LECTURE 1:

› ​Microeconomics: deals with individual households, firms, industries and markets​ ›

focuses on
- relative prices
- allocation of output, employment etc.

› ​Macroeconomics: deals with the economy as a whole, including both the financial and
real sides​ › focuses on
- the overall price level
- aggregate (i.e. total) output
- aggregate employment and
- unemployment
- interest rates and exchange rates

Scarcity: resources are limited, so that not all wants and needs can be met
› For example, if I use my money to buy one product, then I cannot use it to buy something else
› Under scarcity, individuals need to make choices:
- What to produce and in what quantities? E.g. Do we produce more cars or do we extend the
public transport system?
- How to produce? E.g. Do we use people (labour) or machinery (capital goods) to produce the
goods? - Who should get what is made? E.g. Do ‘wealthy’ consumers receive most of the
goods, or how might we reallocate goods so that they are shared more ‘equally’? - Where to
produce? Do we produce in Australia or Japan? That is, do we undertake international trade? -
When to produce? E.g. Will a supermarket operate 24 hours per day 7 days a week, or, 8 hours
for 6 days a week?
Because of scarcity, any choice involves a trade-off, or opportunity cost
› ​The opportunity cost is the value of the sacrificed alternative when a choice is made,​ i.e.
the value of the best alternative foregone.
o = what we give up when we make that choice, or “the value of the next best forgone
alternative”.
o This concept applies to any resource used when making a choice: how an individual spends
their time and other resources
o For example, a consumer buys a sandwich. Her next preferred product is sushi. Given this,
the opportunity cost of buying a sandwich is foregoing (not having) sushi.

Examples of opportunity cost: - On Saturday night you decide to watch a movie on TV with your
flatmate but you could have also accepted a babysitting job for $25/hour. - What´s the
opportunity cost of spending your time (2 hours) watching a movie on a Saturday night?

Elizabeth prefers to spend Saturday afternoon walking. Her next best choice would have been
to sleep, and her third best choice is to go swimming. - Therefore, if Elizabeth goes for a walk,
the opportunity cost of going for a walk is sleeping – her best foregone opportunity. - The option
of swimming is not relevant here, because it is not the next best opportunity.

Opportunity costs include both explicit costs and implicit costs.

o ​Explicit costs​ are costs that involve direct payment (or, in other words, costs that would be
considered as costs by an accountant).
o ​Implicit costs​ are opportunities that are foregone that do not involve an explicit cost.

Example: o Stephen decides to go to university, and his next best option is to work at a
construction site and earn $80K over the year. - Total opportunity cost = explicit costs + implicit
costs - The explicit costs are those that Stephen must directly pay to go to university, such as
student fees, the cost of textbooks, and so on. Lets say that it costs $20k a year to go to
university. - The implicit costs are the opportunities that Stephen must forgo – that is, working at
the construction site and earning $80K. - The total opportunity cost is thus $100k a year.

Opportunity cost does not include unrecoverable or sunk costs.

o For example, a business spent $100m on an advertising campaign last year and needs to
decide whether to keep the campaign going for another year. o It cannot recoup the money (or
the effort) spent on last year’s campaign by deciding to stop the campaign now o Thus
$100m=sunk cost, not part of the total oppportunity cost of continuing the campaign now.

Marginal means additional or extra. ​We use the term repeatedly in economics.
o Marginal benefit
o The additional benefit received from consuming an extra unit of something.
o Marginal cost
 o The additional cost incurred through buying one more unit of something).

› Marginal analysis is useful as it allows us to examine the behaviour of individuals in market.

o If the marginal benefit (MB) of an activity is greater than its marginal cost (MC), an agent is
better off doing that activity; if the MB is less than the MC, they are worse off if they do the
activity.
o Decision making is thinking at the margin.
o Example:

Here, the individual should only consume 3 ice creams, as they would be worse off consuming
the 4th ice cream.

Correlation ​– an association between two or more factors whereby the factors are observed to
be increasing/decreasing together or moving in opposite directions.
Causation​ – a change in one variable brings about, or causes, a change in another variable.
o Economic theory, providing a framework for how the world works, allows us to distinguish
between correlation and causation.
› Correlation does NOT imply a causation

› In the real world, many things change at the same time (prices, income, tastes, taxes, and so
on).
› To isolate the impact of one factor, economists examine the impact of one change at a time,
holding everything else constant – this is called ​ceteris paribus ​(or ‘other things equal’).
o If we are interested in the impact of the change in the price of a good on the quantity
demanded, we analyse this holding income, and any other relevant variables constant.

At any point in time individuals (and economies) have constraints given by

- Resources, i.e. land, the ‘factors of production’ labour, capital, and entrepreneurship
- Technology
› Land: any natural resource provided by nature. Land includes anything above and below the
ground such as forests, gold, diamond, oil, rivers, lakes, air, the sun, the moon…etc.
› Labour: mental and physical capacity of workers to produce goods and services
› Capital: physical plants, machinery, and equipment used to produce goods and services
 - Include financial capital: the money used to purchase physical capital ›
Entrepreneurship: the ability of individuals to seek profits by combining resources to produce
innovative products
A PPF graphs the output that an individual (or a country) can produce with a particular set of
resources.
› A country’s PPF shows all the combinations of goods and services that a country can produce
given its resources and its current state of technology.
- Note that if the country does not trade with others, the PPF also describes the country’s
consumption choices.
Notice that the slope of this PPF increases as we move down along it. Or, in words, the PPF is
concave Why is that? - If we produce no guns but only butter (point A) and then decide to
produce 100 guns, how much butter do we need to give up? - But if instead we were producing
the bundle E, what’d then be the opportunity cost of producing 100 additional guns? - Here, the
opportunity cost of each good is increasing in the level of output of that good
If either the amount of resources available or the state of technology changes, the shape of the
PPF can also change.
o An improvement of technology could shift the curve out (if it improves productivity for both
goods) or rotate the PPF out or up (if the new technology only improves production for one of
the goods).
› The slope of the PPF is the opportunity cost of producing an additional unit of a good in terms
of the other. › It depends on the country’s productive resources (labour, capital, land, etc.) and
the current state of technology.

A basic tenant of economics is that trade makes people better off.

o Trade helps allocate goods to those who value them most. This is the gains from exchange.
o Trade = economic interaction
o Trade helps allocate goods to those who value them most. This is the gains from exchange.
o Gains from exchange = Improvements in income, production or satisfaction owing to the
exchange of goods or services

A simple example (with consumers): - Suppose Baz owns a bicycle he rarely rides and thus he
values little, say at $10. - Chloe would like to have a bike. She is ‘willing to pay’ (i.e, values a
bike) at $100. - If Baz sells the bike to Chloe for $40, then: - Chloe is better off because she
gets a $100 value bike for $40 - Baz is better off because he gets $40 when he only valued the
bike at $10. - This trade is Pareto improving –both agents are better off. - Provided the price is
between $10 and $100 both parties can be made better off by trading the bike

Key here is that exchange is voluntary - Leaves both parties better off - Whether the Pareto
improving trade is weak or strong depends on the valuations of each of the parties - How much
individuals benefit will depend on the terms under which trade occurs: - a higher price suits the
seller, a lower price the buyer. › Trade also allows people to take advantage of gains from
specialization, reducing overall costs of producing and increasing output. - related to
“comparative advantage” in production

Consider economy when Robert can only wash clothes and Matt can only cook. - gains from
trade, allows each to consume a new good › When each can perform both tasks, but Robert can
only cook at great cost and Matt can only wash clothes with a substantial effort. - specialising
lowers cost, can make both better off › But what if one party is better at producing both
services?
Party A has an absolute advantage over Party B in the production of a good if, for a given
amount of resources, A can produce a greater number of that good than B.
› Party A has a comparative advantage over Party B in the production of a good if A's
opportunity cost of producing that good is lower than B's opportunity cost of producing the same
good.

› Matt needs 3 hours to produce 1 basket. In that time she could produce 6 meals - opportunity
cost of 1 basket is 6 meals - reflected in the slope of the ppf (-6) › Robert’s opportunity cost of 1
basket is 2 meals - slope of ppf -2 › Note, the opp cost for Matt of producing 1 meal is 1/6
baskets - it takes 30 minutes to make a meal, in that time would wash 1/6 a basket › Also, opp
cost for Robert of producing 1 meal is 1/2 baskets

• Differences in opportunity costs of production create gains from specialisation and trade •
Each person specialises in the good in which they have a comparative advantage • Because
economic pie increased in size everyone can be better off - each party can obtain the good for a
lower price than his/her opportunity cost - i.e. Robert buys each meal for 3/10 basket of laundry
while his opportunity cost of cooking is 1/2 a basket of laundry.

› Total output increases because trade allows parties to specialise in producing the good in
which they have the lower opportunity cost. o With more output, both trading parties can
potentially be made better off. o Trade creates an environment for specialization to be feasible,
increasing the size of the economic pie. o This increase in output can potentially be shared so
as to make everyone better off than without trade.
› This concept is very general: o Trade is beneficial to individuals (and indeed countries)
because it allows them to specialize in industries where they have the comparative advantage,
and trade with others for things that would cost them more to produce personally. o Moreover,
this principle holds even if one party has the absolute advantage in the production of both
goods; what matters is the comparative advantages or opportunity costs of the parties.

WEEK 2 Lecture 2: Firm Behaviour: Production, Costs and Firm Supply

Outline
1 The Firm
2 Production Function
3 The Costs of Production
Short-run Costs
Long-run Costs
4 Technology and Economic Efficiency
5 Firm Supply

Economic profit versus accounting profit

› We assume that firms aim to maximise profits, where
profit = Economic profit
› Economic profit may differ from accounting profit
› ​Accounting profits​ are revenues minus all explicit costs
› ​Economic profits​ are revenues minus total opportunity cost

Economic Profit
Profit: total revenue minus total costs
Pi = TR – TC
Total revenue​ : the amount a firm receives for the sale of its output
Total cost ​: the amount a firm pays to buy the inputs of production + forgone opportunities =
total opportunity cost of producing goods/services
● Opportunity costs include
○ explicit costs (that are not sunk) = direct payments for inputs or factors of
production
○ implicit costs (value of foregone opportunities) e.g. forgone wages, interest
earnings
Example: Helen uses $300000 of savings, interest rate at 5 %. Thus Helen gives up $15000 per
year in interest Not an explicit cost – but it is an opportunity cost while she is running the firm, so
needs to be included in costs (and measures of economic profit).

Zero economic profit ​– revenues just cover opportunity costs

› Firm’s goal is to maximise profit where profit = economic profit

› Economic profit may differ from accounting profit
› Accounting profits are revenues minus all explicit costs
› Economic profits are revenues minus total opportunity cost

Bazza recently opened a restaurant. This requires Bazza to (temporarily) give up a job working
as a lecturer at the university that pays $20 000 a year. The restaurant is located in a house he
inherited from his grandmother, of which he is the sole owner. The house would otherwise be
rented out at a price of $30,000 a year. This year, the restaurant has revenue of $200 000,
personnel costs of $50 000 and costs of food inputs of $20 000. What is Bazza’s economic
profit of running his restaurant this year?
A - $80,000
› Explanation: Economic profit = Total revenue – Explicit costs – Implicit costs › Here, revenue =
$200,000 › Explicit costs = $50,000 (personnel costs) + $20,000 (food inputs) = $70,000 ›
Implicit costs = $20,000 (forgone wages) + $30,000 (forgone rental income) = $50,000 ›
Therefore, Economic profit = $200,000 - $70,000 - $50,000 = $80,000

› What is a firm ?
● A firm, using the available technology, converts inputs – labour, machinery (often called
capital), natural resources (typically called land) – into output that is sold in the
marketplace.
● Typically, a firm will require more than one input to produce its final output.

› We define the short run and the long run of a firm in relation to whether or not any of the
factors of production (inputs) are fixed
- An input is ‘fixed’ if it cannot be changed regardless of the output produced

› The short run is the period of time during which at least one of the factors of production is fixed
- or example, the size of a factory might not be able to be changed.

› In the long run, all factors of production are variable (that is, not fixed).
 - Therefore, in when the firm's lease of the factory ends, the firm is free to decide whether
or not to renew the lease for that factory.

› The short run and the long run is not defined in relation to a set period of time, but rather in
relation to how long it takes for all of a firm's inputs to become variable – this will differ between
industries.

Production
› A firm requires inputs or factors of production (labour, capital, land, etc.) in order to produce its
final output (i.e. goods or services).
› ​A production function ​shows the relationship between quantity of inputs used and the
(maximum) quantity of output produced, given the state of technology.

Shortrun Example
› Jonathan owns a factory that makes umbrellas. › Assume the factory size cannot be changed
– that is, we are in the short run. › Jonathan chooses how many workers to use o with one
worker, he can make 60 umbrellas; with two workers, 110 umbrellas; three workers, 150
umbrellas; four workers, 180 umbrellas. › The relationship between inputs (number of workers)
and output (number of umbrellas) is the production function. › Often a production function is
represented using an equation. o For example, q=f(L) where q is the level of output and L the
amount of labour.

More Laborers, the amount of q becomes less

Marginal product
› The marginal product (MP) is the change in output when one more input is used.
› In the umbrella example above:
- Hiring one worker (rather than having no workers at all) allows 60 umbrellas to be made
rather than 0 – the MP of the first worker is 60.
- If Jonathan has one worker and hires one additional worker, output increases from 60 to
110 – the MP of the second worker is 110 - 60 = 50.
- If Jonathan has three workers and hires one additional worker, is output will increase
from 150 to 180; the MP of the fourth worker is 30 umbrellas.
› MP is the slope of the production function

Diminishing MP
› MP of an input changes as we increase the use of that input.
› If the MP becomes progressively smaller, this is called ​diminishing marginal product​.
- In the example above concerning Jonathan's umbrellas, the marginal products of the
second, third and fourth workers respectively are 50, 40 and 30, indicating diminishing
marginal product;
- that is, each additional worker contributes less to output than the worker before.

› Diminishing MP is very common

- In the short run there is a fixed input of some kind which creates a capacity constraint;
- this will mean that each additional worker will contribute to output less and less than
those hired before.
› Crucially, diminishing MP is a ​short-run​ concept
- It relies on the idea that at least one input (like the factory) is fixed.
- Think of it as initially, the first few workers have a lot of space to do productive work.
However, the more workers are added, the more crowded the factory becomes and the
less productive each additional worker is as they do not have enough space to do
productive work.

Production in the LONG RUN

› Allow all inputs into the production process to be variable.
- In our umbrella manufacturing example, Jonathan can now vary all inputs in production
process; he can choose the factory size as well as the amount of labour utilized.

› Given all factors of production are variable, we are in the long run.
› We are interested in how the quantity of output changes when we change the quantity of all of
the factors of production.
- production function in the LR: q = f (L,K)

RETURN TO SCALE - FOR LONG RUN

› Returns to scale refers to how the quantity of output changes when there is a proportional
change in the quantity of all inputs.
- If output increases by the same proportional change,
there are ​constant returns to scale ​– if we double
the quantity of all the inputs and output also doubles
in quantity.
- If output increases by more than the proportional
increase in all inputs, we have ​increasing returns to
scale.
 - If output increases by less than the proportional increase in all inputs, there are
decreasing returns to scale.
› Note, it is possible that a firm has diminishing MP in the short run, and still has increasing
returns to scale in the long run!

› The production function relates inputs and outputs › The firm’s cost function relates the total
cost of production and output › There is a one-to-one relationship between the production
function and cost function › The production function and the cost function ‘tell the same story’ ›
They are two sides of the same coin

› A cost function is an equation that links the quantity of output with its associated production
cost. - For example, TC = f(q), where TC represents total cost and q represents the quantity of
output. › Example: Helen’s cakes, wage for a worker is $10

A Typical Short run cost curve

› Several points are worth noting:
› When output is zero, total cost is positive
- this is because, in the short run, some factors of production are fixed and must be paid
for.
› The total cost curve rises as output increases
- costs increase when more inputs are required
› The total cost curve rises at an increasing rate
- this captures diminishing MP: as output increases, a greater quantity of inputs is needed
to increase output by the same amount.

Fixed and variable cost

› In the short run, some inputs will be fixed and some inputs will be variable; as a consequence,
a firm will have some fixed costs and some variable costs.
› Fixed costs (FC) are costs that do not vary with output. When output is zero, all the costs are
fixed costs.
› By contrast, Variable costs (VC) are costs that vary with output. All costs that are not fixed
costs will be variable costs.
VC = TC – FC
› And hence Total costs (TC) consist of fixed and variable costs:
 TC = VC + FC

Average Cost
› Average fixed cost (AFC) is fixed cost per unit of output: AFC = FC/q
- Note that the AFC curve is always downward-sloping – why?
› Average variable cost (AVC) is variable cost per unit of output: that is, AVC = VC/q
- Because of diminishing MP, the AVC curve will eventually be upward-sloping.
› Average total cost (ATC) is total cost per unit of output; ATC = TC/q
- As ATC = AFC + AVC, its shape is affected by both.
- At very low levels of output, ATC is usually the decline in AFC dominates, but at higher
levels of output, it is usually upward sloping because the increasing AVC dominates.
- Together, this will give the ATC curve a U-shape (i.e. initially decreasing, but eventually
increasing with output).

Marginal Costs
› Marginal cost (MC) is the increase in total cost from an extra unit of output.
› Due to diminishing MP, a typical MC curve will eventually be increasing in output; MC often
has a positive slope.
- In our umbrella example, each worker costs the same to hire but produces progressively
less than the previous hire (diminishing MP).
- The extra cost of producing another unit of output (MC) must go up.
- In the short run
diminishing MP
implies increasing
MC
› AFC declines as Q increases. Why? (hint: think about the TFC)
› AVC declines initially, reaches a minimum , and then increases again. It looks like an U shape.
Why?
› MC also declines sharply, reaches a minimum and then rises rather sharply. Why? (think about
the law of diminishing returns)
› The MC curve cuts both the AVC and ATC curves at their minimum points. Why?
- When MC > ATC
- ATC increases
- When MC < ATC
- ATC falls
- When ATC = MC
- ATC is at its minimum

Relationship between ATC, AVC and MC

› The relationship between MC, AVC and ATC is important. › As a rule, MC passes through the
minimum of ATC and AVC. o Think of a student’s test scores; if the next test score (the marginal
score) is higher than the student’s average, the average rises; if the next test score (the
marginal score) is lower than the average, the average falls. o The same logic applies to costs:
if MC is above ATC, ATC rises; if MC is less than ATC, ATC is falling; it follows then that MC
intersects ATC at the minimum of ATC. o The same applies to MC and AVC; MC intersects the
minimum of AVC (from below).

› Example: MC = 10, 20, 30, 40, 50, 60, 70. FC = 100

› ATC(1) = (100 +10)/1 = 110
› ATC(2) = (100+10+20)/2 = 65
› ATC(3) = (160)/3 = 53.3
› ATC(4) = 50
› ATC(5) = 50
› ATC (6) = 51.7
› ATC (7) = 54.3
› When MC below ATC, ATC is falling as q increases
› when MC above ATC, ATC is increasing as q increases

Long Run costs

All factors are variable in the long run
- All costs are variable.
- No fixed cost (If a firm does not want to produce anything, its costs will be zero)
- The firm can alter its plant capacity or capital
- A firm producing a positive output has more flexibility to adjust all of its inputs, so long-run
costs should not be more than short-run costs (for a given level of output)
› In the LR, the firm will choose:
- The most efficient production method
- The cheapest combination of all inputs – recall that all inputs are variable in the LR

Long-run marginal and average cost

› Long-run marginal cost (LR MC) is the marginal cost of increasing output by one unit. It must
take into account the fact that all inputs can be varied to achieve this increase. Thus, the LR MC
will not be more than SR MC.
› The long-run ATC shows the lowest per-unit cost at which any output can be produced after
the firm has had time to make all appropriate adjustments in its plant size
- Depend on the output, firm adjust its plant size and achieve the lowest per-unit cost
› Given the firm’s extra flexibility in the long run, long-run average cost can be no greater than
short-run average cost.
› As a result of this, the long-run average cost curve will be the lower envelope of all of the
short-run average cost curves. See the following figure – it illustrates how to derive a long-run
average cost curve from several short-run average cost curves
Economies of Scale
› ​Economies of scale​ is when long-run average
costs decrease with output.
› ​Diseconomies of scale​ is when long-run
average costs increase with output.
› ​Constant returns to scale​ is when long-run
average costs are constant as output expands.

› ​Economies of Scale​: are the cost advantages

that a business obtains due to expansion. They
are factors that cause a producer’s long-run average cost per unit to fall as production is
increased.
› It is the portion on the LRAC curve when LRAC is decreasing.
› As a firm double the input (cost of inputs are double), output more than doubles.
› Economies of scale arise from:
- Labour specialization​ Firms producing at a large scale employ a large number of
workers. This allows the firms to practice specialization by splitting jobs into smaller
tasks. These individual tasks are assigned to separate workers. In this way workers
spend all their work time on the part they know best and it also allows them to perfect
their skills.
- Managerial specialization​ Firms might be able to lower average costs by improving the
management structure within the firm. The firm might hire better skilled or more
experienced managers.
- Efficient capital​ The most efficient machines and equipment are based on cutting edge
technology and have high production capacity. Firms with large scale production can
afford such equipment and benefit from their full capacity. At full utilization such
machinery or equipment achieves lower production cost per unit. Firms having small
scale production either cannot afford such equipment or cannot utilize such machinery to
its full capacity.
- Bulk-buying products ​With greater buying power, a large firm can purchase its factor
inputs in bulk at discounted prices. They can buy more from suppliers at a lower price.
Constant Returns to Scale:​ ATC constant as plant size increases. Here, if we double all
inputs, output would exactly double, hence ATC is constant

Diseconomies of Scale
› ​Diseconomies of scale: ​As firm increases its scale of output, LRAC increases. Diseconomies
of scale are the forces that cause larger firms to produce goods and services at increased
per-unit costs.
› Reasons:
- Duplication of effort​ — When firms grow to thousands of workers, it is inevitable that
someone, or even a team, will take on a project that is already being handled by another
person or team.
- Top-heavy companies​ —The more employees a firm has, the larger percentage of the
workforce will be "management". If a manager does nothing other than manage the
workers under them, then the productivity of the firm will be reduced.
- Inertia ​— unwillingness to change, because ‘we’ve always done it that way’.
- Cannibalization​ — a small firm only competes with other firms, but larger firms
frequently find their own products are competing with each other.
- Inelasticity of Supply​ — a company which is heavily dependent on its resource supply
will have trouble increasing production. For instance a timber company can not increase
production above the sustainable harvest rate of its land.

Returns to Scale and Economies of Scale

› There is a direct relationship between returns to scale and economies of scale
› Economies of scale reflect the relationship between output and costs.
› Recall that returns to scale refers to how the quantity of output changes when there is a
proportional change in the quantity of all inputs.
› The relationship arises as the production function (inputs and outputs) is a mirror image of the
cost function (relationship between costs and output)
› Returns to scale & economies of scale
› When a firm experiences increasing returns to scale (increasing inputs proportionally leads to
a more than proportional increase in outputs), it also experiences ‘economies of scale’ or falling
average cost of production.
› When a firm experiences decreasing returns to scale (increasing inputs proportionally leads to
a less than proportional increase in outputs), it also experiences ‘diseconomies of scale’ or
increasing average cost of production.
› When a firm experiences constant returns to scale (increasing inputs proportionally leads to a
proportional increase in outputs), it experiences neither ‘economies or diseconomies of scale’.
That is, average cost of production is constant.
› Typically, we think that a firm has regions where it exhibits each of these.

SUPPLY
› Now we use costs to derive an individual firm's supply function and the market supply function.
› We focus on competitive markets, in which there are many buyers and sellers, such that no
individual buyer or seller has the power to materially affect the price in the market.
› As a consequence, both sellers and buyers in the market are price takers.

Firm Supply
› ​Supply: number of units​ of a good or service firms are w ​ illing and able to produce ​and sell
during a period ​at a particular price.
› The ​supply curve ​traces out all combinations of
(i) market price and
(ii) quantities that a firm is willing and able to sell.
› Firm supply curve is drawn by changing the price of output, holding everything else that is
relevant constant (ceteris paribus), and seeing how many units of output the firm would be
willing and able to sell.
Q: Now how much is a firm willing and able to supply at a given price?

› Competitive supply price measures the opportunity cost of each marginal unit (i.e. the marginal
cost MC) – for each additional unit produced, the opportunity cost of producing that unit is the
marginal cost of producing the unit.
› ​A firm should sell up until P = MC.
› The marginal revenue (MR) for each unit that the firm sells is the price, P.
- MR=P (competitive market)
- Remember, a competitive firm is a price taker – it cannot affect market price. This means
price is unchanged, regardless as to how much an individual firm sells.
› First, if a firm is selling a quantity where P > MC for the last unit sold (and this is true for at
least one additional unit), the firm can increase its profit by making more units.
- If that firm increases its output by one unit, it will increase its profit since the additional
revenue from selling that extra unit (P) outweighs the MC.
› Second, if a firm is producing where P < MC for the last unit made, the firm can increase profit
by not making that last unit
- The extra revenue (P = MR) is less than the extra costs that are incurred.
› A firm should sell up until P = MC. › Now if price P changes – from P1 to P2 in the next figure. ›
As price rises, so does the firm’s MR; it now continues to produce until P = MC for the last unit
produced. › As MC is often increasing, the quantity supplied in the market is higher when price
is higher. › A movement along the supply curve when output price changes is called a ‘change
in the quantity demanded’; if output is increasing it is ‘an increase in the quantity demanded’ or
for a decrease ‘a decrease in the quantity demanded’.

The Law of Supply

› This means that a firm's supply curve is given by its MC curve.

› The MC curve is upward sloping due to diminishing marginal product of inputs.
› This gives a positive relationship between the price of a good and the quantity of that good
supplied.
› This positive relationship is known as the law of supply.
- Note, the law does not always hold, but it often does.

› ​The Law of Supply:​ there is a positive relationship between the price of a good and the
quantity supplied, all else constant.
› If the price increases then
- it’s ‘worth it’, i.e. more profitable, to divert resources to producing more
- the relatively higher price will compensate for the increased opportunity costs of
producing more
Shifts in supply
› The firm's supply curve is derived by assuming that only the price and quantity supplied of the
product can change.
› We assume that all other relevant factors, other than the
own price and quantity of the, are held constant (ceteris
paribus).
› If any other relevant factors change, the supply curve
itself will shift.
- These factors include the cost of inputs,
technology and expectations about the future. If
there is a change in one of these factors there will
be a ‘change in supply’, either:
- ‘an increase in supply’ for shifts of the supply curve to
the right (S1 to S2); or
- ‘a decrease in supply’ for shifts of supply to the left (S2 to S1).

Supply Determinants
› Supply of a good (or service) depends on - price of the good itself (p) - price of other goods -
substitutes in supply goods (Substitutes-in-production are two or more goods that can be
produced using the same resources. Producing one good prevents sellers from using resources
to produce another. Produce one or produce the other, but not both) e.g. corn or soy-beans -
compliments in supply goods (Complements-in-production are two or more goods that are jointly
produced using a given resource. The production of one good automatically triggers the
production of another, often as a by-product) e.g. beef and leather - price of intermediate inputs
e.g. coffee beans in coffee - prices of factors of production - labour - capital and land -
technology - expected future prices - number of suppliers
Market Supply
› Given that an individual firm's supply curve is given by its MC curve, we can use this to derive
the market supply curve.
› The market supply curve shows the quantity supplied in a market for at different market prices,
holding everything else constant.
- Suppose the market price of carrots is $1 and the market consists of 2 suppliers only. At
this price, Jackson is willing to sell five carrots and Jared is willing to sell eight carrots.
This means that, at $1, the total quantity supplied in the market is 13 carrots. Repeat this
for every price to derive the market supply curve.
› Graphically, the market supply curve is the horizontal summation of the individual supply
curves.
- That is, the individual MC curves summed horizontally along the q-axis.

› The law of supply also holds for the market supply curve.
› We also use the term ‘change in the quantity supplied’ to refer to movements along the market
supply curve,
› The term ‘change in supply’ again refers to a shift of the supply curve itself.
WEEK 3 - LECTURE 3: Consumer Behaviour: Demand and Utility

Benefit and willingness to pay

›A consumer derives some benefit from consuming a particular good or service.
- The benefit a consumer gets is also known as their willingness to pay (WTP).
- The maximum price a consumer will pay for a good is equal to the benefit they anticipate
getting from the item (in money terms).
› Generally, we expect marginal benefit to decline with each
additional unit consumed (declining or diminishing MB).
- The extra benefit a consumer gets from a good gets
smaller the more of that good the consumer has already
enjoyed.
› When the consumer buys many units of a good, typical to have
a continuous (smooth) MB curve.

Individual demand
› We can use a consumer's marginal benefit curve to derive his individual demand curve.
›An ​individual’s demand ​is the quantity of a good or service that a consumer is willing and able
to buy at a certain price.
- Hence, the individual demand curve traces out all combinations of (a) market price and
(b) individual demand at that price, holding everything else constant (ceteris paribus).

Individual demand
› A consumer purchases units of a good up to P=MB
› Consequently, a consumer's individual demand curve is her MB curve.
- Due to diminishing MB, individual demand is downward sloping.
› A demand curve represents how much a consumer is willing and able to buy at different
prices.

LAW of DEMAND
● The downward slope of the demand curve means that a consumer consumes fewer units
when the price is higher.
​ nd ​quantity d
● This negative relationship between​ price a ​ emanded is known as the​ law of
demand.
 › For some goods, demand
falls when income increases
● These are inferior
goods
● Shifts the demand
curve inwards
› Why?
● Can afford more
expensive and desirable
alternatives

Market demand
● An individual consumer's demand curve is given by his MB curve.
○ We can use this to derive the market demand curve.
● The ​market demand curve​ traces out combinations of
(a) market price​ and
(b) quantities that all consumers in a market
are together willing and able to buy at that price

Demand Curve
Law of Demand
● Note, the law of demand also holds for the market demand curve.
● If the law of demand holds for all individual demand curves, it will hold for the market
demand curve, which is the horizontal summation of individual demand curved.
● We can also use the term ​change in the quantity demanded​ to refer to movements
along the market demand curve, and the term ​change in demand​ to refer to a shift of
the market demand curve itself.

Change in Quantity Demanded vs. Change in Demand

Change in Demand
Demand shifters: related goods
● Substitute goods
○ Goods that can be used for the same or similar purpose
○ Eg. laptop computers for tablets, apples for bananas
○ If price of a substitute increases, it become relatively more expensive
○ Consumers stop buying apples and buy more bananas
○ Demand curve for apples shifts outwards due to price change for bananas

● Complements
○ Goods that are used together
○ Eg. apps for tablets, hot dog sausages and hot dog rolls
○ If price of complement increases, it become relatively more expensive to buy
both goods and consume both
○ Consumers buy less hot dog sausages when the price of hot dog rolls increases
○ Demand curve for hot dog sausages shifts inwards

Demand shifters: tastes

● Tastes and fashion affect the demand for goods
○ When a new product is heavily marketed or becomes a trend, its popularity may
increase and so demand shifts outwards
○ Eg. fidget spinners
○ Or a bad publicity shock can reduce demand for a product
○ Eg. demand for ready meals in the UK after horse meat found in lasagna
○ Or seasonal variation: ice cream is more popular in summer

Demand shifters: population

● When demographics change, demand changes
 ○ As the population gets older on average, there is more demand for healthcare
services
○ If the proportion of men vs women in the population increases (eg. via
immigration), demand for “male” goods will increase
○ If immigration increases, demand for goods more intensively consumed by the
immigrant population increases

Demand shifters: future prices

● Consumers also choose when to buy a product
○ If we expect the price to fall, we wait (eg. a sale is coming)
○ If we expect the price to increase, we buy now (eg. a new tax is expected)
○ So, if a future price decrease is announced, demand today will fall, shifting the
demand curve inward

Concluding comments - Demand

● We have now derived the individual and market demand curves.
● A demand curve answers the question ‘if the consumer faces a certain price, what
quantity would they buy?’, for a range of possible prices.
● Note, it is only possible to answer this question if the consumer is a price taker – that is
the individual consumer’s choices have no impact on price.

Market Equilibrium and Welfare Analysis

● So far we have introduced supply and demand, now we bring them together to analyse
markets and market equilibrium
● Equilibrium in a market occurs when price balances the buying plans of buyers & selling
plan of sellers.
○ At equilibrium, the quantity demanded equals the quantity supplied
○ That is, the price is the ‘market clearing price’ or equilibrium price
○ If a market is not in equilibrium, there will be pressure on price and quantity to
move towards the equilibrium price and equilibrium quantity.
Market equilibrium

Excess Supply
● If the market price is above the equilibrium price, the quantity supplied exceeds the
quantity demanded.
○ This difference is called excess supply.
○ Sellers cannot find buyers for all units supplied to the market.
■ There will be downward pressure on prices, as sellers try to bring more
consumers into the market; at the same time, the quantity supplied will fall
in response to the decrease in prices.
■ The quantity demanded will increase in response to the decrease in
prices.
○ This downward pressure on prices will continue until the excess of supply is
eliminated, moving the market towards equilibrium.
○ The quantity supplied decreases and the quantity demanded increases until they
are equal. When they are equal, the market is in equilibrium.

Excess supply – price above market clearing price

Excess Demand
● If the market price is below the equilibrium price, there is excess demand.
○ The quantity demanded exceeds the quantity supplied - sellers do not supply
enough units to meet consumer demand.
○ There will be upward pressure on prices, as buyers compete for limited units in
the market; this increase in prices will increase the quantity supplied and also
decrease quantity demanded.
○ This upward pressure on prices will continue until the excess of demand is
eliminated, moving the market towards equilibrium.
○ The quantity supplied increases and the quantity demanded decreases until they
are equal. When they are equal, the market is in equilibrium.

Equilibrium Example
Comparative Static Analysis
● Markets can be affected by a change or event beyond the direct control of buyers or
sellers in that market.
● In such cases, we may want to analyse how that change or event affects the choices of
firms and/or consumers in the market, and how those choices affect market outcomes.

● How do we deal with it?

1. Assume that the market in question is initially in equilibrium.
2. Ascertain whether the change or event will affect the demand curve or the supply curve
of the market (or both).
a. That is, which curve will shift, and which way will it move.
3. Use the demand and supply diagram to compare prices and quantities traded in the
market before and after the change.

Example: car market

Example: car market with an increase in the steel price

Comparative Static Analysis – Shift in Supply

Comparative Static Analysis – Shift in Demand

Welfare
● Markets are one of the main ways that good and services are produced and distributed.
● Consumers and firms will only participate in the markets if it is beneficial to them.
● We can measure and observe changes in these benefits to these participants using
welfare analysis.
● Key questions to ask:
○ How happy are you when you eat chocolate ice-cream?
○ How happy are producers when they sell it?
● So one way to measure welfare of consumers and producers is to look at their benefit
when consuming and selling the goods or services.

Consumer surplus
● Consumer surplus (CS)​ is the welfare consumers receive from buying units of a good
or service in the market.
● We can measure consumer surplus by evaluating the net value of a good or service to
the consumer, as he or she perceives it.
● That is, consumer surplus is given by the consumer's willingness to pay, minus the price
actually paid, for each unit bought.

Consumer Surplus – Intuition

● Bob buys a chocolate bar. His willingness to pay (or marginal benefit) for the chocolate
bar is $5.50, but the price is $2.
● He receives $5.50 benefits, minus the price actually paid of $2.
● Therefore, his surplus from buying the chocolate bar is $3.50.
● Repeating this process for every unit purchased calculates the CS Bob receives from all
the chocolate bars he buys.

Consumer Surplus and the Demand Curve

 ● Recall the individual demand curve traces out a consumer's marginal benefit or
willingness to pay,
● An individual's CS is by calculating the area between the individual demand curve and
the price line (the area above the price line and below the demand curve for all units
consumed).
○ Similarly, we can find the CS of all consumers in the market by calculating the
area between the market demand curve and the price line.

Consumer surplus

Change in CS with a decrease in price

Consumer Surplus
Producer surplus
● Producer surplus (PS) is the welfare producers (that is, firms) receive from selling units
of a good or service in the market.
● Producer surplus can be measured by considering the net benefit of selling a good or
service.
○ That is, producer surplus is given by the price the producer receives, minus the
cost of production, for each unit of the good or service bought

Producer surplus – intuition

● Adam sells chocolate bars. The price of chocolate bars is $2. The marginal cost to Adam
of producing the chocolate bar is $0.50.
● If Adam sells the chocolate bar, his net benefit is the $2 received, minus $0.50 in extra
production costs. › Therefore, his PS from selling the chocolate bar is $1.50.
● If Adam sells multiple units, add up the surplus from each chocolate bar to get his PS
from selling chocolate bars.

Producer surplus and the supply curve

Producer surplus with an increase in price

Producer Surplus
 ● Producer surplus is related to but not equal to profit.
● Why? Because of fixed costs
● Producer’s surplus subtracts only variable costs from revenues, while profit subtracts
both variable and fixed costs. PS = TR – TVC and Profit= TR – TVC – TFC. Thus,
producer’s surplus is always greater than profit.
● In fact (and you should show this): PS = profit + TFC

Total Surplus

Pareto Efficiency
● To analyse welfare further, we introduce the concept of Pareto efficiency.
● An outcome is Pareto efficient if it is not possible to make someone better off without
making someone else worse off. Conversely, an outcome is not pareto efficient if it is
possible to reallocate resources (or do things differently in the market) and make
someone better off without making someone else worse off.
● Another way of thinking about pareto efficiency in this context is that the Pareto efficient
outcome maximizes total surplus.
Competitive market outcome and efficiency

● If fewer than Q* units are traded, this outcome

is not Pareto efficient, because it is possible to
increase the number of units traded in order to make
the consumer and/or the producer better off, without
making any one worse off.
● If more than Q* units are traded we know that
MC > MB. All units traded beyond Q* make someone
worse off: either the buyer paid more than his MB, the
seller received a price less than her MC, or both.
Therefore, this outcome is not pareto efficient,
because total surplus would decrease if output were
reduced (back to Q*).

● In the competitive-market equilibrium, all the potential gains from trade are exhausted.
○ There are no consumers left in the market with a willingness to pay higher than
any seller’s MC to provide an additional unit.
○ The price mechanism ensures that the people with the highest value for the
product (those that are willing to pay more than the price) end up with the goods,
and that those firms with the lowest cost are the ones who make the goods (the
firms who have a MC less than the market price).
○ While these actions are completely decentralized, in the sense that there is no
one person coordinating the actions of the many parties in the market, a
 competitive market manages to maximize total surplus (that is, reach a Pareto
efficient outcome).

Caveat regarding Pareto efficiency

● Pareto efficiency has a very strict and specialized definition.
● It does not imply either uniqueness or fairness/equity.
○ It is possible that there are more than one outcomes in an economy that are
pareto efficient.
○ Further, an outcome that is pareto efficient is not automatically the most fair or
equitable, or even the most desirable.

LECTURE 4: ELASTICITY & PERFECTLY

COMPETITIVE MARKETS
● ELASTICITY: responsiveness of one variable to a change in another variable -
○ Examples: how does the equilibrium quantity traded respond to a change in the
market price? How does demand respond to changes in consumer income? How
does supply respond to a change in input prices?
○ How do we measure it?
● Elasticity concepts considered:
○ own price elasticity of demand
○ price elasticity of supply
○ cross-price elasticities of demand
○ Income elasticity of demand

Elasticity
● We are often interested in measuring how a change in one variable affects another
○ E.g. how does the equilibrium quantity traded responds to a change in the market
price, or how demand responds to changes in consumer income?
● One issue with measuring quantitative changes is that different markets use different
units of measurement (litres, kilograms, ounces), each market has its own price level (a
few cents or millions of dollars).
● Elasticity is a way we can compare quantitative changes across different situations by
looking at proportional (or percentage) changes.
● Elasticity measures of responsiveness of one variable to another holding all else
constant
○ if ‘responsive’, refer to as ‘elastic’
○ if ‘unresponsive’, refer to as ‘inelastic’

● Elasticity measures how responsive one variable (y) is to changes in another variable
(x).
 ○ That is, when we increase x by a certain amount, does y change by a small
amount or by a large amount?
○ We can calculate elasticity (є) by dividing the percentage change in y by the
percentage change in x. Note: ∆ simply means ‘change'.

○ This says for 1% change in x there will be an є% change in y.

○ Note the larger the absolute value of є the more responsive y is to changes in x,
and vice versa.

Elasticity – proportional change

● Generally, we can calculate the proportional change in a variable by dividing the change
in the variable by the variable itself:

● However, it is not always obvious how to determine the proportional change in a

particular variable.
● Two classic methods are: the point method, using the initial values; and the midpoint
(arc) method, that uses the averages of the initial and final points.

Elasticity of Demand
Point Method
● At times we are interested in the elasticity around a particular outcome:
○ For example, what is the elasticity on a demand curve around the point (Q1, P1)?
○ In other words, how responsive is the quantity demanded to a change in the
price, at (Q1, P1) ?
● Point elasticity is elasticity at a specific point on the demand curve.
● This method of calculating elasticity is used when the changes between two points are
likely to be very small (responsiveness of quantity demanded to an infinitesimal price
change)

Point elasticity: example

● Suppose the demand curve for forks is given by Q = 100 - 2P, and the price of forks is P
= 30. What is elasticity at this point?
● From the demand equation, we know that when P = 30, Q = 40. The slope of this line is
-2.
● Substituting these values into the point formula gives:

● The interpretation is: at this price, if price of forks increases by 1%, the quantity
demanded of forks falls by 1.5%.

Arc (Midpoint) Elasticity Method

● Arc (midpoint) elasticity is elasticity over a region of the demand curve.
○ For example, suppose the price of a good changes from P o to P1. , which
causes the quantity demanded to change from Q 0 to Q1.
○ It is unclear in this situation whether we should measure the change in price (or
quantity) as a percentage of P 0 or P1 (or Q 0 or Q1). To solve this ambiguity, we
use the midpoint method to calculate the proportional changes using the average
(i.e. midpoint) of P and Q (or the variables of interest).
○ That is, we ask what is the percentage change of average price and average
quantity
Midpoint elasticity: example
● When the price of spoons is $10, the quantity demanded is 50 units. When the price
increases to $20, the quantity demanded falls to 30 units.

Recap : the formulas for the price elasticity of demand

Price Elasticity of Demand

● Price elasticity of demand:
○ A measure of the responsiveness of the quantity demanded of a good to a
change in its price, ceteris paribus
○ Percentage change in the quantity demanded in response to a one per cent
change in market price
● Why use elasticity of demand rather than some other approach?
● Consider …
Why do we care ?
● Why is it useful to have an understanding of the responsiveness of quantity demanded
to a change in price?
○ Business might be interested in the effect of a price change on quantity sold,
revenue and profits
■ For example, the price of milk
○ Governments might want to know how (consumer or firm) behaviour changes
when a specific policy is put in place
■ For example, a carbon tax, a change in the price of a toll road, a change
in the price of public transport, a change in minimum wage, a change in
the tax on alcohol,...
Interpretation of the elasticity of demand
● Given the law of demand, the elasticity of demand will normally be negative (or at least
non-positive).
● For this reason, some authors find it convenient to drop the minus sign when reporting
the elasticity of demand, treating the negative sign as implicit.
● We will not adopt that convention here, but it should be noted that either approach is
fine, so long as it is consistently applied.
Interpretation of elasticity of demand
Price Elasticity of Demand

Price Elasticity of Demand

Price Elasticity of Demand

Perfectly inelastic and elastic demand

Price elasticity of demand Along a straight-line demand curve

● The price elasticity of demand depends on the ​slope​ of the line, but also the ​reference
point ​on the curve used to calculate elasticity.
● Thus the price elasticity of demand changes along a linear (straight-line) demand curve.
○ Because the ​slope​ of the demand curve is ​constant​, the elasticity varies
because the proportional change in quantity (and price) varies depending on the
size of quantity (or price) at a particular point.
○ For every linear demand curve, there is an ​inelastic​ section (when quantity is
high and price is low); a point that is ​unit elastic​ (in the middle of the demand
curve); and an ​elastic​ section (when quantity is relatively low and price relatively
high).
■ The price elasticity of demand ranges from 0 (when it cuts the Q-axis) to -
∞ (at the P-axis).
Elasticity along the Linear Demand Curve
 ● For a linear demand curve, except in the cases of perfectly inelastic and perfectly elastic
demand curve, elasticity varies along the demand curve
○ elastic at the ‘high end’ (quantity demanded is very responsive to changes in
price)
○ unitary elasticity point at its midpoint a linear demand curve
○ inelastic at the ‘low end’ (quantity demanded is not very responsive to changes in
price)

● Consider the following demand curve:

P = 80-2Q
● Find the own price elasticity of demand when price is equal to $20, $40 and $60.
● Using the point elasticity formula:
○ Rewriting the demand curve: Q = 40 – P/2
○ Yields answers: - at P=$20: єd = -1/3 (inelastic demand),
○ at P=$40: єd = -1 (unit elastic demand) and at P=$60: єd = -3 (elastic demand)
Importance of the Price Elasticity of Demand
● Remember comparative statics?
○ Using the price elasticity of demand we can evaluate the (expected) effect on
price and quantity of a change in supply.
○ Not only the ​direction​ of the effects, but also the amount …
○ and its effect on revenue.
The effect of an increase in supply with a high price elasticity of demand i.e. relatively elastic
demand (demand curve is relatively flat) is a large decrease in quantity for a small increase in
price that results from the supply curve shifting.
The effect of an increase in supply with a low price elasticity of demand i.e. relatively inelastic
demand (demand curve is relatively steep) is a small decrease in quantity for a large increase in
price that results from the supply curve shifting.

Elasticity and revenue

● We can determine from the elasticity of demand how total revenue in the market will
change as price changes.
○ As we know from the demand curve, the quantity demanded in the market (q)
depends upon the market price (P). This means that we can write the quantity
demanded as a function of price: q(P).
○ Total revenue as a function of P is: TR(P) = P. q(P)
Total revenue and elasticity
Changes in revenue and elasticity

Changes in revenue and elasticity

● This equation provides a direct link between the price elasticity of demand and the
change in total revenue.
● In order for TR to increase with a price increase, the right-hand side of the equation must
be positive.
○ This will be true if and only if єd > -1; that is, if demand is inelastic.
○ On the other hand, if demand is elastic ( єd < -1), TR will fall when the market
price rises.
● On the ​elastic part​ of the demand curve (the upper part) the price needs to be lowered
in order to increase total revenue. On the ​inelastic part​ of the demand curve (the lower
part) the price needs to be raised to increase revenue. The means that total revenue is
maximized when demand is ​unit-elastic​, in the middle of the demand curve.
Elasticity and Total Revenue

● The ​intuition​ for the result is:

○ If demand is ​elastic​, a 1% increase in price will cause a greater than 1% fall in
the quantity demanded. This means that the increase in P is more than offset by
the decrease in Q d, causing ​TR to fall​ overall.
○ If demand is ​inelastic​, a 1% increase in price will cause quantity demanded to
fall but by less than 1%; the increase in P outweighs the decrease in Q d causing
TR to increase​ overall.
Income Elasticity
● The demand for a good may also depend, in part, on a consumer's income.
● Income elasticity (η)​ measures how sensitive the quantity demanded of a good (Q) is to
changes in income (Y), ​ceteris paribus​.
● The midpoint formula is, using the midpoints for quantity ( QM ) and income ( Y M ):
 ● Using the point elasticity formula:

Income Elasticity – Characterisation of Goods

We can characterize the good, depending upon its income elasticity:
● If η < 0​, demand decreases when income rises. This type of good is called an ​inferior
good.
○ For example, consumers might substitute away from an inferior cut of meat as
income rises.
● If η = 0​, demand is invariant to changes in income; this is a neutral good.
● When 0 < η ≤ 1​, if income rises by 1%, demand for the good increases by less (or, more
correctly, not more) than 1%; this is a ​normal​ good.
○ Many (if not most) goods are normal goods, for example food.
● If η > 1​, when income rises by 1%, demand for the good increases by more than 1%;
this is a ​luxury​ good.
○ For example, caviar, sports cars, skiing holidays etc
Income Elasticity

● Using the mid-point method, we find that the income elasticity of demand is 0.84.
● This means that for a 1% increase (decrease) in average weekly earnings, the quantity
demanded of new cars increased (decreased) by 0.84%.
● Thus, cars are a normal good.

Cross-Price Elasticity
● Sometimes we are interested in the relationship between the quantity demanded of one
good and the price of another related good.
 ● This relationship can be examined using the cross-price elasticity. This measures how
sensitive the quantity demanded of a Good A (QA) is to changes in price of Good B
(PB).
● For the point method, the cross price elasticity formula is:

● For the midpoint (or arc) method, the formula for cross-price elasticity is:

Cross Price Elasticity – Characterisation of Goods

● If єAB < 0​, an increase in the price of Good B is associated with a fall in the quantity
demanded of Good A (at any given price of Good A). This means that the Good A and
Good B are ​complements.
○ They are goods that are likely to be consumed together (bacon and eggs, a car
and petrol).
● єAB → - ∞ for perfect complements​ (goods which only provide utility or happiness
when they are consumed together) e.g. left and right shoes
● If єAB > 0​, an increase in the price of Good B is associated with a rise in the quantity
demanded of Good A (at any given price of Good A). Goods A and B are substitutes.
○ For example tea and coffee, the bus or the train.
● єAB → ∞ for perfect substitutes​ (goods which are viewed as identical) e.g. gold from
two different mines
● If єAB = 0​, an increase in the price of Good B is not associated with any change in the
quantity demanded of Good A (at any given price of Good A) – they are​ independent
goods.
○ For example, ice cream and chainsaws.

Cross-Price Elasticity

● Using the mid-point method, we find that the cross price elasticity of demand is -1.15.
 ● This means that for a 1% increase (decrease) in the price of gas, the quantity demanded
of gas stoves decreases (increases) by 1.15%. Thus, gas and gas stoves are
complementary goods.
● Example: Suppose that, when the price of teabags is $4 per box, Candice sells 100 litres
of milk. If the price of teabags rises to $8 per box, Candice only sells 60 litres of milk.
● Use the midpoint formula to calculate cross-price elasticity.
● Here, ∆ QA = -40 and ∆ P B =4. The average values for price and quantity are QM A =80
and P M
B =6.
● Therefore, cross-price elasticity is єAB = ∆ QA / ∆ P B . P M M
B / QA
= -40/4 . 6/80
= -0.75.
● Thus, milk and teabags are complementary goods.
Elasticity of Supply
● Elasticity can also be applied to supply.
● Elasticity of supply​ є s measures how sensitive the quantity supplied of a good ( q s ) is to
changes in price (P).
● That is, what is the proportional change in quantity supplied of a good, given a 1%
change in its price.
● The midpoint (arc) method for calculating elasticity of supply is:

● The point method for calculating elasticity of supply is:

Price Elasticity of Supply

● The elasticity of supply is typically ​positive​, due to the law of supply.
● If 0 < є s < 1, supply is inelastic​.
○ For a 1% change in price, the change in quantity supplied is less than 1%. The
quantity supplied is not very responsive to changes in price.
● If є s = 1 supply is unit elastic.
○ For a 1% change in price, there is a 1% change in quantity supplied – the
quantity supplied changes by the same proportion as price.
● If є s > 1 supply is elastic​.
○ For a 1% change in price, the change in quantity supplied is more than 1% - the
quantity supplied is relatively responsive to changes in price.
Perfectly inelastic and elastic supply
● If є s = 0 is perfectly inelastic.
 ○ For a 1% change in price, there is no change in the quantity supplied. The supply
curve is vertical.
● If є s = ∞, supply is perfectly elastic.
○ For a small decrease in price, quantity supplied will drop to zero.
○ This means that if the price of a good falls at all below a certain price, firms will
stop supplying the product. The supply curve is horizontal.

Price Elasticity of Supply

Concluding comments - Elasticity

● Elasticity measures the proportional change in one variable, given a proportional change
in another variable.
● This unit-free measure of responsiveness can be applied to any two variables of interest.
○ Common applications: ​the (price) elasticity of demand, the elasticity of supply,
cross-price elasticity and income elasticity.
○ However, can be used for ​other uses​ – like the effectiveness of an advertising
campaign or consumers' response to a government subsidy.
 ● Elasticity will depend on a range of factors, including the ​timeframe​.
○ Generally expect greater elasticities in the long run than in the short run.

PERFECT COMPETITION

Market Structures
● We will look at four different types of markets in turn and consider the implications for
market outcomes:
● Perfectly competitive markets
○ These markets have ​many buyers and sellers​, low barriers to entry and an
identical product.
○ Consequently, firms do not have the market power to set prices.
● Monopoly markets
○ A market with one seller and high barriers to entry and the power to choose its
price.
● Monopolistically-competitive markets
○ There are many firms selling slightly differentiated products.
○ These sellers have scope to set their own prices, but there are low barriers to
entry into these markets.
● Oligopoly markets
○ These markets are characterized by only having a few firms.
○ Consequently, the strategic interaction between these firms is critical to the
outcome in these markets: actions by a firm are dictated by the actions of other
firms in the market.
Perfectly Competitive Markets
● Perfectly competitive markets have the following characteristics:
○ Many buyers and sellers.​ All buyers and sellers are a very small part of the total
market.
○ Homogeneous products​. Consumers are indifferent as to who they purchase
from. All firms have access to the same technology.
○ Price taker.​ No individual buyer or seller has sufficient market power to influence
market prices – that is, every participant is a price taker.
 ○ Free entry and exit.​ Firms can freely (that is, costlessly) enter and exit the
market in the long run – there are no barriers to entry in the long run.
The Supply curve in Perfect Competition
● Short-run (SR)
○ Each firm’s plant size is given
○ Why? Some inputs cannot be altered (fixed inputs, eg capital goods)
○ Thus number of firms in the industry is fixed (firms cannot enter and exit the
industry)
● Long run (LR)
○ Each firm can change the size of its plant
○ All inputs can be varied
○ Firms can enter (and exit) the industry, thus number of firms is variable
Short Run Supply Under Perfect Competition
● At least one of a firm's factors of production is fixed in the short run.
○ Firm has a fixed cost of production that will be incurred regardless of its output.
○ In deciding the ​level of output to produce​ in the short run, a firm will ignore its
fixed costs.
● If a firm produces output, its supply curve is given by its ​marginal cost curve.
● However, if a firm chooses not to produce output in the short run (q=0), we say that the
firm ​shuts down​.
● In the short run, the firm should only take into account its ​variable costs​, as its fixed
costs are sunk.
● Hence, we can derive the ​shut-down condition​ that a firm will shut down in the short
run if total revenue is less than variable cost.
TR< VC
● We can also divide the ​shut-down condition​ by the level of output q to yield.
TR/q < VC/q or that p < AVC

The Short-Run Supply Decision for a Firm

● Thus, if price falls below AVC, a firm will shut down.
● If a firm does produce a positive output, it chooses the level of output in accordance with
its supply curve – that is, its MC curve
○ Reminder: a firm produces units until P=MC
● Remember that the MC curve intersects the AVC curve at the minimum of the AVC
curve.
● Hence the ​shut-down rule​ for a competitive firm is:
P < AV C M IN
● On the other hand, a firm will supply a positive quantity provided:
P ≥ AV C M IN
● Hence a firm's short-run supply curve is its MC curve that lies above AV C M IN
A Firm’s Short-Run Supply Curve
● The firm’s short-run supply curve is the dashed line in the image below.
 ● It is the portion of the firm’s MC curve which lies above the firm’s AVC curve.
● For prices at which the MC curve sits under the minimum of the AVC curve, the firm
produces 0 units and can be said to be shut-down.

Market Supply in the Short Run

● In the short run, there is ​no entry or exit of firms​ in the competitive market.
○ A firm is prevented from exiting the market by its fixed costs (as some inputs are
invariable).
■ If a firm in the market wishes not to produce anything, it shuts down (but
does not exit).
○ No new firms can enter in the short run.
● Hence, the​ number of firms​ in the market is fixed in the short run.
● Thus the ​short-run market supply ​results from horizontal summation of the individual
firms’ supply curves
Profits and Losses in the Short Run
● In a competitive market, it is possible for firms to make profits, break even, or incur
losses in the short run.
● If a firm is making a ​loss​, total revenue must be less than total costs
● Conversely, if a firm is making ​profits​: TR > TC, or P > ATC
○ The difference between P and ATC at the quantity supplied is the average profit
(or loss) a firm is making.
● A firm will be willing to continue to sell in the short run when making a loss provided P >
AV C M IN .
○ The firm is better off than shutting down because the extra revenue (in excess of
its variable costs) help it pay for some of its fixed costs.
Profits in the Short Run
● A firm in a perfectly competitive market, making a profit at the market equilibrium price
(P*>ATC*). The grey-shaded area represents the size of that profit.
● Size of profit = (p*- ATC*) . q*
Losses in the Short Run
● A firm in a perfectly competitive market, making a loss at the market equilibrium price
(P<ATC*). The grey-shaded area represents the size of that loss.
● Size of loss = (ATC* - p*) . q*

Supply in the LONG RUN

● In the long run all production inputs are variable.
● In the long run, there is ​free entry and exit of firms​ in the market.
○ Firms can exit a market/industry, new firms can start operating in a market.
○ This means that all costs are opportunity costs (no sunk costs).
○ Hence, a firm deciding its level of output in the long run will take into account the
costs of all inputs.
● A firm will ​enter or exit the market ​depending on its (anticipated) level profit or loss in
the market.
● The market will reach its ​long run equilibrium ​when there is no longer any entry into or
exit from the market – this occurs when firms are making zero (economic) profits.
○ Recall that economic profits is total revenue less both implicit and explicit costs
(opportunity costs) and accounting profit is total revenue less explicit costs only.
Firm Supply: The Exit/Entry Decision in the Long Run
● With free entry and exit in the long run, if a firm chooses to ​exit​ it incurs no costs (unlike
the FC incurred in the short run)
● Hence, a firm will choose to ​exit​ the market if its total revenue is less than its total costs
○ This means that a firm will exit if: P < AT C M IN .
● Hence a​ firm’s long-run supply curve ​is the section of its (long-run) MC that lies above
(LR) AV C M IN .
Elimination of Profits and Losses
● In the long run, firms can enter or exit depending on whether they are going to make a
profit or loss.
● When firms in the market are profitable (P > AT C M IN ) firms will want to ​enter​ the market
– potential profits induces entry.
● The entry of more firms into the market will progressively shift the shortrun market supply
curve to the right, driving the ​equilibrium price​ ​downwards.
● When firms in the market are sustaining losses (P < AT C M IN ), firms will tend to exit the
market.
● This shifts the short-run supply curve left, pushing the ​equilibrium price upwards ​as
firms leave the industry.
Potential Profits Induce Entry
● When the market price is above average total cost, profits will encourage entry into the
market, resulting in an increase in supply from S to S'. This will put downward pressure
on market prices.

Losses Induce Exit

● When the market price is below average total cost, firms in the market make a loss. This
encourages exit, shifting the supply curve left from S to S‘ (decrease in supply), causing
price to rise.
Long Run Equilibrium
● Because of free exit and entry of firms, prices:
○ Decrease when it is above ATC; and
○ Increase when it is below ATC.
● Thus, price will equal ATC in the long run.
● Because the firm supply curve cuts the ATC at its minimum, the long-run market price
will be p = AT C M IN . › As price equals average total cost, a competitive firm will make
zero (economic) profits in the long run (just covers it opportunity costs so it has no
incentive to exit and no potential entrant has an incentive to enter). › When price equals
to ATC, there is no longer any entry into or exit from the market.

Long Run Equilibrium

● In the long run, there are zero profits in a perfectly competitive market. This requires p =
AT C M IN .
● Because there are zero profits, there is no incentive for any further exit or entry. The
long-run equilibrium price is p*, the quantity traded in the market is Q* and the output of
a firm is q*.

Market Supply Curve in the Long Run

● For the long-run market supply curve, we need to account for the fact that the market
responds to demand via ​the entry and exit of firms.
 ● As noted above, in the long run price adjusts back to the minimum of average total cost,
no matter what the quantity traded in the market is.
● Hence, taking account of exit/entry, the long-run industry supply curve is ​horizontal​ at
AT C M IN .
● An industry with a perfectly elastic long-run industry (or market) supply curve is ​a
constant-cost industry.
○ Unless otherwise stated, a competitive industry is assumed to be a constant-cost
industry.
Market Supply Curve in the Long Run
● Note that it is the upwards sloping short-run market supply curve that shifts when firms
enter and exit – this shifting is what affects the market price and thus profit level.
● The long-run market supply curve is horizontal at AT C M IN

.
Achieving Long Run Equilibrium
● Following an unanticipated increase in demand, in the short run price rises and firms in
the industry increase output (q* to q1) and make positive economic profits.
● The positive profits induces more firms to enter the market, shifting the supply curve
outwards from S1 to S 2. This forces prices back down to the p* = AT C M IN . Each firm
again sells q* units and economic profits are zero.

Increasing-Cost Industry
● In a constant-cost industry, entry and exit in the long run ensures that all firms earn zero
profits and the price is P* = AT C M IN .
 ● This assumes that all firms have access to the same technology and have the same cost
structure, and this cost structure does not change as the industry grows.
● However, the long-run industry supply curve need not be perfectly elastic.
● The long-run supply curve can instead be upward sloping; this is known as an
increasing cost industry.
○ If potential entrants have higher costs than incumbent firms (already in the
market)
○ Some resources used in production may be available only in limited quantities
(input prices rise as industry expands), thus costs for all firms rise
○ Congestion may rise with industry output (e.g. airlines)
● In an increasing-cost industry, the long-run industry supply curve is upwards sloping.

Decreasing-Cost Industry
● Suppose that as output in an industry expands, costs for all firms fall.
○ If there are economies of scale in input markets
○ For example, the computer software industry – as the market has expanded
average costs for all firms could actually fall.
● If this is the case, following an increase in demand, as entry will continue until it is no
longer profitable, the new long-run equilibrium price has to be lower than the initial
equilibrium price.
● In this case, the long-run industry supply curve is downward sloping – this is a
decreasing cost industry
● In a decreasing-cost industry, the long-run industry supply curve is downward sloping.
Dynamics in the Long Run
● Achieving long run equilibrium in industries with different costs structures.
● Here, the diagrams show how long run equilibrium is achieved following an increase in
demand.

Summary
● Perfectly competitive market
● If a competitive firm supplies a positive quantity in a market, it sells a quantity where P =
MC:
○ In the short run if P < AVCmin, a firm shuts down and sells zero output (incurring
its fixed costs); if P > AVCmin it supplies where P = MC.
○ In the long run a firm exits if P < ATCmin; if P > ATCmin the firm sells where P =
MC.
● In the short run a competitive firm can either make an economic loss or profit, or zero
economic profits.
● In the long run, with free entry and exit, market price is driven back to ATCmin.
○ A competitive firm makes zero economic profits (just covers it opportunity costs
so it has no incentive to exit and no potential entrant has an incentive to enter).
○ The long-run industry supply curve is perfectly elastic at P = ATCmin (or might be
upward or downward sloping if min cost changes as industry expands or shrinks).