies of Scale in Industry Level

Internal Factors: Increase sales opportunity, sharing resources , Strong Distribution

External Factor: The century infrastructure, and availability of low cost supporting functionsandthe experts of the industry are located in a certain location, which reduce the cost when starting toestablish a new firm.

o e.g. Watches industry focused in Swedish. Arabic Movies industry focused in Egypt.


23/51

Avarage /Total Cost Curvs vs the Marginal Cost ( Extra Graphs)


24/51


25/51

Law of Diminishing Marginal Returns

Law of Diminishing Marginal Returns Definition: If we have number of factors for production , and weincrease on factor only , while fixing all other factors , the marginal productivity of the factor weincrease it is start decreasing .

As a firm uses more of a variable factor of production with a given quantity of the fixed factor ofproduction, the marginal product of the variable factor eventually diminishes.

Law of Diminishing Marginal Returns Occur when the marginal product of an additional worker is lessthan the marginal product of the previous worker.

Arise from the fact that more and more workers are using the same capital and working in the samespace, if we increase one of the factors of production while holding all other factors, marginalproductivity of this factor decreases.

Producers are focus on two things when hiring new peopleProductivity and Price.

To reach Equilibrium or , Where W: Wages, I: Interest

, This indicates that the cost of Labors is less than the cost of Capital.

This will increase no of labors.

, This indicates that the productivity of Capital relevant to the cost is greater than

the productivity of labors relevant to their wages. Decrease the number of labor.

The producer prefer the Factor that have higher


26/51

ISOQuant Curves( (Represents different combination of two factorsof

production that produce same level of output productivity.

ISOCostLine( (Illustrates all the possible combinations of two factorsthat can

be used at given costsand for a given producers budget.

In case of increasing Wages & Interest, ISO cost slope will shift down.

In case of increasing Interest, ISO cost slope will change as shown in i1 In case of increasing Wages and decreasing Interest, ISO cost slope will change as shown in i2

By applying the two graphs, the ISO cost slope will tangent with one of ISO quant curves, the point of

tangency is called Tangency Levelat which

The Tangency Level or the point of tangency is when I can maximizethe productivity levels using all the

budget I have

Note: the Marginal Costcurve is the inverse of the Marginal Productioncurve


27/51

Profit Maximization and Market Stature

Do we need all this Diagrams?

Total product, Marginal product, Average product, Total cost. Total fixed cost. Total variable cost.Average fixed cost, Average variable cost. Marginal cost , Thats a lot of graphs. !!

Truthfully, we dont need to keep carrying around all of these diagrams, as long as all of the informationfrom one can be found in another. Let me show you what I mean.

Let's compare our old average product/marginal product diagram with the average cost/marginal costdiagram.

What do you notice? The range of increasing average product or increasing productivity is reflected in thecost diagram by decreasing per-unit costsThe more productive your resources are, the cheaper it is to produce a unit of your product.

Now, what happens when there is a declining average productdecreasing productivity?This is reflected in the cost diagram by increasing per-unit costs; as your resources become lessproductive, the more expensive it is per unit to produce your product.

In the end, because we can see all the productivity information reflected in the costs, we no longer need touse the product curves.


28/51


29/51

This leaves only marginal cost.Marginal costis just the extra dollars I add to mycost by producing one more unit of output.

In this case, because six units cost $60 and sevenunits cost $63, the marginal cost of the seventh unitis $3; it cost three dollars more to produce thatseventh unit.

It looks like I can get all the cost information fromthis diagram.

Now, what about the average cost diagramcan I get total cost, total fixed cost, totalvariable cost, and all the rest of them?

Let's take the easy ones first: I can readstraight from the diagram :

Average Total Cost ($9),

Average Variable Cost ($6),

Marginal Cost ($3)

Average a single unit costs $9, $6 of whichis variable, meaning the other $3 must bethe average fixed cost component.

If one unit costs $9, how much do

seven units cost? $9 per unit, timesseven units, is $63.

The variable piece per unit is $6,

so the variable cost of all sevenunits must be $42.

Therefore, the remaining $21

represents fixed costs.

Conclusion: we can get ALL of the cost information from either of the diagrams.

Which one will we continue to use?, We're going to continue by using the average cost curves diagram.


30/51

There is good reason for using Average Cost Curves Diagrams

Our next step in looking at business decisions that are based on maximizing profit is to bring ininformation about the product price, so that we can compare that to the cost.Since goods are priced per unit, we need to be able to clearly see the cost per unit.

Let me show you: if I go back to the average cost diagram that we just looked at, but nowI put in a price tag, you should be able to tell me instantly if this producer is making money or losing

money.

Remembering that the average total cost,or cost per unit, is $9

What happens if the product price is $10?

This producer makes a dollar in every unitabove and beyond the cost per unit,

so there is $7, total, of profit.

Now, what if price is $8?

The producer is not bringing in enough per unitcover the cost;

in fact, the firm loses a dollar on each unit,

so there is a seven dollar loss.

Now will I know if the producer is reaching the objective of maximizing his or her profit?


31/51

Maximizing Profits

Profit: Total revenue minus total cost P=TR-TCTotal Revenue: Its just pricetimes quantity, TR=TP*Q

How do I figure out how much output yields the maximum amount of profit?

Assuming price is always P* (let me say, for the moment, that P* is five dollars), if that's true, then for

output equals zero revenue is equal to $0. But if output equals one, revenue is $5. And at output of two,revenue is $10, and so on.

That means that for Perf ect Competi tion, Total Revenue is just a straight line, increasing at each unit

by the amount of the price.

But what about profit? Remember that Profit is the combined effect of Total Revenue and Total Cost .This still doesn't show profit directly, but it does give us the information needed to figure out what profitsgoing to look like.

For example, at output levels. Q1 and Q2,

Whatsthe profit?At both of these output levels, the total revenueis exactly equal to the total cost, so the profit'szero.

Area of Losses when Total Cost is higher thanTotal Revenue

This leaves us with output levels from Q1 to Q2.In this range, total revenue exceeds total cost, soprofits are earned

.


32/51


33/51

For maximum profit, the firm owner chooses the level of output at which marginal revenue equalsmarginal cost.

Marginal revenue equals marginal cost is ALWAYS the profit maximizing rule.Think about it this way: What if marginal revenue is NOT equal to marginal cost?

For example, what if marginal revenue is greater than marginal cost?

This means that more is being added to revenue than to cost, so profits are still rising you would want toincrease your output until marginal revenue equals marginal cost.

And what if marginal revenue is less than marginal cost? In this case, more is being added to cost than torevenue, so profits are falling.

Notice this does not necessarily mean that profits are negative; just that profits have gone past themaximum, and are now decreasing.

In this case, you would want to cut back on your output, until marginal revenue equals marginal cost.

In the end marginal revenue equals marginal cost is always the profit maximizing rule no matter

what the market structure.

Before Going into defiles in any of the Different Market Structures, our main rules are:

Average/Marginal cost curve do not change in any market stature

The Profit maximization Rule is the quantity in which the firm produces maximum Profit,At marginal revenue equals marginal cost. (MR= MC)

MR Curve is different from one market stature to another


34/51

Market Structures Summery

Now, cost curves are always going to look the same, but other elements, like price, revenue, anddemand, will differ depending on the market structurethat the business operates in.

Are there other lots of producers, or only a few? Is my product just like everyone else or is it unique?

The characteristics of a market will clue you in as to the type of market structure you're dealing with.Really there is a continuum of market structures, letstake a look.

Perfect Competition, at one extreme, we have Perfect Competition.

Perfect Competition Characteristics

Large number of producersmeans that there are so many competitors that each one is too small toaffect the market.

Since nothing you do affects the market, no one really cares what you do, and you are free to makedecisions without worrying about how the competition will react.

Producing exactly the same thing orthe product is identical-- or homogeneous, or non-differentiated

Itseasy for firms to come and go from the industry that is, there is free entry and exit.

Think about it. This industry has lots of producers. Why? Because it's easy to get in and set up shop.In an industry like this -- lots of producers, all producing exactly that the same thing how much MarketPower (where market power is defined as the ability to control the price ) does an individual firmhave? None.

You have no ability to drive the price, becauseo Youreso small,o Everyone else produces exactly what you do.


35/51

Monopoly

Now let's take a look at the opposite extreme of the market structure spectrum. Instead of a huge numberof producers, there's only one producer for the whole market, or a Monopoly(the prefix Mono meaningone).

Monopolist Product Characteristics

The Monopolist product is unique; there really are no substitutes for this product. In a monopolistic industry, entry by other firms it nearly impossible due to the extremely high barriers

to entry.

Given all of these characteristics -- only one producer, a unique product, and no one else can get into theindustry to compete with youHow much market power (ability to control price) does the monopoly producer have?

The monopolist has complete control over the price, within the boundaries of what consumers arewilling to pay.

Monopolistic Competition and Oligopoly

Are there other structures? Sure -- in fact, most real-world industries will fall somewhere in the middleground, not at the theoretical extremes of perfect competition or monopoly.Two of these midrange structures are monopolistic competition and oligopoly.

Monopolistically Competitivestructure is still competitive, so there are still a lot of producers; giventhere are lots of producers, We can assume that entry into the industry is easy The products are not exactly the same, (Highly similar, yes; highly substitutable, yes; but not

identical.

Oligopoly(the prefix Ol imeans Few, so I'll have

Few large producers making up the market, each with a large amount of control, or market power.There are some.

Barriers to entry, so it's hard, but not impossible, to get in. The product in an oligopolistic market can be identical, like the members of OPEC who produce oil,

or differentiated, like car manufacturers

The key is that there are few enough producers that each one has a fairly large chunkof the market;large enough that any individual producer can affect what happens in the market.

Because everyone's actions matter, the producers become mutually interdependent; whatever one doesaffects everyone else.

This mutual interdependence actually makes the oligopoly the most complicated type of market structureto operate in.


36/51

Summery Comparison

Market Structure Perfect

Competition

Monopolistic

Competition

Oligopoly

Monopoly

Number of Producers Huge 20 and Up 2 to 20 One

Barriers to Enter and Exit the

Market

Easy So Difficult

Homogeneity of Products Homogeneous Differentiated : Real andImaginary Differentiation

Dose Not Apply

Need For Advertising No Need Yes Yes No Need

Interdependent Between Film No No Yes(StrongFirms haveto keep eyeon eachother)

Not Apply

Summitry of Information

(Same information betweenBuyer and Seller )

Yes High asymmetry


37/51


38/51

Note that this also means, because the firm charges P* regardless of the quantity demanded,That P* represents the Firm's Demand, as well.

The Demand is in the Perfect CompetitionPerfectly Elastic Demand, whereconsumers are sohypersensitive to price that price is

A perfectly competitive firm may notbe able to choose its price,But the firm owner will choose the level of output that will maximizehis/her profits

You will always choose the level of output were marginal revenue equals marginal cost:

Let start with Marginal Revenue:

Marginal revenue is the additional revenue that you earn when you sell an additional unit of

output.

For a perfectly competitive firm, since all units are sold for the same price, each unit sold alwaysadds the same amount of revenue, P*.

For example, if price is $5, then the total revenue for zero units is $0, for one unit is $5, for twounits is $10, and so on. Selling one more unit generates five additional dollars of revenue eachtime.

Therefore marginal revenueis equal to the equilibrium price. MR=P*

Note that this is only true for perfect competition.

Marginal cost:

Those cost curves in the same regardless of the structure wereoperating in.

This means that the marginal cost for the perfectly competitive firm is just marginal cost


39/51

Marginal Revenue and Marginal cost Curve for a Perfect Competition Market

Now all we need to do is select the level of output were marginal revenue equals marginal cost.

Now, because there are no average cost curves in this diagram yet, I can't actually show you how large orsmall the profits are ; only that q* will be the best level of output for this particular producer, based on theprofit-maximizing rule.

Let's look at just one example of how to find profit using this model,

What if my perfectly competitiveproducer is operating in an industrywhere price is greaterthan the cost perunit?

I can already tell that this producer willbe making profits,since there's morecoming in for each unit than there isbeing paid out in cost, but let's see whatit looks like.

Notice that I positioned the average costcurves below the price line.

Where is MR = MC? This gives me q*. At q*, what is the total revenue coming in?


40/51


41/51

Different Examples of Profits or Losses Calculations (Comparative static analysis)

Abnormal Profit

Industry Selling Price is Higher than

Average Variable Cost , and Average Total Cost

Normal Profit

Industry Selling Price is Higher than

Average Variable Cost , and Just Equal to AverageTotal Cost

Losses

Industry Selling Price is Higherthan average variable cost , butless than average total cost(Covering all the Variable Costsand part of the total cost)

Losses

Industry Selling Price is Equal toaverage variable cost , but lessthan average total cost(Just Covering the VariableCosts)

Losses

Industry Selling Price is less thanboth average variable cost ,average total cost(Cant Cover Average VariableCosts or total costs )

Note: Sing the market as Perfect Competition may depend on the customer buying behavior or knolege onthe product ) , )

P*=d

P*=d=MR

P*=

P*=d=MR

P*=d=MR


42/51

Monopoly

How will you know a monopoly if you see one?

Single seller, someone who sells a product for which there are no close substitutes,

There are significant barriers to entry, barriers that are so high, in fact, that no other producers can enterthe industry.

What kinds of barriers could there be that would keep competitors out? Patents ( ) would keep others out, at least until the patent expired, or unless you sell the

right to use the idea to other people; Sole ownership of a key resource would prevent competition. Extremely high costs would keep many other producers out; in fact, in the case of extraordinarily high

fixed costs, you can get a situation where economies of scale kick in, and you're actually better off tohave only one producer (as power generation plants)

Natural Monopoly or Atypical Monopoly

In case of Extremely high costs to establish a business (like power generation plants ) So, if there'sjust one company incurring all those upfront costs, that firm can spread the costs out over a largequantity of production, and the cost per unit ends up being very low.

But if you break this company up, creating 10 smaller firms that would compete with each other,each firm must repeat these initial costs, yet has only 1/10 of the customers, in this example. Costper unit ends up being very high.

In a case like this, with huge economies of scale, it's actually more efficient to have only oneproducer, as a natural outcome of the cost structure. This would be a natural monopolyor

atypical monopoly

With a natural monopoly, the enormous fixed costs dominate, so that effectively, the average totalcost curves look like what we're accustomed to seeing in an average fixed cost curve; the moreyou produce, the lower the cost per unit.

This type of monopoly (atypical monopoly)is the exception, though, and not the rule.


43/51

Typical Monopoly

First of all, because the monopoly is the onlyseller of the product, anyone who wants tobuy the product must buy from themonopoly.

This means that the demand faced by themonopolistis the entire industry, or market,demand.

What does marginal revenue look like?

I need to calculate total revenue before I cancalculate marginal revenue, which I do bymultiplying the price per unit times thenumber of units. Then I can address marginalrevenue, or the amount of additional revenue Igenerate by selling another unit.

Since I had NO revenue when my output waszero, the marginal revenue of my first unit is+$10,The second unit adds $8 to revenue; the third

adds $6, and so on.

Notice that, unlike perfect competition, themarginal revenue figures are less than theprices. If I plot out the numbers for demand andmarginal revenue, you can see the contrast.

I use the price and quantity figures to plotdemand, and the marginal revenue and quantityfigures to plot the marginal revenue curve, so I

know that generally demand and marginalrevenue look like this.


44/51

To determine the monopolist's chosen output,though,I need to be able to find the output at whichmarginal revenue equals marginal cost;

so I also need to add a marginal cost curve.Because marginal cost looks the same, no matterwhat the market structure is, (all I need to do is add

our usual J-shaped marginal cost curve to theexisting diagram.)

Now I can see the monopolist's profit-maximizingoutput, Q*.

We don't know the monopolist's price yet.

To find it, you have to remember that this producercan raise the price as high as the consumers arewilling to pay.

Since the demand reflects the buyers' willingness topay,

I go up to the demand curve to see what price I canget for these Q* units of output.

Q* is the monopolist's profit-maximizing output.P* is the price that can be charged for that output.

What's the monopolist's profit, this can be done byadding the average cost curves

A Monopolist who is earning a positive profit. Thismeans that the price must be higher than the costper unit.

Remember that price times quantity yields yourtotal revenue (in green), Average total cost timesquantity gives your total cost (in red) , Theremaining area that I have here in blue is the firm's

profit.


45/51

What happens the monopoly's profit in the long run? I mean, if a competitive firm makes a profit in theshort run, then over time, other firms enter, and profits go to zero.

So what happens to the monopolists profit? Nothing happens. Remember the barriers to entry? Thosebarriers keep competitors out, protecting the monopolist's profit.

Does the monopolist necessarily earn profit?

No; just because you're the only producer of somethingdoesn't guarantee you'll earn a profit.

If the cost per unit exceeds the price, you'll be losingmoney just like any other business owner.

What'll happen in the long run? Any producer who'slosing money in the short run will get out in the longrun, taking his/her resources elsewhere.

Where does this leave industry?If this producer leaves, there isno industry.

Why do so many people consider the monopolist to be the bad guy?This is just a producer, trying to maximize profits like any other producer , Most people are opposed to amonopoly because they prefer the alternative, competition.

If this were a competitive market, instead?

Remember that in a competitive market, the

market supply and the market demand determinethe price and quantity.

We know already that the monopoly faces theindustry, or market, demand;

Where's the industry supply? The marginal costcurve, as long as we're above that minimumaverage variable cost, is the monopolysupply.

And since the monopolist is the only supplier, it's

also the industry supply.

The intersection of industry supply and industry demand yield the price and quantity that we'd see

if this were perfectly competitive market.

Why do people consider the monopolist to be the bad guy?Because the monopolist charges more, and provide less product.The Once who don't like the monopolist are the consumers, who wouldrather see the lower prices and greater quantitiesassociated with acompetitive market


46/51

Monopolistic Competition

As the name of the structure suggests, it'ssomething a mash up of the characteristics of aperfectly competitive market and those of amonopoly market.

I t' s Competi tive, so, like perfect competition, there is large number of sellers a large enough number sothat no individual can affect the overall market, there's free entry and exit; firms find no substantialbarriersto entering or departing this market.

Moving the Direction of the Monopoly, the monopolistic competitors s product is differentiated; thisproduct differentiation gives the monopolistically competitivefirm a small amount of controlover theprice it can charge.

Not a lot of control, because the products are still highly similar, but a little control.

Differentiation may beReal or Artificial, where there are physical differences in the products. It ispossible in this market structure to have artificial differentiation, where two products are physicallyidentical, but through marketing (say, attractive packaging, or celebrity endorsements), consumers areconvinced that the products are different.

In a monopolistically competitive market, perfect information does not exist, and consumers can befooled into believing that products are different by the use of advertising and marketing.

In the end, as long as consumers perceive the products to be different, then the products are different; itdoesn't matter whether the difference is real or artificial.

What does the market look like?

The demand facing each producer will be asmall fraction of the overall market demand.And the demand will be elastic.

The monopolistically competitive firm'sdemand will be downward-sloping, if fairlyflat, showing that the firm has a small amountof control over its price.

From here, you can treat the graph much asyou treated the monopoly graph. With adownward-sloping demand, the firm'smarginal revenue will lie below its demandcurve.


47/51

To find the profit-maximizing output and

price for the firm,

we need to add the marginal cost curve,determine where marginal revenue equalsmarginal cost to get the optimal output, q*,

And then use the demand line to determinehow much the firm owner can get the buyersto pay for those q*units.

Like a monopolist, a monopolisticallycompetitive firm could make money, losemoney, or break even in the short run;

But like perfect competition, the picture will changelong run the firm will end up just breaking even overtime.

Why? Because not only does the firm have very littlemarket power, remember also the assumption of freeentry and exitIf a monopolistically competitive firm is making aprofit in the short run, then other firms will see thatprofit, and they will enter the industry.

This will draw away some customers from the existingfirm, lowering demand, and eventually the existing firmwill just break even.

If profits still exist, new firms continue to enter untilthere are no more profits to be had.


48/51

What if the firm is losing money in the short run?

In the long run, then, some firms will leave; theircustomers will have to shift other sellers,

So that the remaining firms will see their demandcurves increase until such point as they can break even.

At that point, exit from the industry stops.

So in the long run, like the perfectly competitive firm,the profits are driven to zero.

There is an important difference

The perfectly competitive firm in the long run always ends up operating at the most efficient point, that is,the lowest per unit cost on the long-run average total cost curve.

Whereas the monopolistically competitive firm always operates just shy of peak efficiency, operating at aslightly higher cost, and producing fewer units.

To wrap up, let's do a quick recap of this market structure as compared to perfect competition and

monopoly. There are a large number of firms, more like perfect competition; with respect to the productproduced, it's not identical across firms, as with perfect competition, but neither is it unique.

The products are differentiated, but highly similar and therefore highly substitutable. Entry and exit are easy, which affects the ability to sustain profits. All types of firms use the MR=MC rule to maximize profit, and any firm could make money, lose

money, or break even in the short run. But in the long run, only a firm with barriers to entry to protectits profits can sustain those profits.

What about price and output? The result will be somewhere between the two extreme structures --producing more than a monopoly but less than perfectly competitive market; charging less thanmonopoly but more than perfectly competitive market.


49/51

Oligopoly

We've reached our final, and our most complex, market structure: Oligopoly.

In an oligopoly, you would find only a small number of sellers, that is, few enough so that anyindividual seller can affect the market, and the firm's actions will have an impact on all the other

sellers.

The product can be either the same, like oil, or differentiated, like automobiles,

There are fairly high barriers to entry.

What will prices and output look like? What is the potential for profit?

The oligopoly market structure will result in a higher pricethan either competitive market, although notso high as a monopoly, and will be able to maintain some profit, if it exists, into the long run because ofthe barriers to entry.

Why the oligopoly most complex, market structure?Well that's because the actions of any one firm will have an impact on all of the other players in themarket, This mutual interdependence among firms means that each firm keeps an eye on everyone else,

trying not only to anticipate moves but also to have their own reaction plan in place.

The oligopolistic firm's Demand:

This demand (kinked Shape) is effectively composed of twodifferent demand curves, because the game-playingbehavior,If you will, of the firms in this industry will changedepending on whether the firmis implementing a price increase, or a price decrease.

When the oligopolistic firm goes to increase its price:The rivals will not follow; they will let that one firmincrease its price, and then they will gain the customers

as buyers are driven away by the initiating firm's higher

prices.

What this means for the firm is that, if it raises its price,and no other producer follows suit, Then the initiating

firm will see a large decrease in quantity demanded.

i.e., the demand is more elasticwhen the firm attempts to

increase its price.Well, what if the firm lowers its price? The rivals are awarethat they could lose substantial market share if they do notfollow along and lower their pricesas well,

What happens if everyone lowers prices? The firm thatinitiated the price decreasewould see very little changeinquantity demandedbecause, for the most part, customersstay where they are; that is, the demand faced by thefirm is inelastic when there is a price decrease.


50/51


51/51

If the firm makes money in the short run, the barriers to entry help to protect these profits, even in thelong run.Remember, in an oligopoly market structure it is difficult, but not impossible; to enter the market, so theremay be some loss of profit to new rivals over time.

If the firm loses money in the short run, it will exit the industry in the long run, leaving behind morecustomers for the rival firms.

So, in the end, how does the oligopoly compare to the other market structures?

The oligopolistic firm can maintain profit into the long run, but the profits earned aren't quite as high asthe monopoly could earn.

Collusionhappens when the firms of an oligopolyget together and attempt to act like a single largefirma monopoly in order to boost their profits.

Documents

Managerial Economics - My Notes Micro_Rev17