#Introduction
Definitions
· Microeconomics – Study the economic decisions at the individual, firm, or industry level, and with particular markets, specific goods and services, and product and resource prices.
· Market – Where goods and services are sold.
· Industry – The combination of firms that produce a good or service.
Microeconomics is concerned with how markets and industries function and how prices and output levels in an industry are reached. It is also concerned with output and pricing decisions by individual firms (businesses) that operate within an industry or market.
The terms ‘industry’ and ‘market’. Must be understood:
The Demand Curve
· Demand – The quantity of goods and services consumers want to purchase, at various price levels, for a specified period.
· Quantity demanded – The number of goods and services consumers want to purchase at a specific price over a specified period.
· Demand curve – A line on a graph with axes of quantity and price showing demand.
Example 1: Quantity Demanded
The following table shows the demand for product X in Market A for the week:
Price $
Quantity demanded
5
40
6
37
7
32
8
30
If the price of Product A is $5, the quantity demanded by the market is 40.
If the price of Product A is $6, the quantity demanded by the market is 37.
Note that demand falls as the price rises.
The Law of Demand
Key Point
Demand has an inverse relationship with price.
· If prices rise, demand falls.
· If prices fall, demand rises.
· Price is the determinant of demand.
For normal goods, demand is higher when the price is lower.
This is consistent with common sense; higher prices mean buyers must sacrifice more to obtain the good. Some will not purchase as they cannot accept that price.
When prices are low, the good is affordable to more buyers, increasing the quantity demanded.
The demand at various price levels can be shown on a graph:
Element
Description
Price
Y-axis
The determinant of demand.
Quantity
X-axis
The number of units demanded.
Demand curve
Chart line
The quantities demanded at various price levels presented as a line.
The curve’s downward slope shows the inverse relationship between price and demand.
For simplicity, the line in this graph is straight.
P, P1
Price level.
P1 is higher than P. (movement along the demand curve).
Q, Q1
Quantity demanded.
Q1 is lower than Q.
The law of demand dictates:
· Higher prices lead to lower demand (contraction)
· Lower prices lead to higher demand (expansion)
· This is shown as movement along the demand curve.
Shifts in Demand Curve: Determinants of Demand
The determinants of demand shift the entire demand curve left or right, meaning that demand changes despite prices remaining unchanged.
A shift in the demand curve means that demand has changed even though prices remain unchanged.
For example, if demand for a good at $10 has changed from 10,000 units to 12,000 units, the demand curve has shifted right.
For example, if demand for a good at $10 has changed from 10,000 units to 8,000 units, the demand curve has shifted left.
Determinant
Example
Consumer tastes
Preferences of consumers on the desirability of a product (trends and fads).
Marketing can influence the perception of consumers.
RKS Co has had a successful online marketing campaign that significantly increased demand for its cakes.
Judy’s friends have influenced her to buy more organic food.
All the kids in school want to own TS Co’s new game.
Number of buyers
Changes in the number of buyers in the market influence demand
More buyers increase demand.
Fewer buyers decrease demand.
There is less demand for businesses in Village X because its population has been decreasing.
Significant immigration from Country A to B has increased demand for Country A’s products in Country B.
Income levels
Changes in the level of income affect demand.
Different goods types have varying sensitivity to income levels:
Normal goods experience higher demand with higher income levels.
Inferior goods experience lower demand with higher income levels.
As income levels of country A increase, sales of the lowest grade of white rice has declined as consumer opt for higher-quality imported varieties.
Higher income levels have led to significant increases in spending on tuition and enrichment activities for children.
Price of related goods
The prices of related goods impact the demand curve:
A substitute is a good that can replace another good in satisfying needs.
If prices of substitutes decrease, demand for the good decreases as consumers choose the cheaper alternative.
A complement is a good consumed together with another good.
If prices of complements decrease, demand for the good increases as they obtain better value from consuming the goods together.
When cars are cheaper to buy and own, consumers drive more and use less public transport and taxi services.
When petrol is cheaper, consumers drive more, as the cost of travelling via motor vehicle is lower.
When butter prices increase, consumers may switch to alternatives like margarine.
Consumer expectations
Consumers ‘expectations of price and income in the future affect current demand.
Higher expected prices increase current demand.
Higher expected income increases current demand.
Fearing a shortage of coffee beans due to bad weather in source countries may lead to higher prices; consumers buy more coffee beans now.
Joey buys a new watch in anticipation of the bonus he’s expecting to rec
Activity 1 Substitutes and complements
Complete the statements correctly.
Statement
An increase in the price of a complement…
A fall in the price of a substitute product…
An increase in the price of a substitute product…
A fall in the price of a complement…
…will result in a fall in demand for the other product as it will be less attractive to consumers. So, if butter prices fall, the demand for margarine will also drop as people switch to buying the now less expensive butter.
…will result in a fall in demand for both products as their demand curves are linked. So if the price of vehicles rises, fuel demand will decrease as people buy fewer vehicles.
…will increase demand for both products as their demand curves are linked. So, a fall in the price of cars will increase the demand for fuel as more people purchase and drive cars.
…will increase demand for the other product as it will be more attractive to consumers. If the price of butter rises, margarine demand will also grow as margarine is now relatively inexpensive compared to butter.
*Please use the notes feature in the toolbar to help formulate your answer.
Activity 2 Substitutes and complements
Determine whether the goods are substitutes or complements of each other and what would happen to demand if the price of one of them increases.
Goods
Substitute or complement
Change in demand if the price of other good increases.
Increase or decrease
Train journeys and car journeys (petrol costs)
Hammers and nails
Fresh food and frozen food
Electronic book readers and electronic books
Bedsheets and pillowcases
Veblen and Giffen GoodsUsually, demand for goods and services increases as prices fall, or decreases as prices rise, leading to the downward-sloping demand curve discussed above. There are, however, two types of goods where demand increases as prices rise. These are Veblen goods and Giffen goods.
Veblen Goods
Veblen goods are luxury goods where demand increases as the price rises. The name comes from the American economist Thorstein Veblen, who wrote about the concept of “conspicuous consumption” in the late nineteenth century. Veblen goods include items such as luxury yachts, luxury cars and jewellery.
There are various reasons why demand for luxury goods rises as the price increases, including:
The snob effect. Consumers believe that the higher the price of the goods, the more status consumption of the goods confers on them.
The belief that higher price equates to higher quality.
Veblen goods have the following characteristics:
Giffen Goods
Giffen goods are basic, low-cost products that are often essential (in contrast to Veblen goods which are luxury products). Examples include potatoes and rice. Giffen goods are named after the economist Sir Robert Giffen who observed the phenomenon among poor families in Great Britain during the Victorian era.
The reason for demand rising as prices rise is the substitution effect. While potatoes were a staple of the family diet, the family may initially be able to afford more expensive goods such as meat occasionally. However, as the price of potatoes rose, the family had less money available to spend on luxuries, so would buy more potatoes instead.
Giffen goods display the following characteristics:
The Supply Curve
· Supply – The quantity of goods and services producers are willing to supply, at various price levels, for a specified period.
· Quantity supplied – The number of goods and services producers are willing to supply at a specific price over a specified period.
· Supply curve – A line on a graph with axes of quantity and price showing supply.
Example 2: Quantity Supplied
The following table shows the supply for product X in Market A for the week:
Quantity supplied
If the price of Product A is $5, the quantity supplied by the market is 30.
If the price of Product A was $8, the quantity supplied by the market is 40.
Note that supply rises as the price rises.
The Law of Supply
· Supply has a positive relationship with price.
· If prices rise, supply rises.
· If prices fall, supply falls.
· Price is the determinant of supply.
For normal goods, supply is higher when the price is higher.
This is consistent with common sense; higher prices mean producers earn more profit in producing supply. This attracts more producers, increasing the quantity supplied.
When prices fall, producing the good becomes less profitable. Unprofitable suppliers will eventually cease production, reducing the quantity supplied.
The supply at various price levels can be shown on a graph:
The determinant of supply.
The number of units supplied.
Supply curve
The quantities supplied at various price levels presented as a line.
The upward slope of the curve shows the positive relationship between price and supply.
P1 is higher than P. (movement along the supply curve).
Quantity supplied.
Q1 is higher than Q.
The law of supply dictates:
Higher prices lead to higher supply (expansion)
Lower prices lead to lower supply (contraction)
This is shown as movement along the supply curve.
Shifts in Supply Curve: Determinants of SupplyThe determinants of supply shift the entire supply curve left or right, meaning that supply changes despite prices remaining unchanged.
Input prices
Prices of inputs, including machinery, rent, materials, labour, etc., affect supply.
Higher input prices decrease supply
Lower input prices increase supply.
This includes the effects of government intervention (taxes, subsidies, etc.) on inputs.
Lower input costs due to increased production of joint product supply will also increase supply.
Strengthening exchange rates allow C Co’s to buy imported materials at lower prices and increase production.
Increased oil production has also increased the available natural gas supply, a byproduct of oil extraction.
Government grants on labour recruitment have allowed Tuny Co to increase production.
Technology
Improvements in technology enable producers to make more supply with lower marginal cost.
The installation of an automated production process significantly reduced the cost per unit of R Co’s products and increased its production speed.
Prices of production substitutes
A production substitute is an alternative good the producer can supply.
Prices of production substitutes affect supply:
Higher prices of production substitutes reduce supply, as more producers make the substitute.
Lower prices of production substitutes increase supply as producers shift away from making substitutes.
SUVs enjoy higher selling prices than sedans, so BRD Co has shifted production to making more SUVs.
There is a glut (oversupply) of iron bars on the market, so J Co has shifted its production from making iron bars to aluminium parts.
Producer expectations
The producer’s expectation of future prices will affect the current supply.
The reaction to expectations of higher prices varies:
Some firms will increase capacity to produce more supply when prices rise.
Other firms may stockpile or withhold current supply to take advantage of higher future prices.
The demand and price of rubber gloves are expected to increase, so QWER Co has invested in additional production facilities.
Increasing diamond prices have caused DB Co to withhold its stockpiles from the market, maintaining low supply and high prices.
Number of sellers
The greater the number of sellers, the greater the supply.
There are many producers of electronic components in City Z, making it the place to go for low-cost quantities of these parts.
Price Equilibrium
· Equilibrium price – The price level at which quantity supplied and demanded are equal.
· Equilibrium quantity – The quantity at a specific price level where demand and supply are equal.
In theory, the market price should be at the equilibrium price.
However, there may be a shift in the demand curve or the supply curve for a product. When this happens, the equilibrium price and quantity will change.
Change
Equilibrium price change
Equilibrium quantity change
Demand curve shifts left
Lower
Demand curve shifts right
Higher
Supply curve shifts left
Supply curve shifts right
Activity 3
Determine whether the statements are true or false.
True or False
The demand curve shows the total quantity of bread people bought at each price.
There is an increase in labour costs at the bakery, so suppliers will now supply less bread at a given price.
The effect of this will be to move the equilibrium between demand and supply to a higher price and higher quantity.
There is a reduction in the costs of ingredients, such as flour, so the bakery can now supply more bread at a given price.
The effect of this will be to move the equilibrium between demand and supply to a lower price and higher quantity.
Shifts in the demand and supply curves will change the equilibrium quantity and price of demand and supply.
Price Elasticity of Demand (PED)
Price elasticity of demand – The extent demand changes in response to changes in price.
Elastic – The rate of demand change is more than the rate of price change.
Unit elasticity – The rate of demand change is proportional to the rate of price change.
Inelastic – The rate of demand change is less than the rate of price change.
The demand for a product or service varies with the price, but by how much does it change?
For example, if the demand for a can of soft drink is 10,000 units each week at a $1 price, how much would demand change if a can’s price went up to $2?
The amount of change in demand for an item, given a price change, can be measured as the price elasticity of demand (PED).
Price elasticity of demand is usually a negative value; By convention, the negative sign is ignored.
Calculating PED
PED is calculated as follows (ignoring signs):
D1 = Quantity demanded at price P1
D2 = Quantity demand at price P2
P1 = Initial price (before change)
P2 = Price after the change
Example 3 Price Elasticity of Demand
The demand for a soft drink per day has been determined as follows:
Demand (bottles)
2.00
10,000
2.10
9,000
What is the PED of the soft drink?
Answer:
P1 = 2.00
P2 = 2.10
D1 = 10,000.
D2 = 9,000
PED = −2, which ignoring the negative sign is 2.
The soft drink’s PED is 2.
· Price elasticity of demand – The extent demand changes in response to changes in price.
· Elastic – The rate of demand change is more than the rate of price change.
· Unit elasticity – The rate of demand change is proportional to the rate of price change.
· Inelastic – The rate of demand change is less than the rate of price change.
D1 = Quantity demanded at price P1
Activity 4
The demand for a snack product per week has been determined as follows:
Demand (packets)
100,000
2.20
95,000
What is the snack product’s PED?
Classifying PED
Ped is classified as follows:
PED Classification
Calculated PED
Elastic
PED > 1
The rate of demand change is more than the rate of price change.
Unit elasticity
PED = 1
rate of demand change is proportional to the rate of price change
Inelastic
PED < 1
rate of demand change is less than the rate of price change.
The demand for the soft drink in Example 3 is elastic (PED of 2 > 1), whereas the demand for the snack product in Activity 2 is inelastic PED of 0.5 < 1).
Activity 5
Determine whether the products below are likely to have elastic or inelastic demand.
Product
Elasticity of demand
Elastic or Inelastic
Smartphones
Luxury cars
Foreign holidays
Essential groceries
Fuel (petrol, diesel)
Giffen and Veblen Goods
Most products or services have a negative price elasticity of demand, because the change in demand is negative when the change in price is positive, and vice versa. By convention, the minus sign is ignored when discussing the price elasticity of demand.
Giffen goods and Veblen goods both have a positive price elasticity of demand, since any increase in the price is accompanied by an increase in demand.
Determinants of PED
Determinant of PED
Substitutability
The availability of substitutes.
More substitutes available means higher elasticity.
Less substitutes available means lower elasticity.
Also affected by ease of change.
There are many brands of mass market candy available on the market, making demand for candy elastic.
There are not many providers of specialist medical advice, so the price of specialist care is inelastic.
Demand for a digital service and associated devices may be inelastic as users find it challenging to transfer their data to another provider and make the switch.
Proportion of income
The price of the good relative to the consumer’s income.
The higher the good’s price relative to the consumer’s income, the higher the elasticity of demand.
The lower the good’s price relative to the consumer’s income, the lower the elasticity of demand.
Most candy is low-priced relative to income, making demand more inelastic.
Cars are a significant expense for most households, as their unit price is higher relative to income.
This makes the demand for cars more elastic.
Luxury or necessity
The stature of the good as a luxury or necessity affects the elasticity of demand.
Luxury goods (goods easily forgone) usually have elastic demand.
Necessities (goods that must be consumed) usually have inelastic demand.
The demand for salt is usually inelastic, as it is a necessity, has no substitutes, and its unit price relative to income is low.
Jewellery and enrichment classes would have elastic demand as consumers may forgo them without significant hardship.
Elapsed time
The period from the change in price to the change in demand.
The longer the period from the price change, the more elastic the demand.
The more durable a good (used for an extended period), the more inelastic the demand.
Consumers already at their favourite restaurant may still eat there after initially finding out about a price increase.
However, they might consider eating elsewhere due to the price change.
Demand for fuel after a price increase is inelastic in the short term as consumers have no choice but to consume it.
Demand for fuel will be more elastic as time goes on as consumers find ways to save fuel.
Cross Elasticity of Demand (XED)
Definition
Cross elasticity of demand – The sensitivity of demand for one good to changes in the price of another good.
Cross elasticity of demand (XED) measures the sensitivity of demand for one good to changes in the price of another good. The cross elasticity of demand (XED) is equal to the percentage change in quantity demanded of good A (ΔDA%) divided by the percentage change in price of good B (ΔPB%).
XED is calculated as:
XED = ΔDA% / ΔPB%
ΔDA% = (DA2 − DA1) / DA1
ΔPB% = (PB2 − PB1) / PB1
DA1 = Quantity demanded of good A when good B is at price PB1
DA2 = Quantity demand of good A when good B is at price PB2
PB1 = Initial price of good B (before change)
PB2 = Price of good B after the change
The key point when looking at PED is whether the figure is greater or less than one (the negative sign being ignored). The key point when looking at XED is the sign (positive or negative). The XED of substitutes is positive and the XED of complements is negative.
Example 4 Cross Elasticity of Demand
The demand for butter (good A) in relation to the price of margarine (good B) has been determined as follows:
Price of margarine $
Demand for butter (kilos)
1.50
8,000
What is the XED between butter and margarine?
PB1 = 2.00PB2 = 1.50DA1 = 10,000DA2 = 8,000
ΔDA% = (DA2 − DA1) / DA1ΔDA% = (8,000 − 10,000) / 10,000ΔDA% = (−2,000) / 10,000ΔDA% = −0.20
ΔPB% = (PB2 − PB1) / PB1ΔPB% = (1.50 − 2.00) / 2.00ΔPB% = (−0.50) / 2.00ΔPB% = −0.25
XED = ΔDA% / ΔPB%XED = −0.20 / −0.25XED = 0.8
The XED between butter and margarine is 0.8. This is positive because butter and margarine are substitute products. In the above example, when the price of margarine falls by 25%, the demand for butter falls by 20%. This is because when the price of margarine decreases, the demand for margarine increases (because it is cheaper), and so the demand for butter falls.
Impact of Elasticity of Demand on Revenue
Example Price Elasticity
An increase in price when demand is elastic will lead to decreased revenues.
An increase in price when demand is inelastic will lead to increased revenues.
Revenue is calculated as follows:
Revenue = P × D
P is price
D is demand
Activity 6 Impact of PED on revenue
Determine whether the demand is elastic or inelastic and the $ change in total revenue after the price change.
Scenario
PED
Elastic or inelastic
Change in total revenue after price change
The demand for a t-shirt is 10,000 t-shirts at $20 each. If the price increases to $22, demand will fall to 9,500 t-shirts.
The demand for a fashion magazine is 10,000 copies at $5 per copy. If the price is reduced to $4, demand will rise to 15,000 copies.
Demand for a coffee mug is 20,000 at $5 per mug. If the price is reduced to $4.50, demand will rise to 21,000 mugs.
Economic Resources (Factors of Production)
An economy’s production possibility (maximum output) is limited by its available economic resources (factors of production). Generally, there are four categories:
Economic resource
Cost
Land
All natural resources associated with the land:
Land area
Wind, sunlight, arable soil, etc.
Mineral, metal, oil, and other deposits
Biodiversity (flora and fauna)
Rent
Labour
Work (physical and mental) activities of the local population:
Physical actions (labourer, athlete, masseur, etc.)
Mental activities (design, research, writing, drawing, teaching, etc.)
Wages
Capital
Investment in manufactured assets to produce goods and services.
Factories
Premises
Systems
Inventory
Machinery
Infrastructure
Interest
Entrepreneurial ability
Innovation and initiative of entrepreneurs in taking risks and combining resources to produce goods and services.
Profit
The total economic cost of output is the total cost of land, labour and capital plus the normal profit that business owners expect to obtain.
Including normal profit in cost doesn’t make sense to an accountant, but it is an essential concept in microeconomic analysis.
For an economist, ‘normal profit’ is the profit the firm must generate to ensure the entrepreneur is motivated to continue to work in that industry rather than doing something else with their skills.
This is regarded as a fixed economic cost of production.
Average and Marginal Cost
Average and marginal cost must be understood to understand the output (supply) decisions of firms
Average Cost
Average cost (AC) – The average economic cost of output per unit.
Average cost is calculated as follows:
Average cost = Total economic cost of output / Total output
Marginal Cost
Marginal cost (MC) – The incremental economic cost of producing an additional output unit.
Marginal cost (MC) is usually calculated as follows:
MC = Total costn+1 – Total costn
n is the number of output units.
Example: Average and marginal costs
The following information on the production of a good is available:
Output (units)
50
51
Total cost $
500
503
Calculate the average and marginal cost of the good from the above data.
Average cost ($/unit)
10.00
$500 / 50
9.86
$503 / 51
Marginal cost ($/unit)
NA
3
$503 – $500
Activity 7
The following information on the production of televisions is available:
1
2
4
110
210
306
410
520
Calculate the average and marginal cost of televisions from the above data.
Law of Diminishing Returns
Short-run – Economic state in the short-term where the supply of at least one factor of production is fixed.
Long-run – Economic state where the supply of all factors of production is variable.
The law of diminishing returns
In the short run, as output increases, the marginal cost of output (MC) will eventually increase (efficiency declines) at some point.
This will eventually affect the average cost per output unit (AC).
MC < AC AC reduces with additional output
MC = AC AC minimum.
MC > AC AC increases with additional output.
Example Diminishing Returns
Fixed amount of capital
Assume a small pizza restaurant has one oven for making pizzas.
In the short term, it can’t obtain any more ovens, but labour is in unlimited supply.
Increasing returns
The restaurant can hire more employees to work with and around the pizza oven.
By dividing the task by function – making the base, adding toppings, looking after the oven – or increasing the number of staff in the restaurant, efficiency will be improved – so that more pizzas can be made.
The return obtained from each additional worker (each additional unit of the factor of production in unlimited supply) improves. Increasing returns occur when this happens.
Diminishing returns
After a certain point, increasing the number of workers to increase total output becomes less effective.
Workers get in each other’s way. The efficiency of each additional worker is less than the efficiency created by the previous one.
The marginal cost of labour starts to increase, and diminishing returns occur, eventually increasing the average cost per pizza.
The law of diminishing returns states that when at least one factor of production is in fixed supply in the short term (in this case, the pizza oven), adding extra quantities of the variable factors of production (restaurant employees) will improve efficiency up to a certain point – more pizzas can be made.
However, after that, the extra output obtained from each additional unit of the variable factor will fall. The marginal cost of output will rise, and eventually, average costs will increase too.
When the law of diminishing returns applies, there is a relationship between marginal cost and average cost.
Example Relationship between AC and MC
Assuming a fixed amount of capital, the MC reduces, then eventually rises with increasing output.
This can be plotted on a graph as a U-shaped curve.
Up to a point, the reduction in marginal cost per unit causes AC to decrease.
AC will decrease as long as the MC is lower than the AC.
MC < AC AC reduces with additional output.
When the MC is higher than AC, AC will increase with every additional unit produced.
The average cost per unit is minimised when MC is equal to AC.
Long Run Costs
Economies of scale – State where the average cost per unit (AC) reduces with increasing output.
In the long term, it is assumed that all the factors of production – particularly labour and capital – are variable. So the capacity of a factory can be increased by adding an extension. The restriction on one or more factors of production does not apply in the long term, and a firm can acquire as much extra capital, land and labour as it wants.
Economies of Scale
Firms can reduce their costs, in the long term, by growing in size and increasing their output. This is because a larger firm can obtain economies of scale. Economies of scale mean reductions in average costs by getting bigger.
Economies of scale (also called increasing returns to scale) can be achieved in several ways.
Method
Labour and managerial specialisation
As a firm gets bigger, there is greater scope for specialisation in jobs and functions being broken down into smaller components, with some tasks being performed by experts.
Workers may become experts at a single task, significantly increasing their throughput.
Managers may be assigned the optimum number of staff to supervise rather than being under or overworked.
As a result of specialisation (utilising experts, for example), efficiency improvements can be made, reducing average costs.
A small firm may have one or two accountants undertaking all the accountancy functions – they may be generally proficient but not an expert in any one field within the discipline of accountancy.
In a large firm, there may be a specialist treasury management expert.
This expert is quicker and better at managing treasury issues than a generalist.
Efficient capital deployment
Large firms have the volume to utilise the most efficient methods and techniques of mass production, further reducing costs.
A robotised and automated production system will have superior efficiencies to manual methods, but only if the output volume is significant enough to absorb the high fixed costs.
Technological improvement
Larger firms can afford to buy and use more efficient or more technically advanced machines. These are capable of producing more output for lower average costs.
A firm must be of sufficient size to successfully invest in expensive cutting-edge technologies and have enough lead time to train its staff and deploy those technologies.
Smaller firms might find the systems too expensive or require too much retraining and investment to deploy.
Bulk purchasing
Larger firms have the financial capacity to buy materials and other supplies in larger quantities. Such buyers are usually able to negotiate bulk purchase discounts, reducing average materials costs.
A sizeable integrated developer can buy bricks more cheaply than a local building firm.
Lower cost financing
Firms often borrow money to finance their business activities.
Banks often lend to more prominent companies at a lower interest rate than they charge on loans to smaller businesses.
This will be based on an assessment of risk.
A large enterprise may be able to borrow money more cheaply than a small family firm.
Spreading fixed costs
Many overheads and other costs for a firm, such as administration and marketing, may be fixed; they stay at the same amount as output increases.
As output increases, the fixed overhead cost per unit produced will fall.
When a factory makes more output, more units are available to absorb the cost of rent and factory overheads, reducing the average cost per unit.
Large operation efficiencies
Improvements in cost are achievable by growing the firm’s size so that average costs fall as output increases.
On a farm, a two-hundred-hectare field will be more economical than a two-hectare field for producing wheat; for example, specialised machinery can be afforded to gather and process the grain more efficiently.
Activity 8
Determine if the statements are true or false.
True or false
In a competitive industry, firms should seek to minimise their average short-run costs.
A firm can reduce its average costs over the long term by growing in size and achieving economies of scale.
Returns to Scale
· Constant returns to scale – Average cost per unit is constant with increasing output.
· Diseconomies of scale – State where the average cost per unit (AC) increases with increasing output.
Increasing Returns To Scale (Economies Of Scale)
At first, a firm can reduce its costs by increasing in size for reasons that have been explained.
An example might be a factory that buys a second machine to increase production when the factory is large enough with sufficient workers to house and use the machine effectively.
Constant Returns to Scale
A firm will eventually grow to a size where there are no more efficiencies and improvements to be gained by getting bigger.
Although the firm might grow, average costs stay the same.
For example, a firm may invest in a factory to further increase output capacity; the marginal costs of the second factory (rent, labour, etc.) are proportional to the increase in output.
Diseconomies of Scale
As a firm continues to grow, losses in efficiency start to occur.
The main problem is that a firm can grow to a size that is impossible to manage effectively. It becomes too big to control properly, so by increasing even more prominent in size, average costs over the long term begin to rise.
For example, building a second factory on a different, remote site rather than on the same site as an existing factory may mean hiring more managers and administrators to manage the plant and provide a second canteen and other services.
The result may be higher fixed costs which increase the average production cost.
Activity 9
The table below shows the total output that can be produced as a firm gets bigger and takes on more labour and capital.
Input resources
Output volume
(number of sheets washed)
1 unit of labour, 1 unit of capital
120
2 units of labour, 2 units of capital
300
4 units of labour, 4 units of capital
800
8 units of labour, 8 units of capital
1,600
16 units of labour, 16 units of capital
3,000
Given the above information, describe the returns to scale for the scenarios below as either:
Economies of scale
Constant returns to scale
Diseconomies of scale
Returns to scale
Between 1 and 2 units of labour and capital.
Between 2 and 4 units of labour and capital.
Between 4 and 8 units of labour and capital.
Between 8 and 16 units of labour and capital.
Marginal Revenue
Marginal revenue (MR) – The incremental revenue earned from selling an additional unit.
Commercial firms seek to make a profit.
In microeconomic analysis, it is assumed that a firm will always seek to maximise its profit. To maximise profit, a firm’s output volume should be at the level where profits are maximised.
Marginal revenue (MR) is calculated as follows:
MR = Total revenuen+1 – Total revenuen
Example Marginal Revenue
1. Constant selling price
If a firm can sell all its output at the same price, the marginal revenue is the selling price.
For example, if a firm can sell every unit it produces for $2 per unit, the marginal revenue per unit is the selling price, $2, at all output and sales volumes.
A firm sells everything at the same price
Demand
Total revenue
Marginal revenue
$2.00
$2 – $0
$4.00
$4 – $2
$6.00
$6 – $4
$8.00
$8 – $6
If a firm has to reduce its selling prices to sell more output, the marginal revenue will fall as output and sales increase.
A firm reduces its prices
$2.00 – $0
$1.95
$3.90
$1.90
$3.90 – $2.00
$5.70
$1.80
$5.70 – $3.90
$1.85
$7.40
$1.70
$7.40 – $5.70
Profit Maximising Rule
· Profit Maximising Rule
· Profit is maximised when marginal cost equals marginal revenue.
· MR = MC Profit maximised.
Profit is maximised when MC = MR.
Activity 10
The above graph shows three lines, which represent marginal cost, short-run average cost, sales price or marginal revenue, for a market where firms can sell all their output at the current market price to maximise profit.
Match the description side with the corresponding letter indicating the graph’s lines.
Line
(A, B, or C)
Sales price
Short-run average cost
Marginal cost
Perfect Competition
Microeconomics is affected by many market factors. It is often necessary to ensure that some aspects are held constant.
The concept of perfect competition assumes certain factors are consistent in the market:
Factor
Number of firms
There are many firms of similar size in the market, all competing with each other.
There is no dominant firm.
There are many fruit sellers of similar size in the local market.
All firms sell identical homogeneous products.
There are no differences between products – the product is standardised (without differentiation).
All the fruit sellers in the market sell the same kind of banana.
Firms must sell their output at the current market price.
Demand will drop to zero at higher prices as consumers buy their goods from other sellers.
Demand is unlimited at the market price.
Marginal revenue for firms is the same at all levels of output.
The market’s fruit sellers will all aim to sell their fruit at the market price.
If they increase their prices above this level, their sales will drop drastically as consumers will buy from neighbouring stalls at the market instead.
Information
All firms and consumers have perfect knowledge about the market (‘everyone knows everything’), particularly the prices being charged. Consumers will buy at the lowest price obtainable.
The market’s fruit sellers and buyers all have perfect knowledge about the product and prevailing prices.
Free entry and exit
Firms may freely enter and exit the market. There are no market barriers.
Any new fruit sellers can set up shop at the market, and any existing fruit sellers are free to leave.
The Equilibrium Price in Perfect Competition
In perfect competition, firms are price takers, meaning they will sell all their output at the market price. A horizontal demand curve shows this.
It also means that marginal revenue (MR) is the market price.
Note that “normal profits” are already included in MC.
The prospect of “super-normal” profits attracts more suppliers to the market, increasing supply and lowering the equilibrium price to the point that super-normal profits are no longer made.
If firms are inefficient, MC =MR may occur at an output level where AC is higher than the market price, incurring losses for them. This will lead to an exit of firms from the market, reducing supply and increasing equilibrium price to the point that losses are no longer made.
Therefore, in the long run, in a perfect competition market,
MC = MR = AC = Market price
This is where AC is minimised, and only normal profits are made.
Imperfect Competition
Imperfect competition is any market structure that does not satisfy the definition of perfect competition.
Almost all markets are in some form of imperfect competition.
Monopoly
Monopoly – A market structure for which there is a dominant single seller.
A vital characteristic of a monopoly is that consumers have no substitutes for the good or service; they must buy from the monopolist.
This allows a monopolist to be a price-maker, meaning it can set what price it wants (demand would be inelastic).
Higher prices and the lack of alternatives allow the monopolist to generate super-normal profits at the expense of consumers. It may also lead to shortfalls in supply, as the market price is higher than the equilibrium price, pricing many consumers out.
To sustain a monopoly market structure, significant barriers to entry must prevent additional supplies from entering. These include:
How A Monopoly Makes Super-Normal Profits
Because a monopoly dominates the market, the demand curve of the entire market is the demand curve for the monopolising firm. This means that a monopoly can generate more revenue only if it reduces prices for all products sold on the market.
This means that a monopoly’s marginal revenue curve slopes below its demand curve, as the firm has to reduce the price of the marginal unit and all the units it wants to sell (the entire market).
The marginal cost curve of a monopoly slopes upward.
The profit maximising output is when MR = MC. This is usually at a point before shortrun AC is minimised (intersection between AC and MC).
This means the monopoly earns super-normal profits (AC < P) by charging higher prices and producing less, compared to a perfect competition market structure (AC = MC = P).
Remember, in economics, normal profit is already included in economic costs.
If AC is less than the price paid by consumers, the firm is earning super-normal profits.
Note that monopolies will set the profit-maximising price (MC = MR), not the highest price.
Some governments own monopolies as the only way to reduce AC low enough for consumers to afford (public utilities, transport infrastructure, etc.).
The government will regulate state-owned monopolies to ensure that prices remain affordable and that sufficient supply is available for consumers.
Governments have regulations to prevent firms from becoming monopolies; remedies include forcing them to break up, sell part of their operations, or pay compensation to disadvantaged firms.
Activity 11
Choose the correct characteristics that give rise to a monopoly market structure.
Characteristic
Option 1
Option 2
Number of suppliers
Many
One
Monopolist’s relationship with price
Price-maker
Price-taker
Barriers to entry
High
Low
Availability of substitutes
Oligopoly
Oligopoly – A market structure where there are a few dominant sellers. Collusion and interdependence may exist.
Some features of an oligopoly market structure, with examples from an air route flown by three airlines, include:
Feature
Market influence
Because just a few firms dominate the market, each firm has considerable influence, including output and prices.
Because there are only three airlines for the route, they influence how many flights to run and how expensive the ticket fares should be.
Oligopoly firms try to stop new competitors from entering the market. They want to retain their oligopoly status. So it is challenging for new rivals to enter an oligopoly market.
The three airlines would block or resist allowing other airlines to arrange flights on the same route.
Keep an eye on rival firms
Oligopoly firms keep a close watch over what the other firms in the market are doing. They are always ready to respond to any competitor’s initiative.
If one of the three airlines starts offering discount tickets, this may affect the business practices of the other two – for example, they may also begin offering discount tickets.
Some product differentiation
Oligopoly firms will try to make their product seem different from their rivals. In other words, they will use product differentiation competition if they can do so.
One of the three airlines might claim that it offers the best food or most comfortable seats on its flights to differentiate from its rivals.
Oligopoly firms react to what their rivals are doing. As a result, they are generally reluctant to raise their prices because they will lose market share. They are usually only willing to reduce their prices if rivals do the same or if it is for a short time to get rid of a new competitor.
As a result, prices in an oligopoly market tend to be stable, with all firms charging the same price for their products.
Activity 12
Three airlines operate in an oligopoly market: Special Airways, Fantastic Airways and Fast Wings Airways.
Choose the other airlines’ reaction to a change made by one of the airlines.
Special Airways decides to increase the prices of its tickets.
What should Fantastic Airways and Fast Wings Airways do?
Raise their prices
Keep their prices unchanged
Special Airways has decided to reduce the prices of its tickets.
What should Fantastic Airways and Big Wings Airways do?
Reduce their prices
This oligopoly market had just three firms – Special Airways, Fantastic Airways and Big Wings Airways. However, a new airline, Cheery Airways, has just entered the market.
What should the existing three firms do?
Monopolistic Competition
· Monopolistic competition – A market structure with a large number of firms competing with each other to become monopolies.
Monopolistic competition exists in a market where there are a large number of firms competing against each other. The firms try to make themselves more like monopolies by differentiating their products from their competitors.
Some examples of monopolistic competition are between car manufacturers and Internet service providers.
In perfect competition, all firms make identical products. In monopolistic competition, firms make a similar product, but all products have different features and prices.
Some features of monopolistic competition, with an example of sandwich shops along a high street, include:
There are a large number of competing firms.
Many sandwich shops on the high street compete for customers
Product differentiation
Firms try to make their products different in some way from those of their rivals.
Doing this gives them some control over the price they can charge.
One sandwich shop may claim to provide higher quality sandwiches than the other because it uses better quality ingredients or offers more variety or creative combinations of fillings.
Advertising
There is often a large amount of advertising for products.
Advertising helps to differentiate products so that customers want to buy them.
Different sandwich shops will use a variety of marketing and advertising mediums to promote themselves.
The barriers to entry into the market are low compared to an oligopoly.
New firms find it reasonably easy to enter the market.
A new sandwich shop on the high street should be able to find customers reasonably easily.
Pricing
Firms have some control over the price they charge for their product by making the product seem different in the perception of customers.
Customers will often be willing to pay more for better quality food. So, one sandwich shop may offer lower prices than the rival firms to attract customers.
Others may raise prices to create the perception of quality over and above what the competition offers. This would be done to target a different group of customers within the market from those that the lower-price competitors would target.
Activity 13
Select the market structure the company is most likely to operate in:
Monopolistic competition
Company
Market structure
Perfume and cosmetics manufacturer
A water utility supplying a specific area
Content streaming services
Major sports teams in a city
Difference Between Monopolistic Competition and Monopoly
In a monopoly, there is one company producing a product that is unique to that company. So, if consumers want that product, they must buy it from the monopoly producer.
In monopolistic competition, many firms produce similar products, which may fulfil the same function but are slightly differentiated from each other.
For example, hairdressers all fulfil the same function but do it in different ways, with differing levels of skill and price. The consumer can choose which hairdresser they want to use.
