Law of demand: The law of demand suggests that given all other factors, an increase in price of a good leads to a decrease in quantity demanded and a decrease in price leads to an increase in quantity demanded.
The one factor that causes a change in quantity demanded is own price of the good.
When price increase from P1 to P2 the quantity demanded declines from Q1 to Q2.
The main factors that cause a change in demand are change in income, change in tastes and preferences, change in the price of related goods, change in distribution of wealth, growth of population, inventions and innovations, advertisement and such other.
An increase in income increase demand and shifts the demand curve to the right. This is shown from the shifts of the demand curve from DD to D1D1.
An increase in price of book reduces the quantity demanded for books. As here is a change in own price, there is no effect on demand.
Law of supply: Law of supply states a positive association between own price and quantity supplied of good. The law states given all other factors constant, an increase in price increase quantity supplied of the good and a decrease in own price decrease the quantity supplied of the good.
The one factor that causes a change in quantity supplied is own price of the good.
An increase in price from P1 to P2 increases the quantity supplied from Q1 to Q2.
Main factors causing a change in supply are natural condition, technical progress, changes in input prices, and improvements in transportation, natural calamities and others.
A decline in input price reduces cost of production and increase supply. This is shown by a rightward shift of the supply curve from SS to S1S1.
Milk is an input in making ice cream. An increase in price of milk thus increase the cost of production leading to a decrease in supply. This shifts the supply curve to the leftward direction. As there is no change in the own price of ice cream there will be no change in quantity supplied.
When there is a decrease in demand for cars, the demand curve for cars shifts to left. This is shown from the inward shift of the demand curve from DD to D1D1. As a result the equilibrium shifts from E to E’. The decrease in demand decrease both equilibrium price and equilibrium quantity. Equilibrium price decrease from P* to P1 and equilibrium quantity decreases from Q* to Q1.
The increase in demand for candy shifts the demand curve for candy to the right. The increase in cost of production reduces supply of candy shifting the demand curve to the left. As there is both change in demand and supply there are three possible changes in equilibrium. Both the increase in demand and decline in supply give an upward pressure on price. There are however three possible change in equilibrium quantity. If change in demand is greater than change in supply, then equilibrium quantity increase. There is a decline in equilibrium quantity if change in supply exceed that of change in demand. Equilibrium quantity remain the same if demand and supply change by the same magnitude.
Market eliminates shortages and surpluses by using self-correction mechanism through price. For a price above the equilibrium price, there exists surplus as supply exceeds. In order to sell the unsold goods, sellers reduce price of good. The lower prices increase demand. The mechanism continues unless equilibrium price is achieved. In a market, a shortage exists for price below the equilibrium price. In order to eliminate shortage, sellers increase price. This lowers demand. Supply and demand balances at the equilibrium price.
Price elasticity of demand: Price elasticity of demand is an economic measure that captures proportionate change in demand for a corresponding proportionate change in price.
Price elasticity of demand is computed by calculating the percentage change in demand and percentage change in price.
The two determinants of price elasticity of demand are number of available substitutes and proportion of consumers’ income spent on the specific good.
The elastic demand implies, demand changes by a larger magnitude in comparison to corresponding change in price.
The inelastic demand implies percentage change in demand is less than the percentage change in price.
The vertical line, D shows the perfectly inelastic demand curve. As there is an increase in supply, the supply curve shifts to the right from S1S1 to S2S2. Because of inelastic demand, there is no change in equilibrium quantity, which remain fixed at Q*. The equilibrium price falls from P* to P1.
For a perfectly elastic demand, the demand curve becomes horizontal as shown by DD. The increase in supply shifts the supply curve to the right to S2S2. Because of perfectly elastic demand, the equilibrium price remain fixed at P*. Due to increase in supply, there is an increase in equilibrium quantity from Q* to Q1.
The nature of price elasticity of demand determines effect of a price change on revenue. For an elastic demand, change in demand is larger than the change in price. In this case, an increase in price leads to decrease in revenue because demand declines more than increase in price. In case of elastic demand, there is an inverse relation between price and revenue. For an inelastic demand, change in demand is less than the change in price. In this situation, an increase in price leads to an increase in revenue because demand declines less than increase in price. Therefore, for an inelastic demand, there is a positive relation between price and revenue.
The income elasticity of demand captures proportionate change in demand due to a proportionate change in income.
One can know whether a good is normal or inferior by observing the sign of income elasticity of demand. A positive value of income elasticity of demand implies demand increases with increase in income implying a normal good. A negative value of income elasticity of demand implies demand decreases with increase in income indicating the good is an inferior good.
The cross price elasticity of demand refers to the proportionate change in quantity demanded due to proportionate change in price of a related good.
The sign of cross price elasticity of demand implies whether two goods are substitutes or complement. If cross price elasticity is negative, then this implies an increase in price of one good decrease the demand for the related goods indicating the two goods are complementary. The positive value of cross price elasticity implies that an increase in price of one good increases demand for the related goods implying the two goods are substitutes.
The price elasticity of supply is an economic measure capturing percentage change in quantity supplied of a good for a certain percentage change in price.
The marginal benefit refers to the additional benefit enjoyed by an individual from consuming additional unit of a good. In other words, it is the change in total benefit due to unit change in consumption.
Marginal cost in contrast refers to the additional cost for producing one extra unit of a particular good. It is the change in total cost due to unit change in production.
Demand for a good implies willingness of a consumer to purchase a good given the purchasing power. The willingness to pay depends on the additional benefits received from the next unit of good. The marginal benefit curve is same as demand curve because willingness to pay for the additional unit equal to the expected marginal benefit. As marginal benefit decrease with increase in quantity consumed, price falls indicating an inverse relation between price and quantity demand.
Supply curve depicts the relationship between price and quantity supplied. The willingness of a firm to supply additional quantity depends on the additional cost of producing the goods. The additional cost of producing an additional unit is known as the marginal cost. Supply curve thus is same as the marginal cost curve.
In a market, the efficient quantity of output is produced at the point where marginal benefit of a good equals the marginal cost. Corresponding to this price, willingness of buyers equals the willingness of sellers’. If marginal benefit is greater than marginal cost, then use of resources will be efficient if quantity is increased. In this situation there is under consumption of goods. Society would then be benefitted from increase in output and decline in price. Opposite is the case when marginal cost is greater than marginal benefit. In this case resources would be more efficiently allocated if output increases.
The efficient market outcome occurs at point E. At this point, marginal benefit equals the marginal cost. The socially efficient price and quantity are P* and Q* respectively.
Consumer Surplus: Consume surplus is the benefit received by the consumers. It is the marginal benefit less the price consumers pay. In terms of demand curve, consumer surplus is area of the demand curve above the equilibrium price.
Producer Surplus: Producer surplus refers to the additional private benefits received by the producers. It is the difference between equilibrium price and minimum cost of producing the good. It is the area above the supply curve and below the equilibrium price.
Social Surplus: Social surplus of an economic activity refers to total value addition of the activity to all the members of the activity affected by the specific activity. The social surplus is defined as the sum of consumer and producer surplus.
Question 5
Price ceiling refers to the regulated maximum price set by the government to prevent price from rising above a certain level. An example of price ceiling is rent control.
The free market equilibrium price is at P*. Now suppose, government sets a price ceiling at P1. The lower encourages buyers to demand more and demand increases to Q2. The lower price discourages suppliers by lowering profit. The supply thus reduces to Q1. The imposition of price ceiling thus creates a shortage in the market (Q2 – Q1).
Price floor is the regulated minimum price set by the government to ensure a minimum earnings for sellers. Objective of price floor is to prevent price from dropping below a certain level. An example of price floor is agricultural support price.
The unregulated price in the market is given as P*. Now suppose government set a price floor at P2. At the higher price, supply increase to QS and demand falls to QD. The price floor creates a surplus in the market amounts to (QS – QD).
In the above figure the efficient quantity in the market is Q* obtained from equalization of demand and supply. Now, suppose that production is restricted to Q2. This is an example of underproduction. The quantity is socially inefficient. As a result of underproduction there is a welfare or deadweight loss arising from a loss in total surplus. This is also called a social loss.
Laws imposed by government in order to control prices are known as price controls. Any form of price control either price ceiling or price floor intervene in the efficient functioning of market. It prevents the market to adjust to its equilibrium price and quantity. There is a loss in total surplus resulting in deadweight loss. The intervention in the free market results in market inefficiency.
Externality is the positive or negative bearing of an economic activity that is incurred by the third party of the activity. An example of negative externality is the smoke emitted by a factory. This has a negative effect on environment. An example of positive externality is the well-educated labor force in a firm. This has a positive effect on productivity.
Private cost indicates the production cost incurred by an individual firm engage in the commodity production. Private cost determines the available supply in the free market determining the private supply. Social cost in contrast implies the cost imposed on the society as a whole. It takes into consideration private cost as well as external cost borne by the society. The social supply determines the socially efficient supply or social supply.
In presence of negative externality social marginal cost is higher than private marginal cost. In the free market, sellers do not take into consideration the external cost. The private producer thus produces more than socially efficient outcome.
The social marginal benefit curve is shown by the downward sloping curve DD. This is same as the demand curve. The private marginal cost curve is SS. The social marginal cost is higher than social marginal cost and is shown as SMC. The socially efficient outcome occurred where social marginal benefit intersects the social marginal cost. The private market outcome however occurs at E where private marginal cost cuts the social marginal benefit. The socially efficient output is at Q2. With negative externality society incurs a deadweight loss shown by the triangle EE1F.
Private demand: Private demand is the demand that represent only private marginal benefit.
Social demand: Social demand is the demand that include both private and external benefit.
The reason for underinvestment in case of positive externality is that rational consumers and firms are unaware of the social benefits associated with the good. This is shown in the figure below.
The social marginal benefit curve lies to the right of private marginal benefit curve. The free market price and quantity are P* and Q* respectively. The private market outcome is not socially optimal as the marginal benefit remains higher. The socially efficient price and output are PE and QE. The positive externality thus leads to underproduction in the market.
Government policy might have an important role in correcting negative externality. One such policy is to impose a tax equivalent to the external cost. The imposed tax increases the effective cost of production as it includes the spillover cost. Such tax attempts to make producers accountable for production and thus internalize the externality resulting in socially efficient outcome.
Similarly, an example of government policy to correct positive externality is to provide a subsidy for the good having positive spillover effect. Government subsidy helps to lower the effective cost for producing a particular good. This incentivizes the firm to increase their production. As the external benefits are enjoyed by the society subsidy is an effective way to correct positive externality.
Imperfect information affects the market equilibrium. The imperfect information discourages both sellers and buyers to participate in the market. Buyers become reluctance to participate because they are unable to determine quality of the product. Sellers with high or medium quality products are reluctant to participant in the market as it is difficult to convey the true quality of the product. When buyers and sellers are discouraged to participate in the market, the market become very thin. The imperfect information more often leads to market failure by interrupting efficient functioning of market.
In a market with imperfect information, with lack of perfect knowledge buyers anticipates goods to be of poor quality. Sellers on the other hand anticipates that they will not able to sell high quality product in the market and hence leave the market. In the market, there are only poor quality good sold at a lower price.
Moral hazard
Moral hazard refers to a situation when one party involves in a risky affair after knowing it is completely protected and other party bears the cost. An example of moral hazard is that faced by the insurance companies. If an individual’s house if fully insured, then any damage of the house does not lead to any cost to the owner. The owner has less incentive to protect the house as it is fully insured and the insurance company bears the cost.
Adverse selection
The problem of adverse selection occurs when one party of transaction has more information compared to others. Sellers of a product or service may have more information that the buyers, putting the buyers at a disadvantageous position. An example is market for used car.
Assumption of perfect competition model
Under perfect competition, prices are determined from the intersection of market demand and market supply curve. This is known as the equilibrium point and corresponding price is known as equilibrium price.
Marginal Revenue: Marginal revenue is the change in total revenue due to per unit change in output.
Average Revenue: Average revenue refers to the revenue earned from per unit of a good sold.
In perfect competition, as price is given in the market both average and marginal revenue equals the market price.
The marginal decision rules states that profit maximization of a firm occurs when marginal benefit from an additional unit equals the additional cost of producing the unit. The marginal benefit from selling an additional unit of output is captured by the marginal revenue. The first order condition for profit maximization in perfectly competitive market is marginal revenue equals the marginal cost. This in turn implies profit maximization occurs where additional revenue from selling additional unit of output equals additional cost of producing the good, thus satisfying marginal decision rule.
The profit maximizing quantity at price $30 approximately equals 39 units of output
The average total cost approximately equals $21.
Total profit is $351. This is shown in the graph below.
The perfectly competitive firm would choose to shift down if price goes below the minimum of average variable cost.
If a perfectly competitive firm makes positive economic profit, then other firms are encouraged to enter the market. Given free entry, new firm enter the market increasing supply. As market supply increases price falls lowering the profit. New firms continue to enter unless profit falls to only normal profit. This occurs at the long run equilibrium where all firms attain only normal profit.
Long run equilibrium price is p* which approximately equals $11. Thee equilibrium quantity is q* which equals 5 unit.
Characteristics or assumptions of monopoly market
Question 2
Electricity Company: the main source of monopoly power for Electricity Company or any other utility company are the very high set up costs. The high cost prevents new firms to enter the industry sustaining the monopoly power.
Diamonds: In case of diamonds, specific company owns exclusive access to mines. As many companies do not have access to mines it becomes costly for them buy diamonds from other sources. Exclusive ownership over a strategic resource works as a source of monopoly power.
New-life saving drugs: The source of monopoly power for new life saving drug is patent. The company invest a lot of money to invent formula for life saving drugs. Once invented, the companies enjoy the exclusive right to manufacture the particular drugs through intellectual property rights. The company enjoys a monopoly power unless the patent expires.
A monopolist will always operate at the elastic part of the demand curve.
This is because monopolist can never fix its output for the product or service if demand is inelastic. If demand is inelastic then it is always possible for the monopolist to earn a higher revenue by restricting output. Under such situation, total revenue falls with increase in output and marginal revenue become negative. Therefore, as long as demand for monopolist is relatively inelastic, monopolist can always increase profit by restricting output and hence, monopoly equilibrium cannot be attained.
For a monopolist, both the demand and marginal revenue curve slope downward. The Marginal revenue for the monopolist is always lower than demand for a given level of output. This is because the average revenue is same as price. For a monopolist both marginal and average revenue decreases with increase in quantity.
The profit maximizing quantity is Q1 and profit-maximizing price is C.
Price is greater than average cost. Therefore, the monopolist earns a profit shown by the area BFEC.
Unlike competitive industry, monopolist can sustain a positive profit even in the long0-run. Like all other firms, profit maximization of the monopolists occurs where MR= MC. The level of profit depends on the degree of competition. Given entry restricted, the degree of competition in the monopoly market is zero. With o close substitute available, the monopolist can charge a higher price in the long-run and earn a positive economic profit.
Long run equilibrium of the monopolist occurs at point E with equilibrium price being P* and that of equilibrium quantity is Q*. At this, average cost is below the market price and hence, monopolist earns a profit equivalent to the area P*ABC.
Price discrimination: Price discrimination refers to the pricing strategy where seller charges consumers different price for same product or service. It is a common pricing strategy used by the monopolist having discriminating power. Monopolist practices price discrimination in order to gain advantage in the market or to exploit the market position.
Necessary condition for price discrimination
Some examples of monopolistically competitive market include restaurant business, hotels and pubs, specialist retailing, specific customer service like hairdressing and others.
Under condition of perfect competition, firm attains equilibrium at E1. At this point AR = MR = AC = MC. Corresponding to this, the equilibrium output under perfect competition is obtained as OQC. In contrast, for the monopolist equilibrium occurs where marginal revenue equals to the marginal cost. The equilibrium for the monopolist occurs at point E. Output for the monopolist equals OQM. Output for the monopoly thus is lower than that of the perfect competition. In the long run, price under perfect competition equals average cost. Price under perfect competition is equals OPC. The monopolist charges a higher price at OPM. The monopolist thus charges a higher price and sells a lower quantity than that of perfect competition.
Perfectly competitive firm is more efficient than monopoly. Under perfect competition, both allocative and productive efficiencies are achieved. Allocative efficiency is attained as firms under perfect competition charge a price equal to marginal cost. Productive efficiency is attained as competitive firm in the long run operates at the minimum point of average cost. In contrast, under monopoly neither productive nor allocative efficiency are achieved.
Monopsony: Monopsony refers to a market situation where a very large buyer dominates the entire market. The only buyers in the market forces market price to decline. This form of market is opposite to that of a monopoly market.
Assumptions of monopsony
Characteristics of monopolistic competition
In monopoly, there is single firm dominating the entire market in terms of selling a unique product. Monopolistically competitive firm on the other hand compete in an industry where is large number of sellers selling a near substitute good.
In the given figure, profit maximizing price and quantity of the monopolistically competitive firm is A and Q1 respectively.
In the long-run, the monopolistically competitive firm earns only a normal profit. Given free entry or exit of firms, any supernormal profit or economic loss in the short run is eliminated in the long-run leaving only normal profit for firms. For example, if monopolistic firms in the short run enjoy a supernormal profit, then new firms enter the industry. This increases supply and lower price. Firms continue to enter unless profit falls to zero. In case of economic loss, firms leave the industry. This lower market supply and increases price in the market. The adjustment continues unless all the firms earn only normal profit.
Excess Capacity: The excess capacity in a monopolistically competitive industry refers to difference between optimal output (output corresponds to the minimum point of average cost) and level of output actually attained by firms in the long-run.
Advertising refers to the disclosure of various information related to a product by using various media like radio, television, magazines, newspaper and internet. An important feature of monopolistically competitive firm is advertising their products. Advertising in the monopolistically competitive market is more relevant than others market because of the intensive product differentiation in such market. Each firm sells similar but slightly differentiated products. Through advertising firms attempt to convince buyers that their product is better so that it can charge a higher price and enjoy a greater control in the market.
Characteristics of oligopoly
4-firm concentration ratio: The four firm concentration ratio is a measure for identify market concentration in an industry. It is computed based on the market share of four largest firms in the industry. In other words, four firm concentration ratio is the proportion of output of the four largest firm in total output.
Herfindahl-Hirschman Index (HHI): HHI is another accepted measure of market concentration. It is a measure for finding size of a firm relative to the industry and is an indicator of competition among them. It is the sum of square of market share of firms in the industry. The shares are expressed as a fraction of total market output.
Given the share of three firms in the market as 42%, 30% and 28%, the HHI can be computed as
Collusion: Collusion refers to some form of non-competitive or illegal agreement among the rival firms in an industry that disrupts market equilibrium. Collusion is found to occur industries where rival firms agree to cooperate for maximizing their mutual benefits. This mostly takes place in market structure like oligopoly in which decision of small number of firms in the industry has a significant influence on the entire market.
The two types of collusions are cartel and price leadership.
If Blue Spring choses to charge a high price, then it is optimal for Purple Rain to choose low price as it yields a higher profit of $50,000. If Blue Spring choses low price, then optimal strategy for Purple Rain is to choose low price because it yields a higher payoff ($10,000 > $2000). Similar is the case for Blue Spring. Irrespective of strategy of Purple Rain, it is always best for Blue Spring to choose low price. The Nash equilibrium of this Prisoner’s Dilemma is therefore to choose the strategy of low price. At equilibrium, both the companies earn a profit of $10,000.
Difference between Nash equilibrium and dominant strategy
In game theory, Nash equilibrium refers to a stable state where no players have any incentive to deviate from the chosen strategy given the strategy of another player remain constant. Dominant strategy on the other hand refers to the strategy that gives a player highest payoff irrespective of strategy of other players. In case of domain strategy the best strategy of one player, remain unaffected from the action of other. Nash equilibrium is different from the dominant strategy equilibrium in games like repeated prisoners’ dilemma. Here best strategy or Nash equilibrium is to cooperate while dominant strategy would be to choose the outcome of betrayal.
The lessons from Prisoner’s Dilemma is a popular concept used by the economists in order to illustrate challenges that non-collusive oligopolistic firms face in times of deciding pricing strategies, in deciding whether to advertise or not and other strategic decision affecting profits of the firm.
One main feature of oligopoly market is the strategic interdependence among the rival firms. Firms need to take into consideration strategy taken by the other before deciding its own strategy. The lesson from Prisoner Dilemma might be applied in situation where two firms are deciding whether to charge a high or low price in the market. Without collusion, like Prisoners Dilemma firms end up in taking a strategy that is not optimal for sellers. This kind of behavior can be understood from the lesson of Prisoners’ Dilemma.
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