CHAPTER 1: DEMAND AND SUPPLY LEARNING OBJECTIVES the purpose of this lesson is to reach an understanding of how markets operate,

how prices are set and transactions occur. The two market forces of demand and supply are defined and explained. The equilibrium point is studied. Conclusions and applications are offered. MARKET Markets exist for the purpose of facilitating exchanges of products, services or resources. Buyers and sellers are brought together and convey their desire to buy or sell by stating their offered and asked prices for different quantities. Even if a transaction does not take place, information if translated in the pricing of the product. An example of a market is that of the New York Stock Exchange. Its purpose is to facilitate the purchase and sale of securities. The transactions are not performed by the buyers and sellers themselves, but by brokers and dealers on their behalf. Daily transaction prices are reported in many newspapers nationwide because markets also perform the important function of pricing of goods, or in these case securities. DEMAND Demand is the expression of willingness and ability of a potential buyer to acquire certain quantities of an item for various possible prices the buyer can reasonably offer. Demand can be thought of as a schedule of prices and quantities in the mind of the buyer. Dealers of the New York Stock Exchange keep books in which orders from various clients are entered: how many shares and at what price. Such a listing is an illustration of what investors are willing and able to buy. LAW OF DEMAND The law of demand postulates that the relationship between price and quantity in the mind of buyers is inverse. The law of demand is represented graphically by a down sloping demand curve. The law of demand is explained by the diminishing marginal utility, the income effect, the substitution effect and with the help of indifference curves analysis. A retail store would certainly be most interested to know what its customers will be willing

to pay for what they want to buy. Such knowledge would allow the store to price its products most efficiently. This is the reason why market research is conducted to determine what customers want to buy and at what price. LAW OF DEMAND REASONS the law of demand can be explained by - price being an obstacle to consumption, - diminishing marginal utility, - price change income effect and substitution effect. It can also be derived from the diminishing marginal rate of substitution of indifference curves. All department stores have periodic sale days during which the prices are reduced substantially. The purpose of this price reduction is to get rid of old merchandise and stimulate the buying by customers (who may purchase many other items as well). Thus, stores take advantage of the law of demand: merchandise which would otherwise be hard to sell, is sold because customers are willing to pay a lower price. INCOME EFFECT The law of demand can be explained by observing that an unexpected price change affects the purchasing power of consumers. If the price is lower than expected, income is liberated which allows the consumer to buy more. An unexpected price increase would cause the consumer to buy less. When a housewife goes to the supermarket to buy groceries and finds one of the products she intended to buy being reduced in price because of a special sale, it makes her feel wealthier. Indeed, she can buy more with the money she started with. This is the income effect. SUBSTITUTION EFFECT The law of demand can be explained by the substitution effect. If the price of a good is lower than expected then that good appears to the consumer as a bargain opportunity in comparison to the goods which remain at full price. The consumer will temporarily switch his/her pattern of consumption by substituting bargain items for full price items. Suppose a customer is undecided between pork chops and steak before entering the supermarket. If pork chops have been put out on special at a reduced price, while steak has not, that is likely to induce the customer to buy the pork chops with no remaining hesitation. This is an illustration of the substitution effect. DEMAND GRAPH The law of demand is represented graphically by a down sloping

curve showing that when price decreases, quantity increases and vice versa. Graph G-MIC1.1

MARKET DEMAND The market demand is the sum total of individual demands. DEMAND DETERMINANTS Price is the major determinant of the quantity demanded. The nonprime determinants of demand are: - number of buyers, - tastes, - income, - price of other goods (either complementary or substitute), and - expectations about future prices. Advertising by companies shows that customers can be prompted to buy products for a great variety of reasons. The foremost inducement is still price. INFERIOR GOOD. An increase in income will generally cause the consumption of most goods to increase: these goods are said to be normal or superior goods. There are a few goods for which the pattern is reversed: an increase in income causes a decrease in consumption. These goods are known as inferior or Geffen goods. Most often, these inferior goods are tied in the mind of individuals to hard times.

PRICE OF RELATED GOODS The price of related goods affects the demand of an item in two opposite patterns depending if the goods are viewed by the buyer as complementary or substitute. COMPLEMENTARY GOODS Goods are complementary when their consumption is tied to each other. For instance, automobiles and tires: tires are sold because automobiles are sold and vice versa. The increase of the price of automobiles will cause fewer automobiles to be purchased, and thus, fewer tires as well. The relationship between the price of automobiles and the quantity of tires is inverse. Tires and cars, bullets and guns, lamps and lamp shades, cream and coffee, nails and hammer, nuts and bolts, are all items that go together. They are complementary goods. SUBSTITUTE GOODS Substitute goods are goods which can be replaced by each other in the mind of the consumer. For instance, tea and coffee are for many (but not all) consumers interchangeable goods. If the price of tea goes up, the purchases of tea will decrease and the purchases of coffee will increase. Thus, the relationship between the price of tea and the quantity of coffee is direct. Butter and margarine, tea and coffee, taxi and bus, pen and pencil, hotel and motel, radio and record player, are all items which, for most people, can be replaced by each other. They are substitute goods. QUANTITY DEMANDED a change in any of the nonprime determinants will cause the entire demand of consumers to change. Graphically this can be shown as a shift of the demand curve to the right or to the left. These shifts in demand must be distinguished from movements along the demand curve caused by changes in price: these changes in price only cause the quantity demanded to change, but the entire demand schedule remains the same. The availability of new products can change the tastes of consumers. Not long ago, complex calculation used to be done with slide rules. With the arrival of hand calculators, slide rules no longer satisfied customers. SUPPLY Supply is the willingness and ability of sellers or suppliers to make available different possible quantities of a good at all relevant prices. Supply is what we have to offer. All of us have our time and skills to offer to our employers. For some of us, the number of hours of work may change from day to day or from week to week. Then, most often, if additional hours are required to be worked, we can expect a higher price, i.e., overtime pay.

LAW OF SUPPLY The law of supply postulates that the relationship between price and quantity in the mind of sellers or producers is a direct one. When price increases so does quantity. The payment of overtime shows that the more one is expected to supply, the more one can be expected to be paid. In some professions, extra hours over regular overtime are paid at even higher wage rates. LAW OF SUPPLY REASONS The law of supply is explained by - price being an inducement for sellers or producers to sell more, and - cost of production increasing (because of the law of diminishing returns).

SUPPLY GRAPH the law of supply can be shown graphically by an up sloping supply curve. When price increases, quantity increases; thus, the direct relationship is verified. Graph G-MIC1.2

SUPPLY DETERMINANTS Price is the major determinant of supply. Nonprime determinants are:

- number of sellers or producers, - costs of production (including taxes), - technology (since it affects costs), - prices of other goods (as sources of possible profits), - expectations (but the effect is ambiguous). Returning to the employee supplying his/her hours of work, the willingness of the employee to accept changing work schedule is likely to depend on the time devoted to other needs (such as leisure, family, hobbies). Nevertheless, the major determinant will be the price or wage expected. QUANTITY SUPPLIED a change in any one of the supply non price determinants will change the entire supply schedule and shift the supply curve. This shift of the supply curve is to be distinguished from the movement along the supply curve itself when price is changed: this only changes the quantity supplied (not supply). EQUILIBRIUM The price and quantity equilibrium is where demand and supply intersect. At any price above that equilibrium, the quantity supplied exceeds the quantity demanded, which results in a surplus (and no transaction between buyer and seller). At any price below, the quantity demanded exceeds the quantity supplied, which results in a shortage. Only at the intersection of demand and supply are the quantities demanded and supplied equal. The price and quantity equilibrium is stable. Graph G-MIC1.3

SHORTAGE a shortage means that the quantity demanded exceeds the quantity supplied. A shortage exists if the price is below the equilibrium. If the market is free, the shortage will disappear as the price increases. The shortage will continue anytime the market is not free; for instance, if the government has instituted a price ceiling. If the price ceiling is above the equilibrium, it is not relevant and has no bearing on the market. Graph G-MIC1.4

Many cities have rent control laws to make sure that poor people can find apartments they can afford. But landlords do not find it profitable to rent at these prices and sometimes convert their buildings to condominium or cooperative ownership. This reduces the number of apartments available: it creates a shortage. SURPLUS a surplus means that the quantity supplied exceeds the quantity demanded. The surplus exists only above the equilibrium. If the market is free, the surplus will tend to disappear as the price is lowered. The surplus will continue only if the market is not free; that is, a minimum price has been instituted by the government. If the minimum price is below equilibrium, it is irrelevant and has no bearing on the market. Graph G-MIC1.5

The prices of many agricultural commodities, such as milk for instance, are subject to government price support. This higher price encourages farmers to produce too much: this creates surpluses. For instance, in the 1980's, the government has been forced to make cheese from milk surplus and to distribute that cheese free to poor people. INDIFFERENCE CURVES Indifference curves shows the combinations of two goods that an individual would be willing to buy, and which would make him/her equally satisfied (or indifferent). Indifference curves assume that more is preferred to less. They are convex as seen from the origin. The indifference curves form an entire map of various level of satisfaction. Graph G-MIC1.6

The shopping list of any consumer would reveal that, beyond some minimum basic necessities, purchases are a matter of choosing between various items that can provide equivalent satisfaction. This pattern of equivalent satisfaction from the consumption of two selected goods is what the indifference curves portray. MARGINAL RATE OF SUBSTITUTION The quantity of one good an individual must forego in order to increase the quantity of another good and leave the individual indifferent, is called the marginal rate of substitution. This marginal rate of substitution is shown graphically as the tangent to the indifference curve. The marginal rate of substitution is decreasing. This verifies that the indifference curves are convex as seen from the origin. BUDGET LINE The budget line is the locus of combinations of two goods an individual can afford to buy with his/her income. The slope of the line is the price ratio of the two goods: Pa/Pub or relative price of each good. Graph G-MIC1.7

A housewife going to the supermarket with a specific amount of money knows exactly what is the maximum she can spend. The proportions of the different items can change. POINT OF TANGENCY The equilibrium point which will give most satisfaction to the consumer, and which the consumer can afford, is where the budget line is tangent to the highest indifference curve. Graph G-MIC1.8

DERIVATION OF DEMAND Demand can be derived from the indifference curves by lowering (increasing) the price of one good and observing that the budget line will shift as a result, causing the equilibrium point to reflect a larger (smaller) quantity purchased of that good.

CHAPTER 2: ELASTICITY LEARNING OBJECTIVE The purpose of studying elasticity is to determine how a small change in price may result in either a large or small change in quantity. The concept is first defined and explained. Its measurement is discussed. The relationship between total revenue and elasticity is outlined. Supply elasticity and its determinants are analyzed. The concepts are applied to analyze price ceilings, price supports and tax incidence. ELASTICITY The concept of elasticity is intended to measure the degree of responsiveness of a buyer or seller to a change in a key determinant, in particular price. The degree of responsiveness of the quantity demanded to a price change is called the price elasticity of demand. If the price change is that of another good then the study deals with cross elasticitys of demand. Suppose a store manager wants to run a sale. Should he lower the price of a given item? And, if yes, by how much? The answer will depend on whether the increase in purchases by customers will be larger than the price decrease, (both calculated on a relative basis). This change in purchases by customers is what elasticity is intended to measure. ELASTICITY MEASUREMENT if elasticity were measured by absolute quantities, then it would be affected by the units of measure used for both price and quantity. To avoid this difficulty, elasticity is a ratio of relative changes in quantity and price: Ed = (dQ/Q) / (dP/P) Or

Ed = % change in quantity / % change in price. If a grocery store can increase its sale of milk by 12 quarts (from 24 to 36) when the price is dropped by 10 cents (from $1.00 to $.90), the elasticity measured in absolute terms is 1.2 (that is 12/10). But, when the quantity of milk is expressed in gallons, the elasticity in absolute terms is now 0.4 (4/10). If dollars instead of cents are used, it becomes 40 (4/0.1). This difficulty disappears when the elasticity is a relative measure. MIDPOINT ELASTICITY The calculation of elasticity using the formula of change in relative quantity over change in relative price results in different values depending on whether the starting point of the calculation is the highest or lowest price. To avoid this difficulty, both price and quantity are averaged: this is the equivalent of taking the elasticity at the midpoint of the price-quantity range. Ed = ((Q2-Q1)/ ((Q1+Q2)/2)) / ((P2-P1)/ ((P1+P2)/2)) It should be noted that price elasticity of demand is always negative and absolute values are often quoted without indicating the negative sign. If price is decreased by -10 percent (from $1.00 to $.90) to increase sales of milk by 50% (from 24 to 36), the elasticity is -5 (that is 50% divided by -10%). Looking at the same number the other way: there is a decrease in quantity of -33.3% (from 36 to 24) when the price is increased 11.1% (from $.90 to $1.00): an elasticity of -3. The presence of 2 values does not make sense. The midpoint (and correct) elasticity is -3.8 (that is (12/30)/ (-0.10/0.95)). ELASTIC DEMAND if the demand is elastic, it means that a small price change results in a large quantity change. This would generally take place on the upper portion of the demand curve. If the demand is perfectly elastic (which means that the smallest possible price change results in a virtually infinite quantity change), the demand curve is then horizontal. A mother wants to surprise her children by bringing home some fancy pastry for desert. But, after discovering that the pastry shop has raised its prices to unreasonable levels, she decides to skip the pastry. Her reaction shows very high, virtually infinite, elasticity.

INELASTIC DEMAND if the demand is inelastic, it means that even a substantial change in price leads to hardly any change at all in quantity demanded. This generally occurs in the lower portion of the demand curve. If the demand is perfectly inelastic, quantity does not change at all. A perfectly inelastic demand is vertical. For most people, items that are considered as necessities are items for which the demand is inelastic. No matter how much the price may change, if we think we really need an item, we will buy it. Medicine or basic food items are probably in this category. Milk for a family with children is such a basic food: you will always find it somewhere in the refrigerator, no matter its price. TOTAL REVENUE AND ELASTICITY if demand is elastic, then price and total revenue are inversely related; that is, if price is increased, total revenue decreases. If demand is inelastic, price and total revenue are directly related; that is, if price is increased, then total revenue increases as well. In the previous milk example, the demand was elastic: 3.8. The revenues increase from $24 (when the price is $1.00 for 24 gallons) to $32.40 (when the price is lowered to $.90 for 36 gallons). Thus, total revenue is indeed inversely related to price change when demand is elastic. DEMAND ELASTICITY DETERMINANTS The determinants of demand elasticity are - the time framework (market period, short run or long run), - the availability of substitutes, - the proportion the item represents in total income, - the perception of the item as necessity or luxury. The ability to switch to another brand, another product or another form of consumption, is the overall criterion of all the determinants of demand elasticity. It is clearly a very subjective factor, quite different from person to person. SUPPLY ELASTICITY Supply elasticity is the degree of responsiveness of the quantity supplied to a change in price. It is calculated as

Es = % change in quantity / % change in price.

The government is interested to know how much more electricity electric companies would be willing to supply if they were allowed an increase in the rates they charge. What measures this responsiveness of the electric companies is the supply elasticity. Naturally, building a power plant takes a long time. Thus, the supply price elasticity of electricity can be expected to be higher in the long run than in the short run. SUPPLY ELASTICITY DETERMINANTS the major determinants of supply elasticity are - the time framework (market period, short run or long run), - the ability to shift resources. INCREASING COST INDUSTRY when a resource is scarce and the cost of that resource increases over time, the long run equilibrium price of products made from it increases and the industry is referred to as an increasing cost industry. Most industries have increasing costs over time. Some industries do not have scarce resources; they are constant cost industries. New emerging industries may experience decreasing costs for a while. Production of electricity is very likely to be of increasing cost industry type. The various energy sources (gas, coal, fuel, hydropower) are all extensively used. Alternative sources (nuclear, sun, wind) have their own additional danger or costs. That is why our electric bill usually goes up, and is likely to do the same in the future. PRICE CEILING A price ceiling creates a shortage in the short run. Since both demand and supply curves are more elastic as the time framework lengthens, this causes the shortage to increase over time. This can be verified by observing that a price below equilibrium is an incentive for buyers to buy more and a disincentive for suppliers to supply more. In most major cities, rent control laws have been enacted to provide affordable housing to low and middle income families. But, landlords have been discouraged to keep increasing the number of apartments available at those moderate rents, and have often preferred to convert ownership to cooperative or condominium form. This has taken apartments off the rental market and increased shortages of affordable housing in many cities.

PRICE SUPPORT In the short run a price support creates a surplus. In the long run, both demand and supply become more elastic. This causes the surplus to increase over time. The price support, being higher than equilibrium, acts as an incentive for producers to produce more and as a disincentive for buyer to buy. Milk production has been subject to price support for many years in many countries. Consequently, governments have been forced to buy up excess milk produced by farmers. These government stock piles are regularly converted into cheese distributed free to poor people. The surplus of milk continues because farmers have a price incentive to produce more. Now, the government is trying to cut the number of cows farmers are allowed to have. TAX INCIDENCE AND ELASTICITY technically a sales tax is paid by the consumer; the seller only collects the tax on behalf of the taxing authority. A further analysis of the incidence of a sales tax (i.e. the analysis of who really bears the burden of the tax) reveals that the burden of the tax is shared. The price increase resulting from the sales tax reduces the quantity traded and forces the seller to lower the selling price. TAX INCIDENCE AND ELASTIC DEMAND. If the demand is highly elastic (that is, customers are able to switch), the supplier will be forced to lower selling prices considerably to continue on selling some of his/her products. Thus, if demand is elastic while supply is inelastic the burden of the tax is shifted almost in its entirety to the supplier. Suppose a county increases its sales tax while its adjoining county does not. The residents will prefer to buy their products in the county which does not have a sales tax. To retain their customers, merchants of the county which has enacted the sales tax will have to lower their prices. Thus the incidence of the tax has been shifted onto sellers. TAX INCIDENCE AND INELASTIC DEMAND. If the demand is inelastic, the quantity demanded will not change much after the sales tax is imposed, the supplier will not have to lower the price and the burden of the tax is borne almost in its entirety by the buyer. In the example of the adjoining counties, the shift in the incidence takes place because the residents are assumed to be able to shop equally in one or the other county. (That is, they have a highly elastic demand). But, if some barrier existed, such as a toll bridge between the two counties or customs duties, the incidence of the tax would then remain entirely on the consumers.

TAX REVENUE AND ELASTICITY If the purpose of a sales tax is to raise revenue for the government, such tax will be effective only if demand and supply are inelastic. Indeed, if both or either are elastic - which they usually are in the long run - the decrease in quantity purchased will cause the additional revenue from the tax to be minimal or even negative. Many countries have import duties on luxury items. When those import duties are very high (30% or more), smugglers are willing to take the chance on breaking the law. Then, revenues from those duties decline.

SUMPTUARY TAX AND ELASTICITY The purpose of a sumptuary tax is to change the pattern of consumption in a society. Such a sales tax will be effective only if the demand and supply are elastic. Indeed, if both or either are highly inelastic, no matter how large the tax is, the quantity will not change. Sumptuary taxes exist in virtually every country, including the United States. They are most often assessed on items such as cigarettes, wines and liquor. TAX INCIDENCE AND SUPPLY ELASTICITY When supply is elastic; an increase in sales taxes will result in a large increment in the price paid by consumers and the tax burden being largely paid by consumers. When supply is inelastic, an increase in sales taxes will result in a price reduction by sellers, and the tax burden is largely paid by sellers.

CHAPTER 3: PRODUCTION COSTS LEARNING OBJECTIVE The purpose of this chapter is to analyze how costs of production change as output is changed. First the concept of economic costs is investigated. Short run patterns of total, average and marginal costs are derived on the basis of the law of diminishing returns. Long run cost patterns are briefly outlined. OPPORTUNITY COST All costs in economics are said to be opportunity costs because anytime a resource is used for any purpose, it implies that some other good cannot be produced with that quantity of the resource, that some other resource is not used for the given production instead, and that revenues from other production are foregone. Thus, costs are either explicit cost for the resource used or implicit costs from alternative use of the resource. When a student takes a course in economics, the cost of taking the course is more than just the money spent on tuition, textbooks and study aids. For instance, the time devoted to studying could have been used to work in a supermarket and earn a nice salary. That salary is not an out-of-pocket cost, but an opportunity cost, which is a real cost nevertheless. NORMAL PROFIT Among the implicit costs of a firm, normal profit is the most important cost which must be met. Normal profit is that income the business owner, or entrepreneur, would receive if he/she were engaged in some other activity or

employment. Thus, if the business owner does not derive what he/she feels he/she deserves, then he/she may well close the business. The owner of a small retail specialty store uptown should expect the store to generate at least as much income as what he/she could earn working as a manager for the department store downtown. Otherwise, the reasonable decision would be to close the store. PURE PROFIT Pure profit, also known as economic profit, is the excess of revenues over all costs of the firm, explicit as well as implicit (i.e. opportunity) costs (one of which is normal profit). Pure or economic profit, thus, differs from accounting profit since in accounting profit only out-of-pocket explicit costs are taken into consideration. As opposed to normal profit, pure profit is a reward for taking the risk in running a business, and sometimes it can be negative. Thus, the owner of a store will see ups and downs in total profit due to changes in pure profit, which occasionally eats up some of the normal profit. SHORT RUN The short run time framework for a firm is that time period during which some of its resources, and thus costs, are fixed. A typical example of a fixed cost for most firms is rent or the salary of key personnel (such as the president of the company). The number of days, months or years which constitutes the short run differs greatly from firm to firm. Most commercial rentals require a lease (a contract to rent for several months or years). Setting up a business also often requires installation of fixtures, furniture or equipment. Over the duration of the lease, the business would lose a lot of money if it had to change location. Thus, space is pretty much fixed over that period of time. LONG RUN The time framework is considered to be long run when all the costs of a firm can be changed to some extent. For instance, the factory size can be modified. In the long run, there are no truly fixed costs: all costs are variable. At the expiration of the rental lease, a business can move to a more desirable location, which can be larger or smaller. Thus, in the long run, not even the working space of the business has to remain the same: everything can change. DIMINISHING RETURNS The law of diminishing returns shows the observable occurrence that if variable inputs are increased beyond a certain point the incremental (or marginal) quantity produced (or returns) starts to decrease. Starting from a very low level of production, firms usually will benefit from increasing efficiency at first, but

the gains dissipate and production becomes less efficient when the size capacity of the firms is overutilized. In a restaurant, the first employees that need to be hired are probably the manager, the cook and the waiter or waitress. Without them the restaurant would be very inefficient. Other help can be hired later: maitre d', somellier, cashier, kitchen attendants, etc. If there are too many waiters in the restaurant or too many cooks in the kitchen, they may spill or spoil the broth. LAW OF DIMINISHING RETURNS The law of diminishing return takes place only in the short run. It is entirely due to the presence of some fixed resource, and the need to overutilize that fixed resource.

FIXED COSTS Fixed costs are those costs over which a firm has no control. They are usually tied to fixed inputs or resources. The fixed costs must be paid, otherwise the firm may have to close down. Graph G-MIC3.1

Rent is a typical fixed cost. It does not change from month to month (or from year to year) over the period of the lease, no matter what the volume of output may be.

VARIABLE COST Variable costs are those costs which a firm can change at will. They pertain to inputs or resources which are not fixed. Graph G-MIC3.2

Salaries, especially those of extra help and part-time employees are typical variable costs. Many other expenses are also variable: freight and postage, telephone in excess of the basic rate, maintenance and cleaning, and energy consumption. All these change with the volume of production. TOTAL COST Total cost is the sum of all costs: fixed and variable. The total cost curve is represented graphically as an upsloping curve: costs increase as output volume increases. The curve is generally S shaped, reflecting the increasing efficiency starting from a low level of production, and then a decreasing efficiency as the volume of production goes beyond the point of diminishing returns. Graph G-MIC3.3

The total cost of the restaurant increases as the number of meals increases (which is the volume of output here). When the restaurant becomes overcrowded and the law of diminishing returns sets in, the total cost increases very fast because employees become less efficient. AVERAGE FIXED COST Average fixed cost is calculated by dividing total fixed cost by the quantity produced. AFC=TFC/Q. The average fixed cost curve is represented graphically as an ever decreasing curve asymptotic to the horizontal axis. Graph G-MIC3.4

The rent paid by the restaurant is divided (or allocated), among more and more meals as the volume of production increases. The average cost per meals attributable to the fixed rent decreases as the number of meals increases. AVERAGE VARIABLE COST Average variable cost is calculated by dividing total variable cost by quantity produced. AVC=TVC/Q. The average variable cost curve is graphically represented by a U shaped curve reflecting the increasing then decreasing efficiency in production as volume changes. Graph G-MIC3.5

Starting from a few meals and customers, a restaurant can improve its efficiency and decrease its average variable cost per meal as it increases it volume. After having expanded too much, the average variable cost starts to rise as employees start to get in each others way when the restaurant is too crowded. AVERAGE TOTAL COST Average total cost is calculated by dividing total cost by the quantity produced. ATC=TC/Q. It can also be obtained by adding up average fixed cost and average variable cost at each level of production. The average total cost curve is represented graphically as a U shaped curve with a steep decreasing portion and a mildly increasing portion. These are attributable to the fixed and variable cost patterns. Graph G-MIC3.6

The pattern of the average total cost of the restaurant is a combination of the pattern of average fixed costs and average variable costs. As output increases, average total cost decreases then increases with diminishing returns. MARGINAL COST Marginal cost is calculated by dividing the change in total cost by the change in quantity. MC=(change in TC)/(change in Q). The marginal cost curve is represented graphically by a U shaped curve reflecting the increasing then decreasing efficiency as volume increases. The marginal, or additional, cost per meal changes more than the average total cost for each meal. The cost of one additional meal start to increase before average total cost does. MARGINAL COST GRAPH The shape of the marginal cost curve can be explained by the pattern of total cost: it is due to the law of diminishing returns. The trough (or minimum) of the marginal cost curve corresponds to the point of diminishing returns. Marginal cost itself is also the slope of the tangent to the total cost curve. Graph G-MIC3.7

MINIMUM AVERAGE TOTAL COST Marginal cost curve intersects the average total cost curve at its minimum (or trough). One may verify that this must necessarily be true by observing that - if marginal cost is below average cost, average cost decreases, - if marginal cost is above average cost, average cost increases, Average cost remains the same only if marginal cost is neither above nor below. Graph G-MIC3.8

ECONOMIES OF SCALE Economies of scale, or economies of large scale, result from gains in efficiency as the size of production is increased along with appropriate changes in fixed resources to utilize the available resources more fully. Economies of scale can only occur in the long run. Economies of scale are observable in most manufacturing. Automobile production is especially sensitive to volume. A single car (for instance, those constructed for car racing) can cost millions of dollars. But, when the same features are incorporated in millions of parts, the cost becomes affordable. Recent studies indicate the minimum production of a line of cars is 100,000 units. ECONOMIES OF SCALE CAUSES The major causes for the presence of economies of scale are - division of tasks and labor specialization minimizing labor cost, - more intensive use of highly skilled personnel, - more intensive use of capital (for instance, with shifts), - ability to utilize by-products rather than discard them. ECONOMIES OF SCALE GRAPH Economies of scale are observed graphically by a pattern of lowering of the marginal and average total cost curves. The envelope of the short run average total cost curves can be looked upon as a long run cost curve. DISECONOMIES OF SCALE Diseconomies of scale take place when the size of a firm is excessive. A firm may indeed increase its size to take advantage of economies of scale, but the gains disappear when the firm reaches a certain size. Diseconomies of scale belong to the long run and must be clearly distinguished from diminishing returns which occur in the short run. It is often argued that diseconomies of scale are rarely - if ever - observed in industry because firms would cut back on their size. General Motors is still made of several divisions which have never been integrated into a single production. There may be many reasons for this. An apparent one is that keeping the divisions separate stimulates some amount of competition among them, and thus avoids diseconomies of large scale.

DISECONOMIES OF SCALE CAUSES Some of the possible causes of diseconomies of scale are - difficulties in control and supervision, - slow decision making due to excessive size of administration, - lack of employee motivation.

CHAPTER 4: PERFECT COMPETITION LEARNING OBJECTIVE In this topic the principles which guide firms in their price and quantity decisions will be set out in the short and long run. Perfect competition is defined. The demand and marginal revenue are derived. The equivalence between profit maximization and equality of marginal revenue and marginal cost is established. The long run equilibrium is studied. The economic effect of this market form is shown to be optimum for society. PERFECT COMPETITION Perfect competition is a type of market characterized by - a very large number of small producers or sellers, - a standardized, homogeneous product, - the inability of individual sellers to influence price, - the free entry and exit of sellers in the market, and - unnecessary nonprice actions. Examples of markets in perfect competition are extremely rare. Numerous markets in the retail, service and agricultural sectors approach perfect competition best. But, in the agricultural sector, government support price programs distort the market mechanism. Notwithstanding the lack of good examples, this form of market is important because of a general conviction among economists that it is the best form of market. PERFECT COMPETITION NUMBER OF FIRMS The very large number of firms in perfect competition implies that each individual firm is very small in comparison to the total market. Indeed, if one firm were to become significantly large, it would dominate the market and competition would be eliminated or at least diminished. In the milk production segment of agriculture, farms are usually

small. They are especially small compared to the size of the entire market for milk. Note that the milk distributors are occasionally large, but not the productive farms. PERFECT COMPETITION STANDARDIZED PRODUCT The product in perfect competition is said to be standardized (or homogeneous). This means that it does not make any difference to customers which specific firm sells the product: it is absolutely identical. This is the main distinction between perfect competition and monopolistic competition: once some differences can be recognized by customers, firms acquire power over these customers. Milk is a uniform and homogeneous product. It is not possible to make a distinction between the milk of one farm and another. The government has indeed set standards of quality, fat content and cleanliness. PRICE TAKER The firms in perfect competition have no power over price: they have to sell at the going market price. The firms in perfect competition are said to be price takers. Should a firm attempt to raise the price by the smallest possible amount, customers would not buy from it because they could buy the same product from other firms. Lowering the price is also not necessary because the firm can already sell all its output at the going price. A milk producer who would try to raise his/her revenues by increasing the price for milk, would find the company collecting the milk in that region unwilling to buy his/her milk any longer. One individual farmer is thus unable to affect the price of milk in the entire market. PERFECT COMPETITION ENTRY AND EXIT There are no barriers to entry to or exit from a market in perfect competition. This condition assures that no firm will dominate the market and evict other firms. It also assures that the number of firms (although changing) will remain large. Agricultural production can start for most crops by simply planting on a parcel of land. For instance, that is true for fruit trees and vegetables. (It is true. however, that for some products such as milk or tobacco, the government limits production because of the existing overproduction).

PERFECT COMPETITION NONPRICE ACTION Nonprice actions such as advertising, service after sale or warranty, are not necessary in perfect competition because the firm can already sell all its output at the going price, and incurring additional expense would only make it unprofitable. (Nonprice action for the entire industry may however be useful). A single milk producer cannot possibly influence the consumption of milk at large, and needs not advertise. An association of milk producers or a large milk distributor may, however, be in a position to use advertisement effectively. PERFECT COMPETITION DEMAND The demand of firms in perfect competition is perfectly elastic (i.e., the smallest possible price change results in a virtually infinite quantity change). Such demand is represented graphically by a horizontal demand curve: no matter what quantity is sold, the price is the same, and it is the going price in the market. Graph G-MIC4.1

Nationwide, the demand for milk is likely to be downsloping, that is inversely related to price. But for a single milk producer, it is given by the price the farmer can receive: the going market price. It does not change, no matter what quantity the farmer produces. Thus demand is horizontal.

PERFECT COMPETITION MARGINAL REVENUE The horizontal demand curve is also the marginal revenue of a firm in perfect competition. The marginal revenue, or additional revenue from one more unit sold, is just equal to the going price (which is shown graphically by the demand curve itself). Note that the average revenue is also the demand curve and total revenue is an upsloping straight line.

PROFIT MAXIMIZATION A firm must seek to sell a volume of output where its total revenue exceeds its total cost by the largest amount possible; that is, its profit is the maximum.

LOSS MINIMIZATION If a firm fails to derive a profit, it may nevertheless seek, in the short run, to produce at that level of sales where the difference between its cost and its revenue, i.e., its loss, is minimum.

CLOSE DOWN DECISION If a firm has revenues that are insufficient to cover even its fixed costs in the short run, the firm must close down.

BREAK-EVEN POINT The volume of output where total revenue is equal to total cost is known as the break-even point. A firm must be beyond its break-even point in order to be maximizing its profit.

MARGINAL REVENUE MARGINAL COST RULE Producing at the level of output where marginal revenue equals marginal cost is equivalent to profit maximization. Indeed, if one less unit were to be produced, profit would be smaller by the excess of marginal revenue over marginal cost for that last unit. If one more unit were to be produced, profit would also be

smaller, this time by the excess of marginal cost over marginal revenue.

MARGINAL REVENUE MARGINAL COST The marginal revenue = marginal cost rule is applicable to loss minimization as well as profit maximization. However, if marginal revenue intersects marginal cost below average variable cost, it means that revenues are not sufficient to cover fixed costs and the firm should close down.

MAXIMUM PROFIT The maximum profit is obtained by first determining the level of output for which marginal revenue equals marginal cost (thus profits cannot possibly be increased). Then determining 1- total revenue given by price multiplied by quantity, 2- total cost given by average total cost multiplied by quantity, 3- the difference between 1 and 2 above is the profit (or loss).

MAXIMUM PROFIT GRAPH Since maximum profit is the excess of total revenue over total cost, it is shown graphically as the area by which the total revenue rectangle exceeds the total cost rectangle. The height of total revenue rectangle is the price received by the firm, and the width is the optimum quantity (where MR=MC). The height of total cost rectangle is average total cost (on ATC curve), and the width is the optimum quantity. Graph G-MIC4.2

SHORT RUN SUPPLY CURVE The short run supply curve of firms in perfect competition is the upsloping portion of the marginal cost curve (above the average variable cost intersection). Indeed, a firm determines its optimum volume of sales by taking the intersection of marginal revenue and marginal cost. The marginal revenue is also the price it receives. Thus supplier's price-quantity combinations are given by the marginal cost upsloping portion. LONG RUN PERFECT COMPETITION EQUILIBRIUM The long run equilibrium for firms in perfect competition is where demand (and marginal revenue which is identical to it) is tangent to the minimum of average total cost (where marginal cost also intersects average total cost). At that point, there is no profit or loss for the firm. (Note that there is no pure or economic profit, but normal profit must still be covered).

ENTRY OF FIRMS IN PERFECT COMPETITION Should demand be above the minimum of average total cost, pure profit would exist for firms in perfect competition. This profit would attract new firms to the industry. Such entry of new firms is not impeded by any entry barriers in industries in perfect competition. The new firms would increase the total market supply and drive the price down. The lower price pushes

the demand for each firm down toward or even below the equilibrium minimum average total cost point.

EXIT OF FIRMS IN PERFECT COMPETITION Should the demand be below the minimum of average total cost, losses of firms would force some firms to leave the industry. As firms leave, a decreasing total supply pushes price back up. The increasing price lifts the demand curves for individual firms upward toward or even above the equilibrium point. Firms departure or entry will continue until the price settles to be just equal to minimum average cost.

LONG RUN SUPPLY CURVE The long run supply curve for an industry in perfect competition is perfectly elastic (that is horizontal) in constant-cost industries and upsloping in increasing-cost industries. Whether an industry is constant-cost or increasing-cost is determined by the presence of adequate or insufficient resources. PERFECT COMPETITION ECONOMIC EFFECT Perfect competition is seen as an ideal or optimum form of market because of its very beneficial economic effect for society, which comes from - allocative efficiency, and - productive efficiency. But there are a few shortcomings nevertheless. PRODUCTIVE EFFICIENCY The productive efficiency of perfect competition can be observed in the long run equilibrium point of all firms in the industry, which is at the minimum of average total cost. This means that all firms are forced to cut their costs and utilize the best available technology in order to have their minimum average total cost no higher than that of all the other firms in the industry. There is also no under or over utilized capacity.

ALLOCATIVE EFFICIENCY The allocative efficiency in perfect competition comes from the

fact that the quantity produced by each firm is just that for which the price paid by society is equal to the cost of additional resources (marginal cost). More could not possibly be obtained for a lower price. The resources are also the most efficiently allocated among industries since firms will bid for these resources up to the price consumers want to pay for them.

PERFECT COMPETITION SHORTCOMINGS In spite of its beneficial economic effect, perfect competition fails to - provide any correction for income distribution inequity, - generate any public goods since there is not profit, - stimulate technological progress because of lack of profits, - offer diversity in products since these are standardized. CHAPTER 5: PURE MONOPOLY LEARNING OBJECTIVE The goal of this topic is to show how a monopoly determines price and quantity for its maximum profit. The monopoly form of market is defined. Demand and marginal revenue are presented. The rule of equating marginal revenue to marginal cost is shown to secure the optimum quantity and price. The economic effects of monopoly and price discrimination are outlined. The chapter closes with an analysis of regulated monopolies. PURE MONOPOLY Pure monopoly is a type of market characterized by - a single seller or producer, - a unique product, with no close substitute, - the ability of the seller to ask any price it wishes, - entry to the industry completely blocked by legal, technological or economic barriers, and - no need for nonprice actions, except public relations or goodwill advertising. Examples of pure monopolies are not common because monopolies are either usually regulated or prohibited altogether. Cases where a company has substantial amount of monopoly power, but cannot be considered a pure monopoly, can easily be found.

MONOPOLY UNIQUE PRODUCT A monopoly exists when a firm is the only producer of a given product. That product is therefore unique to that firm. Such situation is rarely observed because products providing a similar service can usually be found in other industries or regions of the world. The product is unique in the sense that no close substitutes are presently easily available to consumers. For close to half a century, ALCOA was a virtual monopoly because it had control over mining of the aluminum ore (bauxite). MONOPOLY POWER OVER PRICE A monopoly has extensive power over the price it may want to charge its customers. The monopolist is sometimes referred to as a price maker. It must be noted, however, that a monopolist does not charge the highest possible price. Instead it charges the price for which its profits are the largest. Moreover, a monopolist does not set a price independently of the volume produced: quite the contrary, price setting is implemented by restricting output. MONOPOLY ENTRY BARRIERS Monopoly exists when entry barriers are present; these may be - legal, from the ownership of a patent or a copyright, - legal, from its appointment as public utility for natural monopolies, - technological, from a secret method of production, - due to large size, age, or good reputation, - stemming from access to a key resource (such as ore), or - resulting from unfair tactics or unfair competition. UNFAIR COMPETITION Various strategies used by firms to eliminate competitors by forcing them into bankruptcy or preventing new firms from entering the industry, are referred to as unfair competition. They may include - drastic underpricing of products, or - cornering of a resource market. Most of these tactics have been declared illegal in antitrust legislation. The history of railroad expansion in the United States during the latter half of the 19th century is full of examples of

actions by railroad companies seeking to eliminate competitors MONOPOLY NONPRICE ACTION Since a monopolist is the only firm in the industry, it appears that there is no need for nonprice action, such as advertising. However, advertising and other nonprice action are used as a form of public relations and for the purpose of avoiding customer antagonism. Electric companies are natural monopolies and do not need to advertise because customers have no choice but to receive their electricity from them. But, they do advertise. The purpose is often to convince consumers that the company is on their side by giving them tips on energy conservation, for instance. MONOPOLY DEMAND The demand of a monopoly is downsloping because the monopoly is the only firm in the market, and demand for most products is price sensitive. Graph G-MIC5.1

The demand of natural monopolies, such as an electric company, is downsloping. Indeed, if the electric company were successful in obtaining a large rate increase, many customers may switch to alternative sources of energy, such as gas for heating and cooking.

MONOPOLY MARGINAL REVENUE Marginal revenue is the additional revenue received for the last unit sold. Since the monopolist can sell one more unit only by lowering the price on all the units sold, the marginal or additional revenue is not constant but decreasing. The marginal revenue is less than price at any quantity. If the demand curve is a straight line, the slope of marginal revenue is twice the slope of the demand curve. Simple algebra can show that the slope of marginal revenue is twice that of the corresponding demand curve. If demand can be written as P=-aQ+b, total revenue is PQ, or PQ=(-aQ+b)Q. Then, marginal revenue is the first derivative of total revenue, and that is P=-2aQ+b. Thus, the coefficient of the slope of marginal revenue is -2a, twice that of demand -a. MONOPOLY DEMAND ELASTICITY The upper portion of the demand curve of a monopoly is elastic, and marginal revenue is positive for this region of output. The lower portion of demand is inelastic, and marginal revenue is negative in that region. It follows that a monopolist would never want to be in the inelastic portion of its demand since it can increase revenues by raising price.

MONOPOLY PROFIT A monopoly finds its maximum profit by producing at a level of output where marginal revenue equals marginal cost (i.e. the intersection of marginal revenue and marginal cost curves). If it produces one less unit a profit is foregone (on the last unit it failed to sell), and if it produces one more unit a decrease in profit is incurred (as the marginal cost exceeds the marginal revenue for that last unit). Many of the largest fortunes in the United States are the result of monopoly profits accumulating over time. For instance, Standard Oil (before it was split up) produced the wealth of the Rockefeller family. MONOPOLY OPTIMUM QUANTITY The profit of a monopoly is determined by first finding the optimum quantity with the marginal revenue equal to marginal cost rule. After that, the unit price on the demand curve and

the unit cost on the average total cost curve are found based on the optimum quantity established first. MONOPOLY PROFIT GRAPH The monopoly profit is the difference between total revenue and total cost. Total revenue is represented as a rectangle with price (on the demand curve) as its height, and quantity (determined by MR=MC) as it width. Total cost is a rectangle with average unit cost (on average total cost) as its height, and quantity as its width. The area by which total revenue exceeds total cost is the profit area. Graph G-MIC5.2

MONOPOLY LOSS A monopoly seeks to maximize profits, and is capable of achieving such a goal by controlling price and quantity. However, should customer demand decrease significantly, the monopolist will be content with minimizing loss (in the short run) and may even be forced to close down. Graph G-MIC5.3

MONOPOLY SUBOPTIMAL PROFIT The strategy of a monopoly should be to maximize total profit. Such outcome would not be obtained by maximizing either unit profit, unit price or total revenue. However, in some cases a monopoly may want to use a suboptimal pricing strategy, for instance, to create additional entry barriers or to avoid customer confrontation. MONOPOLY ECONOMIC EFFECT A monopoly form of market is highly undesirable for our society because of the sizable loss of productive and allocative efficiency: the price paid is higher than in perfect competition and the quantity is smaller. The monopoly underutilizes the resources for the production of a good wanted by society. The price charged is much higher than the cost of additional resources used. However, economies of scale and technological progress are possible. OPEC is not a pure monopoly. But, in 1973 and 1979, it acted as a monopoly in successfully increasing prices of oil and fuel by limiting their supply. Many people throughout the world, including the United States, were harmed by these actions. Some could no longer afford the cost of heating their home and the cost of needed transportation. Others lost their jobs as businesses were forced to cut production as costs increased.

MONOPOLY ECONOMIES OF SCALE In spite of the undesirable economic effect of a monopoly in general, a monopoly may in certain circumstances generate substantial economies of scale, which can be passed on to society in a lower price. The small firms of perfect competition are not large enough to bring about the economies of scale. Such economies of scale are to be found primarily in natural monopolies. Some economists have questioned the existence of this beneficial economic effect.

MONOPOLY TECHNOLOGICAL PROGRESS Another potential benefit to society from monopoly type firms is that profits are often the motivation for technological progress and investment in new technology is made possible by the presence of these profits. However, monopolies well protected by entry barriers will not need to seek new technology, and if they do, their goal may be to lower costs for additional profits and new entry barriers.

PRICE DISCRIMINATION Price discrimination exists whenever different prices are charged for the same product and the difference in price cannot be explained by costs. The telephone company charging different rates for night and day calls is a good example of price discrimination. The reason why the telephone company is able to charge the higher day rates is because the demand is inelastic: certain calls have to be made during business hours. The regulatory commission tolerates the price discrimination because it provides a saving for those who can wait until the evening to make their calls. PRICE DISCRIMINATION CONDITIONS In order for the price discrimination to be possible, a firm must - be a monopoly or have some power over price, - be able to segment its market, and - be able to prevent cross selling from one market segment to another. Generally, the market segments will have different elasticities.

PRICE DISCRIMINATION EFFECTS The purpose of price discrimination is to increase the profit of the monopolist. This is achieved by charging a higher price to those customers who are more inelastic. Price discrimination is generally considered harmful to society and an unfair practice. It is declared illegal in the Sherman Act. However, price discrimination is, nevertheless, tolerated in many instances, in part, because it may result in larger overall output, and is occasionally a form of income redistribution. NATURAL MONOPOLY Natural monopolies are said to exist in industries where competition is unworkable and would result in costly duplication of fixed capital. Most natural monopolies are public utilities. These are regulated by commissions. A water supply company is a typical natural monopoly. It is usually the only supplier of water for a given section of a town because it would be wasteful (in fixed assets) to have more than one company offering water to the same house. REGULATED MONOPOLY The major task of the commission regulating a natural monopoly is to set the price (or rate) that the utility is allowed to charge. One method is the fair-return pricing method. The price is set at the point where it is equal to average total cost. The average total cost is allowed to include a market rate of return to make sure that new funds can be attracted for expansion. This practice often results in cost padding by utilities. Gas, water, electric and telephone companies are all regulated companies. Many companies in the transportation sector are also regulated (such as urban bus transportation and trucking). Deregulation of some of the industries has shown that the regulatory process was (for instance in the case of airlines) to the detriment - not benefit - of consumers. REGULATED MONOPOLY SUBSIDY In a few cases of natural monopolies, a price below average cost is imposed on a utility to require a large output from the firm. The loss incurred by the firm is then offset with a subsidy. This is most often present in transportation companies.

CHAPTER 6:

MONOPOLISTIC COMPETITION LEARNING OBJECTIVE The purpose of this topic is to look at a very common form of market where firms are numerous but have some monopoly power. The characteristics of the market are first stated. The short and long run equilibrium is shown. The economic effect of this market is derived. Because of the importance of nonprice action in this market, advertising is given special attention. MONOPOLISTIC COMPETITION Monopolistic competition is a type of market characterized by - a large number of firms, - products which are differentiated and not seen as perfect substitutes by consumers, - some ability of sellers to set prices as they wish, - free entry to and exit from the market, - heavy reliance on nonprice actions to differentiate one's product. The monopolistic competition form of market is extremely common. Almost all retail operations are in this form of market. Small businesses in all sectors fall in this category. Starting a business is relatively easily, but staying in business is not: that requires an ability to convince customers that the product is different and better than that of competitors. MONOPOLISTIC COMPETITION NUMBER OF FIRMS The large number of firms in monopolistic competition implies that the firms are small in comparison to the entire market. Although they have some power over price (to the extent that their products are differentiated), they do not have sufficient power to retaliate if another firm changes its price. This is the major distinction between this market form and oligopoly.

MONOPOLISTIC COMPETITION DIFFERENTIATED PRODUCT The differentiated product sold by a firm in monopolistic competition has some features that makes a customer prefer it over the available similar products of other firms. The features may be physical or created by advertising. The power of any firm over price stems from this very fact that products are not perfect substitutes. Nonprice actions are necessary to make the products differentiated.

MONOPOLISTIC COMPETITION ENTRY TO MARKET No barriers to entry or exit exist in monopolistic competition. However, the need to make one's product differentiated may require nonprice action, which, if unsuccessful, would drive the firm out of the market.

MONOPOLISTIC COMPETITION DEMAND The demand of a firm in monopolistic competition is downsloping because of the preference of customers for the features of the differentiated product. However, because there are many close (if not perfect) substitutes readily available, the demand is highly elastic. Graphically, this means that the demand in monopolistic competition is flatter than in monopoly. The demand of a restaurant is likely to be very elastic because there are many other food outlets available to customers. But the demand is not perfectly elastic (i.e. horizontal) as in the case of perfect competition because, each restaurant has something to offer other restaurants do not: for instance, convenience, location, elaborate menu, or just atmosphere. MONOPOLISTIC COMPETITION PROFIT The profit of a firm in monopolistic competition is determined in the same fashion as in any other type of market by finding the optimum quantity where marginal revenue intersects marginal cost. This optimum level of output, in turn, determines the price charged (on the demand curve) and average unit cost (on the average total cost curve). The profit is the excess of total revenue area over total cost area. A restaurant should accept customers as long as the additional or marginal revenue exceeds the additional or marginal cost of the last meal served. This seems to be apparent in the reservation process which limits the number of patrons. Without reservations, the restaurant would either have to serve customers in overcrowded conditions or make them wait on line. MONOPOLISTIC COMPETITION LONG RUN EQUILIBRIUM The long run equilibrium of a firm in monopolistic competition is where demand is tangent to the average total cost curve. There is no profit. Should there be a profit (if demand is above the average total cost curve), firms would enter the

market and drive the demand down. And should there be a loss (when demand is below average total cost), firms would leave the market and push demand up. Firms may, however, retain some profits by using more nonprice action. All successful restaurants have scores of imitators. Several chains have attempted to duplicate McDonald, and siphoned some of its customers and profits. But, McDonald has fought back with extensive advertising. MONOPOLISTIC COMPETITION ECONOMIC EFFECT The economic effect of monopolistic competition is an overall undesirable loss of allocative and productive efficiency: the customer pays more and is able to buy less than in perfect competition. However, the effect is not as serious as in monopoly and the differentiated products provide a much sought diversity. Nevertheless, some waste is present in excess capacity and in use of nonprice competition. Generic product markets approach perfect competition because they are standardized. Brand name products of the same type (for instance, cookies) are in monopolistic competition because they are not the same uniform item, but somewhat different. Customers have to pay a higher price for brand name products (such as Nabisco or Keebler), but they do not seem to mind too much. MONOPOLISTIC COMPETITION NONPRICE ACTION Nonprice action of firms in monopolistic competition consists primarily in either - product development, or - advertising. Product development is sometimes only cosmetic to give the illusion of novelty. Another danger stems from excessive diversity which may confuse consumers. Brand name producers have a variety of means to make their products special to customers. Most important is advertisement which generic item producers would obviously not use. ADVERTISING - ARGUMENTS IN FAVOR Some of the arguments in favor of advertising are - advertising is informative, - advertising increases sales and permits economies of scale, - advertising increases sales and contributes to economic

growth, - advertising supports the media, - advertising increases competition and lowers prices. New product advertisement is essential: think of a major artistic event that interested viewers would fail to see because it has not been announced widely enough. But, most of the advertisement (on television for instance) is for existing, well-established products such as soft drinks or other consumer products; that advertisement seeks only to sway customers away from competitors. ADVERTISING - ARGUMENTS AGAINST Some of the arguments against advertising are - advertising is not informative but competitive, - the economies of scale are illusory, - advertising raises the cost curve, - advertisers may use their influence to bias the media, - advertising is used as an entry barrier, and - advertising is not a productive activity. CHAPTER 7: OLIGOPOLY INTRODUCTION In this topic the oligopoly form of market is studied. You will learn that fewness of firms in a market results in mutual interdependence. The fear of price wars is verified with the help of the kinked demand curve. Collusive forms and non-collusive forms of market are analyzed. The economic effect of the oligopoly form of market is presented. OLIGOPOLY CHARACTERISTICS The oligopoly form of market is characterized by - a few large dominant firms, with many small ones, - a product either standardized or differentiated, - power of dominant firms over price, but fear of retaliation, - technological or economic barriers to become a dominant firm, - extensive use of nonprice competition because of the fear of price wars. All "big" business is in the oligopoly form of market. Being a major corporation almost automatically implies that the company has means of controlling its market.

OLIGOPOLY CONCENTRATION An oligopoly form of market is characterized by the presence of a few dominant firms. There may be a large number of small firms, but only the major firm have the power to retaliate. This results in a high concentration of the industry in only 2 to 10 firms with large market shares. The gasoline industry is an oligopoly in the United States: it is dominated by a few giant firms such as Exxon, Mobil, Chevron and Texaco. Note, however, that many small firms exist in the market: small independent gas stations which sell in just one city or just a limited region. OLIGOPOLY CONCENTRATION CAUSES The most notable causes for the high concentration in oligopoly type of markets are - economies of scale present in production of certain goods, - business cycles eliminating weak competitors, - benefits from firms merging, and - other barriers such as technological development and advertising. The history of the U.S. automobile manufacturing shows a continuous process of increasing concentration of the market in the hands of the big 3: G.M., Ford and Chrysler. Not long ago, Chrysler acquired the failing American Motors. In the beginning of this century, a new round of concentration is now taking place on a global scale as Daimler acquired Chrysler, Renault acquired Honda and GM seeks to acquire Daewoo. The needed volume of production to be profitable (100,000 vehicles) is a major barrier for any new firm wishing to start producing cars. OLIGOPOLY KINKED DEMAND The demand of a firm in oligopoly is made of two segments of two separate demand curves. The upper part is highly elastic because if the firm raises its price, the other firms will not follow, and the firm will lose its market share. The lower part is inelastic because if the firm lowers its price, the other firms follow, and no firm can expand its market share. Graph G-MIC7.1

Several gas stations are often found next to each other at major highway intersections. They also often have same or similar prices. If one gas station tries to increase its price from the prevailing 125.9 to 127.9, customers will go across the street and the gas station will lose revenues. If the same gas station lowers is price to 123.9, it will attract new customers only until the other also drop their prices; then all will lose revenues. OLIGOPOLY PRICE STABILITY The lesson from the kinked demand is that a strategy of increasing its price will cause a firm to lose revenue, but so will decreasing price. Thus, firms will tend not to change prices. Furthermore, as a result of the kinked demand curve, marginal revenue has a gap or break, and any marginal cost curve would lead to the same optimum quantity. Thus the same price is optimum for many different cost structures. COLLUSION All firms benefit from avoiding price wars and seeking to agree on higher prices and protected sale volumes. These agreements are generally illegal. Thus, secret agreements are sought: these constitute collusion. All businesses tend to watch each other, as in the case of the gas stations. Their actions are however independent. Collusion would occur if all gas stations decided simultaneously to raise their prices in order to increase their revenues. Such a concerted and deliberate action is the form of collusion which is

prohibited. OLIGOPOLY PROFIT The profit of firms in oligopoly is determined exactly in the same fashion as in other forms of markets: from optimum quantity where marginal revenue equals marginal cost, price is determined on the demand curve and unit cost on the average total cost curve. However, this determination may be affected by the kinked demand curve. Furthermore, in a collusive oligopoly, all the firms act as if they constituted one monopoly and the output is divided up among firms. OPEC acts as a monopoly by restricting output of its members with quotas. Each member shares in the profits of the would-be monopoly, but does not set price and output independently. CARTEL A cartel is an official agreement between several firms in an oligopoly. The agreement sets the price all firms will charge and often specifies quotas or market shares of the various firms. Cartels are illegal in most countries of the world. OPEC is a major example of a cartel. It exists because it is beyond the control of an individual country. OPEC is naturally the prototype of a successful cartel. Output quotas of its members produced staggering price increases (from $1.10 to $11.50 per barrel in the early 1970's, and up to $34.00 in the late 1970's: an increase of 3400% in ten years). Recent OPEC difficulties are also characteristic of cartels: new producers, difficulty to enforce quotas and maintaining prices. CARTEL BREAKDOWN Cartels and other forms of collusion tend to break down because - an incentive exists for each firm to undersell, - firms may have different cost structures causing hardship for some, - recessions put additional strains on firms, - new firms entering the market do not abide by the agreement, - when many firms join in, discipline is difficult. Many producers of basic commodities tried to duplicate the success of OPEC during the 1970's. Agreements on quotas were reached for coffee, cocoa, tin and copper, for instance. Within a few years the quotas were not obeyed and the cartels broke

down. OLIGOPOLY MUTUAL INTERDEPENDENCE The mutual interdependence of firms in oligopoly is demonstrated in the necessity to maintain price stability ahown in the kinked demand. It may lead firms to follow strategies which do not constitute outright collusion but produce a similar outcome. These strategies include - price leadership where one firm - usually, the dominant or most dynamic firm - is the first to change its price and all firms follow, and - cost plus pricing where prices are aligned because all firms have the same profit or markup margin on similar costs. The prime rate (i.e. the interest rate charged by commercial banks to their best customers) is usually very similar among major banks. Changes in the prime also take place within a very short period of time (less than one day), at the initiative of one of the banks. It has been established that no outright collusion exists in this simultaneous changes, but a high degree of interdependence. OLIGOPOLY NONPRICE ACTION Both product development and advertising are extensively used in the oligopoly form of market because of the fear of price wars. Furthermore, these strategies are essential to maintain the dominant positions of the firms. Car manufacturers use extensive product development and advertisement. Oil companies (Exxon, Mobil, Chevron) are also in an oligopoly form of market and advertise extensively. They advertise their names more than their product because their product is identical to that of competitors. OLIGOPOLY ECONOMIC EFFECT The oligopoly form of market is harmful to society in comparison to perfect competition because of the loss of productive and allocative efficiency. In addition, the undesirable effect may even be worse than in monopoly because supervision is not possible, less economies of scale are present and more wasteful nonprice actions are used. However, some beneficial effects are argued to exist from technology progress and scale of production. The extreme case of a successful cartel such as OPEC shows the

harm brought on by an oligopoly form of market in reduced availability of a needed product and a much increased price. But even in non cartel situations, some high prices can be observed in many manufactured products. OLIGOPOLY TECHNOLOGICAL PROGRESS The oligopoly form of market is seen as a necessary framework in which profit and competition are present to stimulate technological progress and make it rewarding. However, studies show that most technological breakthroughs are generated by small rather than dominant firms. The computer industry is dominated by a few companies, IBM most notably. While all companies depend heavily on new technology, it is often small companies which come up with the most far reaching breakthroughs. Supercomputers are produced by Cray. A new generation of microcomputers was recently introduced by Next. The extreme case of a successful cartel such as OPEC shows the harm brought on by an oligopoly form of market in reduced availability of a needed product and a much increased price. But even in non cartel situations, some high prices can be observed in many manufactured products.

CHAPTER 8:
ECONOMIC RESOURCES
DEMAND FOR RESOURCES The purpose of this topic is to outline how much and at what price will firms use resources: labor, land, capital and entrepreneurial ability. The demand for resources is shown to be derived from the demand for the goods produced with them. Causes for demand changes and demand elasticity are listed. The optimum combination of resources is set out to be based on the equality of marginal revenue product and marginal resource cost. DERIVED DEMAND The demand for any resource is said to be derived from the demand for the product for which the resource is used.

A restaurant will hire employees if it needs to serve more meals. No demand for meals, no demand for employees. The two go together.

MARGINAL REVENUE PRODUCT The marginal revenue product is the increase in revenue generated by one more unit of a resource used in production. The marginal revenue product can be calculated by multiplying the marginal physical product by the price of the product sold by the firm.

If a restaurant hires one more cook or any other type of employee, that restaurant could not possibly pay the cook or employee more than what he/she generates in additional revenues. Otherwise, the restaurant would obviously go out of business.

MARGINAL PHYSICAL PRODUCT The marginal physical product is the additional quantity of output which can be produced by using one more unit of a resource used in production.

Suppose a restaurant serves 1000 meals a day with the existing staff of waiters. If the number of meals the restaurant can serve increases to 1050 by adding one more waiter, the marginal physical product of the employee is 50 meals.

OPTIMUM RESOURCE USE The optimum quantity of any resource a firm should use is determined by the intersection of the marginal resource cost and the marginal revenue product. Should one less unit of the resource be used, the firm would forego an opportunity for more profit. Should one more unit of resource be used, the additional cost would exceed the additional revenue and profits would be smaller.

Suppose a restaurant needs to hire a few more waiters. It will keep on adding one more waiter to its staff as long as the additional (or marginal) revenue generated by that new waiter exceeds the additional (or marginal) cost of having that new employee. If the additional cost exceed the additional revenue, the restaurant should not keep that last employee.

MARGINAL RESOURCE COST The marginal resource cost is the additional cost resulting from one more unit of a resource used in production. If the resource market is in perfect competition, the marginal resource cost is equal to supply and price of the resource. If a monopsony (i.e. a firm that has the power to pay less than the going price for a resource by limiting how much it

uses of that resource) is present, the marginal resource cost of the monopsonist is higher that the supply curve.

If a firm is able to pay a lower wage for fewer employees, but has to increase the wage it offers to attract more employees, it is in a monopsonistic position. The monopsonist face a supply of labor that is upsloping (see Graph G-MIC9.2 in Chapter 9). If the supply line can be written as W=aH+b (where W is wage, H is hours worked, a and b are coefficients), its total labor cost is WxH, or (aH+b)H, and its marginal cost of labor is MRC=2aH+b. Marginal resource cost is twice as steep as supply.

RESOURCE DEMAND The demand for a resource is the marginal revenue product for that resource. This can be verified by noting that the optimum quantity of resource is given by the intersection of marginal resource cost and marginal revenue product.

The fact that the demand for a resource is the marginal revenue product can be seen in professional sport organizations. A team can hire many good players for a moderate salary, but it can hire only one or very few superstars at an extremely high salary. The reason why the superstar receives the millions of dollars in salary is because he/she attracts fans and generates additional revenues.

RESOURCE DEMAND SHAPE If the firm has some amount of monopolistic power in the product market, the price will decrease as output increases. Thus, the demand for resources of such a firm is steeper than that of a comparable firm which would be in a competitive product market. RESOURCE DEMAND DETERMINANTS Changes in the demand for a resource may be attributed to a(n) - change in demand for the product, - improvement in productivity (for instance from better skills), - change in price of other resources causing an output effect or a substitution effect, - change in the availability of complementary resources. RESOURCE DEMAND SUBSTITUTION EFFECT The decrease in the price of a resource may cause that resource to be used more commonly as a substitute for another resource. For instance, the lower cost of capital results in more automation with less need for labor. But this substitution effect may be in

part offset by an output effect. The lower cost of automation may lead to an expanded output requiring more labor to be used.

Accountants work faster since the advent of the hand calculators. One may think that because accountants are faster fewer are needed (i.e. substitution effect). But, in fact, fast working accountants are in ever greater demand because new tasks are given to them, such as tax preparation. The output effect is larger than the substitution effect.

RESOURCE DEMAND ELASTICITY The elasticity of demand for a resource is affected by - the elasticity of the product sold by the firm, - the rate of decline of the marginal physical product due, for instance, to differences in skills, - the availability of substitute resources, and - the proportion of that resource in total costs.

Fish canning is especially sensitive to wage rates because of the amount of manual work required. The industry shifts its productive location according to labor cost. Thus, because of the high labor cost in the United States, there is virtually no more fish canning here.

OPTIMUM RESOURCE COMBINATION A firm will maximize its profits by combining resources in such a manner that the last dollar spent on any resource is just equal to the revenue generated by that or any other resource. More specifically, the ratio of marginal physical product over marginal resource cost must be equal for all resources. In the special case of perfect competition in a resource market, the ratios of marginal physical product over price of the resources are also equal.

A freight and delivery company may use a variety of vehicles: jet airplanes, trucks, vans, motorcycles and even messenger bicycles. How many of each will be used will depend on each contribution to marginal revenue compared to its cost.

CHAPTER 9:
WAGES
INTRODUCTION The purpose of this lesson is to establish how wages are reached

in markets which are in perfect competition as well as in markets where a monopsony is present. Union strategies are categorized, and the special case of bilateral monopoly is studied. Wage differentials are explained. The role of human capital is analyzed. WAGE Wage includes all forms of remuneration for all human productive activities using one's skills. Thus, wage is the combination of salary, bonus and other forms of compensation. Wage is paid for work as various as that of a blue-collar mechanic, as well as that of a lawyer. The dollar amount received is referred to as nominal wage. The purchasing power of amount received work is real wage.

In economics, wage is a general term. For instance, the work performed by a medical doctor may result in a fee, and various other names are used for different professions. For economists, the different types of work do not matter: it is all labor, and the price or payment is wage.

REAL WAGE The dollar amount received for an hour's work is referred to as nominal wage. Real wage is the nominal wage adjusted for inflation. It is calculated by dividing the dollar amount by one plus the rate of inflation. The rate of change in unit labor cost is equal to the rate of change in real wage less the rate of change in productivity. Thus unit labor cost does not increase as long as the rate of growth of real wage is just equal to the growth of productivity.

What a salary can buy in terms of various goods and services is real wage. It is only used as a comparison to some prior time period. The consumer price index is often used as the rate of inflation.

PRODUCTIVITY The higher productivity of labor is the major explanation of higher wages. This is true for the higher wage and productivity of American workers. Their higher productivity is attributable to 1) large capital, 2) advanced technology, 3) skills and education, and 4) motivation and culture.

American workers are highly paid because of their productivity.

This can be observed in agriculture: using combines on large fields, American farmers are able to produce some of the highest output per man-hour in the world.

PRODUCTIVITY DECLINE The advantage of the American worker's higher productivity, which has been experienced in the past, is recently eroding. Some of the reasons for the decline are tied to slower rate of capital formation and technological progress, as well as erosion in education.

Loss of competitiveness of American products has recently received much publicity. While it is true that we are importing an increasing number of products, it is an indication of the prosperity of the American economy as well as the ingenuity and motivation of the people of several nations (such as Japan and Korea). There are also purely monetary reasons for the U.S. trade deficit.

WAGE DETERMINATION The wage paid by an employer is given by the supply curve at the optimum level of labor for the firm. The optimum quantity of labor is determined first. This is established by the equality MRC=MRP (marginal resource cost equals marginal revenue product) in both competitive and monopsonistic markets. But the wage determination itself is different in the two types of markets.

All businesses determine their need for additional employees on the basis of what they want to produce or sell. Finding the wage is a two step process: first the number of employees is calculated, then the firm knows what it can afford to pay an additional employee.

WAGE DETERMINATION IN PERFECT COMPETITION Perfect competition in a resource market means that there are many small buyers of the resource, and that none can influence the market. The supply curve is identical to the marginal resource cost curve (MRC), and is horizontal. The wage is given directly by the intersection of the supply line and MRP curve (which is the demand for labor).

Graph G-MIC9.1

Take clerical work, for instance. All businesses need someone to do typing, filing and keeping records. Many potential employees are available. There is no need for the firm to offer a higher wage than the currently prevailing wage for that type of work. Nor should the firm offer less, because if it did, it would find no one willing to work.

WAGE DETERMINATION IN MONOPSONY A firm has a monopsonistic power when it is able to pay a lower price for a larger quantity of a resource used. A monopsony typically exists when a firm is the sole employer in a region or a profession. For a monopsony, the marginal resource cost curve is above the supply curve. The optimum quantity of labor is determined by the intersection of MRC and MRP. The wage is obtained by extending that quantity level down to the supply curve.

Graph G-MIC9.2

The news media has reported instances where employees have complained of being underpaid as a result of a company being the dominant or only employer in a town. For instance, such reports appeared about the General Electric, Hormel (a meat packaging plant) and WestPoint-Pepperel (textile manufacturer) in the United-States. In each of these cases, the employer is able to offer a lower wage because local residents have little choice but to work for that employer.

WAGE DETERMINATION IN MONOPSONY The wage paid by a monopsony is lower than the wage paid by firms in perfect competition in the labor market. In addition, the quantity of labor used is also smaller. UNION STRATEGY Unions seek to improve the wages and working conditions of their members; this can be accomplished by - increasing the demand for the product manufactured by the members (for instance, by discouraging imports), - decreasing the supply of labor (e.g. craft unions), - acquiring power over all employees (e.g. industrial unions).

The American union IGLWU (International Ladies Garment Workers Union) periodically used advertisement to encourage purchases of American made garments. The purpose is obviously to boost the sales of the clothing made by their members and therefore their salaries.

BILATERAL MONOPOLY A bilateral monopoly exists when a monopsonist (a dominant employer) faces a monopolist (an all inclusive union). The employer will offer the monopsonist lower wage Wm (given by the intersection of MRP and the supply curve). The union will demand from the monopolist a higher wage Wu (determined by the intersection of MRC and the demand curve). The disparity between the two can only be resolved by external power: this explains lasting bitter strikes and other labor conflicts.

Graph G-MIC9.3

The use of violence in strikes by both, strikers and the company, can be explained by the analysis of bilateral monopoly. The demands of the union and the offer of the employer are irreconcilable in economic terms. To prevail, each side has to revert to means other than economic.

MINIMUM WAGE The minimum wage is necessary to avoid hardship and poverty of low skilled individuals. The minimum wage (as any minimum price) has contributed to a surplus of the labor resource: that is, unemployment. However, some additional positive effects are argued to exist: such as - forcing employers to be more efficient - encouraging automation and providing employees with such means - forcing employers to improve workers' skills and health

Small business owners, especially store owners, often complain

that they cannot afford to hire employees at the minimum wage, and that, if the minimum wage were to be lifted, there would be less unemployment.

WAGE DIFFERENTIALS Differences between wages are explained by - different levels of skills and education, - non-monetary aspects such as risk and seasonality, - market imperfections: lack of knowledge, lack of geographical and socio-economic mobility.

It is rather obvious that a medical doctor would receive a high salary because of his/her knowledge and skills. High salaries of workers in construction or on oil rigs can be explained by the very real hazard these occupations present for workers' safety.

HUMAN CAPITAL Human capital refers to the investment individuals make in their education and health, as well as to their attributes (skills, knowledge) which make them better employees. Statistical studies clearly show a direct relationship existing between education and income levels. The causal explanation of the relationship has, however, been challenged by the observation that the level of education is primarily determined by socio-economic group belonging.

Studies show that some groups in society inculcate their children with a need to achieve. These groups are often the new immigrants in a nation. An example of this can be observed in the number of Westinghouse Science High School awards given to children of newly arrived Asian groups: that number is much higher than that for the general population.

PRODUCTIVITY AND REAL WAGES According to Department of Labor studies, a close relationship exists between real wages and productivity. Real wages generally do not rise unless productivity increases. An increase in output will translate into increased real income. Increased productivity causes the demand for labor to increase in relation to supply, which in turn causes real wages to increase. Increased productivity in the United States has been largely responsible for higher real incomes.

CHAPTER 10:
RENT, INTEREST AND PROFITS
LEARNING OBJECTIVE The purpose of this topic is to apply the principles of resource pricing to rent, interest and profit. For rent, the concept of economic surplus is shown to have lead some to recommend a single tax on rent. Interest differentials are explained by its determinants. Profits are shown to play an important role in permitting economic change. RENT Economic rent is a payment exclusively for the use of land. Difficulties in measurement and analysis result from the fact that the use of land is enhanced by improvements (such as a building) and payment for these improvements is made an integral part of rent.

It is difficult to visualize that the rent paid for an apartment has anything to do with land: it covers so many different expenses such as maintenance, repairs and interest on a mortgage. Very little seems to go for the ownership of land itself. These expenses should not be part of rent in an economist point of view.

RENT DETERMINANTS Rent is entirely determined by the alternative uses which can be made of land. Such determination is therefore void of cost consideration. Indeed, land is a free gift of nature and is costless. Any subsequent payment is rent, but the original cost of land is zero. The fact that demand is the only determinant of rent can also be observed graphically by noting that the supply of land is fixed and therefore vertical.

A parcel of land on Manhattan fetches a very high price. That price, as well as all successive selling prices for a parcel of land come from the potential rent the owner could earn. Indeed, a land value is often calculated as the present value of future possible rent payments. But the initial owner of the land (the Indian tribe) did not have to pay anything, just take possession.

ECONOMIC SURPLUS An economic surplus is a payment made or received only because a market exists and not through any action of the individual. Thus,

a land owner may receive a high rent because his/her land is in high demand without having done anything him/herself or having incurred any cost. Such payment, and rent in general, is considered an economic surplus.

Two individuals purchased houses for the same price 10 years ago, one in Texas, the other in Massachusetts. New England homes have doubled (or more) because a local booming economy. The Texas homes have not fared as well. The home owner of the Massachusetts house has derived a windfall gain from the increase in price: that is a surplus.

ECONOMIC RENT Since rent is a surplus (or windfall gain), by extension, economists call all payments where an economic surplus is present, economic rent. Note that economic rent differs from economic profit, in that no risk is being taken by the owner, which is not true in the case of profit.

The windfall gain of the Massachusetts home owner can be combined with the notion that the initial owner of the land had no cost. Then, the entire price increase is surplus, and that is what economist call economic rent.

SINGLE TAX ON LAND Because rent is a surplus (or windfall gain), proposals to tax rent have been often made but only partially implemented in the present real property tax. Henry George lead a movement to change taxation in the United States to a single tax on land. SINGLE TAX ON LAND In addition to the argument that rent is a surplus, a tax on land is seen as - equitable because the increase in value of land is most often attributable to government expenditure (such as roads), and - efficient because the allocation of resources would not change as a result of tax on land (which is not true of any other tax). SINGLE TAX ON LAND Major difficulties exist in implementing a single tax on land or even most real property taxes. The criticism is tied to difficulties to separate pure rent from payment for

improvements and payment for other resources, which are made part of rent. Real estate taxes have been, in part, blamed for urban decay.

Real estate taxes are based on the market value of a property. The market value of the property depends a great deal on the improvements and construction on the property and on neighboring properties. The land component cannot be separated from the other components. That is a major difficulty of real estate taxes.

INTEREST Interest is a payment for the immediate use of a sum of money. But since money is not itself productive, the payment is made in effect for the capital (or means of production) which can be acquired with it.

If is obviously unwise to borrow if one is unable to pay back. Borrowers usually expect income streams. Businesses expect revenues from sales generated from the machinery, plants and equipment (i.e. investment) purchased with a loan. Interest is the payment for the ability to have this investment.

REAL INTEREST The interest paid for a sum of money compensates the lender for the non-use of that sum of money, as well as for the loss of purchasing power of the sum of money. Interest adjusted for that loss of purchasing power (or inflation) is known as real interest. All investment decisions are made on the basis of real interest rates, not nominal interest rates.

Since the episode of high inflation in the early 1980's, variable or indexed rates have become common. The interest rate is tied to some indicator of inflation. As inflation goes up, so does the interest rate. That implies that a component of interest is due to inflation and another does not change; that second component is real interest.

PURE RATE OF INTEREST Real interest rates include a payment for the risk present in lending to a specific borrower. The interest rate from which all risk is taken out is referred to as the pure rate of interest. Government securities are generally considered as having very low level of risk.

Real interest is void of inflation, but is varies with the

risk present in a particular borrower. If the risk premium is also excluded, what is left is called the pure rate of interest. It is only paid for the non-use of what the sum of money could buy at a given point in time.

INTEREST RATE DETERMINANTS Demand and supply of money determine interest rates. Supply of money is controlled by monetary policy. Demand for money results from transaction demand and asset demand for money (further subdivided in precautionary and speculative demands). Other elements which may affect the interest charged and result in a wide range of values, are: risk level, length of maturity, administrative costs, market imperfections, and inflation rate.

Usually, interest rates are higher on longer maturities because lenders are asked to accept more uncertainty about the future, and not to have access to their money. Occasionally the relationship is not observed; in particular when changes in inflation rates are expected.

INTEREST ECONOMIC EFFECT Interest affects the level of economic activity since it influences consumer purchases and investment decisions. For investment decisions, interest plays a key function in assuring that capital will go where it is most needed.

In socialist countries, allocation of funds is not relying on the market mechanism of interest rates. As a result, consumer items, which would in other countries generate large revenues, are not given the priority over other desirable production.

ECONOMIC PROFIT Economic or pure profit is the excess of revenues over all explicit and implicit cost (including normal profit, that is the opportunity of the owner of the business to derive income from some other activity).

Economic profit is also viewed as the long term change of income streams (or wealth). What the concept focuses on is the uncertainty of future values.

ECONOMIC PROFIT DETERMINANTS Economic profit stem from - uncertainty about economic conditions, tastes of consumers, and other forms of uninsurable risk,

- innovations, inventions, and other entrepreneurial decisions, - monopoly power of the firm.

Each year, close to half a million businesses is formed. The majority will fail in the first few years. This shows that business owners take on risk. If it is desirable to have businesses which can produce the items society needs, then it is necessary for business owners to be given the incentive of a profit to start and own a business.

PROFITS ECONOMIC EFFECT Economic profit would not exist in a riskless and stable economy. Profits are necessary for technological and economic progress. Without profits risk would not be assumed: new products would not be offered to society.

Tastes of society change. High definition television is now being demanded. To assure that the productive structure of the society keeps adjusting to the needs and tastes of society, the reward of a profit has to be present.

INCOME SHARES The shares of the various resources in national income have been relatively stable over the past century: about 80% has been derived in salaries and proprietor's income, the remaining 20% going to property income. The decrease of proprietor's income reflects the decrease in farms, small stores and artisanal businesses.

In light of the significant changes in our society (e.g. family composition, urbanization), it is almost surprising that the income shares of the different forms of income have been quite stable over times. Only small variations in rent, interest and profit are noticeable in the 20% of total income to which these three income sources have summed to over the past century.

GENERAL EQUILIBRIUM A general equilibrium exists if all markets (goods, services and resources) are in equilibrium. If conditions of efficiency are also met (allocative, productive, maximum consumer satisfaction), Pareto optimality is achieved.

If just one market is out of equilibrium, for instance there are too many automobiles produced, then, that implies that all markets are also out of equilibrium, for instance there are

too many workers in the automobile industry. All markets will tend to a simultaneous equilibrium.

INPUT-OUTPUT TABLES Input-output tables are a major application of the concept of general equilibrium. The tables are constructed to show all the flows from each sector of the economy to all others. The tables are useful for forecasting and they are essential for national income accounting.

A timely calculation of the GNP of the United States would not be possible without input-output tables: it is just not possible to add the production of every single firm in the country every year. What is done instead is to establish relationships between different sectors, and use these relationships to determine quickly the activity of numerous sectors on the basis of key sectors, such as steel output.