Chapter Five PDF

Price Change: Income and
Substitution Effects
THE IMPACT OF A PRICE CHANGE
• Economists often separate the impact of a
price change into two components:
– the substitution effect; and
– the income effect.
• The substitution effect involves the substitution of
good x1 for good x2 or vice-versa due to a change in
relative prices of the two goods.
• The income effect results from an increase or
decrease in the consumer’s real income or
purchasing power as a result of the price change.
• The sum of these two effects is called the price
effect.
• The decomposition of the price effect into the
income and substitution effect can be done in
several ways
• There are two main methods:
(i) The Hicksian method; and
(ii) The Slutsky method
THE HICKSIAN METHOD
• Sir John R.Hicks (1904-1989)
• Awarded the Nobel Laureate in Economics
(with Kenneth J. Arrrow) in 1972 for work
on general equilibrium theory and welfare
economics.
THE HICKSIAN METHOD
Optimal bundle is Ea, on indifference curve I1.
X2
Ea
I1
xa
X1
THE HICKSIAN METHOD
A fall in the price of X1
X2 The budget line pivots out from P
*
P
Ea
I1
xa
X1
THE HICKSIAN METHOD
The new optimum is Eb on I2.
X2 The Total Price Effect is xa to xb
Eb
Ea I2
I1
xa xb
X1
THE HICKSIAN METHOD
• To isolate the substitution effect we ask….
“what would the consumer’s optimal bundle be if
s/he faced the new lower price for X1 but
experienced no change in real income?”
• This amounts to returning the consumer to the
original indifference curve (I1)
THE HICKSIAN METHOD
Eb
Ea I2
I1
xa xb
X1
THE HICKSIAN METHOD
Draw a line parallel to the new budget line
X2 and tangent to the old indifference curve
Eb
Ea I2
I1
xa xb
X1
THE HICKSIAN METHOD
The new optimum on I1 is at Ec. The movement
X2 from Ea to Ec (the increase in quantity
demanded from Xa to Xc) is solely in response
to a change in relative prices
Eb
Ea I2
Ec I1
xa xc xb
X1
THE HICKSIAN METHOD
This is the substitution effect.
X2
Eb
Ea I2
Ec
I1
X1
Xa Substitution Effect Xc
THE HICKSIAN METHOD
• To isolate the income effect …
• Look at the remainder of the total price effect
• This is due to a change in real income.
THE HICKSIAN METHOD
The remainder of the total effect is due to a
change in real income. The increase in real
X2 income is evidenced by the movement from I1
to I2
Eb
Ea I2
Ec
I1
X1
Xc Income Effect
Xb
THE HICKSIAN METHOD
X2
Eb
Ea I2
Ec
I1
xa xc xb
X1
Sub Effect
IncomeEff
ect
THE SLUTSKY METHOD
• Eugene Slutsky (1880-1948)
• Russian economist expelled from the
University of Kiev for participating in
student revolts.
• In his 1915 paper, “On the theory of the
Budget of the Consumer” he introduced
“Slutsky Decomposition”.
THE SLUTSKY METHOD
Optimal bundle is Ea, on indifference curve I1.
X2
Ea
I1
xa
X1
THE SLUTSKY METHOD
A fall in the price of X1
X2 The budget line pivots out from P
*
P
Ea
I1
xa
X1
THE SLUTSKY METHOD
Eb
Ea I2
I1
xa xb
X1
THE SLUTSKY METHOD
• Slutsky claimed that if, at the new prices,
– less income is needed to buy the original bundle
then “real income” has increased
– more income is needed to buy the original
bundle then “real income” has decreased
• Slutsky isolated the change in demand due only to
the change in relative prices by asking “What is the
change in demand when the consumer’s income is
adjusted so that, at the new prices, s/he can just
afford to buy the original bundle?”
THE SLUTSKY METHOD
• To isolate the substitution effect we adjust the
consumer’s money income so that s/he
change can just afford the original
consumption bundle.
• In other words we are holding purchasing
power constant.
THE SLUTSKY METHOD
Eb
Ea I2
I1
xa xb
X1
THE SLUTSKY METHOD
Draw a line parallel to the new
X2 budget line which passes through
the point Ea.
Eb
Ea I2
I1
xa xb
X1
THE SLUTSKY METHOD
The new optimum on I3 is at Ec. The
movement from Ea to Ec is the
X2 substitution effect
Eb
Ea I2
Ec
I3
xa xc xb
X1
THE SLUTSKY METHOD
The new optimum on I3 is at Ec. The
movement from Ea to Ec is the
X2 substitution effect
Eb
Ea I2
Ec
I3
xa xc
X1
Substitution Effect
THE SLUTSKY METHOD
The remainder of the total price
effect is the Income Effect.
X2 The movement from Ec to Eb.
Eb
Ea I2
Ec
I3
xc xb
X1
Income Effect
THE SLUTSKY METHOD for NORMAL GOODS
• Most goods are normal (i.e. demand increases

with income).
• The substitution and income effects reinforce
each other when a normal good’s own price
changes.
The income and substitution effects
reinforce each other.
X2
Eb
Ea I2
Ec
I3
xa xc xb
X1
• Since both the substitution and income effects

increase demand when own-price falls, a
normal good’s ordinary demand curve slopes
downwards.
• The “Law” of Downward-Sloping Demand
therefore always applies to normal goods.
Cross Elasticity of Demand (CPed)
• Cross price elasticity (CPed) measures the
responsiveness of demand for good X following a
change in the price of good Y (a related good)
• CPeD = % change in qty D of product A

% change in price of product B
• With cross price elasticity we make an important

distinction between substitute products and
complementary goods and services.
Identify some Substitutes
Identify some Complements
GIFFEN GOODS
• In rare cases of extreme inferiority, the income
effect may be larger in size than the
substitution effect, causing quantity
demanded to rise as own price falls.
• Such goods are Giffen goods.
• Giffen goods are very inferior goods.
Demand forecasting
Definition
 Is a process by which an individual or a firm predicts
future demand for product or products
 Accurate forecasting-enables these firms to produce

required quantities at the right time and arrange
well in advance for the various factors of production
 Better planning and allocation of national

resources.
Factors Influencing DF
 How far ahead?
 Short term
 Long- term
 Should forecast be general or specific
 Problems and methods
 Classification of goods
- consumer
- durable
- consumer goods and services
Factors
 Forecasting at different levels
– Macro
– Industrial
– Firm-level
Purposes of forecasting
 Purposes of short-term forecasting
 Purposes of long –term forecasting

Short-term forecasting
 Production scheduling
 Reducing cost of purchasing raw materials
 Determining appropriate price policy
 Setting sales targets and establishing controls and

incentives
 Evolving a suitable advertising and promotion programme
 Forecasting short-term financial

Long-term forecasting
 Planning of a new unit or expansion of an existing

unit
 Planning of long-term financial requirements
 Planning of man-power requirements

Criteria for a good forecasting
 Accuracy
 Plausibility
 Simplicity
 Economy
 Availability
 Durability
Methods of demand forecasting
 Survey or buyer’s intention  Smoothing techniques
 Delphi method  Analysis of time series and

trend projections
 Expert opinion
 Use of economic indicators
 Collective opinion
 Controlled experiments
 Naïve models
 Judgmental approach
• There are several methods and techniques available
for forecasting demand for a product. All the
methods have their own limitations and advantages,
merits and demerits, in varying degrees. The
applicability and usefulness of a method depends on
the purpose of forecasting and availability of reliable
and relevant data. The analyst should, therefore,
choose a method or a technique of demand
forecasting which is relevant to the purpose,
convenient to handle, applicable to the available data
and also inexpensive.
Survey or buyers method
 Direct method of estimating sales in the near future
 Asking customers what the buyer’s are planning to buy

Known as opinion survey
 The burden of forecasting goes to buyer
 Method is best when bulk of sales is made.
 Customers may misjudge or mislead or may be uncertain about

quantity
 Not useful in case of house old customers
 Does not measure and expose the variables under managements

control
 Survey methods
- experts opinion
- consumer survey
- complete enumeration
- sample survey
- end- use
- Delphi method
- market experimentation
- stimulated market method
- actual market method
 Statistical method
- trend analysis
- heading indicator analysis
- regression method
- simultaneous equation
Survey Methods
 conducted by sales agencies
 a direct method of addressing people
 helps in gaining first hand information

Expert’s opinion
 business firm prefers to depend on survey of
experts
 Experts are those who have the feel about the

product
 opinion poll is conducted among experts
 Sometimes this method is also called the “hunch

method”
Advantages
 This method is very easy and less costly to carry

out.
 This method produces quick results
 When a firm intends to bring a new product, this

method is very useful to elicit the opinion of experts
on its marketing plans
Disadvantage
 The experts must have wide knowledge and
experience otherwise their opinion may be
personal based on guess work.
 Experts opinion may be biased for a number of

reasons.
Consumer survey
 interviewing the consumers directly to get
information about their purchase plans at a number
of possible prices over a particular period of time.
 information collected through questionnaire
 The data will have to be classified and tabulated for

systematic presentation and analysis.
Complete enumeration method/ census
method:
 All consumers of a product are contacted and they
are interviewed to know their probable demand for
the forecast period.
 This individual probable demand is added to

ascertain the demand forecast for the firm’s
product.
 For example there are N consumers, each

demanding commodity X, then the total demand
forecast would be EN * n. where n=1.
Advantages
 This method simply records the data and
aggregates; it does not introduce any value
judgment of his own.
 The demand forecast through this method is

likely to be more accurate than many other
methods.
Disadvantages
 It is time consuming and costly method
 There can be large number of errors in the data

collection, as it is a tedious and cumbersome
process.
Sample survey
 Only few consumers are selected by using some
appropriate sampling technique.
 They are interviewed to ascertain their probable demands

for the product for the forecast period.
 Their average demand is then calculated.
 This average demand for the sample is multiplied by the

total number of consumers to obtain the aggregate
demand forecast for the product in question.
Advantages
 It is a direct method of collecting data from

consumers. The information obtained is first hand,
it is more reliable.
 This method saves time, cost and energy. It is

economical, if information is collected by postal
questionnaire.
Disadvantages
 There may be sampling error. The smaller the size of
the sample, the larger the sampling error.
 This method provides scope for errors. The

consumer may not understand the significance of
the questions asked, they may be dishonest,
reluctant or shy to reply or they may be either
vague or imaginary replies. This reduces the
usefulness of information collected.
End-use Method
 the demand for a product is forecasted through a survey of
its users.
 A product may be used for final consumption by house old

sector and government and as an intermediate product by
different industries as well as may be exported and
imported.
 purposes can be obtained through a survey of all or

selected consumers, exporters and importers and
industries using it as an input thus the total demand
forecast can be obtained as the sum of the demand
forecast of all three components.
Advantages
 It provides use-wise or sector-wise demand
forecasts.
 This method is used now as a standard tool in

economic analysis and are extensively used by
governmental and no-governmental agencies.
Disadvantages
 This method assumes that technical structure of
production remains unchanged overtime, which is
not true. Because with economic development
technical innovations continue to take place and
lead to technological changes in the industrial
structure.
 This method needs extensive information on the

probable demands of the final goods sector. No
company how so ever large can hope to possess this
information.
Delphi method
 In this method an attempt is made to arrive at a

consensus in an uncertain area by questioning a
group of experts repeatedly until some sort of
unanimity is arrived among all experts.
 These meetings help to narrow down different

views of experts.
Advantages
 In this method it is possible to pose the problem to

experts directly
 It generates a reasonable opinion in place of

unstructured opinion.
 It is a cheap method, save time and resources.

Disadvantages
 The success of this method depends upon wide

knowledge and experience of experts.
 It could be tedious and costly method if the experts

are not too large and are cooperative and forecaster
has the necessary funds and ability to perform the
task.
Statistical method
 Time series data: Refers to data collected over a

period of time recording historical changes in
variables like price, income, etc. that influenced
demand for a commodity Time series analysis
relate to determination of change in variable in
relation to time.
Statistical method
 Cross sectional :Is undertaken to determine the
effect of changes in variables like price, income, etc.
on demand for a commodity at a point of item. In
cross sectional analysis, different levels of sales
among different income groups may be compared
at a specific point of time and income elasticity is
then estimated on the basis of these differences.
Statistical methods
 Trend analysis: A firm which has been in existence for a
long time will have accumulated data on sales pertaining
to different time periods.
 When such data is arranged, chronologically it is know as
“Time Series”.
 A typical time series has four components, trend, cyclical
fluctuations, seasonal variations and random or irregular
fluctuations.
 This method is highly subjective and considerably
depends on the bias of the person drawing the curve.
 The main advantage of this method is that it does not
require the formal knowledge of economic theory and the
market, it only needs the time series data.
Regression method
 involves a study of the dependence of one variable
on the other variables.
 In demand forecasting demand is estimated with

the help of a regression equation where in demand
is the dependent variable and price, advertising
expenditure, consumer’s income, etc is the
independent variable.
The Production Process and
Costs
The Theory and Estimation of
Production
• The Production Function

• The Cost Function
The Production Function
• A production function defines the relationship between
inputs and the maximum amount that can be produced within
a given time period with a given technology.
• Mathematically, the production function can be expressed as

Q=f(K, L)
• Q is the level of output
• K = units of capital
• L = units of labour
• f( ) represents the production technology
The Production Function
• When discussing production, it is important to distinguish
between two time frames.
• The short-run production function describes the maximum

quantity of good or service that can be produced by a set of
inputs, assuming that at least one of the inputs is fixed at
some level.
• The long-run production function describes the maximum

quantity of good or service that can be produced by a set of
inputs, assuming that the firm is free to adjust the level of all
inputs
Production in the Short Run
• When discussing production in the

short run, three definitions are
important.
•Total Product
•Marginal Product
•Average Product
• Total product (TP) is another name for output
in the short run.
• The marginal product (MP) of a variable input
is the change in output (or TP) resulting from
a one unit change in the input.
• MP tells us how output changes as we change
the level of the input by one unit.
• The average product (AP) of an input is the
total product divided by the level of the input.
• AP tells us, on average, how many units of
output are produced per unit of input used.
• Consider the two input production function Q=f(X,Y)
in which input X is variable and input Y is fixed at
some level.
• The marginal product of input X is defined as
holding input Y constant.
Q
MPX 
X
• The average product of input X is defined as
holding input Y constant.
Q
APX 
X
The table below represents a firm’s production function,
Q=f(X,Y):
Units of Y
Employed Output Quantity (Q)
8 37 60 83 96 107 117 127 128
7 42 64 78 90 101 110 119 120
6 37 52 64 73 82 90 97 104
5 31 47 58 67 75 82 89 95
4 24 39 52 60 67 73 79 85
3 17 29 41 52 58 64 69 73
2 8 18 29 39 47 52 56 52
1 4 8 14 20 27 24 21 17
1 2 3 4 5 6 7 8
Units of X Employed
In the short run, let Y=2. The row highlighted below
represents the firm’s short run production function.
Units of Y
Employed Output Quantity (Q)
8 37 60 83 96 107 117 127 128
7 42 64 78 90 101 110 119 120
6 37 52 64 73 82 90 97 104
5 31 47 58 67 75 82 89 95
4 24 39 52 60 67 73 79 85
3 17 29 41 52 58 64 69 73
2 8 18 29 39 47 52 56 52
1 4 8 14 20 27 24 21 17
1 2 3 4 5 6 7 8
Units of X Employed
Variable
Input Total Product
• Rewriting this row, we (X) (Q or TP)
can create the
0 0
following table and
calculate values of 1 8
marginal and average 2 18
product. 3 29
4 39
5 47
6 52
7 56
8 52
Calculation of Marginal Product
Variable Marginal
Input Total Product Product
(X) (Q or TP) (MP)
0 0 Q 8
ΔX=1 ΔQ=8  8
1 8 X 1
2 18
3 29
4 39
5 47
6 52
7 56
8 52
Calculation of Marginal Product
Variable Marginal
(X) (Q or TP) (MP)
0 0
8
1 8 10
2 18 11
3 29
10
4 39 8
5 47 Q 5
ΔX=1 ΔQ=5 X  1  5
6 52
7 56 4
-4
8 52
Calculation of Average Product
Variable Total Average
Input Product Product
(X) (Q or TP) (AP)
0 0 ---
Q 88
1
1 8
8  8
X 1
1
2 18
3 29
4 39
5 47
6 52
7 56
8 52
Calculation of Average Product
Variable Total Average
Input Product Product
(X) (Q or TP) (AP)
0 0 ---
1 8 8
2 18 9
3 29 9,67
4 39 9,75
5 47 9,4
6 52 8,67
7 56 8
8 52 6,5
• The figures
illustrate TP, MP,
and AP
graphically.
• If MP is positive then TP is
increasing.
• If MP is negative then TP
is decreasing.
• TP reaches a maximum
when MP=0
• If MP > AP then AP is
rising.
• If MP < AP then AP is
falling.
• MP=AP when AP is
maximized.
The Law of Diminishing Returns
• Definition
– As additional units of a variable input are
combined with a fixed input, at some point the
additional output (i.e., marginal product) starts to
diminish.
Diminishing Returns
Variable Marginal
(X) (Q or TP) (MP)
0 0 8
1 8 10 Diminishing
2 18 11 Returns
3 29 10 Begins
4 39 8 Here
5 47
6 52 5
7 56 4
8 52 -4
The Law of Diminishing
Returns
• Reasons
Increasing Returns
Teamwork and Specialization
MP Diminishing Returns Begins
Fewer opportunities for teamwork
and specialization
X
MP
The Three Stages of Production
• Stage I
– From zero units of the variable input to where AP
is maximized
• Stage II
– From the maximum AP to where MP=0
• Stage III
– From where MP=0 on
The Three Stages of Production
Technology advancement
C
Q
100
B O3
A
50 O2
O1
0 1 2 3 4 5 6 7 8 9 10 L
Production in the Long Run
• In the long run, all inputs are variable.

• Isoquant defines cominations of
inputs that yield the same level of
product
Isoquant
K E
5
3
A B C
2
Q3 =90
D Q2 =75
1
Q1 =55
1 2 3 4 5 L
Marginal rate of technical
substitution (MRTS)
K
7
6 ΔK=3
5
MRTS  K
4
ΔL=1
L
3 ΔK=1
ΔL=1
1 ΔK=1/3
ΔL=1
0
0 1 2 3 4 5 6 7 L
Perfect Substitution
K
Q1 Q2 Q3
0 C
L
No substitution (Leontief isoquants)
K
C
Q3
B
Q2
K1 A
Q1
0
L1 L
• The long run production process is

described by the concept of returns
to scale.
• Returns to scale describes what
happens to total output as all of the
inputs are changed by the same
proportion.
• If all inputs into the production process are
doubled, three things can happen:
– output can more than double
• increasing returns to scale (IRTS)
– output can exactly double
• constant returns to scale (CRTS)
– output can less than double
• decreasing returns to scale (DRTS)
Market Structures
Market Structures
• Type of market structure influences how a
firm behaves:
– Pricing
– Supply
– Barriers to Entry
– Efficiency
– Competition
Market Structures
• Degree of competition in the industry
• High levels of competition – Perfect
competition
• Limited competition – Monopoly
• Degrees of competition in between
Market Structure
• Determinants of market structure
– Freedom of entry and exit
– Nature of the product – homogenous (identical),
differentiated?
– Control over supply/output
– Control over price
– Barriers to entry
Market Structure
• Perfect Competition:
– Free entry and exit to industry
– Homogenous product – identical so no consumer
preference
– Large number of buyers and sellers – no individual seller
can influence price
– Sellers are price takers – have to accept the market price
– Perfect information available to buyers and sellers
Market Structure
• Examples of perfect competition:
– Financial markets – stock exchange,
currency markets, bond markets?
– Agriculture?
• To what extent?
Market Structure
• Advantages of Perfect Competition:
• High degree of competition helps allocate resources
to most efficient use
• Price = marginal costs
• Normal profit made in the long run
• Firms operate at maximum efficiency
• Consumers benefit
Market Structure
• What happens in a competitive environment?
– New idea? – firm makes short term abnormal profit
– Other firms enter the industry to take advantage of
abnormal profit
– Supply increases – price falls
– Long run – normal profit made
– Choice for consumer
– Price sufficient for normal profit to be made but no more!
Market Structure
• Imperfect or Monopolistic Competition
– Many buyers and sellers
– Products differentiated
– Relatively free entry and exit
– Each firm may have a tiny ‘monopoly’ because of the
differentiation of their product
– Firm has some control over price
– Examples – restaurants, professions – solicitors, etc.,
building firms – plasterers, plumbers, etc.
Market Structure
• Oligopoly – Competition amongst the few
– Industry dominated by small number of large firms
– Many firms may make up the industry
– High barriers to entry
– Products could be highly differentiated – branding or homogenous
– Non–price competition
– Price stability within the market - kinked demand curve?
– Potential for collusion?
– Abnormal profits
– High degree of interdependence between firms
Market Structure
• Examples of oligopolistic structures:
– Supermarkets
– Banking industry
– Chemicals
– Oil
– Medicinal drugs
– Broadcasting
Market Structure
• Measuring Oligopoly:
• Concentration ratio – the proportion of market share
accounted for by top X number of firms:
– E.g. 5 firm concentration ratio of 80% - means top 5 five
firms account for 80% of market share
– 3 firm CR of 72% - top 3 firms account for 72% of market
share
Market Structure
• Duopoly:
• Industry dominated by two large firms
• Possibility of price leader emerging – rival will
follow price leaders pricing decisions
• High barriers to entry
• Abnormal profits likely
Market Structure
• Monopoly:
• Pure monopoly – industry is the firm!
• Actual monopoly – where firm has >25%
market share
• Natural Monopoly – high fixed costs – gas,
electricity, water, telecommunications, rail
Market Structure
• Monopoly:
– Firm controls price OR output/supply
– Abnormal profits in long run
– Possibility of price discrimination
– Consumer choice limited
– Prices in excess of MC
Market Structure
• Advantages and disadvantages of monopoly:
• Advantages:
– May be appropriate if natural monopoly
– Encourages R&D
– Encourages innovation
– Development of some products not likely without some
guarantee of monopoly in production
– Economies of scale can be gained – consumer may benefit
Market Structure
• Disadvantages:
– Exploitation of consumer – higher prices
– Potential for supply to be limited - less choice
– Potential for inefficiency –
X-inefficiency – complacency over
controls on costs
Market Structure
Price
Kinked Demand Curve
£5
D = elastic
Kinked D Curve
D = Inelastic
100 Quantity
Market Structure
• Market structure – identifies how a market
is made up in terms of:
– The number of firms in the industry
– The nature of the product produced
– The degree of monopoly power each firm has
– The degree to which the firm can influence price
– Profit levels
– Firms’ behaviour – pricing strategies, non-price competition, output
levels
– The extent of barriers to entry
– The impact on efficiency
Market Structure
Perfect Pure
Competition Monopoly
More competitive (fewer imperfections)

Market Structure
Perfect Pure
Competition Monopoly
Less competitive (greater degree

of imperfection)
Market Structure
Pure
Perfect
Monopoly
Competition
Monopolistic Competition Oligopoly Duopoly Monopoly
The further right on the scale, the greater the degree

of monopoly power exercised by the firm.
Market Structure
• Importance:
• Degree of competition affects
the consumer – will it benefit
the consumer or not?
• Impacts on the performance
and behaviour of the company/companies
involved
Market Structure
• Characteristics of each model:
– Number and size of firms that make up
the industry
– Control over price or output
– Freedom of entry and exit from the industry
– Nature of the product – degree of homogeneity
(similarity) of the products in the industry (extent
to which products can be regarded as substitutes
for each other)
– Diagrammatic representation – the shape
of the demand curve, etc.
Market Structure
Characteristics: Look at these everyday products – what type of
market structure are the producers of these products operating
in?
Remember to
think about the
nature of the
product, entry and
exit, behaviour of
the firms, number
and size of the
firms in the
industry.
You might even
have to ask what
the industry is??
Canon SLR Camera
Bananas
Perfect Competition
• One extreme of the market structure spectrum
• Characteristics:
– Large number of firms
– Products are homogenous (identical) – consumer
has no reason to express a preference for any firm
– Freedom of entry and exit into and out
of the industry
– Firms are price takers – have no control
over the price they charge for their product
– Each producer supplies a very small proportion
of total industry output
– Consumers and producers have perfect knowledge about the market
Perfect Competition
Diagrammatic representation Given
The
AtThe average
The
the
thisMC industry
assumption
is the
output costcost
price
curve
theofofisfirm
profit
is the
standard
maximisation,
producing ‘U’ –additional
determined the
shaped
by
firmtheproduces
curve.
demand
Cost/Revenue atis making normal atprofit.
MC MCan
(Q1).
(marginal)
This
lowest
cuts
output
and supply
falls
as is
Thisat
thewhere
a
point
a first
AC
units
long
whole.
output
of
curve
because
(due
MC
of
theoutput.
run
level
The
industry
=
to firm
the
of
MR
its It
is athe
law
is a of
fraction
mathematical
equilibrium position. rises
diminishing
veryof the
small total
relationship
returns)
supplier
industry
then
within
supply.
between
asthe
output
industry
marginal
rises.and andhas average
no
AC values.
control over price. They will
sell each extra unit for the
same price. Price therefore
= MR and AR
P = MR = AR
Q1 Output/Sales
Perfect Competition
Diagrammatic representation Because the model assumes
perfect
Nowlower
The
Average knowledge,
assume
and
ACMarginal
aand
firmMC the firm
makes
costs
would
Cost/Revenue
MC gains
imply
could
short
the
some that
be
form
time
its product
earning
but price,
advantage
expected
the
of modification
firm is
inbefore
abnormal
orthe
gains
for
others
short
profit
be only
tonow
some
run,
to a
lower
copy
form
MC1 the idea or are
of cost advantage
(AR>AC)
remains the attracted
represented
same.(sayby atonew
thethe
industry
production
grey by method).
area. the existence Whatof
AC abnormal
would happen?profit. If new
enter the industry, supply will
firms
increase, price will fall and the

AC1 firm will be left making normal
profit once again.
P = MR = AR
Abnormal profit
AC1
P1 = MR1 = AR1
Q1 Q2 Output/Sales
Monopolistic or Imperfect Competition
• Where the conditions of perfect competition do

not hold, ‘imperfect competition’ will exist
• Varying degrees of imperfection give rise to
varying market structures
• Monopolistic competition is one of these – not to
be confused with monopoly!
• Characteristics:
– Large number of firms in the industry
– May have some element of control over price due to the
fact that they are able to differentiate their product in
some way from their rivals – products are therefore close,
but not perfect, substitutes
– Entry and exit from the industry is relatively easy – few
barriers to entry and exit
– Consumer and producer knowledge imperfect
Implications for the diagram:
MC We Marginal
assume Cost
that and
the firmand
Cost/Revenue This
IfSince
The
the
is demand
firm
a the
short
produces
additional
run
curve
equilibrium
Q1
facing
produces
Average where
Cost will
MR a = MC
be the
position
sells
the firm
revenue
eachforwill
received
a
unit
firm
befordownward
in£1.00
from on
(profit
same maximising
shape. However,
output).
monopolistic
average
sloping
each unit
with
andsold
market
represents
thefalls,
costthe(onthe
At because
this output
forthe level,
products
AR>AC
AC structure.
average)
AR
MR
and
60p,
are
earned
curve
the
lies
from
each
differentiated
AR curve.
under
firm makes in
sales.
unit
the firm will make 40p x
the
being
abnormal
Q1some
£1.00 way,
profitthe(the
firmgrey
will
in abnormal profit.
shaded
only be area).
able to sell extra
output by lowering
Abnormal Profit price.
£0.60
MR D (AR)
Q1
Output / Sales
Monopolistic or Imperfect
Competition
MC Because there is relative
Cost/Revenue
freedom of entry and exit
into the market, new
firms will enter
AC encouraged by the
existence of abnormal
profits. New entrants will
increase supply causing
price to fall. As price falls,
the AR and MR curves
shift inwards as revenue
from each sale is now
less.
MR1 AR1 D (AR)

MR
Q1 Output / Sales
Competition
MC Notice that the existence
Cost/Revenue
of more substitutes makes
the new AR (D) curve
more price elastic. The
AC firm reduces output to a
point where MC = MR
(Q2). At this output AR =
AC and the firm will make
AR = AC
normal profit.
MR1 AR1 D (AR)

MR
Q2 Q1 Output / Sales
Competition
MC This is the long run
Cost/Revenue
equilibrium position
of a firm in monopolistic
competition.
AC
AR = AC
MR1 AR1
Q2 Output / Sales
• Some important points about monopolistic
competition:
– May reflect a wide range of markets
– Not just one point on a scale – reflects many
degrees
of ‘imperfection’
– Examples?
• Restaurants
• Plumbers/electricians/local builders
• Solicitors
• Private schools
• Plant hire firms
• Insurance brokers
• Health clubs
• Hairdressers
• Funeral directors
• Estate agents
• Damp proofing control firms
• In each case there are many firms
in the industry
• Each can try to differentiate its product
in some way
• Entry and exit to the industry is relatively free
• Consumers and producers do not have perfect knowledge of
the market – the market may indeed be relatively localised.
Can you imagine trying to search out the details, prices,
reliability, quality of service, etc for every plumber in the UK in
the event of an emergency??
Oligopoly
• Competition between the few
– May be a large number of firms in the industry but the
industry is dominated
by a small number of very large producers
• Concentration Ratio – the proportion of total market
sales (share) held by the top 3,4,5, etc firms:
– A 4 firm concentration ratio of 75% means the top 4 firms
account for 75% of all
the sales in the industry
Oligopoly
• Example:
The music industry has
• Music sales – a 5-firm concentration
ratio of 75%.
Independents make up
25% of the market but
there could be many
thousands of firms that
make up this
‘independents’ group.
An oligopolistic market
structure therefore
may have many firms
in the industry but it is
dominated by a few
large sellers.
Market Share of the Music Industry 2002. Source IFPI: http://www.ifpi.org/site-content/press/20030909.html
Oligopoly
• Features of an oligopolistic market structure:

– Price may be relatively stable across the industry –
kinked demand curve?
– Potential for collusion
– Behaviour of firms affected by what they believe their rivals
might do – interdependence of firms
– Goods could be homogenous or highly differentiated
– Branding and brand loyalty may be a potent source of competitive advantage
– Non-price competition may be prevalent
– Game theory can be used to explain some behaviour
– AC curve may be saucer shaped – minimum efficient scale
could occur over large range of output
Oligopoly
Price The kinked demand curve - an explanation for price stability?
The
Assume
IfThe
thefirm
principle
firmthe
therefore,
seeks
firm
ofto
is
thelower
effectively
charging
kinked
its price
demand
a faces
price to of
£5‘kinked
a
gain and
a curvedemand
competitive
producing
rests on curve’
an forcing
advantage,
the
output itsit rivals
principle
of 100. to
will follow
maintain that:
asuit.
stableAnyorgains
rigid pricing
it makes will
If it chose to raise price above £5, its
quickly beOligopolistic
structure. lost and the firms
% changemay in
rivals
a. would
If a firm
not raises
followitssuit
price,
anditsthe firm
demand will
overcome this
beby smaller
engagingthaninthenon-%
effectively
rivalsfaces
will not
an follow
elasticsuitdemand
reduction
price in price – total revenue
competition.
curve for its product (consumers would
would
b. Ifagaina firmfall
lowers
as theitsfirm
price,
nowitsfaces
buy from the cheaper rivals). The %
£5 a relatively
rivalsinelastic
will all dodemand
the same
change in demand would be greater
curve.
than the % change in price and TR
Total would fall.
Revenue B
Total Revenue A
D = elastic
Total Revenue B Kinked D Curve
D = Inelastic
100 Quantity
Duopoly
• Market structure where the industry is dominated
by two large producers
– Collusion may be a possible feature
– Price leadership by the larger of the two firms may exist – the
smaller firm follows the price lead
of the larger one
– Highly interdependent
– Cournot Model – French economist – analysed duopoly –
suggested long run equilibrium would see equal market share and
normal profit made
– In reality, local duopolies may exist
Monopoly
• Pure monopoly – where only
one producer exists in the industry
• In reality, rarely exists – always
some form of substitute available!
• Monopoly exists, therefore,
where one firm dominates the market
• Firms may be investigated for examples of
monopoly power when market share exceeds
25%
• Use term ‘monopoly power’ with care!
Monopoly
• Monopoly power – refers to cases where firms influence

the market in some way through their behaviour –
determined by the degree
of concentration in the industry
– Influencing prices
– Influencing output
– Erecting barriers to entry
– Pricing strategies to prevent or stifle competition
– May not pursue profit maximisation – encourages unwanted
entrants to the market
– Sometimes seen as a case of market failure
Monopoly
• Origins of monopoly:
– Through growth of the firm
– Through amalgamation, merger
or takeover
– Through acquiring patent or license
– Through legal means – Royal charter,
nationalisation, wholly owned plc
Monopoly
• Summary of characteristics of firms exercising
monopoly power:
– Price – could be deemed too high, may be set to destroy
competition (destroyer or predatory pricing), price
discrimination possible.
– Efficiency – could be inefficient due to lack of competition
(X- inefficiency) or…
• could be higher due to availability of high profits
Monopoly
• Innovation - could be high because
of the promise of high profits, Possibly encourages
high investment in research and development (R&D)
• Collusion – possible to maintain monopoly power of
key firms
in industry
• High levels of branding, advertising
and non-price competition
Monopoly
• Problems with models – a reminder:
– Often difficult to distinguish between a monopoly
and an oligopoly – both may exhibit behaviour
that reflects monopoly power
– Monopolies and oligopolies do not necessarily aim
for traditional assumption of profit maximisation
– Degree of contestability of the market may influence behaviour
– Monopolies not always ‘bad’ – may be desirable
in some cases but may need strong regulation
– Monopolies do not have to be big – could exist locally
Monopoly
Costs / Revenue
This(D)
AR
Given isthe
both
curve
barriers
the
forshort
a to
monopolist
entry,
run and
MC likely
the
long monopolist
run
to be
equilibrium
relatively
will be
position
price
able to
inelastic.
exploit
for a monopoly
abnormal
Output assumed
profits in the
to
£7.00
be atrun
long profit
as maximising
entry to the output
here – not all
AC (note caution
market is restricted.
monopolists may aim
Monopoly for profit maximisation!)
Profit
£3.00
MR AR
Output / Sales
Q1
Monopoly
Welfare
Costs / Revenue implications of
monopolies
MC
A look back at the
anddiagram for
The
The higher
price
monopolyin
price
a competitive
price lower
would be
£7 perfect competition will reveal
output
market
£7 permeans
unit
would with
that
beoutput
£3
consumer
withlevels
AC that inat
surplus
output
lower equilibrium,
is
levels
Q2.
reduced, price will by
at Q1.indicated be
Loss of consumer equal to the MC
the grey shaded area. of production.
On the face of it, consumers
surplus We
facecan lookprices
higher therefore
and atlessa
comparison of the differences
choice in monopoly conditions
£3 between
comparedprice and competitive
to more output in a
competitive situation compared
environments.
to a monopoly.
AR
MR
Output / Sales
Q2 Q1
Monopoly
Welfare
monopolies
MC
The monopolist will benefit
be
£7 affected
from additional
by a loss
producer
of producer
AC surplus equal
showntobythe
thegrey
grey
triangle rectangle.
shaded but……..
Gain in producer
surplus
£3
AR
MR
Output / Sales
Q2 Q1
Monopoly
Welfare
monopolies
MC The value of the grey shaded
£7 triangle represents the total
welfare loss to society –
AC sometimes referred to as
the ‘deadweight welfare loss’.
£3
AR
MR
Output / Sales
Q2 Q1
Contestable Markets
• Theory developed by William J. Baumol,
John Panzar and Robert Willig (1982)
• Helped to fill important gaps in market
structure theory
• Perfectly contestable market – the
pure form – not common in reality but a
benchmark to explain firms’ behaviours
Contestable Markets
• Key characteristics:
– Firms’ behaviour influenced by the threat
of new entrants to the industry
– No barriers to entry or exit
– No sunk costs
– Firms may deliberately limit profits made
to discourage new entrants – entry limit pricing
– Firms may attempt to erect artificial barriers to entry –
e.g…
Contestable Markets
• Over capacity – provides the
opportunity to flood the market
and drive down price in the event
of a threat of entry
• Aggressive marketing and branding
strategies to ‘tighten’ up the market
• Potential for predatory
or destroyer pricing
• Find ways of reducing costs and
increasing efficiency to gain competitive
advantage
Contestable Markets
• ‘Hit and Run’ tactics – enter the
industry, take the profit and get
out quickly (possible because of
the freedom of entry and exit)
• Cream-skimming – identifying
parts of the market that are high
in value added and exploiting
those markets
Contestable Markets
• Examples of markets exhibiting
contestability characteristics:
– Financial services
– Airlines – especially flights
on domestic routes
– Computer industry – ISPs, software,
web development
– Energy supplies
– The postal service?

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Price Change: Income and

• Most goods are normal (i.e. demand increases

• Since both the substitution and income effects

• CPeD = % change in qty D of product A

• With cross price elasticity we make an important

 Accurate forecasting-enables these firms to produce

 Better planning and allocation of national

 Should forecast be general or specific

 Problems and methods

 Purposes of short-term forecasting

 Purposes of long –term forecasting

 Reducing cost of purchasing raw materials

 Determining appropriate price policy

 Setting sales targets and establishing controls and

 Evolving a suitable advertising and promotion programme

 Forecasting short-term financial

 Planning of a new unit or expansion of an existing

 Planning of long-term financial requirements

 Planning of man-power requirements

 Delphi method  Analysis of time series and

 Asking customers what the buyer’s are planning to buy

 The burden of forecasting goes to buyer

 Method is best when bulk of sales is made.

 Customers may misjudge or mislead or may be uncertain about

 Not useful in case of house old customers

 Does not measure and expose the variables under managements

 conducted by sales agencies

 a direct method of addressing people

 helps in gaining first hand information

 Experts are those who have the feel about the

 opinion poll is conducted among experts

 Sometimes this method is also called the “hunch

 This method is very easy and less costly to carry

 This method produces quick results

 When a firm intends to bring a new product, this

 Experts opinion may be biased for a number of

 information collected through questionnaire

 The data will have to be classified and tabulated for

 This individual probable demand is added to

 For example there are N consumers, each

 The demand forecast through this method is

 It is time consuming and costly method

 There can be large number of errors in the data

 They are interviewed to ascertain their probable demands

 Their average demand is then calculated.

 This average demand for the sample is multiplied by the

 It is a direct method of collecting data from

 This method saves time, cost and energy. It is

 This method provides scope for errors. The

 A product may be used for final consumption by house old

 purposes can be obtained through a survey of all or

 This method is used now as a standard tool in

 This method needs extensive information on the

 In this method an attempt is made to arrive at a

 These meetings help to narrow down different

 In this method it is possible to pose the problem to

 It generates a reasonable opinion in place of

 It is a cheap method, save time and resources.

 The success of this method depends upon wide

 It could be tedious and costly method if the experts

 Time series data: Refers to data collected over a

 In demand forecasting demand is estimated with

• The Production Function