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Lecture notes - Economics - complete

Economics (University of Saskatchewan)

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ECON 111

Intro – Nature of Economics

 Resources
o Land
o Labour (L)
o Capital (K)
 Commodities – things produced
 Goods – Tangible
 Services – Intangible
 Production – act of making goods and services
 Consumption – act of using good and services
 Scarcity
o Choice
o Cost
 Production possibilities curve (downward sloping because resources are scarce)
o Right of curve = unattainable
o Left of curve = attainable
o On curve = can be obtained if all resources are used
 Production possibilities curve
o Scarcity
o Choice
o Opportunity cost
 Market economy – private households and firm interact with some assistance from the
government
 Centrally planned/command economy – centralized decision makers decide what to do and issue
commands
 Free market economy – individual households are firms exert major influence on allocation of
resources
 Three groups of decision makers
o Households (demand)
o Firms/producers (supply)
o Government (authority of households and firms)
 Market – place where goods are traded
 Two markets
o Product market – products sold by firms
o Factor market – factors of production sold by households

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 Circular flow diagram

factor
markets

firms households

product
markets

 Positive statements – concern what is

 Normative statements – concern what ought to be
 Empirical evidence – positive statements can be proven with fact, normative statements cannot
 Laws of large numbers –irregularities cancel each other out and regularities show up in
observations
 Theory – explains why
o Variables, assumptions, hypotheses, predictions
 Variable – can take on different values
o Endogenous (with theory) exogenous (outside theory)
o Stock (no time dimension) flow (time associated with it)
 Functional relation – describes relation between variable
 Four ways to present a theory
o Verbally
o Graphically
o Numerical table
o Mathematical equation

Theory of Demands

 Quantity demanded – total amount of a commodity all households want to buy

o Flow variable
o Desired purchases
o Quantities households are willing to buy given a price
o All households (not just one)
 Quantity demanded is influenced by:
o Price (P)

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o Prices of related goods (Pj)

o Average household income (M)
o Tastes (T)
o Distribution of income (M*)
o Size of population (N)
 As price increases, quantity demanded decreases (P-down, Qd-up and P-up, Qd-down)
 Curves slopes down because
o Substitution effect
o Income effect
 Change in Demand
o Shifts demand curve (Pj (Substitutes, complements, independent goods), M, T, M*, N)
o Shifts RIGHT (Ps-up, Pc-down, M-up, T-up, N-up, M*-up) increase in demand
o Shifts LEFT (Ps-down, Pc-up, M-down, T-down, N-down, M*-down) decrease in demand
 Change in quantity demanded
o Increase in quantity demanded, movement UP curve, fall in price
o Decrease in quantity demanded, movement DOWN curve, rise in price

Theory of Supply

 Quantity supplied – amount that all firms wish to sell

o Flow variable
o Amount willing to sell
 Qs influenced by:
o Commodities price (P)
o Price of other commodities (Pj)
o Cost of inputs (C)
o Goals of firm (∏)
o State of technology (t)
 P-up, Qs-up and P-down, Qs-down
 Upward sloping because P-up = ∏ and Qs-up
 Change in supply
o Factors that shift supply curve (Pj (substitutes, complements), C, ∏, t)
o Shifts RIGHT (rise) ∏-up, t-up, Psj-down, Pcj-up, C-down)
o Shifts LEFT (fall)∏-down, t-down, psj-up, pcj-down, C-up)
 Change in quantity supplied
o Increase in Qs, move UP curve, price rises
o Decrease in Qs, move DOWN curve, price falls

Demand and Supply

 Interact to determine price in a competitive market (large number of buyers and sellers)
 Excess supply = negative and excess demand = positive

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 Qd=Qs at equilibrium price (any other price is inequillibrium price)

 Price below equilibrium price means excess demand
o Shortages occur, upward pressure on price
 Price above equilibrium price means excess supply
o Surplus occurs, downward pressure on price
 Rise in demand
o Rise in equilibrium price and equilibrium quantity
 Fall in demand
o Decrease in equilibrium price and equilibrium quantity
 Rise in supply
o Decrease in equilibrium price and increase in equilibrium quantity
 Fall in supply
o Increase in equilibrium price and decrease in equilibrium quantity

Elasticity

 Demand with steep slope – varies slightly with large change in price
 Demand with flat slope – varies greatly with small change in price
 Price elasticity of demand – responsiveness of quantity demanded to change in own price
o Percentage change in quantity demanded divided by percentage change in its own price
o (Change in quantity demanded divided by (Q1 +Q2)/2) (Change in price divided by
(P1+P2/2))
 ɳ = 0 quantity demanded does not change as price changes (perfectly inelastic)
 0<ɳ<1 percentage change in quantity demanded < percentage change in price (inelastic)
 ɳ=1 percentage change in quantity demanded = percentage change in price (unit elastic)
 1<ɳ<∞ percentage change in quantity demanded > percentage change in price (elastic)
 ɳ=∞ at some price, buyers will buy all they can and at a slightly higher price will buy none
(perfectly elastic)
 Total revenue – price elasticity of demand is used to determine changes in revenue of firms and
expenditures of households
 TR = Total expenditures = PQ
 Demand = Elastic P-down, TR-up
 Demand= Inelastic P-down, TR-down
 Demand =Unity TR does not change with P
 Two factors in determining ɳ
o Number of substitutes (large number= elastic, small number=inelastic)
o Widely or narrowly the commodity is defined (widely (food) =inelastic =few substitutes)
 Income elasticity of demand
o Percentage change in quantity demanded divided by percentage change in income
o Positive = normal good
o Negative = inferior good
 Cross elasticity of demand

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o Percentage change in quantity demanded of product x divided by percentage change in

price of product y
o Negative = complements
o Positive = substitutes
 Elasticity of supply
o Percentage change in quantity supplied divided by percentage change in price
 Depends on:
o Substitutes
o Widely and narrowly defined

Applications of Supply and Demand

 Households – demand
 Firms – supply
 Market failure – government alters allocation if outcome is undesirable
 Price ceiling – highest price producers may legally charge
o PC set above equilibrium price = no effect on price and allocation of resources
(ineffective)
o PC set below equilibrium price = will develop shortages and put upward pressure on
price (effective)
o First come, first serve… seller’s preference… government preferences through rationing
o Price ceilings lead to black markets
o Reasons for price ceilings
 Keep prices down (only works if no black market)
 Equitable distribution of a scarce commodity
 Restrict total supply to release resources to other production
 Price Floor – minimum price producers may sell a product at
o PF set above equilibrium price = no effect (ineffective)
o PF set below equilibrium price = surplus occurs and downward pressure on price
(effective)
 Problems in agriculture
o Short term fluctuations
 Instability in supply fluctuations due to
 Inelastic demand
 Unplanned fluctuations in supply
 Instability in demand fluctuations due to
 Low price elasticity of supply
 Unplanned fluctuations in demand
 Shifts in curves lead to large fluctuations in price, total revenue and net income
 The more inelastic the curves, the greater the change in price
o Long term trends
 Changes in long term supply

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 Technology changes and increase productivity

 Shifts supply curve right through time
 Changes in long term demand
 Economic growth led to increase in income
 Demand for food shifts SLOWLY right because elasticity for food is low
 Agricultural stabilization
o Ever normal granary
 When farmers get together and form a producer organization in an attempt to
stabilize supply coming onto market regardless of change in production
o Government price support at equilibrium price
 Government buys grain at fixed price (Pe)
 Surplus – stores gain
 Shortage – depletes storage
 Producers face perfectly elastic demand curve
 Stabilize prices but not producers revenue
 Canada is small, can’t influence market supply curve by changing production
o Government price supports above equilibrium price
 Support price is equal to price floor, government must buy surplus
 Growing surplus and more resources used in production of agricultural products
than a competitive market dictates
o Price supports through quotas
 No one can produce product without government issues quota
 Quotas hold production at desired level below free market output level
 Drives price above free market equilibrium
 Quota below equilibrium quantity maintains price above Pe without generating
surplus

Consumer Choice

- Demand curve for all HH’s are downward sloping

- HH’s maximize utility over bundles of goods subject to their budget constraint
- (x1, x2) = HH’s consumption bundle
o X1 = quantity of good one
o X2 = quantity of good two
o P1 = price of good one
o P2= price of good two
o M= money income
- Budget constraint
o P1x1 + P2x2 <(or equal to) M
 P1X1 = amount of money household spend on good one
 P2X2 = amount of money household spends on good two

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o Budget constraint requires amount of money spent on goods doesn’t exceed total
amount household has to spend
- X2 = M/P2 – (p1/p2) x1
o Equation for a straight line y=mx+b
o M/P2 = vertical intercept
o (p1/p2) = slope
- Slope of budget line is the opportunity cost of consuming one good
- Changing M or (p1,p2)
o A) rise in M; p1,p2 remain constant
 M1>M
 the vertical intercept rises
 No change in slope and budget line shifts out in a parallel manner
o B) fall in p1; M and p2 stay the same
 P11<P1
 No change in vertical intercept
 Budget lines becomes flatter (rotates out)
- Indifference curve – shows all combinations of the two goods (x1,x2) that yield the same level of
satisfaction to the HH
- A and B are yield the same satisfaction to the household
- Bundle e which lies above the curve is superior to any point on the curve because this bundle
has more units of at least one of the goods
- Marginal rate of substitution = slope of indifference curve
o Measures the rate the household is willing to substitute x2 for x1
o MRS = change in x1/ change in x2
- Well behaved indifferences curve
o Negative slope
o Convex to origin
- The rate at which a person is willing to substitute x2 for x1 decreases (in absolute terms) as we
must increase the amount of x1
- Whole series of indifference curves in x1-x2 space
- We can draw another i.c. through point e on the diagonal
- All points on this i.c. yield the same level of satisfaction as the consumption bundle at point e
- The further away from the origin, the higher the level of satisfaction
- Label the ic as i0, i1…. Etc.
- Optimal choice
o If the household chooses the best bundle of goods they can afford, the bundle will be
chosen where the budget line is just tangent to the highest i.c.
o This is the bundle that yields highest satisfaction
- At point e, the consumer will choose
o X1* units of x1 and x2* units of x2
o In equilibrium

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 MRS = p1/p2
- Comparative Statics
o Change only M
 Engel curve
 Plots quantity demanded of good against M
o Change only p1
 Demand curve
 Plots quantity demanded of a good against its own price
 Demand curve for individual household
- Market Demand Curve
o Horizontal sum of all individual demand curves
o Add up the quantity demanded of all households at given prices
- Total Utility: total satisfaction resulting from the consumption of the total quantity of a good in a
given time period
- Marginal Utility: change in total utility resulting from consuming a little more or a little less
o MU = change in TU / change in x1
- Total utility rises with each additional unit of a good
- Marginal utility decreases with each additional unit of a good
- Equilibrium for the household
o The utility maximizing household will allocate its income between commodities so that
the marginal utility of the last dollar spent on each is equal
o MU1/p1 = MU2/p2
o MU1/MU2 = p1/p2
- P1/p2 = slope of the budget line and the ratio of market prices which are exogenous to the
household
- MU1/MU2 = ratio of MUs which the household can change by adjusting the quantities of x1 and
x2 that it purchases. It is also the slope of the indifference curve.
- If MU1/MU2 > p1/p2
o Household can increase total utility by purchasing a little less of x2 and a little more of x1
- If MU1/MU2 < p1/p2
o Household can increase total utility by purchasing a little less of x1 and a little more of x2
- Prediction: downward sloping demand curve for household
o If MU1/MU2 = p1/p2
 P1 decreases to p1-1
 MU1/MU2 > p1-1/p2
 Household can increase total utility by spending a little less on x2 and a
little more on x1 until
 MU1/MU2 = p1/p2
 As a result of the decrease in price, the quantity of x1 rises
 Downward sloping demand curve for households

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**see notes for graphs

Theory of the Firm

- Firms seek to maximize profit (∏ = TR-TC)

- Uses inputs to produce outputs
- Technology efficiency
o Given level of output produced with fewest inputs
- Productive efficiency
o Given level of output produced with least cost
- Costing of factors produced
o 1) explicit costs
 Purchased factors: market price is used as cost
 Hired factor: rental price is the cost
o 2) implicit Costs
 Cost of money owned by firm
 Depreciation
 Risk taking
- Risk taking can be viewed as a factor of production and has a cost associated with it (risk
premium)
- All costs (implicit and explicit) > Revenue
o Econ Losses
- All costs = Revenue
o Zero econ profit
- Economists include all implicit costs
- Accountants exclude most of these
- Econ profits = zero, satisfactory
- Econ ∏ earning (Revenue > opportunity cost) move into this industry
- Econ ∏ loss (Revenue < opportunity cost ) shift from this industry
- Zero Econ ∏ (revenue = opportunity cost) no incentives to move to or from this industry

Production and Cost: Short Run

- Q = f (L, K)
o Q = quantity of output
o L = labour
o K = amount of capital
- Time horizons and production
o Short run
 At least one significant factor is fixed (K* = fixed) (L = variable)
o Long run
 All inputs are variable but technology is fixed

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o Very long run

 All variable and technology is changed
- Total Product (Q)
- Average Product (AP) = AP = Q/L
- Marginal Product (MP) = change in Q / change in L (slope of production function)
- AP rises, max, falls as L rises
- Max of AP is point of diminishing marginal productivity
- Law of diminishing return
o As quantities of variable rise to a given amount of fixed factor, eventually MP and AP of
variable will fall
- AP and MP
o MP lies above AP, AP is rising
o MP lies below AP, AP is falling
o MP = AP, AP is max
- Total Costs (TC or C)
o TC = TFC + TVC or C=rk*+wL
- Average Costs (AC) = u-shaped
o AC = TC/Q
o (TFC+TVC)/Q
o AFC + AVC
- Marginal Costs (MC)
o MC = change in TC / change in Q
- TC and TVC rises with output, first at a decreasing rate, then at an increasing rate
- AFC decreases as output rises
- AVC and AC first decline, reach a min, then rise
- MC declines, reaches a min, then rises
- MC cuts AVC and AC at their lowest points
- Capacity of firm is min of AC
- Smaller output than min AC, excess capacity

Production and Costs: Long Run

- All inputs can vary but technology is constant

- Profit-max firm will choose inputs that produce a specific level of output at lowest cost
- ∏-max -> cost min
- Q = f (L, k)
- Isoquant – combos of L and K that are technologically efficient in producing a given level of
output
- Higher the output, further isoquant is away from origin
- ASSUME
o Negative slope and convex to origin

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- Slope of isoquant measures rate at which firm is willing to substitute one factor for another
while output stays constant
- MRS or TRS = change in k/ change in l OR MP(L)/MP(K)
- TRS – technical rate of substitution (diminishing when convex)
- Rate at which a firm is willing to substitute K for L (down arrow) as we increase the amount of L
- Isocost Line: alternative combos of factor inputs that yield a given cost
- wL + rK = C
- K = C/r – (w/r)L
o C/r is the vertical intercept
o w/r is the slope
- Optimal choice point
o Tangency point of isoquant associated with given output level and the lowest isocost line
- Equilibrium
o TRS = MA/MP(k)=w/r
o TRS = slope of isoquant
- Convex isoquant yields diminishing TRS
- MP(l)/MP(k) > w/r
o Costs minimized by using more L and less K
- MP(l)/MP(k) < w/r
o Costs minimized by using less L and more K
- Principle of substitution: the method of production will change if relative prices of factors
change
- TC Curve: can be plotted by solving the cost min problem for each different level of output
- If factor prices are given, a min cost can be found for each output level and if each min cost is
expressed as cost/unit we can get long run average cost curve
- The LRAC shows the point where it costs the least to produce
- 0-Q(m) (up arrow returns to production)
o LRAC is decreasing as output increases
o Decreasing costs
- To the right of Q(m) (down arrow returns to production)
o LRAC is increasing as output increases
o Increasing costs
- At Q(m) (constant returns to production)
o Lowest producing cost
- Wants to produce Q(0) choose SRAC(0)
- LRAC is called envelope curve because it encloses SRAC curves
- SRAC curve is tangent to LRAC curve at output level for which quantity of the fixed factor is
optimal
- Factor price rises, SRAC and LRAC shift up
- Factor price decreases, SRAC and LRAC shift down
- Technological advance, curve shifts down

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- ∏-max decides
o To produce or not in short run
o How much to produce
- If firm shuts down in short run, costs are fixed
- If firm produces nothing, losses = fixed cost
- If firm produces, cost = variable + fixed
- In short run, if revenue > variable costs
o Part of fixed costs are being covered
o PRODUCE since losses < fixed costs
- In short run, if revenue < variable costs
o Losses = fixed costs and part of variable cost
o SHUTDOWN since losses > fixed costs
- Rule 1
o Shutdown if AR<AVC
o Produce if AR>(or equal to)AVC
o If MR > MC
 ∏ increased by increase in output
o If MR < MC
 ∏ decreased
- Rule 2
o ∏-max should expand when MR>MC until MR=MC

Theory of Perfect Competition

- Market structure (4 Types)

o Perfect competition
o Monopoly
o Monopolistic Competition
o Oligopoly
- Perfect Competition
o Firm is a price taker (take price given)
o Freedom of entry into and exit from industry
- Characteristics
o Homogenous product (product of one firm is the same as the other)
o Large number of firms
o Mobility of resources
- Almost perfectly elastic
- Demand = price
- Demand curve for perfectly competitive firm is horizontal
- Little effect on world (small in relation to total market)
- Three ways to view revenue

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o Total revenue (TR)

 TR = PQ
 P = price
 Q = quantity
o Average Revenue (AR)
 AR = TR/Q
 AR= (PQ)/Q
 AR= P
o Marginal Revenue (MR)
 MR = change in TR / change in Q
 MR= P
- D=MR=AR=P
- 2 rules for ∏-max
o AR=P>AVC for firm to produce in short run
o Produce output where MR=MC
- if firms produce to the left of Qe
o MR>MC
o Firms can increase total revenue by increasing output
- If firms produce to the right of Qe
o MR<MC
o Firm can increase total revenue by decreasing output
- To max ∏ firms adjust quantity to the point where MR=MC
- AR<AVC min firm will supply nothing
- Above AVC, firm will produce where MR= MC
- MC curve = supply curve
- Industry supply curve is the horizontal sum of the individual supply or MC curves of all firms
- Three cases of profitability
o Case 1: SRAVC < P < SRAC, P=MR=MC
 Suffering losses, P<AC, firm will shut down
 Supply curve shifts left
 P increases
 Other firms increase output
o Case 2: P = AC
 No profit, no losses
 Zero ∏ equilibrium
 No incentive for k to enter or exit
o Case 3 = P>AC
 Making profit
 Econ ∏
 New k enters
 Industry expands

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 Supply curve shifts right

 P decreases
 Existing firms decrease output
- L-R equilibrium
 P=SRMC
 P=SRAC min
 LRAC min
- If condition 3 doesn’t hold
 Firm “a” increases size to lower cost
 Firm “b” decreases size to lower cost
 Until P=MR=SRMC=SRAC min=LRAC min
- Assume
 Technology is constant
 Firms are in long run equilibrium initially
 Introduce a change in demand
- What adjustments occur?
o Short run
 D shifts to right
 Upward pressure on price
 Rise in price leads to rise in output leads to rise in ∏s
o Long run
 Making econ ∏
 New firms enter
 S curves shifts right
 decrease in price leads to decrease in production
- Case 1: Constant Cost Industry
o P1, Q long run equilibrium change in D from D1 to D2
o P increase from P1 to P2
o Firms increase output, Q1 moves to Q2, P2-MR2=MC
o ∏s
o New firms enter
o S curve, S1 to S2
o P decreases
o Horizontal S curve
o Cost of production remains constant
- Case 2: Declining Cost Industry
o P1, Q1 change in D from D1 to D2
o P increases from P1 to P2
o ∏s
o New firms enter
o S shifts right

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o Price decreases
o Downward sloping S curve
- Case 3: Rising Cost Industry
o P1, Q1 change in D from D1 to D2
o P increases from P1 to P2
o ∏s
o New firms enter
o S shifts right
o P decreases
o Upward sloping S curve

Monopoly

- The market structure where the output of the industry is controlled by a single seller
- Assume
o One firm in industry
o Firm is price maker, monopolist chooses price and quantity
- AR =TR/Q
o AR=P
- Demand curve represents AR also therefore D=AR
- Revenue depends on elasticity of D curve
o N>1, if P decreases when TR increases
o N<1, if P decreases when TR decreases
o N=1, if P decreases when there is no change in TR
- At v-intercepts D->0 therefore MR=P
- Where TR is max, MR=0
- Connecting these gives MR curve
- MR for monopolist has twice slope of D curve
- Never operate where MR<0 (inelastic)
o Why? Costs always > 0 therefore MR > 0
- Range of output lies between Q1 and Q2
o Points to left of Q1 and right of Q2
 AC>P
 Losses
- Output that max ∏ is where MR=MC at Qm
- Monopolist sets price corresponding to this at Pm
- If monopolist makes positive ∏s in the short run, new firms will NOT enter because there are
barriers to entry
 Monopolist may control factor inputs
 Fixed costs may be too high (LRAC curve is continuously decreasing)
 Government gives monopolist legal rights to industry

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 Patent laws: confer sole right to produce a certain commodity to the patent
holder
- Given cost curves and D curve for monopolist, decides:
o Level of output to produce where MR=MC
o Set price according to D curve
- Monopolist can make econ ∏, econ losses and zero econ ∏
- No supply curve for monopolist because P cannot equal MR=MC
- If product has substitutes
o Setting price may shift D curve for substitute
o New price for substitute
o Shift in monopolist D curve
- In this case, may not have total power: Imperfect competition
- Collusion: several firms agree on a common price
- Quantitative variable: degree to which firms can set price
- Two common measures of monopoly power:
o Concentration ratio : total market sales controlled by largest group of sellers
 Greater ratio means more power
o Profits
 Greater ∏s, more power
- Price discrimination (change price depending on consumer)
- Non-discriminatory prices (if price differences are due to cost differences)
- Two conditions of pd
o Sellers control supply of production
o Sellers prevent resale from one buyer to another
- Case 1: Perfect Price Discrimination
o Unit sold to person paying highest price
o Ex. Monopolist charges $5.00 for first unit, $4.00 for second, etc.
 TR= 5+4+3+2+1 = $15.00
 ∏ = TR-TC = 15-5=$10.00 AR=TR/Q
o Limited to one price= P3, 3 units, TR = 3(3) = $9.00 ∏=TR-TC=$6.00
- Case 2: Price discrimination with separate markets
o Markets have different elasticity’s of demand
o MC= MRA + MRS = Total MR
o ∏ max is at Q in diagonal where MC=MR
o Allocates output so
 MR(a) = MR(b) = MC +changes
 A price according to D curve
- Price discrimination results in:
o Higher TR, AR, ∏s compared to single priced monopoly
o Larger output levels compared to single priced monopoly

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Imperfect Competition

- Imperfect competition includes monopoly, oligopoly, monopolistic competition

- Firms can set price
- MONOPOLISITIC COMPETITION
o Characteristics of monopolistic competition
 Freedom of entry and exit
 A large number of small firms
 Firms engage in NON-PRICE COMPETITION such as advertising
 Firms employ product differentiation (where products are distinguished by
differences)
 Quality differences
 Packaging
 Labeling
 Brand image
o Downward sloping demand curve that is elastic because there are many close
substitutes
o No perfect substitute
o Max profit by producing where MR=MC then setting the price corresponding to this level
of output according to the demand curve
o No barriers to entry
 New firms must share total market demand with old firms
 The demand curve and MR curve for the firm shift left
 This process continues as long as there are profits in the industry
 Industry expands
o Long run equilibrium is attained at zero profit equilibrium
o The l-r equilibrium output level is less than AC MIN output so excess capacity (Q*-Q1)
exists for the firm
o Equilibrium price will be greater than AC MIN
o If costs are similar under monopolistic competition and perfect competition, the
equilibrium price will be greater and the equilibrium quantity less
o Monopolistic competition produces a wide range of products but at a higher cost than
perfect competition
o Usually profitable to engage in product differentiation and non-price competition (may
change the shape and position of the D curve, increasing TR, thus increasing profit)
- OLIGOPOLY
o Characteristics
 A few large firms
 The market demand curve is not the oligopolist demand curve
 Demand curve downward sloping
 Engage in non-price competition and product differentiation

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If oligopoly persists, there are barriers to entry

Mutual interdependence (must consider reaction of its competitors when
deciding on price and output) (strategic behavior)
o Analytic methods for developing models of oligopoly
 Model based approach
 Make assumptions about how firms react and develop models based on
these assumptions
 Empirical approach
 Develop hypothesis of oligopoly behavior and empirically test them
 After a number of hypothesis have seen accepted, we can formulate a
general theory
o Barriers to entry maintain profits and maintain oligopoly structure
o Type of barriers to entry
 Absolute cost advantage
 Existing firms have AC curves lower over their entire range of output
than those of new entrants
 Set limit price
 Losses for companies who enter and charge below the limit price
 Scale advantage
 Minimum efficient scale – smallest size firm that can reap all the
available economy of the large scale
 If there is a large MES, barrier to entry
 Created barriers to entry
 Predatory pricing
o When an entry occurs, existing firms cut prices to force entrant
into bankruptcy
 Advertising
o Advertising shifts up cost curves
o New entrants must also advertise
o Set-up costs rise for potential new entrants
o Advertising increases total costs to ATC, scale advantage to large
sellers
 Brand proliferation
o Where existing firms sell a large number of differentiated
products so that entry on a small scale is difficult

Economic Efficiency

- Form a producers association or cartel, it increases industry price and decreases industry output
- Assume costs are not changed by this
- A decrease in industry output is accomplished by persuading each firm to decrease output
- A successful cartel must be able to:

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o Reduce output levels of individual firms

o Enforce output restrictions on all firms
o Restrict entry of new firms so as to maintain monopoly price and profits in the long run
- Decreasing costs result in greater change in P and Q under perfect competition than under
monopoly. The monopolist’s MR curve is steeper than its D curve.
- If the cost curves are the same for perfect competition industry and monopoly, we would expect
that the monopoly would charge a higher price and produce a lower level of output vis-à-vis
perfect competition.
- Perfect competition industry sets equilibrium P and Q where D=S=MC
- A monopoly determines quantity where MR=MC and sets price according to D curve
- Price
o What households are willing to pay for the last unit of a commodity purchased
o Marginal benefit (MB)
- MC
o The opportunity cost of producing the last unit of a commodity
- In perfect competition P=MC
o What households are willing to pay for the last unit = opportunity cost of producing the
last year
- In monopoly, P>MC
o Households are willing to pay MORE for the last unit than the opportunity cost of
producing it
- Pareto optimal
o An economy where all industries are characterized by P=MC
o Aka allocative efficiency
- Pareto Optimal
o The theory of 2nd best
 We know that P=MC is best, but if best can’t be attained, we do not know what
second best is
o Divergence of private and social costs
 Firms private cost may not reflect the opportunity costs to society
 If social costs > private costs, restricting the output may be socially desirable
o Society may have goals other than allocative efficiency
 It may be concerned with the distribution of income
o Cost advantages to a monopoly
 A monopoly charges a lower price and produces more output than does a
perfect competition industry
o A monopoly and oligopoly may have more of an incentive to innovate than does perfect
competition
- Incentives to innovate (try to decrease costs) depend on:
o The possibility of decreasing costs and raising profits
o The means and resources to engage in research and develop

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o The magnitude of expected extra profits

o The time period over which the extra profits are expected to exist
- Monopolist has greater incentive to innovate (decrease profit) because of barriers to entry
- Profits can be attained in both s-r and l-r while in perfect competition profits can be attained
only in the short s-r
- Two forms of public policy toward monopoly
o Competition policy
 Combine laws or competition act in Canada and antitrust laws in US
 Legislation or laws which prohibit certain restrictive trade practices, conspiracy
in the restraint of trade and acquisition and exercise of certain types of
monopoly power which are trade to “unduly” lessen comp which would be
harmful to public interest.
o Direct regulation
 In the case of a natural monopoly where the economies of scale are so large
such one firm can supply the entire market more efficiently than a number of
smaller firms, the government had granted a monopoly exclusive production
rights in exchange for being regulated.
 Public ownership (Canada post, sasktel, etc.) or public utility regulation
(SaskPower)
 Unregulated
 Output is where MR=MC and price is set at Pm
o AR>AC
o Large econ profits
 Regulated
 Price is set where AR=AC and output is Qr
o Average cost pricing
o Zero econ profit
o Positive accounting profit
 Regulatory commission set price as low as possible such that all costs are
covered (zero econ profits)

Factor Markets

- Basic factors of production are land, labour (L) and capital (K)
- Households are assumed to own ALL of the factors produced
- Demand for factors of production is a derived demand
- Total demand is the sum of all demands for it in each productive activity
- Demand curve for factor of production is downward sloping because
o The relationship between the demand for the commodity and the factor of production
 If w increases
 Increase cost of production
 Supply curve for output shifts upward

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 Increase Pe
 Decrease Qe
 Qd decreases
o Substitution among factors
 If w increases
 Firms will use more of the cheaper factor
 Firms substitute K for L
 Qd decreases
- Elasticity of demand for a factor of production
o Percentage change in Qf / percentage change in Pf and varies directly with the following
 Elasticity of demand for the final product
 The more elastic for the demand for the final product, the more elastic
for derived demand for the factor
 The more inelastic the demand for the final product, the more inelastic
the derived demand for the factor
 The degree of substitutability
 The greater the ease with which one factor can be substituted, the
greater the elasticity of demand
 The proportion of total costs of production
 The more the factor accounts for total costs, the more elastic the
derived demand for the factor
- Profit max rule for a firm in perfect competition
o Produce where MR=MC
- Profit max for factor of production
o MC=MRP
o MRP is the marginal revenue product of labour
- MRP = MP x MR

= MP x P

- w – MRP
- w is the price of a unit of L
- if we sum over ALL firms we get the market demand curve for L
- net advantage
o including both monetary and non-monetary rewards to a factor in a particular use
- hypothesis of equal net advantage
o owners of factors will choose that use of their factors that produces the greatest net
advantages to themselves
- upward sloping supply curve for a factor in a particular use
- elasticity of supply
o if factor moves easily between uses in response to a small change in incentives
 highly mobile and very ELASTIC

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o if factor does NOT move easily between alternatives uses in response to a large change
in incentives
 highly immobile, very INELASTIC
- Why might factor-price differentials exist?
o Dynamic (disequilibrium) differentials
 Brought about by circumstances such as the growth of one industry and decline
of another
 Results in reallocation of factors and are eliminated in equilibrium
o Equilibrium differentials
 Differences in factor prices which persist in equilibrium without generating
forces to eliminate them
 They are related to
 Intrinsic differences in the factors themselves
 Differences in the cost of acquiring skills
 Different non-monetary advantages of different factor employments

Wage Determination

- Case 1: Competitive Labour Markets

o Large number of buyers of L
o Large number of sellers of L
- Case 2: UNION in a Competitive Labour Market
 Single seller of L, the union, which sets the wage rate
 Large number of buyers
o the union sets the wage rate at w
 the quantity of L employed to Q
 surplus of L equal to Q0-Q1
 UNEMPLOYMENT
o Effects of union setting wage above w are:
 To increase the wage rate of those who remain employed
 To decrease the actual amount of employment in the industry
 To create a group of workers who would like to obtain jobs in the industry but
cannot
- Case 3: Monopsonistic labour market without a union
 Single buyer of L, the monopsonist
 Large number of sellers of L
o The labour supply curve is the AC curve for the monopsonist i.e. the S curve shows the
wage rate per hour that it must offer
o The MC is upward sloping and is greater than AC
o The monopsonist employs less labour at a lower wage rate than a perfect competitor
- Case 4: A union in a monopsonistic labour market
 Single seller of L, the UNION

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 Single buyer of L, the MONOPSONIST

o The union turns firm into price taker and can prevent the exercise of the firms
monopsonistic power and can therefore increase both wages and employment
o If it chooses to increase wages further, we can the outcome in case 2
o Collective bargaining
 The negotiation, administration and interpretation of an agreement between
the union and employer
o The outcome of collective bargaining
 Labor is traded in a different manner than goods or services. Labor is traded in a
market which is dominated by medium-term contracts which last 1-3 years.
o Unions may restrict the supply, putting upward pressure on the wage rate
o Methods used to restrict supply
 Occupational licensing
 Restricted openings for trainees
 Exclusive unionism (only union members can be employed)
 Immigration quotas on certain types of labor
o All the above create a barrier to entry
o No surplus of labor at a higher wage rate

Market Success

- Society must decide

o What to produce
o How to produce
o How much to produce
o For whom to produce
- The allocation of resources is determined by the price system or market mechanism
- Firms make decisions about what to produce and how much by estimating the cost of
production and potential sales receipts
- Input prices determine how goods will be produced
- Effects of change in economy
o Impact effect
o Spill out effect
o Feedback effect
- Partial equilibrium analysis
o Analysis of the effect of a change within a market or sector
- General equilibrium analysis
o Analysis of a change focusing on impact, spill out and feedback effects
- Price system is successful when
o MNSB = MNPB (marginal net social benefits = marginal net private benefits)
- Private benefits

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o Benefits which accrue to the parties directly involved in the transaction

- Social benefits
o Benefits to society
- Sources of market failure
o Externalities
 Effects on parties not directly involved
o Market imperfections
 Imperfections that hinder resource allocations, such as
 Factor immobility
 Monopoly power
 Barriers to entry
 Lack of knowledge
o Public (or Collective Consumption) Goods
 Goods or services which provide benefits to a large number of people and
where it is difficult or impossible to exclude individuals from receiving the
benefits of these goods
 Two characteristics: non-rivalry and non-excludability
 Free rider problem
o Ability to collect revenue
 The market system will produce less than the social optimum if the cost of
collecting revenues is prohibitive
o Non-market goods
 Even if the market system allocates resources efficiently, society may have other
goals which may not be achieved via the price system
 Quasi-public goods
 Goods and services which could be produced and delivered in such a
way that the exclusion principle applies
- Methods to correct market failure
o Rule making
o Establish a legal mechanism
o Changing private incentives through use of taxes, penalties, subsidies
o Public provision of the good or service
o Unconditional grants and gift
- How to get firms to produce Q*
o Nationalize and let the government produce Q*
o Regulate such that firms produce Q*
o Fine the firm if production is less than Q*
o Give the firm a subsidy or grant if it does not produce more than Q*
o Make firms internalize the externality
- Methods of internalizing externalities
o Effluent charge

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 Fee, fine or tax per unit of output equal to the per unit external cost
 Firms must pay the external cost
 Supply curve shifts left
 Profit max firm now produces Q*
o Force firms to compensate society which incurs the external cost at a dollar amount =
external cost
 Firms must pay the external cost
 Supply curve shifts left
 Profit max firm now produces Q*

Government Taxation and Expenditure

- Revenue less expenditures

- Purpose
o To raise revenue to finance government expenditures
o To change the distribution of income
o To affect the allocation of resources
- Progressivity of taxation
o How the ratio of taxes over income changes as income increases
- Progressivity of taxation
o A tax is proportional if the ratio stays constant as Y increases
 The amount of taxes changes in direct proportion to income
o A tax is regressive if the ratio decreases as Y increases
 The tax is a smaller percentage of income as Y increases and the is a large
percentage of income as Y decreases
o A tax is progressive if the ratio is increasing as Y increases
 A tax is a larger percentage of income as Y increases and a smaller percentage of
income as y decreases
- Distributional effects of taxes
o Excise (quantity) tax
 Tax on each unit of a good purchased
 Regressive if takes a larger percentage of the familys income, the lower
the family’s income
 Progressive if tax is on a commodity such as jewelry where the rich
spend a larger proportion of their income than the poor
o General sales tax
 Tax on the value or price of a good
 Regressive
o Individual income tax
 Progressive
- Tax incidence
o Who ultimately pays the tax and what is the burden of the tax

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- Case 1: Per Unit Tax

o Perfect competition
 In the short run, part of the tax was paid by consumer and part by producer
 In the long run, the consumer paid all the tax
o Monopoly
 The per unit tax shifts up both MC and AC
 Full incidence falls o n consumers
- Case 2: Lumpsum Tax
o Not dependent on output, fixed cost
o Doesn’t shift MC curve, shifts AC curve
o Perfect competition
 Short run, output will not change since MC does not change
 Short run, full incidence on producers
 Long run, full amount paid by households
o Monopoly
 Does not affect the output level since it doesn’t affect MC curve
 AC curve shifts up
- Case 3: Tax on pure econ profits
o Tax falls totally on producers
o Doesn’t affect price or output level

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