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General Econs Level 1 p1

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General Econs Level 1 p1

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konjohmike1
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We take content rights seriously. If you suspect this is your content, claim it here.
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Institut Universitaire et Stratégique de l’Estuaire

Estuary Academic and Strategic Institute (IUEs/Insam


Sous la tutelleacadémique des Universités de Dschang et de Buea.

Academic Year: 2023/2024

Course : Micro-Economics

Level : I

COURSE FACILITATOR: M. KONJOH MICHEL

Tel: 699558571
PART I: MICROECONOMICS

CHAPTER 1: THE CENTRAL PROBLEM OF ECONOMICS

INTRODUCTION

Economics is the study of how society allocates limited resources to the production of goods and
services to satisfy unlimited human wants.

There are two main branches of economics: microeconomics and macroeconomics.


Microeconomics deals with the analysis of individual parts of the economy. It concerns factors
determining the behaviour of a consumer, the behaviour of a firm, the demand for a good, the supply
of a good, the price of a good, the quantity of a good, the performance of a market, etc.
Macroeconomics deals with the analysis of the whole economy. It concerns factors determining
aggregate variables such as aggregate demand, aggregate supply, national output, unemployment,
inflation, the balance of payments, etc. As opposed to microeconomics which focuses on the
individual parts of the economy, macroeconomics looks at the big picture of the economy.

Economists often distinguish between positive economics and normative economics. Positive
economics is concerned with facts. It tells us what was, what is or what will be. Disagreement over
positive economics can be settled by an appeal to facts. In other words, positive economics is
verifiable.

Consider the following statement:

‘A decrease in personal income tax will lead to a rise in unemployment.’

In the above statement, both personal income tax and unemployment are measurable and hence the
statement is verifiable. Therefore, the statement is a positive statement. It is important to take note that
a positive statement can be true or false. What makes the statement a positive statement is not that it is
true but that it is verifiable. In fact, the statement is false.

Normative economics is concerned with value judgments. It tells us what should be. Disagreement
over normative economics cannot be settled by an appeal to facts. In other words, normative
economics is not verifiable.Consider the following statement:

‘A redistribution of income from the rich to the poor will increase social welfare.’

In the above statement, although redistribution of income is measurable, social welfare is not and
hence the statement is not verifiable. Therefore, the statement is a normative statement. It is important
to take note that a normative statement can be true or false. Although the statement is true, what makes
it a normative statement is not that it is true but that it is not verifiable.

2 FACTORS OF PRODUCTION

In order to produce goods and services, an economy needs to have resources. The larger the amount of
resources an economy has, the larger will be the amount of goods and services it can produce.
Resources can be divided into four categories known as the four factors of production: land, labour,
capital and enterprise.

Land : Land refers to the gifts of nature that are used to produce goods and services. It includes plots
of land, natural resources, fishes in the sea and trees in the forests.
Labour : Labour refers to the physical and mental effort that people devote to the production of goods
and services.

Capital : Capital refers to the goods that are produced for use in the production of other goods. It
includes factories and machinery.

Enterprise : Enterprise refers to the ability and the willingness to take risk.

Note: Students should not mix up capital in economics, which is known as physical capital, and
capital in business, which is known as financial capital. Although financial capital refers to the money
needed to start a business, physical capital refers to factories and machinery.

3 SCARCITY, CHOICE AND OPPORTUNITY COST

Although resources are limited, human wants are unlimited, and this gives rise to scarcity. Scarcity is
the situation where limited resources are insufficient to produce goods and services to satisfy
unlimited human wants. Scarcity necessitates choice. In other words, due to scarcity and hence the
inability to produce all goods and services, society must choose what goods and services to produce.
The opportunity cost of a course of action is the benefit forgone by not choosing its next best
alternative. When a choice is made, an opportunity cost is incurred. In other words, when society
chooses what goods and services to produce, it is choosing what goods and services not to produce.

4 THE PRODUCTION POSSIBILITY CURVE

4.1 The Production Possibility Curve, Scarcity, Choice and Opportunity cost

The production possibility curve (PPC) shows all the possible combinations of two goods that can be
produced in the economy when resources are fully and efficiently employed, given the state of
technology, assuming the economy can only produce the two goods.

Possible Combinations of Good Y and Good X

Combination Good X Good Y


A 0 50
B 10 48
C 20 45
D 30 40
E 40 33
F 50 23

In the above table, A, B, C, D, E and F are the possible combinations of good Y and good X that the
economy can produce using its resources fully and efficiently.

Production Possibility Curve

The PPC reflects scarcity, choice and opportunity cost. Although the points inside and on the PPC are
attainable, the points outside the PPC are not. Scarcity is reflected by the unattainable points that lie
outside the PPC, such as point G and point H. The PPC is a series of points rather than a single point.
Choice is reflected by the need for society to choose among the series of points on the PPC, such as
point C and point D. The PPC is downward sloping. Opportunity cost is reflected by the negative
slope of the PPC which indicates that an increase in the production of one good will lead to a decrease
in the production of the other good.
4.2 Movements along versus Shifts in the Production Possibility Curve

A change in the tastes and preferences of society will lead to a movement along the PPC which
reflects a change in choice. The tastes and preferences of society may change due to several factors
such as technological advancements and campaigning. For example, the inventions of smartphones
and tablets have led to a change in the tastes and preferences of society from print publications to
digital publications. Healthy living campaigns have led to a change in the tastes and preferences of
society from non-diet soft drinks to diet soft drinks.

An increase in the production capacity in the economy will lead to an outward shift in the PPC
resulting in a decrease in scarcity, and vice versa. When the PPC shifts outwards, some of the points
which were previously unattainable will become attainable. The production capacity in the economy
may increase due to an increase in the quantity or the quality of the factors of production in the
economy. For example, education and training which will lead to greater human capital will increase
the skills and knowledge of labour and hence the production capacity in the economy. Research and
development which will lead to technological advancement will increase the efficiency of capital and
hence the production capacity in the economy.

Note: When the economy moves into a recession, the PPC will not shift, at least not immediately.
Rather, the economy will move from a point on the PPC to a point inside the PPC, assuming resources
are initially fully and efficiently employed.

A decrease in investment expenditure will not lead to a leftward shift in the PPC. Rather, it will cause
the PPC to shift outwards at a slower rate as firms are still producing new capital. However, if the
amount of new capital falls below the level necessary to replace the amount of worn-out capital, the
PPC will shift inwards.

4.3 Shape of the Production Possibility Curve

The PPC is concave to the origin because the opportunity cost of producing each good increases as its
quantity increases as resources are not equally suitable for producing different goods. As the economy
produces more and more of a good, it has to use resources that are less and less suitable for producing
the good to actually produce the good. This means that increasingly more units of resources are
needed to produce each additional unit of the good. Therefore, increasingly more units of other goods
have to be forgone to produce each additional unit of the good resulting in an increase in the
opportunity cost.

4.4 Economic Efficiency

Due to the problem of scarcity, all economies must make three fundamental economic decisions: what
and how much to produce, how to produce and for whom to produce. In making these three
fundamental economic decisions, the objective is to maximise the welfare of society. Efficiency is one
of the criteria used to determine whether this objective is achieved.

Productive Efficiency

The economy is productively efficient when it is impossible to increase the production of some goods
without decreasing the production of other goods, given the quantity and the quality of the factors of
production in the economy. This occurs when the economy is producing on the PPC where resources
in the economy are fully and efficiently employed. Resources in the economy are efficiently employed
when all firms are productively efficient and are fully employed when there is no unemployment of
resources.

Allocative Efficiency
The economy is allocatively efficient when it is impossible to change the allocation of resources in a
way that will increase the welfare of society. This occurs when the economy is producing at the point
on the PPC that is tangent to the social indifference curve where the marginal rate of transformation is
equal to the marginal rate of substitution. Productive efficiency is a necessary condition for allocative
efficiency. In other words, for the economy to be allocatively efficient, it must be productively
efficient.

Note: The economy is economically efficient when it is productively efficient and allocatively
efficient. This means that an economy which is productively efficient but allocatively inefficient is not
economically efficient.

5 ECONOMIC SYSTEM

As discussed previously, all economies face the problem of scarcity and hence are required to make
the three fundamental economic decisions of what and how much to produce, how to produce and for
whom to produce. However, economies vary in the way they make these three fundamental economic
decisions in terms of the degree of government intervention. An economic system is a way of making
the three fundamental economic decisions of what and how much to produce, how to produce and for
whom to produce. There are three types of economic systems: the market system, the command
system and the mixed system.

5.1 The Market System

The market system is an economic system in which the three fundamental economic decisions of what
and how much to produce, how to produce and for whom to produce are made by private individuals
with no government intervention. The market system is also known as the free market system, the free
enterprise system and the laissez-faire system. The market system was first advocated by Adam Smith
in his famous book, ‘An Inquiry into the Nature and Causes of the Wealth of Nations’, which was
published in 1776. He argues that the pursuit of self-interest will lead to the benefit of society.

In the market system, all the factors of production in the economy are owned by private individuals.
All economic decisions are made by private individuals. Private individuals can engage in productive
activities, choose what to buy, where to work, etc. There is total economic freedom and the role of the
government is confined to the provision of national defence, maintaining law and order, issuing
currency, etc. Private individuals pursue self-interest. Firms seek to maximise profit, consumers seek
to maximise satisfaction and owners of factors of production seek to maximise factor income.
Competition exists in all economic activities. Firms compete for resources and sales, consumers
compete for goods and services and owners of factors of production compete for employment of their
resources.

In the market system, the three fundamental economic decisions of what and how much to produce,
how to produce and for whom to produce are made by private individuals with no government
intervention.

What and How Much to Produce?

The types and amounts of goods to produce are jointly determined by consumers and firms through the
price mechanism. The price mechanism refers to the system in a market economy whereby changes in
price due to shortages and surpluses equate quantity demanded and quantity supplied. Consumers
indicate to firms the types and amounts of goods that they want by the prices that they are able and
willing to pay for them. Firms that seek to maximise profit will only produce the types and amounts of
goods that consumers are able and willing to pay for. Therefore, prices signal the types and amounts of
goods that are in demand and hence, the profitability of producing these goods. This signalling role of
prices is the essence of the price mechanism.
How to Produce?

The profit motive of firms implies that they will choose the least-cost method to produce any amount
of output and this is determined by relative factor prices. If labour is cheaper than capital, firms will
use more labour and less capital in production. However, if capital is cheaper than labour, firms will
use more capital and less labour in production. Therefore, relative factor prices determine the ways in
which goods are produced.

For Whom to Produce?

The market system distributes goods to consumers with the ability and the willingness to pay for the
goods and this is determined by their preferences and income levels.

5.2 The Command System

The command system is an economic system in which the three fundamental economic decisions of
what and how much to produce, how to produce and for whom to produce are made by the
government with no involvement of private individuals. The command system is also known as the
centrally planned system. The command system was first advocated by Karl Marx in his famous book,
‘Das Kapital’, which was published in 1867. He argues that capitalism will fall which will lead to the
rise of socialism and eventually to communism.

In the command system, all the factors of production in the economy are owned by the government.
All economic decisions are made by the government. Private individuals cannot engage in productive
activities, choose what to buy and where to work, etc. There is no economic freedom. Private
individuals cannot pursue self-interest and competition does not exist.

In the command system, the three fundamental economic decisions of what and how much to produce,
how to produce and for whom to produce are made by the government with no involvement of private
individuals. In other words, economic decision-making is centralised. To do this, the government must
choose the combination of goods that it thinks will maximise the welfare of society, direct resources to
produce the goods by planning the output level of each industry, decide on the method of production
and how the goods are to be distributed. The government can distribute goods directly which is usually
done through the issue of rationing coupons, or it can decide on the distribution of income, in which
case, it will decide who should be paid what.

5.3 The Mixed System

The mixed system is an economic system in which the three fundamental economic decisions of what
and how much to produce, how to produce and for whom to produce are partly made by private
individuals and partly made by the government. Therefore, a mixed economy is comprised of the
private sector and the public sector. In reality, every economy is a mixed economy. Due to the flaws of
both the market system and the command system, all economies in the world are a mixture of both
economic systems. Even command-oriented economies such as North Korea and Cuba rely on the
market system to some extent and market-oriented economies such as Singapore and Hong Kong have
some degree of government intervention.

In the mixed system, some of the factors of production in the economy are owned by private
individuals and some are owned by the government. Economic decisions are partly made by private
individuals and partly made by the government. Although private individuals can engage in productive
activities, choose what to buy and where to work, they are restricted by the government. Although
there is economic freedom, it is restricted by the government. Although private individuals can pursue
self-interest, they are restricted by the government. Although competition exists, it does not happen in
all forms of economic activities.
In the mixed system, the three fundamental economic decisions of what and how much to produce,
how to produce and for whom to produce are partly made by private individuals and partly made by
the government.

5.4 Advantages and Disadvantages of Economic Systems

Advantages of the Market System and Disadvantages of the Command System

In the market system, allocative efficiency may be achieved as private individuals themselves are in
the best position to know what they want. There will be incentive for workers to work hard and for
firms to be efficient as they will be rewarded with high income and profit. There will fast decision-
making as each private individual only needs to make economic decisions pertaining to their interest.
There will be liberty as private individuals are allowed to choose their ways of life.

The advantages of the market system are the disadvantages of the command system.

Advantages of the Command System and Disadvantages of the Market System

In the command system, allocative efficiency may be achieved as externalities will be taken into
consideration by the government. There will be no unemployment as the government will provide a
job for every private individual. The distribution of income will be equitable as no private individuals
will earn very high or very low income. Public goods will be produced by the government through
taxation. There will be no private firms with substantial market power which can charge high prices.

NOTE : The advantages of the command system are the disadvantages of the market system.

CHAPTER 2: DEMAND AND SUPPLY

1 INTRODUCTION

In Chapter 1, we learnt that the allocation of resources in the market system is determined by the
market forces of demand and supply. Therefore, to have a good understanding of the allocation of
resources in the market system, we need to understand the concepts of demand and supply. Indeed, as
demand and supply are two fundamental economic concepts which permeate the study of economics, a
good understanding of the concepts is essential for understanding economics.

2 DEMAND

2.1 Relationship between Price and Quantity Demanded

The demand for a good is the quantity of the good that consumers are willing and able to buy at each
price over a period of time, ceteris paribus. The quantity demanded of a good refers to the quantity of
the good that consumers are willing and able to buy. The law of demand states that there is an inverse
relationship between price and quantity demanded. When the price of a good falls, the quantity
demanded will rise. Conversely, when the price of a good rises, the quantity demanded will fall. The
demand curve of a good shows the quantity demanded of the good at each price over a period of time,
ceteris paribus. The demand curve is downward sloping due to the law of demand.

Demand Curve
In the above diagram, when the price (P) is P0, the quantity demanded (Q) is Q0. A fall in the price
from P0 to P1 leads to an increase in the quantity demanded from Q0 to Q1.

The law of demand can be explained with the concept of diminishing marginal utility. Utility refers to
the satisfaction obtained by consumers from consuming a good. Marginal utility is the additional
satisfaction resulting from consuming one more unit of a good. The more a consumer has of a good,
the less they will value it at the margin and this is known as diminishing marginal utility. Due to
diminishing marginal utility, consumers will only increase the consumption of a good if the price falls.
The law of demand can also be explained with the concepts of substitution effect and income effect.
When the price of a good falls, the real income of consumers will rise as they will be able to buy a
larger amount of goods and services with the same amount of nominal income. This will induce them
to buy more of the good. This effect is known as the income effect of a price fall. Furthermore, when
the price of a good falls, the good will become relatively cheaper than other goods. This will induce
consumers to substitute the good for other goods. This effect is known as the substitution effect of a
price fall.

Note: Ceteris paribus is Latin which means other things being equal.

The demand curve of a consumer is downward sloping due to the law of demand. The market demand
curve is the horizontal summation of the demand curves of all the consumers in the market and hence
is also downward sloping.

2.2 Movements along versus Shifts in the Demand Curve

A change in quantity demanded occurs when quantity demanded changes due to a change in price.
This is shown by a movement along the demand curve.

In the above diagram, the quantity demanded (Q) increases from Q0 to Q1 due to a fall in the price (P)
from P0 to P1. This is called an increase in quantity demanded.

A change in demand occurs when quantity demanded changes due to a change in a non-price
determinant of demand. In other words, quantity demanded changes at the same price. This is shown
by a shift in the demand curve.

In the above diagram, the quantity demanded (Q) increases from Q0 to Q1 at the same price (P0) due to
a change in a non-price determinant of demand. This is called an increase in demand.

2.3 Non-price Determinants of Demand

Tastes and Preferences : A change in tastes and preferences towards a good will lead to an increase
in the demand and vice versa. Tastes and preferences are affected by a number of factors such as
technological advancements and campaigning. For example, the inventions of smartphones and tablets
have led to a change in tastes and preferences from print publications to digital publications.

Prices of Substitutes and Complements: Substitutes are goods which are consumed in place of one
another such as Coke and Pepsi. A rise in the prices of substitutes for a good will induce consumers to
buy less of the substitutes resulting in an increase in the demand for the good and vice versa. For
example, if the price of Pepsi rises, consumers will buy less Pepsi and more Coke. Complements are
goods which are consumed in conjunction with one another such as car and petrol. A fall in the prices
of complements for a good will induce consumers to buy more of the complements resulting in an
increase in the demand for the good and vice versa. For example, if the prices of cars fall, consumers
will buy more cars and more petrol
Level of Income: When consumers’ income rises, the demand for some goods will increase and these
goods are called normal goods. A normal good is a good whose demand rises when consumers’
income rises. There are two types of normal goods: necessity and luxury. A necessity is a good whose
demand rises by a smaller proportion when consumers’ income rises. Examples of necessities include
agricultural products and stationery. A luxury is a good whose demand rises by a larger proportion
when consumers’ income rises. Examples of luxuries include private cars and branded watches. When
consumers’ income rises, the demand for some goods will decrease and these goods are called inferior
goods. An inferior good is a good whose demand falls when consumers’ income rises. Inferior goods
are typically relatively low in quality.

Expectations of Price Changes : If consumers expect the price of a good to rise, they will bring
forward the purchase to avoid paying a higher price in the future. If the good can be resold such as
residential properties, consumers will also buy the good to sell it at a higher price later. When these
happen, the demand for the good will increase. Conversely, if consumers expect the price of a good to
fall, they will put off the purchase to enjoy a lower price in the future which will lead to a decrease in
the demand.

Size of the Population: An increase in the size of the population will lead to an increase in the
demand for certain goods and services. With the exception of a few countries such as Japan, most
countries have been experiencing an increase in the size of the population.

Structure of the Population

If the population is greying, the demand for pharmaceutical products will increase. An example is
Singapore. If the birth rate rises, the demand for infant products will increase.

Government Policies

The government is the biggest spender in every economy. Therefore, if the government increases
expenditure on goods and services, the demand for certain goods and services will increase and vice
versa. The government can also affect private expenditure by changing interest rates and tax rates. For
example, if the government cuts income taxes, consumers will experience a rise in their disposable
incomes which will lead to an increase in the demand for certain goods and services.

Weather Conditions

In winter, the demand for coats and sweaters will increase and the demand for ice creams will
decrease. The opposite is true in summer

3 SUPPLY

3.1 Relationship between Price and Quantity Supplied

The supply of a good is the quantity of the good that firms are willing and able to sell at each price
over a period of time, ceteris paribus. The quantity supplied of a good refers to the quantity of the
good that firms are willing and able to sell. The law of supply states that there is a direct relationship
between price and quantity supplied. When the price of a good falls, the quantity supplied will fall.
Conversely, when the price of a good rises, the quantity supplied will rise. The supply curve of a good
shows the quantity supplied of the good at each price over a period of time, ceteris paribus. The supply
curve is upward sloping due to the law of supply.

Supply Curve
In the above diagram, when the price (P) is P0, the quantity supplied (Q) is Q0. A rise in the price from
P0 to P1 leads to an increase in the quantity supplied from Q0 to Q1.

Note: The supply curve of a firm is upward sloping due to the law of supply. The market supply curve
is the horizontal summation of the supply curves of all the firms in the market and hence is also
upward sloping.

3.2 Movements along versus Shifts in the Supply Curve.

A change in quantity supplied occurs when quantity supplied changes due to a change in price. This is
shown by a movement along the supply curve.

In the above diagram, the quantity supplied (Q) increases from Q0 to Q1 due to a rise in the price (P)
from P0 to P1. This is called an increase in quantity supplied.

A change in supply occurs when quantity supplied changes due to a change in a non-price determinant
of supply. In other words, quantity supplied changes at the same price. This is shown by a shift in the
supply curve.

In the above diagram, the quantity supplied (Q) increases from Q0 to Q1 at the same price (P0) due to a
change in a non-price determinant of supply. This is called an increase in supply..

3.3 Non-price Determinants of Supply

Cost of Production

A rise in the cost of production will lead to a decrease in supply and vice versa. When the cost of
production rises, firms will increase the price at each quantity to maintain profitability. In other words,
they will reduce the quantity supplied at each price which will lead to a decrease in supply. The
converse is also true. There are several factors that can lead to a change in the cost of production. For
example, a fall in factor prices such as wages will lead to a fall in the cost of production and vice
versa. Subsidy will decrease the cost of production and tax will have the opposite effect. Labour
productivity refers to output per hour of labour. When labour productivity rises, which may be due to
an increase in the skills and knowledge of labour or the efficiency of capital, firms will need a smaller
amount of labour to produce any given amount of output. Therefore, the cost of production will fall.

Production Capacity

If the production capacity in the industry increases, which may occur due to an increase in the number
of firms in the industry or an expansion of the production capacities of the existing firms, the supply of
the good will increase. The converse is also true.

Expectations of Price Changes

If firms expect the price of a good to rise, they will hoard some of the output that they currently
produce to sell it at a higher price in the future. This will lead to a fall in the supply of the good. The
converse is also true.

Profitability of Goods in Joint Supply

Goods in joint supply refer to goods that are produced in the same production process. An example is
petrol and diesel. In the process of refining crude oil to produce petrol, other grade fuels such as diesel
are also produced. Therefore, if the demand for petrol increases which will lead to an increase in the
profitability, more petrol will be produced. When this happens, the supply of diesel will also increase.
The converse is also true.

Profitability of Substitutes in Supply

Substitutes in supply refer to goods that are produced using the same factor inputs. An example is
potatoes and tomatoes. If the demand for tomatoes increases which will lead to an increase in the
profitability, some farmers who are currently producing potatoes will switch to the production of
tomatoes which will lead to a decrease in the supply of potatoes. The converse is also true.

Disasters (Natural and Man-made)

Natural disasters such as floods and earthquakes, and man-made disasters such as wars which may kill
workers and destroy factories and machinery, may lead to a decrease in the supply of certain goods
including agricultural products.

Weather Conditions

When weather conditions become less favourable, the supply of agricultural products will fall as
harvests will decrease. The converse is also true. In the event of severe weather conditions, the supply
of air travel will fall as airlines will be forced to cancel flights.

4 demand and supply function

4.1 demand function

This is an algebraically or mathematical representation of the law of demand. A demand function in its
simplest form is; Qd = a – bp, where; Qd is the quantity demanded and p, the price. Example,
suppose, a= 50, b= 2.5, p= 10, therefore; Qd = 50 – 2.5(10) and Qd = 25units.

4.2 supply function

This is an algebraically or mathematical representation of the law of supply. A supply function in its
simplest form is; Qd = a + bp, where; Qd is the quantity supplied and p, the price. Example, suppose,
a= 15, b= 1, p= 10, therefore; Qd = 15 + 1(10) and Qd = 25units.

5 EQUILIBRIUM

5.1 Equilibrium Price and Equilibrium Quantity

An equilibrium is a state where there is no tendency to change. The equilibrium of a market is


determined by the market forces of demand and supply.

In the above diagram, given the demand (D) and the supply (S), the equilibrium price and the
equilibrium quantity are PE and QE. At a price below PE, such as P1, the quantity demanded (QD) is
greater than the quantity supplied (QS) and this results in a shortage (QD – QS). As the price rises, the
quantity demanded falls and the quantity supplied rises and this process continues until the price rises
to PE where the quantity demanded and the quantity supplied are equal at QE. Similarly, if firms supply
more of a good than what consumers demand at a particular price, the quantity supplied will exceed
the quantity demanded. The resultant surplus will push down the price. This is because when firms
cannot sell all the output that they produce, their stocks will build up. Therefore, they will lower the
price to reduce their stocks. A fall in the price of the good will incentivise firms to decrease the
production due to the lower profitability and consumers to increase the consumption due to the lower
relative price and the higher real income. Therefore, the quantity supplied will fall and the quantity
demanded will rise. The price will continue falling until the quantity demanded is equal to the quantity
supplied, at which point the surplus is eliminated and an equilibrium is established.

5.2 Effects of a Change in Demand on Price and Quantity

Increase in Demand

An increase in demand will lead to a rise in price and quantity.

In the above diagram, an increase in the demand (D) from D0 to D1 leads to a rise in the price (P) from
P0 to P1 and a rise in the quantity (Q) from Q0 to Q1. Given the demand (D0) and the supply (S0), the
price and the quantity are P0 and Q0. When the demand increases from D0 to D1, although the quantity
demanded rises at the same price (P0), the quantity supplied remains at Q0 and this results in a
shortage. As the price rises, the quantity demanded falls and the quantity supplied rises and this
process continues until the price rises to P1 where the quantity demanded and the quantity supplied are
equal at Q1.

Decrease in Demand

A decrease in demand will lead to a fall in price and quantity.

In the above diagram, a decrease in the demand (D) from D0 to D1 leads to a fall in the price (P) from
P0 to P1 and a fall in the quantity (Q) from Q0 to Q1. Given the demand (D0) and the supply (S0), the
price and the quantity are P0 and Q0. When the demand decreases from D0 to D1, although the quantity
demanded falls at the same price (P0), the quantity supplied remains at Q0 and this results in a surplus.
As the price falls, the quantity demanded rises and the quantity supplied falls and this process
continues until the price falls to P1 where the quantity demanded and the quantity supplied are equal at
Q1.

Note: When demand changes, price and quantity will change in the same direction.

5.3 Effects of a Change in Supply on Price and Quantity

Increase in Supply

An increase in supply will lead to a fall in price and a rise in quantity.

In the above diagram, an increase in the supply (S) from S0 to S1 leads to a fall in the price (P) from P0
to P1 and a rise in the quantity (Q) from Q0 to Q1. Given the demand (D0) and the supply (S0), the price
and the quantity are P0 and Q0. When the supply increases from S0 to S1, although the quantity
supplied rises at the same price (P0), the quantity demanded remains at Q0 and this results in a surplus.
As the price falls, the quantity demanded rises and the quantity supplied falls and this process
continues until the price falls to P1 where the quantity demanded and the quantity supplied are equal at
Q1.

Decrease in Supply

A decrease in supply will lead to a rise in price and a fall in quantity.

In the above diagram, a decrease in the supply (S) from S0 to S1 leads to a rise in the price (P) from P0
to P1 and a fall in the quantity (Q) from Q0 to Q1. Given the demand (D0) and the supply (S0), the price
and the quantity are P0 and Q0. When the supply decreases from S0 to S1, although the quantity
supplied falls at the same price (P0), the quantity demanded remains at Q0 and this results in a
shortage. As the price rises, the quantity demanded falls and the quantity supplied rises and this
process continues until the price rises to P1 where the quantity demanded and the quantity supplied are
equal at Q1.

Note: When supply changes, price and quantity will change in opposite directions.

6 SURPLUS

6.1 Consumer Surplus

Consumer surplus is the difference between the maximum amount that consumers are willing and able
to pay for a good and the amount that they actually pay.

In the above diagram, consumers are willing and able to pay $10 for the first unit of the good, $9 for
the second unit, $8 for the third unit and $7 for the fourth unit. Suppose that consumers buy 4 units of
the good. When the quantity demanded is 4 units, the price is $7. In this case, although the maximum
amount that consumers are willing and able to pay is $34 ($10 + $9 + $8 + $7 = area of trapezium), the
amount that they actually pay is $28 ($7 x 4 = area of rectangle). Therefore, the consumer surplus is
$6 ($34 – $28 = area of trapezium – area of rectangle) and is represented by the area below the
demand curve and above the price.

In the above diagram, given the demand curve (D) and the price (P0), the maximum price that
consumers are willing and able to pay for each unit of the good is higher than the price they actually
pay from the first unit to Q0. Therefore, consumers will maximise consumer surplus by consuming the
quantity (Q0) as each unit of the good from the first unit to Q0 produces a consumer surplus. The
consumer surplus is represented by the shaded area.

6.2 Producer Surplus

Producer surplus is the difference between the minimum amount that firms are willing and able to
receive for a good and the amount that they actually receive.

In the above diagram, firms are willing and able to receive $4 for the first unit of the good, $5 for the
second unit, $6 for the third unit and $7 for the fourth unit. Suppose that firms produce 4 units of the
good. When the quantity supplied is 4 units, the price is $7. In this case, although the minimum
amount that firms are willing and able to receive is $22 ($4 + $5 + $6 + $7 = area of trapezium), the
amount that they actually receive is $28 ($7 x 4 = area of rectangle). Therefore, the producer surplus is
$6 ($28 – $22 = area of rectangle – area of trapezium) and is represented by the area below the price
and above the supply curve.

7 ELASTICITY OF DEMAND AND SUPPLY

Given any change in price, in addition to the direction of the change in quantity demanded,
economists are interested to find the magnitude of the change. In other words, they are interested to
find the degree of responsiveness of consumers to a change in price. To measure this, they use the
concept of price elasticity of demand. Furthermore, economists are also interested to find the degree of
responsiveness of consumers to a change in income and a change in the prices of related goods. To
measure this, economists use the concepts of income elasticity of demand and cross elasticity of
demand. This chapter provides an exposition of the concepts of price elasticity of demand, income
elasticity of demand, cross elasticity of demand and price elasticity of supply.

7.1 PRICE ELASTICITY OF DEMAND


7.2 Measurement and Interpretation of Price Elasticity of Demand

The price elasticity of demand (PED) for a good is a measure of the degree of responsiveness of the
quantity demanded to a change in the price, ceteris paribus.

The PED for a good is calculated by dividing the percentage change in the quantity demanded by the
percentage change in the price.

% Δ QuantityDemanded
PED = ————————————–
% Δ Price

Due to the law of demand, the PED for a good is always negative. However, the common practice
among economists is to omit the negative sign.

If the PED for a good is greater than one, the demand is price elastic which means that a change in the
price will lead to a larger percentage/proportionate change in the quantity demanded. A good with a
price elastic demand has a relatively flat demand curve. If the PED for a good is less than one, the
demand is price inelastic which means that a change in the price will lead to a smaller
percentage/proportionate change in the quantity demanded. A good with a price inelastic demand has a
relatively steep demand curve. If the PED for a good is equal to one, the demand is unit price elastic
which means that a change in the price will lead to the same percentage/proportionate change in the
quantity demanded. The demand curve for a good with a unit price elastic demand is a rectangular
hyperbola.

Special cases:

If the PED for a good is zero, the demand is perfectly price inelastic which means that a change in the
price will not lead to any change in the quantity demanded. A good with a perfectly price inelastic
demand has a vertical demand curve. If the PED for a good is infinity, the demand is perfectly price
elastic which means that a rise in the price will lead to an infinite decrease in the quantity demanded.
In theory, this means that the quantity demanded will fall from infinity to zero. A good with a
perfectly price elastic demand has a horizontal demand curve.

Note: It is important to understand that the concept of elasticity is about relative changes and not
about absolute changes.

7.3.1 Applications of Price Elasticity of Demand

The concept of PED allows a firm to determine how to change price to increase total revenue.

If the demand for the good produced by a firm is price elastic, the firm can decrease the price to
increase the total revenue as the quantity demanded will increase by a larger percentage.

If the demand for the good produced by a firm is price inelastic, the firm can increase the price to
increase the total revenue as the quantity demanded will decrease by a smaller percentage.

If the demand for the good produced by a firm is unit price elastic, the firm cannot change the price to
increase the total revenue as the quantity demanded will change by the same percentage.

In addition to firms, the concept of price elasticity of demand may be useful to the government. The
main source of revenue for the government is tax revenue. If the government imposes a tax on a good,
the cost of production will rise which will lead to a decrease in the supply. When this happens, the
price will rise which will lead to a fall in the quantity demanded. If the demand for the good is price
elastic, the quantity demanded is likely to fall by a large extent. As the tax revenue is the product of
the tax per unit of the good and the quantity, a large decrease in the quantity demanded is likely to
limit the amount of tax revenue which the government is able to collect. Therefore, if the government
wants to collect a large amount of tax revenue from imposing a tax on a good, it should do so for a
good with a price inelastic demand. Examples of goods with a price inelastic demand include tobacco
and alcohol due to their addictive nature. The government may also impose a tax on a good to reduce
the consumption. This is generally a good which society deems undesirable and the government thinks
people should be discouraged from consuming, commonly known as a demerit good. Examples of
demerit goods include tobacco and alcohol. However, due to the addictive nature of tobacco and
alcohol which makes the demand price inelastic, a tax on these goods is likely to lead to a small
decrease in the quantity demanded. Therefore, for a tax on tobacco and alcohol to be effective for
reducing the consumption, the government should ensure that it is sufficiently high.

7.3.2 Determinants of Price Elasticity of Demand

Number of Substitutes

The PED for a good will be higher the larger the number of substitutes. Conversely, the PED for a
good will be lower the smaller the number of substitutes. For example, the demand for a brand of
smartphones is likely to be price elastic due to the large number of substitute brands in the market such
as Apple, Samsung, LG, HTC, Sony, BlackBerry, etc.

Degree of Necessity

The PED for a good will be higher the lower the degree of necessity. Conversely, the PED for a good
will be lower the higher the degree of necessity. For example, the demand for oil is price inelastic due
to the high degree of necessity, apart from lack of close substitutes.

Proportion of Income Spent on the Good

The PED for a good will be higher the larger the proportion of income spent on the good. Conversely,
the PED for a good will be lower the smaller the proportion of income spent on the good. For
example, the demand for private cars is likely to be price elastic due to the large proportion of income
spent on the goods as they are generally expensive. In contrast, the demand for stationery is likely to
be price inelastic due to the small proportion of income spent on the good as it is generally cheap,
apart from the high degree of necessity.

Time Period

The PED for a good will be higher the longer the time period under consideration. Conversely, the
PED for a good will be lower the shorter the time period under consideration. This is because
consumers need time to adjust their consumption patterns and find substitutes. For example, given any
increase in the price of petrol, the quantity demanded will not fall significantly in the short run as
people need to drive their cars. However, the quantity demanded will fall more significantly over time
as more fuel-efficient cars can be developed and people can switch to smaller cars which consume less
fuel.

7.4 INCOME ELASTICITY OF DEMAND

7.4.1 Measurement and Interpretation of Income Elasticity of Demand

The income elasticity of demand (YED) for a good is a measure of the degree of responsiveness of the
demand to a change in income, ceteris paribus.
The YED for a good is calculated by dividing the percentage change in the demand by the percentage
change in income.

% Δ Demand
YED = ———————–
% Δ Income

If the YED for a good is positive, the good is a normal good. A normal good is a good whose demand
rises when consumers’ income rises. There are two types of normal goods: necessity and luxury. A
necessity is a normal good with a YED between zero and one. In other words, the demand for a
necessity is income inelastic. An example of a necessity is agricultural products. A luxury is a normal
good with a YED greater than one. In other words, the demand for a luxury is income elastic. An
example of a luxury is private cars. If the YED for a good is negative, the good is an inferior good. An
inferior good is a good whose demand falls when consumers’ income rises. An example of an inferior
good is public transport.

7.4.2 Applications of Income Elasticity of Demand

The concept of YED allows a firm to determine the future size of the market for the good and hence its
production capacity. Suppose that the YED for a good is positive. If a firm predicts an economic
expansion which is a period of time during which national income is rising, it should increase its
production capacity in order to be able to meet the higher demand when the economic expansion
comes. Furthermore, the higher the YED is, the larger will be the increase in the demand and hence the
larger the extent the firm should increase its production capacity. Conversely, if the firm predicts an
economic contraction which is a period of time during which national income is falling, it should
decrease its production capacity to minimise excess capacity when the economic contraction comes.

The concept of YED may enable a firm to determine how to formulate its marketing strategy. Suppose
that a firm sells two goods. Further suppose that one of the goods is a normal good and the other good
is an inferior good. If the economy is expanding and hence national income is rising, the firm should
focus its marketing strategy on the normal good. Conversely, if the economy is contracting and hence
national income is falling, the firm should focus its marketing strategy on the inferior good.

7.4.3 Determinants of Income Elasticity of Demand

Degree of Luxury

The YED for a good will be higher the more luxurious the good. Conversely, the YED for a good will
be lower the less luxurious the good. For example, the YED for high-end private cars is higher than
those for mid-range and low-end private cars as high-end private cars are more luxurious than mid-
range and low-end private cars.

Level of Income

The YED for a good will be higher the lower the level of income. Conversely, the YED for a good will
be lower the higher the level of income. For example, the YED for private cars in the Philippines is
higher than that in Singapore as the level of income in the Philippines is lower than that in Singapore.

7.5 CROSS ELASTICITY OF DEMAND

7.5.1 Measurement and Interpretation of Cross Elasticity of Demand


The cross elasticity of demand (XED) for a good with respect to another good is a measure of the
degree of responsiveness of the demand for the first good to a change in the price of the second good,
ceteris paribus. Let the two goods be good A and good B.

The XED for good A with respect to good B is calculated by dividing the percentage change in the
demand for good A by the percentage change in the price of good B.

% Δ Demand for Good A


XEDAB = ————————————–
% Δ Price of Good B

If XEDAB is positive, good A and good B are substitutes. Substitutes are goods which are consumed in
place of one another such as Coke and Pepsi. If the price of good B rises, consumers will buy less of it.
Since good A and good B are substitutes, they will buy more good A. If XEDAB is negative, good A
and good B are complements. Complements are goods which are consumed in conjunction with one
another such as car and petrol. If the price of good B rises, consumers will buy less of it. Since good A
and good B are complements, they will buy less good A.

7.5.2 Applications of Cross Elasticity of Demand

The concept of XED allows a firm to determine how a change in the price of a related good produced
by another firm will affect the demand for its good. For example, if a rival firm decreases its price, the
demand for the good produced by the first firm will fall due to the positive XED between substitutes.
To avoid a decrease in sales, the firm may need to decrease its price. However, if this is likely to lead
to a price war, the firm may consider engaging in non-price competition such as product promotion
and product development instead of decreasing its price. If a rival firm increases its price, the demand
for the good produced by the first firm will increase if it keeps its price constant. However, the firm
may not experience an increase in sales if it has no or little excess capacity.

The concept of XED may enable a firm that produces two or more goods which are complements to
increase total revenue. For example, a telecommunications firm may reduce the price of its mobile
devices even if the demand is price inelastic. Although the revenue from the sale of its mobile devices
will fall as the quantity demanded will rise by a smaller proportion, the demand and hence the revenue
from the provision of its mobile network services will rise due to the negative XED between mobile
network services and mobile devices. Therefore, the total revenue of the telecommunications firm may
increase.

7.5.3 Determinants of Cross Elasticity of Demand

The XED between two goods will be higher the more closely they are related. For example, the XED
between Coke and Pepsi is higher than that between coffee and tea as Coke and Pepsi are closer
substitutes than coffee and tea are.

7.6 PRICE ELASTICITY OF SUPPLY

7.6.1 Measurement and Interpretation of Price Elasticity of Supply

The price elasticity of supply (PES) of a good is a measure of the degree of responsiveness of the
quantity supplied to a change in the price, ceteris paribus.

The PES of a good is calculated by dividing the percentage change in the quantity supplied by the
percentage change in the price.
% Δ Quantity Supplied
PES = ————————————
% Δ Price

Due to the law of supply, the PES of a good is always positive.

If the PES of a good is greater than one, the supply is price elastic which means that a change in the
price will lead to a larger percentage/proportionate change in the quantity supplied. A good with a
price elastic supply has a relatively flat supply curve. If the PES of a good is less than one, the supply
is price inelastic which means that a change in the price will lead to a smaller percentage/proportionate
change in the quantity supplied. A good with a price inelastic supply has a relatively steep supply
curve. If the PES of a good is equal to one, the supply is unit price elastic which means that a change
in the price will lead to the same percentage/proportionate change in the quantity supplied.

Special Cases: If the PES of a good is zero, the supply is perfectly price inelastic which means that a
change in the price will not lead to any change in the quantity supplied. A good with a perfectly price
inelastic supply has a vertical supply curve. If the PES of a good is infinity, the supply is perfectly
price elastic which means that a fall in the price will lead to an infinite decrease in the quantity
supplied. In theory, this means that the quantity supplied will fall from infinity to zero. A good with a
perfectly price elastic supply has a horizontal supply curve.

7.6.2 Determinants of Price Elasticity of Supply

Production Time and ‘Stockability’ of the Good

When the price of a good rises, firms can increase the quantity supplied in two ways: increase
production and draw from stock. Therefore, if the production time of a good is long and if it cannot be
stocked in large quantities, the supply is likely to be price inelastic, and vice versa. The ‘stockability’
of a good depends on the size of the good and whether it is perishable. Goods that are small in size and
non-perishable can be stocked in large quantities, and vice versa. For example, the production time of
agricultural products is long due to the long gestation period and they cannot be stocked due to the
perishable nature. Therefore, the supply of agricultural products is price inelastic. In contrast, with
today’s production technology, most manufactured goods are mass produced on assembly lines which
are highly automated. Therefore, the production time of manufactured goods is likely to be short and
hence the supply is likely to be price elastic. Different types of manufactured goods, however, have
different production times. The supply of luxuries is likely to be price inelastic as the production time
is likely to be long because they are typically high quality goods that normally undergo stringent
quality control. In contrast, the supply of necessities and inferior goods is likely to be price elastic as
the production time is likely to be short due to the limited focus on the quality.

Excess Capacity

Given any increase in the price of a good, the lower the output level and hence the larger the amount
of excess capacity, the slower the marginal cost of production will rise as firms increase output. The
slower the marginal cost of production for a good rises as firms increase output in response to a rise in
the price, the larger the increase in output. Therefore, the lower the output level of a good and hence
the larger the amount of excess capacity, the more price elastic the supply. Conversely, the higher the
output level of a good and hence the smaller the amount of excess capacity, the less price elastic the
supply.

Time Period

The longer the time period after an increase in the price of a good, the more price elastic the supply as
firms are able to increase the production by a larger amount with more time. Time period can be
divided into the immediate run, the short run and the long run. The immediate run is the time period
that is so short that the output level is fixed. The supply of the good is perfectly price inelastic,
assuming firms do not keep stock of the good. The short run is the time period during which at least
one of the factor inputs used in the production process is fixed. In the short run, when the price of a
good rises, firms can increase the production only by employing more of the variable factor inputs
used in the production process. The long run is the time period after which all the factor inputs used in
the production process are variable. The supply of a good is more price elastic in the long run than in
the short run as firms can increase the production by employing more of all the factor inputs used in
the production process.

Mobility of Factors of Production

The ease with which factors of production can be moved from the production of one good to another
will influence the price elasticity of supply of a good. The supply of a good will be more price elastic
the higher the mobility of factors of production. Conversely, the supply of a good will be less price
elastic the lower the mobility of factors of production. For example, if a manufacturing firm in the city
is able to swiftly employ rural farmers to increase output, the supply of the good is likely to be price
elastic.

CHAPTER 3: GOVERNMENT INTERVENTION IN THE MARKET

1 INTRODUCTION

In the free market, the equilibrium of a market is determined by the market forces of demand and
supply. However, the equilibrium price and the equilibrium quantity may not be the optimal price and
the optimal quantity. For example, the price of food may be too high especially in times of war, the
quantity of education will be too low and the quantity of tobacco will be too high in the absence of
government intervention. Therefore, there is a role for the government in the market. This chapter
provides an exposition of government intervention in the market through tax, subsidy, maximum price
and minimum price.

2 TAX

2.1 Effects of an Indirect Tax on Price and Quantity

A tax is a levy imposed on a good, service, income or wealth by the government. Taxes are often
classified into direct taxes and indirect taxes. A direct tax is a tax imposed on income or wealth.
Examples include personal income tax and corporate income tax. An indirect tax is a tax imposed on a
good or service. Examples include goods and services tax and excise tax.

There are two types of indirect taxes: specific tax and ad valorem tax. A specific tax is an indirect tax
of a certain amount per unit sold. An ad valorem tax is an indirect tax of a certain percentage of the
price of the good.

An indirect tax will lead to a rise in the cost of production. When this happens, firms will increase
price by the amount of the tax at each quantity supplied to maintain profitability. In other words, they
will decrease quantity supplied at each price which will lead to a decrease in supply.
Consider the demand and the supply schedules of wine and the effect of a specific tax of $3 per bottle.

Price Quantity demanded Quantity supplied Quantity supplied

(before tax) (after tax)


12 6 15 9
11 7 13 7
10 8 11 5
9 9 9 3
8 10 7 1
7 11 5 —
6 12 3 —
5 13 1 —

In the above diagram, the initial price and quantity are $9 and 9 bottles. Firms pay a tax of $3 to the
government for each bottle sold and this induces them to increase the price by $3 at each quantity
supplied to maintain profitability. However, the new price is $11 instead of $12 as the quantity
supplied exceeds the quantity demanded at the price of $12. The tax revenue of $21 ($3 × 7) collected
by the government is represented by the shaded area.

Note :A progressive tax is a tax that increases more than proportionate with income. Direct taxes are
progressive taxes. A regressive tax is a tax that increases less than proportionate with income.
Indirect taxes are regressive taxes.

2.2 Tax Incidence

Tax incidence is the distribution of the burden of tax between firms and consumers.

When the government imposes a tax on a good, firms and consumers will each pay a proportion of the
tax. A tax on a good will lead to a rise in the cost of production. When this happens, firms will pass on
the rise in the cost of production to consumers in the form of a higher price in order to maintain
profitability. However, as the demand for a good is not perfectly price inelastic, the rise in the price
will be less than the rise in the unit cost of production which is the amount of the tax. Therefore,
consumers will pay the tax in the form of a higher price and firms will pay the tax as the rise in the
price will be less than the amount of the tax. In the previous example, the tax of $3 leads to a vertical
upward shift in the initial supply curve (S0) by the amount of the tax to the new supply curve (S1). The
vertical distance between S0 and S1 is the tax of $3. Consumers pay a higher price of $11 and firms
receive a lower effective price of $8 after paying the tax of $3 to the government. Therefore,
consumers pay two-thirds [($11 – $9)/$3] of the tax and firms pay one-third [($9 – $8)/$3] of the tax.
In this case, consumers pay a larger proportion of the tax.

In general, whether consumers or firms will pay a larger proportion of a tax on a good depends on the
price elasticity of demand relative to the price elasticity of supply. The side of the market which is less
responsive to a change in the price will pay a larger proportion of the tax. If the demand is more price
elastic than the supply, firms will pay a larger proportion of the tax. When consumers are more
responsive to a change in the price than firms, firms will not be able to pass on a larger proportion of
the tax to consumers in the form of a large increase in the price without causing a large decrease in the
quantity demanded. Conversely, if the demand is less price elastic than the supply, consumers will pay
a larger proportion of the tax. When consumers are less responsive to a change in the price than firms,
firms will be able to pass on a larger proportion of the tax to consumers in the form of a large increase
in the price without causing a large decrease in the quantity demanded.

Demand is more Price Elastic than Supply


In the above diagram, the demand is more price elastic than the supply and hence the demand curve
(D) is flatter than the supply curve (S). The proportion of the tax (t) paid by firms, which is [P 0 – (P1 –
t)]/t or B/(A + B), is greater than the proportion paid by consumers, which is (P1 – P0)/t or A/(A + B).

Demand is less Price Elastic than Supply

In the above diagram, the demand is less price elastic than the supply and hence the demand curve (D)
is steeper than the supply curve (S). The proportion of the tax (t) paid by consumers, which is (P 1 –
P0)/t or A/(A + B), is greater than the proportion paid by firms, which is [P0 – (P1 – t)]/t or B/(A + B).

3 SUBSIDY

3.1 Effects of a Subsidy on Price and Quantity

A subsidy is a payment made by the government to a firm to lower the cost of production and
therefore increase supply.

A subsidy will lead to a fall in the cost of production. When this happens, firms will decrease price by
the amount of the subsidy at each quantity supplied to maintain competitiveness. In other words, they
will increase quantity supplied at each price which will lead to an increase in supply.

In the above diagram, a subsidy leads to a vertical/parallel downward shift in the supply curve (S)
from S0 to S1 as the amount of the subsidy is the same at each quantity supplied.

Consider the demand and the supply schedules for wheat and the effect of a subsidy of $3 per sack.

Price Quantity demanded Quantity supplied Quantity supplied

(before subsidy) (after subsidy)


12 6 15 —
11 7 13 —
10 8 11 —
9 9 9 15
8 10 7 13
7 11 5 11
6 12 3 9
5 13 1 7

In the above diagram, the initial price and quantity are $9 and 9 sacks. Firms receive a subsidy of $3
from the government for each sack sold and this allows them to decrease the price by $3 at each
quantity supplied to maintain competitiveness. However, the new price is $7 instead of $6 as the
quantity demanded exceeds the quantity supplied at the price of $6. The expenditure of $33 ($3 x 11)
on the subsidy incurred by the government is represented by the shaded area.

Note: The effects of a subsidy on price and quantity will be discussed in greater detail in economics
tuition by the Principal Economics Tutor.

3.2 Subsidy Incidence

Subsidy incidence is the distribution of the benefit of subsidy between firms and consumers.
When the government gives a subsidy on a good, firms and consumers will each receive a proportion
of the subsidy. A subsidy on a good will lead to a fall in the cost of production. When this happens,
firms will pass on the fall in the cost of production to consumers in the form of a lower price in order
to maintain competitiveness. However, as the demand for a good is not perfectly price inelastic, the
fall in the price will be less than the fall in the unit cost of production which is the amount of the
subsidy. Therefore, consumers will receive the subsidy in the form of a lower price and firms will
receive the subsidy as the fall in the price will be less than the amount of the subsidy. In the previous
example, the subsidy of $3 leads to a vertical downward shift in the initial supply curve (S 0) by the
amount of the subsidy to the new supply curve (S1). The vertical distance between S0 and S1 is the
subsidy of $3. Consumers pay a lower price of $7 and firms receive a higher effective price of $10
after getting the subsidy of $3 from the government. Hence, consumers receive two-thirds [($9 –
$7)/$3] of the subsidy and firms receive one-third [($10 – $9)/$3] of the subsidy. In this case,
consumers receive a larger proportion of the subsidy.

In general, whether consumers or firms will receive a larger proportion of a subsidy on a good depends
on the price elasticity of demand relative to the price elasticity of supply. The side of the market which
is less responsive to a change in the price will receive a larger proportion of the subsidy. If the demand
is more price elastic than the supply, firms will receive a larger proportion of the subsidy. When
consumers are more responsive to a change in the price than firms, firms will not need to pass on a
larger proportion of the subsidy to consumers in the form of a large decrease in the price to induce
them to increase the quantity demanded substantially. Conversely, if the demand is less price elastic
than the supply, consumers will receive a larger proportion of the subsidy. When consumers are less
responsive to a change in the price than firms, firms will need to pass on a larger proportion of the
subsidy to consumers in the form of a large decrease in the price to induce them to increase the
quantity demanded substantially.

Demand is more Price Elastic than Supply

In the above diagram, the demand is more price elastic than the supply and hence the demand curve
(D) is flatter than the supply curve (S). The proportion of the subsidy (s) received by firms, which is
[(P1 + s) – P0]/s or A/(A + B), is greater than the proportion received by consumers, which is (P0 –
P1)/s or B/(A + B).

Demand is less Price Elastic than Supply

In the above diagram, the demand is less price elastic than the supply and hence the demand curve (D)
is steeper than the supply curve (S). The proportion of the subsidy (s) received by consumers, which is
(P0 – P1)/s or B/(A + B), is greater than the proportion received by firms, which is [(P 1 + s) – P0]/s or
A/(A + B).

4 MAXIMUM PRICE (PRICE CEILING)

4.1 Effects of a Maximum Price on Price and Quantity

A maximum price, or a price ceiling, is the highest price that firms are legally allowed to charge.

The government may set a maximum price on a good to prevent the price from rising above a certain
level in order to ensure the affordability to consumers. An example is the rent control in Canada. A
binding maximum price is a maximum price set below the equilibrium price. A binding maximum
price will lead to a fall in the price resulting in an increase in the quantity demanded and a decrease in
the quantity supplied. Therefore, a binding maximum price will lead to a shortage.

In the above diagram, the initial price (P) and quantity (Q) are P0 and Q0. A binding maximum price
(PMAX) leads to a fall in the price from P0 to PMAX. The quantity demanded increases from Q0 to QD and
the quantity supplied decreases from Q0 to QS. Therefore, the quantity demanded (QD) is greater than
the quantity supplied (QS) resulting in a shortage. When a shortage occurs, a black market may
emerge. In other words, the good may be illegally sold at prices above the price ceiling which will
render it ineffective. In the extreme case where black marketeers buy up the quantity supplied at P MAX,
the price will rise from P0 to PBM.

To solve the shortage problem, the government can draw on its buffer stock, assuming it has a buffer
stock of the good. However, this can only be a short-term measure if the shortage problem is persistent
as the government will deplete its buffer stock in time to come. In this case, the government can only
solve the shortage problem by decreasing the demand or increasing the supply. The government can
decrease the demand by developing substitutes for the good or increase the supply by direct
government production or by giving a subsidy to firms to induce them to increase output..

5 MINIMUM PRICE (PRICE FLOOR)

5.1 Effects of a Minimum Price on Price and Quantity

A minimum price, or a price floor, is the lowest price that firms are legally allowed to charge.

The government may set a minimum price on a good to prevent the price from falling below a certain
level in order to protect the producers’ income. An example is the minimum price on rice in Thailand.
The government may also set a minimum price on a good to decrease the consumption. An example is
the minimum price on vodka in Russia. A non-binding minimum price is a minimum price set below
the equilibrium price. A binding minimum price is a minimum price set above the equilibrium price. A
binding minimum price will lead to a rise in the price resulting in an increase in the quantity supplied
and a decrease in the quantity demanded. Therefore, a binding minimum price will lead to a surplus.

In the above diagram, the initial price (P) and quantity (Q) are P0 and Q0. A binding minimum price
(PMIN) leads to a rise in the price from P0 to PMIN. The quantity supplied increases from Q0 to QS and
the quantity demanded decreases from Q0 to QD. Therefore, the quantity supplied (QS) is greater than
the quantity demanded (QD) resulting in a surplus. When a surplus occurs, a black market may emerge.
In other words, firms may illegally sell the good at prices below the price floor to reduce their stocks
which will render it ineffective.

To solve the surplus problem, the government can buy the surplus and keep it as buffer stock.
However, this can be a costly measure if the surplus problem is persistent as it will lead to an over-
accumulation of the buffer stock. In this case, the government may want to solve the surplus problem
by increasing the demand or decreasing the supply. The government can increase the demand by
finding alternative uses for the good or decrease the supply by imposing an output quota.

Note: An output quota, or a production quota, is a limit imposed on the quantity of a good that can
be produced.

CHAPTER 4: PRODUCTION AND COSTS

1 INTRODUCTION

Production is the process by which factor inputs are transformed into output. An increase in the
quantity of factor inputs will lead to an increase in output. The theory of production is the study of
how the output level changes as the quantity of factor inputs changes. To increase output, firms need
to employ more factor inputs which will lead to an increase in costs. The theory of costs is the study of
how the cost of production changes as the output level changes. When a firm expands its scale of
production, its average cost will usually fall and this phenomenon is called internal economies of
scale, or simply known as economies of scale. However, when the scale of production of a firm
reaches a certain size, a further expansion may lead to a rise in its average cost and this phenomenon is
called internal diseconomies of scale, or simply known as diseconomies of scale. A firm may
experience a fall or rise in its average cost when the industry expands, even though its scale of
production remains unchanged, and these phenomena are called external economies of scale and
external diseconomies of scale respectively. This chapter provides an exposition of the theory of
production and the theory of costs.

2 THE SHORT-RUN THEORY OF PRODUCTION

2.1 Marginal Returns

If a firm wants to increase output, it can almost immediately employ more labour. However, it will not
be able to employ more capital in the same time frame as acquisition of capital takes time. In
economics, we distinguish between two types of factor inputs: variable factor input and fixed factor
input. Variable factor inputs are factor inputs whose quantities can be changed in the short run. An
example is labour. Fixed factor inputs are factor inputs whose quantities are fixed in the short run. An
example is capital.

The short run is the time period during which at least one of the factor inputs used in the production
process is fixed. It does not correspond to any specific number of weeks, months or years as it varies
from firm to firm and from industry to industry. For example, a web hosting firm may take only a few
weeks or even days to increase its production capacity by purchasing more servers. However, an oil
refining firm may take many years to increase its production capacity due to the long time period
needed to build oil refineries.

Suppose that a firm employs two factor inputs: capital and labour. In this case, the fixed factor input is
capital and the variable factor input is labour. As the quantity of capital is fixed in the short run, the
firm can increase output only by employing more labour.

Example

Capital Labour Total Output Additional Output


5 0 0 —
5 1 3 3
5 2 7 4
5 3 12 5
5 4 18 6
5 5 22 4
5 6 24 2
5 7 24 0
5 8 23 -1
5 9 20 -3

In the above table, from the first unit of labour to the fourth, each additional unit of labour is adding
more to total output than the previous additional unit and hence the firm is experiencing increasing
marginal returns. Increasing marginal returns occur when each additional unit of a variable factor input
(e.g. labour) is adding more to total output than the previous additional unit. This occurs due to under-
utilisation of the fixed factor inputs (e.g. capital). However, from the fifth unit of labour onwards, each
additional unit of labour is adding less to total output than the previous additional unit and hence the
firm is experiencing diminishing marginal returns. Diminishing marginal returns occur when each
additional unit of a variable factor input (e.g. labour) is adding less to total output than the previous
additional unit. This occurs due to over-utilisation of the fixed factor inputs (e.g. capital). Diminishing
marginal returns set in when the fifth unit of labour is employed. Furthermore, the seventh unit of
labour is actually redundant. Total output even falls when the eighth unit of labour is employed.

The law of diminishing marginal returns states that if an increasing quantity of a variable factor input
is used with a constant quantity of fixed factor inputs, an output level point will be reached beyond
which each additional unit of the variable factor input will add less to total output than the previous
additional unit. To put it somewhat differently, the law of diminishing marginal returns states if a firm
increases output continually in the short run, it is a matter of time that diminishing marginal returns
will set in. If the firm starts with a small quantity of fixed factor inputs, diminishing marginal returns
will set in earlier. If the firm starts with a large quantity of fixed factor inputs, diminishing marginal
returns will set in later.

2.2 Total Product, Marginal product and Average product

Total Product

Total product (TP) is the total output produced with a given amount of factor inputs.

The total product curve is S-shaped.

Total Product Curve

In the above diagram, the TP curve shows how total output varies with the quantity of labour, given
the quantity of capital. From the first unit of labour to QL0, the firm is experiencing increasing
marginal returns and hence total output is rising at an increasing rate when the quantity of labour
increases. After QL0, the firm is experiencing diminishing marginal returns and hence total output is
rising at a decreasing rate when the quantity of labour increases. After QL2, the problem of diminishing
marginal returns becomes so severe that additional units of labour actually lead to a fall in total output.

Marginal Product

Marginal product (MP) is the additional output resulting from employing one more unit of labour.

Marginal product is calculated by dividing the change in total output by the change in the quantity of
labour.

ΔTP

MP = ——–

ΔQL

The marginal product curve is inverted-U-shaped.

Marginal Product Curve


In the above diagram, from the first unit of labour to QL0, the firm is experiencing increasing marginal
returns and hence MP is rising. After QL0, the firm is experiencing diminishing marginal returns and
hence MP is falling. After QL2, the problem of diminishing marginal returns becomes so severe that
additional units of labour actually lead to negative MP.

Average Product

Average product (AP) is the output per unit of labour.

Average product is calculated by dividing total output by the quantity of labour.

TP

AP = ——–

QL

The average product curve is inverted-U-shaped.

Average Product Curve

In the above diagram, from the first unit of labour to QL1, MP is higher than AP and hence AP is
rising. After QL1, MP is lower than AP and hence AP is falling. The above analysis does not only
explain why the AP curve is inverted-U-shaped, it also explains why the MP curve cuts the AP curve
at the maximum point.

3 THE LONG-RUN THEORY OF PRODUCTION

3.1 The Least-cost Combination of Factor Inputs

The long run is the time period after which all the factor inputs used in the production process are
variable. In the long run, if a firm wants to increase output, not only can it employ more labour, it can
also employ more capital whose quantity is fixed in the short run. Like the short run, the long run does
not correspond to a specific number of weeks, months or years as it varies from firm to firm and from
industry to industry.

The least-cost combination of factor inputs is used when the last dollar of each factor input employed
produces the same additional output. If a firm employs two factor inputs, labour (L) and capital (K),
the least-cost condition can be expressed as MPL/PL = MPK/PK, where MP denotes marginal product
and P denotes price.

Suppose that MPL/PL is twice MPK/PK. In other words, the additional output produced by the last
dollar of labour employed is twice the additional output produced by the last dollar of capital
employed. In this case, the firm can reduce the total cost of producing the same amount of output by
employing more labour and less capital. For example, if the firm employs one more dollar of labour
and two dollars less of capital, although total cost will fall by one dollar, total output will remain
constant which will lead to a fall in the total cost of producing the same amount of output. However,
as the quantity of labour increases, MPL will fall due to diminishing marginal returns. Similarly, as
less capital is employed, MPK will increase. This process will continue until MPL/PL = MPK/PK. In
other words, the additional output resulting from employing the last dollar of labour is equal to the
additional output resulting from employing the last dollar of capital.

3.2 Returns to Scale


When the quantities of all the factor inputs used in the production process are increased by the same
proportion in the long run, the scale of production expands. An increase in the scale of production will
lead to one of three scenarios: increasing returns to scale, constant returns to scale or decreasing
returns to scale.

Increasing Returns to Scale

Increasing returns to scale occur when the same percentage/proportionate increase in the quantities of
all the factor inputs used in the production process leads to a larger percentage/proportionate increase
in total output.

Constant Returns to Scale

Constant returns to scale occur when the same percentage/proportionate increase in the quantities of
all the factor inputs used in the production process leads to the same percentage/proportionate increase
in total output.

Decreasing Returns to Scale

Decreasing returns to scale occur when the same percentage/proportionate increase in the quantities of
all the factor inputs used in the production process leads to a smaller percentage/proportionate increase
in total output.

Example

Percentage
Percentage
increase in the
Capital Labour Total output increase in total Returns to scale
quantities of all
output
factor inputs
20 4 — 100 — —
40 8 100 250 150 IRS
60 12 50 420 68 IRS
80 16 33.33 560 33.33 CRS
100 20 25 672 20 DRS
120 24 20 780 16 DRS

From the output level 100 to the output level 420, the firm is experiencing increasing returns to scale
(IRS). Increasing returns to scale occur due to greater division of labour and the use of larger
machines. Division of labour is the process whereby each job is broken up into its component tasks
and each worker is assigned one or a few component tasks of the job. An expansion of the scale of
production may enable the firm to engage in greater division of labour and hence greater specialisation
which will lead to higher labour productivity resulting in increasing returns to scale. Furthermore,
larger machines are often more efficient than smaller machines as they generally make more efficient
use of materials and labour. Therefore, an expansion of the scale of production may enable the firm to
use larger machines that are often more efficient than smaller machines which will also lead to higher
labour productivity resulting in increasing returns to scale. From the output level 420 to the output
level 560, the firm is experiencing constant returns to scale (CRS). From the output level 560 to the
output level 780, the firm is experiencing decreasing returns to scale (DRS). Decreasing returns to
scale occur due to greater division of labour. When division of labour increases to a high degree,
workers may become demotivated as performing the same task all the time may lead to boredom. This
is especially true if the task is mundane. If this happens, labour productivity will fall which will lead to
decreasing returns to scale.

4 THE SHORT-RUN THEORY OF COSTS

4.1 Fixed Costs, Variable Costs, Explicit Costs and Implicit Costs

Fixed costs are costs that do not vary with the output level. Examples of fixed costs include rent and
interest payments on loans. An increase in the output level will not lead to an increase in fixed costs.
Fixed costs will be incurred even if the firm shuts down production. Variable costs are costs that vary
directly with the output level. Examples of variable costs include the cost of labour and the costs of
materials. An increase in the output level will lead to an increase in variable costs as more variable
factor inputs are needed to produce more output. Variable costs will not be incurred if the firm shuts
down production.

Explicit costs are costs that involve monetary payments. Examples of explicit costs include the cost of
labour and the costs of materials. Implicit costs are costs that do not involve monetary payments.
Examples of implicit costs include the cost of the owner’s labour and the cost of the owner’s financial
capital. Profit is the excess of total revenue over total cost. Accounting profit is the excess of total
revenue over accounting costs. Accounting costs are costs computed by accountants which include
only explicit costs. Economic profit is the excess of total revenue over economic costs. Economic
costs are costs computed by economists which include both explicit costs and implicit costs. As
economic costs are higher than accounting costs, economic profit, which is the profit that economists
are concerned with, is lower than accounting profit.

4.2 Total Cost, Marginal Cost, Average Cost, Average Variable Cost and Average Fixed Cost

Total Cost

Total cost (TC) is the cost of the factor inputs required for the production of an amount of output.

In the short run, total cost is the sum of total fixed cost (TFC) and total variable cost (TVC) and is
positively related to the output level. The total cost curve is inverse-S-shaped.

Total Cost Curve

In the above diagram, as fixed costs do not vary with the output level, the TFC curve is horizontal.
However, as more variable factor inputs are needed to produce more output, the TVC curve is upward-
sloping. As TC is the sum of TFC and TVC, the TC curve is geometrically similar to the TVC curve,
except that the former is higher than the latter by TFC at each output level. From the first unit of
output to Q0, the firm is experiencing increasing marginal returns. Recall that this means each
additional unit of the variable factor input is adding more to total output than the previous additional
unit. Therefore, each additional unit of output requires fewer units of the variable factor input to
produce and this makes the TC curve and the TVC curve rise at a decreasing rate. After Q 0, the firm is
experiencing diminishing marginal returns. Recall that this means each additional unit of the variable
factor is adding less to total output than the previous additional unit. Therefore, each additional unit of
output requires more units of the variable factor input to produce and this causes the TC curve and the
TVC curve to rise at an increasing rate.

Marginal Cost

Marginal cost (MC) is the additional cost resulting from producing one more unit of output.
Marginal cost is calculated by dividing the change in total cost by the change in total output.

ΔTC

MC = ——–

ΔQ

The marginal cost curve is U-shaped or Nike-shaped which some like to call it.

Marginal Cost Curve

In the above diagram, from the first unit of output to Q0, the firm is experiencing increasing marginal
returns and hence MC is falling. After Q0, the firm is experiencing diminishing marginal returns and
hence MC is rising.

Average Cost

Average cost (AC) is the cost per unit of output.

Average cost is calculated by dividing total cost by total output.

TC

AC = ——–

The average cost curve is U-shaped.

Average Cost Curve

In the above diagram, from the first unit of output to Q2, MC is lower than AC and hence AC is
falling. After Q2, MC is higher than AC and hence AC is rising. The above analysis does not only
explain why the AC curve is U-shaped, it also explains why the MC curve cuts the AC curve at the
minimum point.

Average Variable Cost

Average variable cost (AVC) is the variable cost per unit of output.

Average variable cost is calculated by dividing total variable cost by total output.

TVC

AVC = ——–

The average variable cost curve is U-shaped.


The relationship between average value and marginal value applies to average variable cost and
marginal cost.

Average Variable Cost Curve

In the above diagram, from the first unit of output to Q1, MC is lower than AVC and hence AVC is
falling. After Q1, MC is higher than AVC and hence AVC is rising. The above analysis does not only
explain why the AVC curve is U-shaped, it also explains why the MC curve cuts the AVC curve at the
minimum point.

Average Fixed Cost

Average fixed cost (AFC) is the fixed cost per unit of output.

Average fixed cost is calculated by dividing total fixed cost by total output.

TFC

AFC = ——–

The average fixed cost curve is a rectangular hyperbola.

Average Fixed Cost Curve

In the above diagram, as TFC is constant, AFC falls when the output level increases.

The following diagram shows the relationships between the marginal cost curve, the average cost
curve, the average variable cost curve and the average fixed cost curve.

In the above diagram, from the first unit of output to Q0, MC is falling due to increasing marginal
returns, and is rising thereafter due to diminishing marginal returns. From the first unit of output to Q 1,
MC is lower than AC and AVC and hence AC and AVC are falling. After Q1, MC is higher than AVC
and hence AVC is rising. After Q2, MC is higher than AC and hence AC is rising. As AC is the sum of
AVC and AFC, the vertical distance between the AC curve and the AVC curve is equal to AFC. As
AFC falls when the output level increases, the vertical distance between the AC curve and the AVC
curve narrows as the output level increases.

5 THE LONG-RUN THEORY OF COSTS

5.1 Long-run Average Cost

The long-run average cost (LRAC) curve shows the lowest average cost of production at each output
level when all the factor inputs used in the production process are variable in the long run. Each point
on the LRAC curve is a point of tangency to the AC curve with the lowest average cost of producing
the corresponding output level.

As fixed factor inputs in the short run become variable in the long run, a firm can choose the quantity
of fixed factor inputs that achieves the lowest average cost of producing any output level. Suppose that
a firm can choose among three quantities of fixed factor inputs: small quantity, medium quantity and
large quantity. For simplicity, one can think of a small quantity of fixed factor inputs as a small
factory, a medium quantity as a medium factory and a large quantity as a large factory.
In the above diagram, the average cost (AC) curves that correspond to the three quantities of fixed
factor inputs are AC0, AC1 and AC2, where AC0 corresponds to the small quantity, AC1 corresponds
the medium quantity and AC2 corresponds to the large quantity. As a larger scale of production
enables the firm to produce a larger amount of output, AC1 is on the right of AC0 and AC2 is on the
right of AC1. Furthermore, AC1 is lower than AC0 as the expansion of the scale of production from the
small quantity of fixed factors to the medium quantity enables the firm to reap more economies of
scale. However, AC2 is higher than AC1 as the expansion of the scale of production from the medium
quantity of fixed factors to the large quantity causes the firm to experience diseconomies of scale.
Economies of scale and diseconomies of scale will be explained in greater detail in Section 5.2. If the
firm wants to produce an output level below Q’, the lowest-average-cost quantity of fixed factor inputs
will be the small quantity that corresponds to AC0. If the firm wants to produce an output level
between Q’ and Q”, the lowest-average-cost quantity of fixed factor inputs will be the medium
quantity that corresponds to AC1. If the firm wants to produce an output level above Q”, the lowest-
average-cost quantity of fixed factor inputs will be the large quantity that corresponds to AC 2.
Therefore, the LRAC curve is the bold curve in the diagram.

5.2 Internal Economies of Scale and Internal Diseconomies of Scale

Internal Economies of Scale

When a firm expands its scale of production, its average cost will usually fall. Internal economies of
scale (IEOS), or simply known as economies of scale (EOS), refer to the decrease in average cost
when the scale of production expands. Economies of scale are shown by a downward movement along
the long-run average cost curve. Unless otherwise stated, economies of scale refer to internal
economies of scale which are different from external economies of scale which will be explained in
greater detail later. There are several sources of economies of scale.

Technical Economies of Scale

Recall that division of labour is the process whereby each job is broken up into its component tasks
and each worker is assigned one or a few component tasks of the job. An expansion of the scale of
production may enable the firm to engage in greater division of labour and hence greater specialisation
which will lead to higher labour productivity resulting in increasing returns to scale. Furthermore,
larger machines are often more efficient than smaller machines as they generally make more efficient
use of materials and labour. Therefore, an expansion of the scale of production may enable the firm to
use larger machines that are often more efficient than smaller machines which will also lead to higher
labour productivity resulting in increasing returns to scale. Recall that increasing returns to scale occur
when the same percentage/proportionate increase in the quantities of all the factor inputs used in the
production process leads to a larger percentage/proportionate increase in total output. When this
happens, the percentage/proportionate increase in total output will be greater than the
percentage/proportionate increase in total cost resulting in a fall in average cost.

Managerial Economies of Scale

Larger firms may be able to afford to create more specialised departments where specialists perform
specific administrative functions. These specific administrative functions include human resource,
purchasing, finance and marketing. Greater specialisation in these areas of expertise will lead to
greater efficiency resulting in a fall in average cost.

Organisational Economies of Scale

Larger firms are able to spread overheads such as marketing cost and training cost over a larger
amount of output. Spreading overheads will lead to lower overheads per unit of output resulting in a
fall in average cost. For example, as the cost of an advertisement is independent of the amount of
output produced, larger firms that produce a larger amount of output have a lower marketing cost per
unit of output.

Purchasing Economies of Scale

Larger firms produce a larger amount of output. Therefore, they require a larger amount of factor
inputs. It follows that larger firms are able to obtain a higher trade discount for the larger amount of
factor inputs that they purchase which will lead to a fall in their average costs.

Financial Economies of Scale

Larger firms are generally perceived to be more financially stable. Greater financial stability is
commonly associated with lower default risk. Therefore, larger firms generally are able to obtain loans
at lower interest rates which will lead to a fall in their average costs.

Internal Diseconomies of Scale

When the scale of production of a firm reaches a certain size, a further expansion may lead to a rise in
its average cost. Internal diseconomies of scale (IDOS), or simply known as diseconomies of scale
(DOS), refer to the increase in average cost when the scale of production expands. Diseconomies of
scale are shown by an upward movement along the long-run average cost curve. Unless otherwise
stated, diseconomies of scale refer to internal diseconomies of scale which are different from external
diseconomies of scale which will be explained in greater detail later. There are several sources of
diseconomies of scale.

Technical Diseconomies of Scale

When division of labour increases to a high degree, workers may become demotivated as performing
the same task all the time may lead to boredom. This is especially true if the task is mundane. If this
happens, labour productivity will fall which will lead to decreasing returns to scale. Recall that
decreasing returns to scale occur when the same percentage/proportionate increase in the quantities of
all the factor inputs used in the production process leads to a smaller percentage/proportionate increase
in total output. When this happens, the percentage/proportionate increase in total output will be
smaller than the percentage/proportionate increase in total cost resulting in a rise in average cost.

Managerial Diseconomies of Scale

When more specialised departments are created, coordination of the departments in the firm may
become difficult. This is especially true if a system of coordination is not put in place. If this happens,
efficiency in the various departments will fall which will lead to a rise in average cost.

5.3 External Economies of Scale and External Diseconomies of Scale

External Economies of Scale

A firm may experience a fall in its average cost when the industry expands, even though its scale of
production remains unchanged. External economies of scale (EOS) refer to the decrease in average
cost when the industry rather than the scale of production expands. External economies of scale are
shown by a downward shift in the long-run average cost curve. There are several sources of external
economies of scale.

When the industry expands, the demand for factor inputs will increase which will allow firms that
supply factor inputs to the industry to expand their scales of production. When this happens, they may
reap more economies of scale and hence charge lower prices to firms in the output industry. If this
happens, as firms in the output industry will pay lower prices for the factor inputs that they purchase,
their average costs will fall.

When an industry is small, training schools may find it unprofitable to design and conduct training
courses to cater for the industry. However, when the industry expands, these training courses may
become profitable to design and conduct. If this happens, firms in the industry will experience a fall in
their training costs which will lead to a fall in their average costs.

An expansion of the industry may induce the government to improve the infrastructure such as the
transportation network to support the industry. If this happens, firms in the industry will experience a
fall in their transportation costs which will lead to a fall in their average costs.

When the industry expands, specialist firms which supply components to the industry may be set up. If
this happens, as these specialist firms use dedicated machinery to produce the components, the costs of
production will be lower which will lead to lower prices. As a result, firms in the industry will
experience a fall in their average costs.

An expansion of the industry may lead to an increase in the number of researchers from both academia
and industry who will devote their researches to the industry. If this happens, the researches conducted
by these researchers will be published in research journals and be made accessible to interested parties
for a fee. If the researches lead to better production technologies in the industry, average cost will fall.

External Diseconomies of Scale

A firm may experience a rise in its average cost when the industry expands, even though its scale of
production remains unchanged. External diseconomies of scale (DOS) refer to the increase in average
cost when the industry rather than the scale of production expands. External diseconomies of scale are
shown by an upward shift in the long-run average cost curve. There are several sources of external
diseconomies of scale.

When the industry expands, the demand for factor inputs will increase which will lead to a rise in the
prices. When this happens, as firms in the industry will pay higher prices for factor inputs, their
average costs will rise.

An expansion of the industry may exert a strain on the infrastructure such as the transportation
network which will lead to congestion. If this happens, firms in the industry will experience a rise in
their transportation costs which will lead to a rise in their average costs.

CHAPTR 5: MARKET STRUCTURE

1 INTRODUCTION

Economists are interested to study the behaviour of firms such as whether they will charge a high or
low price, whether they will make a large or small amount of profit and whether they will produce
efficiently. The answers to these questions will depend on the market structure. Market structure refers
to the characteristics of a market such as the number of firms, the nature of their products, the
availability of knowledge and the extent of barriers to entry which affect the behaviour of the firms in
the market. For example, a firm that faces competition from many firms is likely to charge a low price,
make a small amount of profit and produce efficiently. The converse is also true. To maximise profit, a
firm may not charge the same price for each unit of a good and this practice is known as price
discrimination. Price discrimination affects the firm, consumers and society as a whole. Although
firms generally seek to maximise profit, some firms seek to maximise market share, sales revenue and
long-run profit. This chapter provides an exposition of the four types of market structures: perfect
competition, monopoly, monopolistic competition and oligopoly, price discrimination and the
alternative objectives of firms.

2 PERFECT COMPETITION

2.1 Characteristics of Perfect Competition

Large Number of Small Firms

In perfect competition, there are a large number of small firms each with a small market share.

Homogeneous Products

In perfect competition, firms sell homogenous products that are perfect substitutes.

Perfect Knowledge

In perfect competition, consumers and firms have perfect knowledge about the price, quality,
availability and production technology of the product.

Price-takers

Due to small market share, product homogeneity and perfect knowledge, perfectly competitive firms
are price-takers in the sense that they are unable to influence the market price by changing their output
levels. Therefore, perfectly competitive firms can only sell their output at the market price that is
determined by the market forces of demand and supply. In other words, perfectly competitive firms
face a perfectly price elastic demand curve at the market price. At the market price, perfectly
competitive firms can sell an infinite amount of output and hence they do not have the incentive to
charge a lower price. Furthermore, perfectly competitive firms do not have the incentive to charge a
price higher than the market price as the quantity demanded is zero.

No Barriers to Entry

In perfect competition, there are no barriers to entry which means that firms can make only normal
profit in the long run. This will be explained in greater detail in Section 2.3.

Perfect competition does not exist in reality due to the unrealistic assumption of perfect knowledge.

Market Representative firm

In the above left-hand diagram, the market price (P0) is determined by the market demand (D) and the
market supply (S). In the above right-hand diagram, the perfectly competitive firm faces a perfectly
price elastic demand curve (D0) at P0. At P0, the quantity demanded of the good produced by the firm
is infinite. Total revenue is the amount of money received from selling a quantity of a good which is
the product of the price and the quantity. Average revenue is revenue per unit of a good. It is
calculated by dividing total revenue by the quantity. Therefore, average revenue is the price of the
good and hence the average revenue curve (AR0) is the demand curve. Marginal revenue is the
additional revenue resulting from selling one more unit of a good. It is calculated by dividing the
change in total revenue by the change in the quantity. If the perfectly competitive firm wants to sell
one more unit of the good, it does not need to decrease the price. Therefore, marginal revenue is equal
to the price of the good and hence the marginal revenue curve (MR0) is the demand curve.
Note: The word ‘perfect’ in ‘perfect competition’ does not mean ‘the best’ or ‘the most desirable’.
Rather, when it is used with the word ‘competition’, perfect means ‘of the highest degree’.Although
perfect competition does not exist in reality, there are some markets which approximate perfect
competition, such as the agriculture market.

2.2 The Profit-maximising Condition

A firm will maximise profit when it produces the output level where marginal cost is equal to marginal
revenue.

In the above diagram, profit is maximised at Q0 where marginal cost (MC) is equal to marginal
revenue (MR). If the firm increases output from Q0, both total revenue and total cost will rise.
However, at an output level higher than Q0, such as Q1, MC is higher than MR. Therefore, the increase
in total cost will be greater than the increase in total revenue and hence the increase in output will lead
to a decrease in profit. If the firm decreases output from Q0, both total revenue and total cost will fall.
However, at an output level lower than Q0, such as Q2, MR is higher than MC. Therefore, the decrease
in total revenue will be greater than the decrease in total cost and hence the decrease in output will
lead to a decrease in profit. Since profit cannot be increased by changing output from Q 0, it must be
maximised at Q0. The profit is represented by the shaded area, assuming the firm is making
supernormal profit.

Furthermore, MC is equal to MR at two output levels, Q0’ and Q0. At Q0’, where MC is falling, profit
is NOT maximised. Between Q0’ and Q0, MR is higher than MC. If output increases from Q0’ to Q0, a
profit will be made on each unit of output and this means that the profit at Q0 is higher than the profit
at Q0’. Therefore, the profit of a perfectly competitive firm is maximised at the output level where MC
is equal to MR, assuming MC is rising.

Note: Although the profit-maximising condition states that marginal cost must be equal to marginal
revenue for profit to be maximised, the condition is generally not applied in practice. This is mainly
due to the difficulty in measuring marginal cost in reality. For firms that engage in mass production
on assembly line, marginal cost is virtually impossible to measure. This is also true for firms that
provide services. In practice, most firms set their prices by adding a certain percentage mark-up to
their average costs and this is known as cost-plus pricing.

2.3 Equilibrium of a Perfectly Competitive Market

A perfectly competitive market is in short-run equilibrium when all the firms in the market are
producing the profit-maximising output level. However, this does not necessarily mean that they are
making positive economic profit. In the short run, a perfectly competitive firm can make three types of
profit: supernormal profit (positive economic profit), normal profit (zero economic profit) and
subnormal profit (negative economic profit or economic loss).

Supernormal Profit

In the above diagram, at the profit-maximising output level (Q0) where marginal cost (MC) is equal to
marginal revenue (MR), average revenue (AR) is higher than average cost (AC). Therefore, the firm is
making supernormal profit represented by the shaded area.

Normal Profit

In the above diagram, at the profit-maximising output level (Q0) where marginal cost (MC) is equal to
marginal revenue (MR), average revenue (AR) is equal to average cost (AC). Therefore, the firm is
making normal profit.
Subnormal Profit

In the above diagram, at the profit-maximising output level (Q0) where marginal cost (MC) is equal to
marginal revenue (MR), average revenue (AR) is lower than average cost (AC). Therefore, the firm is
making subnormal profit represented by the shaded area.

If the firms in a perfectly competitive market are making supernormal profit, potential firms will enter
the market in the long run due to the absence of barriers to entry. As the number of firms in the market
increases, the market supply will increase which will lead to a fall in the market price resulting in a fall
in the profits of the firms. This process will continue until the firms in the market make only normal
profit.

2.4 The Shut-down Condition

If a firm is making supernormal profit (i.e. positive economic profit) which means that the total
revenue is greater than the total cost, it is obvious that it should continue production. However, if a
firm is making subnormal profit (i.e. negative economic profit or economic loss) which means that the
total revenue is less than the total cost, it does not mean that it should shut down production. In the
short run, a firm should continue production so long as the total revenue is greater than or equal to the
total variable cost. In other words, in the short run, a firm should only take into consideration variable
costs and ignore fixed costs when it is deciding whether to continue or shut down production as fixed
costs will be incurred in any case.

In the long run, as all costs are variable, there is no distinction between fixed costs and variable costs.
Therefore, in the long run, if a firm makes subnormal profit which means that the total revenue is less
than the total cost, it should shut down production and leave the market. It follows that in the long run,
a firm should continue production if the total revenue is greater than or equal to the total cost.

Note: The short-run and long-run shut-down conditions discussed above apply to firms in all market
structures.

2.5 Supply Curve in Perfect Competition

Recall that the supply of a good is the quantity of the good that firms are able and willing to sell at
each price over a period of time, ceteris paribus, and the supply curve shows the quantity supplied at
each price. The portion of the marginal cost curve above the average variable cost curve of a perfectly
competitive firm is the supply curve. As the supply curve shows the quantity supplied at each price,
this means that given the price of a good, the quantity supplied is determined entirely by the supply
curve.

In the above diagram, given the market price of the good (P0) that is determined by the market forces
of demand and supply, the quantity supplied (Q0) is determined entirely by the marginal cost (MC).
Intuitively, given the price of a good, the quantity supplied is determined by the marginal revenue and
the marginal cost. However, in the case of a perfectly competitive firm, price is equal to marginal
revenue. Therefore, given the price of the good produced by a perfectly competitive firm, the quantity
supplied is determined entirely by the MC curve. Furthermore, at a price below the average variable
cost (AVC), the firm will shut down production to avoid making a loss greater than the total fixed
cost. Therefore, the supply curve of a perfectly competitive firm is the portion of the marginal cost
curve above the average cost curve. The industry supply curve of a perfectly competitive industry is
the horizontal summation of the supply curves of all the firms in the industry.

2.6 Advantages and Disadvantages of Perfect Competition

Advantages of Perfect Competition


Productive Efficiency

A firm is productively efficient when it produces on its long-run average cost curve, from firm’s
perspective. This occurs when it is x-efficient and technically efficient. A firm is x-efficient when it is
not lax in cost control. In other words, it uses the most efficient production technology, it is not
overstaffed, it does not occupy premises that are larger than necessary for its output level, etc. A firm
is technically efficient when it uses the least-cost combination of factor inputs to produce its output
level which means that the last dollar of each factor input that it employs produces the same additional
output. From society’s perspective, a firm is productively efficient when it produces at the minimum
efficient scale. Due to competition in the market, perfectly competitive firms are not lax in cost
control. Therefore, perfectly competitive firms are x-efficient and hence productively efficient.

Allocative Efficiency

A firm is allocatively efficient when it cannot change the allocation of resources in the economy in a
way that will increase the welfare of society. This occurs when it charges a price equal to its marginal
cost, assuming no externalities. When the price of a good is equal to the marginal cost, the marginal
benefit that consumers place on the last unit of the good is equal to the forgone marginal benefit that
they place on the amount of other goods that could have been produced using the same resources.
Therefore, the firm cannot change its output level to increase the total benefit for consumers and hence
is allocatively efficient. In perfect competition, price equals marginal revenue and firms maximise
profit by producing the output level where marginal revenue equals marginal cost. Therefore, perfectly
competitive firms charge a price equal to their marginal cost and are hence allocatively efficient.

In the above diagram, at the profit-maximising output level (Q0) where marginal cost (MC) is equal to
marginal revenue (MR), the price (P0) is equal to the marginal cost (MC0).

Lower Price

Firms with greater market power are able to charge a higher price relative to their marginal cost
compared to firms with less market power. Unlike a monopoly that has substantial market power,
perfectly competitive firms have no market power and hence the price charged by perfectly
competitive firms is lower than the price that would be charged by a monopoly operating in the same
market, assuming the cost structure of a monopoly is the same as that of a perfectly competitive
industry.

In the above diagram, the perfectly competitive price (PPC) is lower than the monopoly price (PM).

Income Equity

As perfectly competitive firms can make only normal profit and monopolists and oligopolists can
make supernormal profit in the long run, the distribution of income in an economy that abounds with
perfectly competitive markets will be more equitable than one that abounds with monopolistic markets
and oligopolistic markets.

No Price Discrimination

Perfectly competitive firms are price-takers and hence they are unable to exploit consumers through
price discrimination. Price discrimination is commonly considered a form of consumer exploitation as
it will convert some of the consumer surplus to the producer surplus. Price discrimination will be
explained in greater detail in Section 6.

Disadvantages of Perfect Competition


Higher Price

Firms which reap more economies of scale are able to pass on their lower average costs of production
to consumers in the form of a lower price. As a perfectly competitive firm is smaller than a monopoly,
a perfectly competitive industry reaps less economies of scale than a monopoly and hence the price
charged by perfectly competitive firms may be higher than the price that would be charged by a
monopoly operating in the same market.

In the above diagram, the perfectly competitive price (PPC) is higher than the monopoly price (PM).

Dynamic Inefficiency

Perfectly competitive firms do not engage in research and development due to lack of ability and
incentive and hence are dynamically inefficient. Research and development will lead to product
innovations and process innovations. Product innovations will lead to higher product quality and better
product features and process innovations will lead to a better production technology and hence a lower
cost of production which may be passed on to consumers in the form of a lower price. However,
research and development requires high expenditure which perfectly competitive firms are unable to
finance as they can make only normal profit in the long run. Furthermore, due to perfect knowledge,
any innovation can easily and quickly be copied by other firms.

3 MONOPOLY

3.1 Characteristics of Monopoly

Single Large Firm

In monopoly, there is a single large firm which dominates the whole market.

Unique Product

A monopoly sells a unique product that has no close substitutes.

Price-setter

A monopoly is a price-setter in the sense that it is able to set its price by setting its output level. In
other words, a monopoly faces a downward sloping demand curve.

High Barriers to Entry

In monopoly, there are high barriers to entry which means that the firm can make supernormal profit
in the long run.

Note: In reality, a monopoly is defined as a firm that has more than a certain percentage of the
market share and the percentage varies from country to country.

The demand curve of a monopoly is also the market demand curve as it is the single firm in the
market.

3.2 Barriers to Entry

A barrier to entry is an obstacle which restricts potential firms from entering a market to compete with
the incumbent firm or firms.
Economies of Scale

A monopoly may emerge naturally if it can reap very substantial economies of scale due to very high
capital costs such that the market can accommodate only one firm. In such a market where the market
demand is low which results in a high minimum efficient scale relative to the market demand and
hence the long-run average cost curve falling over the entire range of market demand, a single firm
can meet the market demand at an average cost which allows it to make supernormal profit. However,
with two or more firms, all firms will make subnormal profit as there is simply no price that will allow
any firm to cover its average cost. A monopoly that emerges in this way is known as a natural
monopoly. An example of a firm with the characteristics of a natural monopoly is an electricity utility
firm.

Financial Barriers

Some industries have high start-up costs which are difficult to finance. These high start-up costs which
make it difficult for potential firms to enter the industries may be due to expensive capital goods. They
may also be due to heavy advertising which is costly especially when there are established brand
names in the market.

Legal Barriers

A firm may have obtained its monopoly position through the acquisition of a patent or copyright. A
patent is granted to an inventor to allow him the exclusive right to produce the good or use the
production process that is patented. In the latter, potential firms cannot enter the market as they do not
have access to the technology. The aim of awarding patents is to promote research and development.
A copyright, which is similar to a patent, is granted on plays, textbooks, novels, songs, computer
software, and the like. Patents and copyrights are known as intellectual properties.

Control of Key Factor Inputs or Wholesale and Retail Outlets

If a firm controls the supply of some key factor inputs, it can deny access to these factor inputs to
potential firms which will make it difficult for them to enter the market. Similarly, if a firm controls
the outlets through which the good is sold, it can prevent potential firms from gaining access to
consumers which will make it difficult for them to enter the market.

3.3 Equilibrium of a Monopolistic Market

A monopolistic market is in short-run equilibrium when the monopoly is producing at the profit-
maximising output level as seen on the diagram below.

Unlike perfectly competitive firms, a monopoly can make supernormal profit in the long run. If a
monopoly is making supernormal profit, potential firms would like to enter the market. However, due
to high barriers to entry, they are unable to do so. Therefore, apart from normal profit, a monopoly can
make supernormal profit in the long run.

3.4 Advantages and Disadvantages of Monopoly

Advantages of Monopoly

Lower Price

Firms which reap more economies of scale are able to pass on their lower average costs of production
to consumers in the form of a lower price. As a monopoly is larger than a perfectly competitive firm, a
monopoly reaps more economies of scale than a perfectly competitive industry and hence the price
charged by a monopoly may be lower than the price that would be charged by perfectly competitive
firms operating in the same market.

In the above diagram, the monopoly price (PM) is lower than the perfectly competitive price (PPC).

Dynamic Efficiency

As a monopoly can make supernormal profit in the long run, it has the ability to engage in research
and development. Therefore, a monopoly may engage in research and development and hence be
dynamically efficient. Research and development will lead to product innovations and process
innovations. Product innovations will lead to higher product quality and better product features and
process innovations will lead to a better production technology and hence a lower cost of production
which may be passed on to consumers in the form of a lower price.

Price Discrimination

A monopoly is a price-setter and hence it may be able to practise price discrimination which may be
beneficial to consumers. Price discrimination may allow a firm to reach a market that otherwise would
not be reached or to produce a good that otherwise would not be produced. Price discrimination will
be explained in greater detail in Section 6. Furthermore, if the increase in profit from price
discrimination is ploughed back into research and development, more benefits to consumers will be
created.

Disadvantages of Monopoly

Productive Inefficiency

Recall that a firm is productively efficient when it produces on its long-run average cost curve, from
firm’s perspective. This occurs when it is x-efficient and technically efficient. A firm is x-efficient
when it is not lax in cost control. In other words, it uses the most efficient production technology, it is
not overstaffed, it does not occupy premises that are larger than necessary for its output level, etc. A
firm is technically efficient when it uses the least-cost combination of factor inputs to produce its
output level which means that the last dollar of each factor input that it employs produces the same
additional output. From society’s perspective, a firm is productively efficient when it produces at the
minimum efficient scale. Due to the absence of competition in the market, a monopoly may be lax in
cost control. Therefore, a monopoly may be x-inefficient and hence productively inefficient. However,
if a monopoly faces potential competition, it may be x-efficient and hence productively efficient to
prevent potential firms from entering the market. A monopoly may also be x-efficient and hence
productively efficient due to the pursuit of greater profit.

Allocative Inefficiency

Recall that a firm is allocatively efficient when it cannot change the allocation of resources in the
economy in a way that will increase the welfare of society. This occurs when it charges a price equal
to its marginal cost, assuming no externalities. When the price of a good is equal to the marginal cost,
the marginal benefit that consumers place on the last unit of the good is equal to the forgone marginal
benefit that they place on the amount of other goods that could have been produced using the same
resources. Therefore, the firm cannot change its output level to increase the total benefit for consumers
and hence is allocatively efficient. In monopoly, price is higher than marginal revenue and the firm
maximises profit by producing the output level where marginal revenue equals marginal cost.
Therefore, a monopoly charges a price higher than its marginal cost and is hence allocatively
inefficient.
Higher Price

Firms with greater market power are able to charge a higher price relative to their marginal cost
compared to firms with less market power. Unlike perfectly competitive firms that have no market
power, a monopoly has substantial market power and hence the price charged by a monopoly is higher
than the price that would be charged by perfectly competitive firms operating in the same market,
assuming the cost structure of a monopoly is the same as that of a perfectly competitive industry.

Dynamic Inefficiency

Although a monopoly has the ability to engage in research and development as it can make
supernormal profit in the long run, it may not have the incentive to engage in research and
development due to the absence of competition in the market. Therefore, a monopoly may not engage
in research and development and hence be dynamically inefficient.

Income Inequity

As a monopoly can make supernormal profit and perfectly competitive firms and monopolistically
competitive firms can make only normal profit in the long run, the distribution of income in an
economy that abounds with monopolistic markets will be less equitable than one that abounds with
perfectly competitive markets and monopolistically competitive markets.

Price Discrimination

A monopoly is a price-setter and hence it may be able to exploit consumers through price
discrimination. Price discrimination is commonly considered a form of consumer exploitation as it will
convert some of the consumer surplus to the producer surplus.

control of monopolies

Marginal Cost Pricing

The government can pass a pricing regulation that requires the monopoly to charge a price equal to its
marginal cost to achieve allocative efficiency, assuming no externalities, and this is known as marginal
cost pricing.

In the above diagram, marginal cost pricing leads to a fall in the price (P) from P M to PMC and an
increase in the output level (Q) from QM to QMC. As the price (PMC) is equal to the marginal cost
(MCMC), allocative efficiency is achieved. The output level (QMC) is equal to the allocatively efficient
output level (QAE). However, to make more profit, the monopoly may provide false information about
its cost structure to the government by overstating its marginal cost. If this happens, the use of
marginal cost pricing in a monopolistic market will not achieve allocative efficiency. Furthermore,
assuming the monopoly is unable to use a two-part tariff, marginal cost pricing will cause the
monopoly to make a loss represented by the shaded area as the price (PMC) is lower than the average
cost (AC) at QMC. Therefore, the government needs to give the monopoly a lump-sum subsidy to allow
it to cover its loss. However, if the government is unwilling or unable to do so, marginal cost pricing
will not be feasible.

Average Cost Pricing

In the event that marginal cost pricing is infeasible, the government can pass a pricing regulation that
requires the monopoly to charge a price equal to its average cost to reduce allocative inefficiency and
this is known as average cost pricing.
In the above diagram, average cost pricing leads to a fall in the price (P) from P M to PAC and an
increase in the output level (Q) from QM to QAC. As the difference between the price (P) and the
marginal cost (MC) decreases from (PM – MCM) to (PAC – MCAC), allocative inefficiency is reduced.
The output level (QAC) is closer to the allocatively efficient output level (QAE). However, although the
use of average cost pricing in a monopolistic market will reduce allocative inefficiency, it will not
achieve allocative efficiency.

Subsidy

The government can give a subsidy to the monopoly to achieve allocative efficiency. A subsidy will
lead to a fall in the cost of production. When this happens, the monopoly will increase output which
will reduce allocative inefficiency.

Nationalisation

Nationalisation refers to the conversion of a private firm to a state-owned firm. The government can
nationalise the firm to produce the good itself. In order to achieve allocative efficiency, it can charge a
price equal to its marginal cost. However, opponents of nationalisation argue that as state-owned firms
do not need to consider factors such as profitability and survival, they are likely to be x-inefficient and
hence productively inefficient. Therefore, although nationalisation can solve the problem of allocative
inefficiency, it is likely to create the problem of productive inefficiency.

4 MONOPOLISTIC COMPETITION

4.1 Characteristics of Monopolistic Competition

Large Number of Small Firms

In monopolistic competition, there are a large number of small firms each with a small market share.

Differentiated Products

In monopolistic competition, firms sell differentiated products that are close substitutes. Differentiated
products are products that are sufficiently similar to be distinguished as a group from other products.
An example is restaurant foods.

Price-setters

Monopolistically competitive firms are price-setters in the sense that they are able to set their prices by
setting their output levels. In other words, monopolistically competitive firms face a downward
sloping demand curve.

Low Barriers to Entry

In monopolistic, there are low barriers to entry which means that firms can make only normal profit in
the long run.

Note: As monopolistically competitive firms sell differentiated products, there are no market demand
and market supply curves in monopolistic competition. Therefore, the theory of monopolistic
competition is only analysed at the level of the firm.

4.2 Equilibrium of a Monopolistically Competitive Market


A monopolistically competitive market is in short-run equilibrium when the firms in the market are
producing the profit-maximising output level. However, this does not necessarily mean that they are
making positive economic profit. In the short run, a monopolistically competitive firm can make three
types of profit: supernormal profit (positive economic profit), normal profit (zero economic profit) and
subnormal profit (negative economic profit or economic loss).

Supernormal Profit

In the above diagram, at the profit-maximising output level (Q0) where marginal cost (MC) is equal to
marginal revenue (MR), average revenue (AR) is higher than average cost (AC). Therefore, the firm is
making supernormal profit represented by the shaded area.

Normal Profit

In the above diagram, at the profit-maximising output level (Q0) where marginal cost (MC) is equal to
marginal revenue (MR), average revenue (AR) is equal to average cost (AC). Therefore, the firm is
making normal profit.

Subnormal Profit

In the above diagram, at the profit-maximising output level (Q0) where marginal cost (MC) is equal to
marginal revenue (MR), average revenue (AR) is lower than average cost (AC). Therefore, the firm is
making subnormal profit represented by the shaded area.

If the firms in a monopolistically competitive market are making supernormal profit, potential firms
will enter the market in the long run due to low barriers to entry. As the number of firms in the market
increases, the demand for the good produced by each firm will decrease which will lead to a fall in the
price resulting in a fall in the profits of the firms. This process will continue until the firms in the
market make only normal profit.

In the above diagram, the supernormal profit represented by the shaded area induces potential firms to
enter the market in the long run, which leads to a leftward shift in the demand curve of each firm (D)
from D0 to D1. When this happens, the price (P) falls from P0 to P1. At P1, as the firms in the market
make only normal profit, the incentive for potential firms to enter the market disappears.

Note: The extent of barriers to entry in a market does not only determine the type of profit made by
firms in the long run, it also determines the number of firms in the market. For example, low barriers
to entry in monopolistic competition lead to a large number of firms in the market and high barriers to
entry in monopoly result in a single firm in the market.

4.3 Advantages and Disadvantages of Monopolistic Competition

Advantages of Monopolistic Competition

Productive Efficiency

Recall that a firm is productively efficient when it produces on its long-run average cost curve, from
firm’s perspective. This occurs when it is x-efficient and technically efficient. A firm is x-efficient
when it is not lax in cost control. In other words, it uses the most efficient production technology, it is
not overstaffed, it does not occupy premises that are larger than necessary for its output level, etc. A
firm is technically efficient when it uses the least-cost combination of factor inputs to produce its
output level which means that the last dollar of each factor input that it employs produces the same
additional output. From society’s perspective, a firm is productively efficient when it produces at the
minimum efficient scale. Due to competition in the market, monopolistically competitive firms are not
lax in cost control. Therefore, monopolistically competitive firms are x-efficient and hence
productively efficient.

Lower Price

Firms with greater market power are able to charge a higher price relative to their marginal cost
compared to firms with less market power. Monopolistically competitive firms have less market power
than a monopoly and hence the price charged by monopolistically competitive firms may be lower
than the price that would be charged by a monopoly operating in the same market. The price charged
by monopolistically competitive firms may also be lower than the price that would be charged by a
monopoly operating in the same market due to low barriers to entry which does not allow them to
charge a price higher than their average cost in the long run.

Income Equity

As monopolistically competitive firms can make only normal profit and monopolists and oligopolists
can make supernormal profit in the long run, the distribution of income in an economy that abounds
with monopolistically competitive markets will be more equitable than one that abounds with
monopolistic markets and oligopolistic markets.

Variety of Choices

Monopolistically competitive firms sell differentiated products which offer consumers a great variety
of choices. In contrast, perfectly competitive firms sell homogeneous products and hence offer
consumers no variety of choices.

Disadvantages of Monopolistic Competition

Allocative Inefficiency

Recall that a firm is allocatively efficient when it cannot change the allocation of resources in the
economy in a way that will increase the welfare of society. This occurs when it charges a price equal
to its marginal cost, assuming no externalities. When the price of a good is equal to the marginal cost,
the marginal benefit that consumers place on the last unit of the good is equal to the forgone marginal
benefit that they place on the amount of other goods that could have been produced using the same
resources. Therefore, the firm cannot change its output level to increase the total benefit for consumers
and hence is allocatively efficient. In monopolistic competition, price is higher than marginal revenue
and firms maximise profit by producing the output level where marginal revenue equals marginal cost.
Therefore, monopolistically competitive firms charge a price higher than their marginal cost and are
hence allocatively inefficient.

Higher Price

Firms which reap more economies of scale are able to pass on their lower average costs of production
to consumers in the form of a lower price. As a monopolistically competitive firm is smaller than a
monopoly, monopolistically competitive firms reap less economies of scale than a monopoly and
hence the price charged by monopolistically competitive firms may be higher than the price that would
be charged by a monopoly operating in the same market. Furthermore, firms with greater market
power are able to charge a higher price relative to their marginal cost compared to firms with less
market power. Unlike perfectly competitive firms, monopolistically competitive firms have market
power and hence the price charged by monopolistically competitive firms may be higher than the price
that would be charged by perfectly competitive firms operating in the same market.
Dynamic Inefficiency

Monopolistically competitive firms do not engage in research and development due to lack of ability
and hence are dynamically inefficient. Research and development will lead to product innovations and
process innovations. Product innovations will lead to higher product quality and better product
features and process innovations will lead to a better production technology and hence a lower cost of
production which may be passed on to consumers in the form of a lower price. However, research and
development requires high expenditure which monopolistically competitive firms are unable to
finance as they can make only normal profit in the long run.

5 OLIGOPOLY

5.1 Characteristics of Oligopoly

Small Number of Large Firms

In oligopoly, there are a small number of large firms each with a large market share.

Differentiated Products

Oligopolists generally sell differentiated products such as cars and electrical appliances. Some
oligopolists, however, sell homogeneous products such as cement and steel.

Price-setters

Oligopolists are price-setters in the sense that they are able to set their prices by setting their output
levels. In other words, oligopolists face a downward sloping demand curve.

High Barriers to Entry

In oligopoly, there are high barriers to entry which means that firms can make supernormal profit in
the long run.

Strategic Interdependence (also known as Mutual Interdependence)

In oligopoly, due to the small number of large firms and hence the large market share of each firm, the
actions of one firm affect and are affected by the actions of the other firms in the market, and this is
known as strategic interdependence. When an oligopolist changes its price, it will have a significant
effect on the other firms in the market. The rival firms will hence react by changing their prices which
will affect the first firm. Therefore, when an oligopolist makes pricing and output decisions, it must
take into consideration the reactions of the other firms in the market. In this sense, the pricing and
output decisions of an oligopolist depend on the behavior of competitors. An example of oligopoly is
the pharmaceutical market.

5.2 Collusive versus Competitive (non-collusive) Behaviour

Due to strategic interdependence, oligopolists may collude or compete.

Collusive Behaviour

Formal Collusion
Oligopolists can collude openly by having a formal collusive agreement and this is known as formal
collusion. Formal collusion typically takes the form of cartelisation. In cartelisation, the firms agree on
a common target price which is higher than the prices that they currently charge. To achieve the
common target price, the firms will agree on a set of output quotas to decrease production. A likely
method to decide on the set of output quotas is to divide the market according to the market shares of
the firms. There are certain factors that favour cartelisation. Cartelisation is more likely in a market
where there are no government measures to prevent collusion, there are a small number of firms, the
firms produce homogeneous products, the firms have the same cost structure, the demand is stable and
the barriers to entry are high which will prevent disruptions to the agreement by new firms.
Cartelisation is illegal in many countries. For example, the competition policy in Singapore and the
anti-trust laws in the United States prohibit attempts to distort competition.

Tacit Collusion

In countries where cartelisation is illegal, such as Singapore and the United States, oligopolists can
collude covertly without having a formal agreement and this is known as tacit collusion. Tacit
collusion typically takes the form of price leadership. In price leadership, the price leader will set the
price and the price followers will take the price set by the price leader. The price followers will also
follow any price increase or decrease by the price leader. The price leader may be the firm with the
largest market share which is called the dominant firm price leadership. The price leader may also be
the firm with the most information about the market conditions which is called the barometric firm
price leadership. Apart from price leadership, tacit collusion may also take the form of a rule of thumb.
An example is mark-up pricing. In mark-up pricing, which is also known as cost-plus pricing, a firm
sets its price by adding a certain mark-up for profit to its average cost. Firms may engage in tacit
collusion by following the same mark-up pricing.

Competitive Behaviour

If oligopolists collude, there will be price stability. At first thought, if they do not collude, price war
will be inevitable. However, price stability has been found to be an empirical regularity in most
oligopolistic markets, even in those where the firms do not collude. This phenomenon can be
explained by the theory of the kinked demand curve.

The theory of the kinked demand curve is based on two asymmetrical assumptions. First, if a firm in
an oligopolistic market increases its price, its rivals will not follow suit because by keeping their prices
the same, they can attract consumers from the firm. Accordingly, if a firm in an oligopolistic market
increases its price, its quantity demanded will decrease by a larger percentage as consumers will
switch from the firm to the rivals which will lead to a fall in revenue for the firm. Second, if a firm in
an oligopolistic market reduces its price, its rivals will follow suit to avoid losing consumers to the
firm. Accordingly, if a firm in an oligopolistic market reduces its price, its quantity demanded will
increase by a smaller percentage as consumers will not switch from the rivals to the firm, which will
lead to a fall in revenue for the firm. Therefore, oligopolists do not have the incentive to change their
prices, assuming no substantial changes in the cost of production.

The theory of the kinked demand curve can be illustrated with a diagram. A firm in an oligopolistic
market faces a demand curve that is kinked at the equilibrium and the kink on the demand curve leads
to a discontinuity on the marginal revenue curve.

In the above diagram, as the price (P) and the output level (Q) are P0 and Q0, the marginal cost (MC)
curve must be cutting the marginal revenue (MR) curve at the discontinuity. A change in the cost of
production will lead to a shift in the MC curve. However, as long as the MC curve lies between MC’
and MC”, the price will remain constant and this explains price stability in oligopolistic markets where
there is no collusion. In the event of a substantial change in the cost of production, the MC curve will
shift out of the range between MC’ and MC” which will lead to a change in the price and the output
level. If this happens, firms may plunge into a price war before they reach a new equilibrium and the
new demand curve will be kinked at the new equilibrium.

Although the theory of the kinked demand curve can explain price stability in the absence of collusion,
it does not explain how the price is set in the first place. Furthermore, price stability may be due to
other factors. For example, oligopolists may not want to change price too frequently to prevent
upsetting consumers.

5.3 Non-price Competition

Firms engage in non-price competition through product development and product promotion. Product
development will improve the quality and the features of the good and product promotion will increase
the awareness and the appeal. Product development and product promotion will lead to an increase in
the demand for the good. Furthermore, they will make the demand for the good less price elastic as the
good will become more different from its substitutes and this is known as product differentiation.
There are two types of product differentiation: real product differentiation and imaginary product
differentiation. Product development will lead to real product differentiation as it will result in
physical changes of the good. Product promotion will lead to imaginary product differentiation as it
will only affect the perception of consumers.

5.4 Advantages and Disadvantages of Oligopoly

Advantages of Oligopoly

Productive Efficiency

Recall that a firm is productively efficient when it produces on its long-run average cost curve, from
firm’s perspective. This occurs when it is x-efficient and technically efficient. A firm is x-efficient
when it is not lax in cost control. In other words, it uses the most efficient production technology, it is
not overstaffed, it does not occupy premises that are larger than necessary for its output level, etc. A
firm is technically efficient when it uses the least-cost combination of factor inputs to produce its
output level which means that the last dollar of each factor input that it employs produces the same
additional output. From society’s perspective, a firm is productively efficient when it produces at the
minimum efficient scale. As oligopolists face competition in the market, they are not lax in cost
control and this is true even in the presence of collusion as oligopolists which collude still face non-
price competition. Therefore, oligopolists are x-efficient and hence productively efficient.

Lower Price

Firms which reap more economies of scale are able to pass on their lower average costs of production
to consumers in the form of a lower price. As an oligopolist is larger than a perfectly competitive firm
and a monopolistically competitive firm, oligopolists reap more economies of scale than perfectly
competitive firms and monopolistically competitive firms and hence the price charged by oligopolists
may be lower than the price that would be charged by perfectly competitive firms and
monopolistically competitive firms operating in the same market.

Dynamic Efficiency

As oligopolists can make supernormal profit in the long run, they have the ability to engage in
research and development. Furthermore, competition gives them the incentive to engage in research
and development and this is true even in the presence of collusion as oligopolists which collude still
face non-price competition. Therefore, oligopolists engage in research and development and hence are
dynamically efficient. Research and development will lead to product innovations and process
innovations. Product innovations will lead to higher product quality and better product features and
process innovations will lead to a better production technology and hence a lower cost of production
which may be passed on to consumers in the form of a lower price.

Variety of Choices

Oligopolists generally sell differentiated products which offer consumers a variety of choices. In
contrast, perfectly competitive firms sell homogeneous products and hence offer consumers no variety
of choices.

Price Discrimination

Oligopolists are price-setters and hence they may be able to practise price discrimination which may
be beneficial to consumers. Price discrimination may allow a firm to reach a market that otherwise
would not be reached or to produce a good that otherwise would not be produced. Price discrimination
will be explained in greater detail in Section 6. Furthermore, if the increase in profit from price
discrimination is ploughed back into research and development, more benefits to consumers will be
created.

Disadvantages of Oligopoly

Allocative Inefficiency

Recall that a firm is allocatively efficient when it cannot change the allocation of resources in the
economy in a way that will increase the welfare of society. This occurs when it charges a price equal
to its marginal cost, assuming no externalities. When the price of a good is equal to the marginal cost,
the marginal benefit that consumers place on the last unit of the good is equal to the forgone marginal
benefit that they place on the amount of other goods that could have been produced using the same
resources. Therefore, the firm cannot change its output level to increase the total benefit for consumers
and hence is allocatively efficient. In oligopoly, price is higher than marginal revenue and firms
maximise profit by producing the output level where marginal revenue equals marginal cost.
Therefore, oligopolists charge a price higher than their marginal cost and are hence allocatively
inefficient.

In the above diagram, at the profit-maximising output level (Q0) where marginal cost (MC) is equal to
marginal revenue (MR), the price (P0) is higher than the marginal cost (MC0).

Higher Price

Firms with greater market power are able to charge a higher price relative to their marginal cost
compared to firms with less market power. Unlike perfectly competitive firms that have no market
power and monopolistically competitive firms that have little market power, oligopolists have
substantial market power and hence the price charged by oligopolists may be higher than the price that
would be charged by perfectly competitive firms and monopolistically competitive firms operating in
the same market. Furthermore, an oligopolist is likely to be smaller than a monopoly. Therefore,
oligopolists are likely to reap less economies of scale and hence charge a higher price than a
monopoly.

Income Inequity

As oligopolists can make supernormal profit and perfectly competitive firms and monopolistically
competitive firms can make only normal profit in the long run, the distribution of income in an
economy that abounds with oligopolistic markets will be less equitable than one that abounds with
perfectly competitive markets and monopolistically competitive markets.
Price Discrimination

Oligopolists are price-setters and hence they may be able to exploit consumers through price
discrimination. Price discrimination is commonly considered a form of consumer exploitation as it will
convert some of the consumer surplus to the producer surplus.

5.5 Market Concentration Ratio

The market concentration ratio, or simply known as the concentration ratio, is a measure of the
combined market share of a specified number of the largest firms in the market. It is calculated by
summing the market shares of a specified number of the largest firms in the market. The market share
of a firm is the domestic sales of the firm expressed as a percentage of the domestic sales of all the
domestic firms in the market. The concentration ratio can range from close to 0% to 100%.

It is commonly believed that the degree of competition in a market is directly related to the number of
firms. Although this is true to some extent, the number of firms in a market is not a perfect indicator of
the degree of competition. In a market where there are a large number of firms, the degree of
competition may be low if the bulk of the market share is concentrated in the hands of a few large
firms. To overcome this problem, economists use the concentration ratio to show the extent of market
control of a specified number of the largest firms in the market and hence the degree to which the
market is oligopolistic. A commonly used concentration ratio is the four-firm concentration ratio
(CR4). The four-firm concentration ratio (CR4) measures the combined market share of the four largest
firms in the market. A four-firm concentration ratio (CR4) of between 0% and 50% indicates low
market concentration and a market with low concentration may be monopolistic competition or an
oligopoly. In this range, the higher the concentration ratio, the more likely the market is oligopolistic
and vice versa. A four-firm concentration ratio (CR4) of between 50% and 80% indicates medium
market concentration and a market with medium concentration is likely to be an oligopoly. A four-
firm concentration ratio (CR4) of between 80% and 100% indicates high market concentration and a
market with high concentration may be an oligopoly or a monopoly. In this range, the lower the
concentration ratio, the more likely the market is oligopolistic and vice versa.

Apart from the four-firm concentration ratio (CR4), the one-firm concentration ratio (CR1) is also
commonly used. The one-firm concentration ratio (CR1) measures the market share of the largest firm
in the market. It is used to indicate the degree to which the largest firm in the market is monopolistic.
In the United Kingdom, the largest firm is considered a monopoly if the one-firm concentration ratio
(CR1) is 25% and above. Such a monopoly is commonly known as an actual monopoly as opposed to a
pure monopoly which is a single large firm in a market. In Singapore, the largest firm is considered a
dominant firm, which can be interpreted as a monopoly, if the one-firm concentration ratio (CR1) is
60% and above.

The concentration ratio is subject to several limitations. First, the concentration ratio does not provide
information about the distribution of the market shares among the specified number of the largest
firms in the market. For example, assuming the four-firm concentration ratio (CR4) in a market is 80%,
the degree of competition will be lower if one firm has 70% of the market share and the other three
firms have the remaining 10%, compared to the case where each of the four firms has 20% of the
market share. Second, the concentration ratio does not provide a comprehensive picture of the market
shares of all the firms in the market as only the market shares of the specified number of the largest
firms are included. In contrast, the Herfindahl-Hirschman index (HHI), which is another measure of
market concentration, takes into account the market shares of all the firms in the market. Third, the
concentration ratio does not capture all aspects of competition in the market. For example, it does not
capture any collusive behaviour among the firms in the market or potential competition. Fourth, the
concentration ratio does not take into account the domestic sales of foreign firms as it only includes
the domestic sales of domestic firms rather than the total domestic sales. The omission of imports from
the concentration ratio causes it to understate the degree of competition in the market. Fifth, the
concentration ratio is a national total but the relevant market may be regional or local due to the
characteristics of the good or high transport costs. If this happens, the concentration ratio will
overstate the degree of competition in the relevant market.

Note: The Herfindahl-Hirschman index (HHI) is another measure of market concentration. It is


calculated by squaring the market share of each firm in the market and then summing the results. The
HHI can range from close to zero to 10,000. The U.S. Department of Justice and the Federal Trade
Commission consider a market with an HHI of less than 1500 to be an unconcentrated market, a
market with an HHI of between 1500 and 2500 to be a moderately concentrated market and a market
with an HHI of greater than 2500 to be a highly concentrated market. .

6 PRICE DISCRIMINATION

6.1 Types of Price Discrimination

Price discrimination is the practice of using a pricing scheme more sophisticated than charging the
same price for each unit of a good to increase profit. According to Arthur Cecil Pigou, although
discriminatory pricing can take many forms, it can usefully be classified into three degrees: first-
degree, second-degree and third degree.

First-degree Price Discrimination

First-degree price discrimination is the practice of charging each consumer the highest price that they
are able and willing to pay for each unit of the good. Therefore, under first-degree price
discrimination, the consumer surplus is zero.

Second-degree Price Discrimination

Second-degree price discrimination is a pricing scheme where a certain price is charged for the first so
many units of a good for which there are no substitutes, a lower price for the next so many units, and
so on. Many public utility firms use block pricing..

Third-degree Price Discrimination

Third-degree price discrimination is the practice of charging different prices for the same good in
different markets. For example, cinema operators charge different prices for the same movies to
different groups of consumers. To practise third-degree price discrimination, a firm must be able to
identify at least two distinct markets which differ in terms of their price elasticities of demand. In
addition, it must be able to prevent consumers in the lower-priced market from reselling the good to
consumers in the higher-priced market which is known as arbitrage prevention

Note: For a firm to be able to practise price discrimination, it must have price-setting ability and this
is true for all types of price discrimination. Therefore, only a firm that operates in an imperfect market
may be able to practise price discrimination.

7 ALTERNATIVE OBJECTIVES OF FIRMS

Firms generally seek to maximise profit. However, some firms seek to maximise market share, sales
revenue and long-run profit.

Profit Maximisation

Firms generally seek to maximise profit for several reasons.


A firm generally seeks to maximise profit as it can be used to finance expansion of its scale of
production. A firm can expand its scale of production by ploughing back its profit into increasing its
production capacity. It can also expand its scale of production by using its profit to take over other
firms that produce the same good which is known as horizontal acquisition. Therefore, to ensure its
survival, it is imperative that a firm increases its cost-competitiveness to increase its price-
competitiveness.

A firm generally seeks to maximise profit as it can be used to make dividend payments to its
shareholders

Market Share Maximisation

A firm may seek to maximise market share. For example, if a firm is a new entrant, it may want to
maximise market share to compete with the incumbent firms. In this case, although profit will not be
maximised, the larger market share may ensure the survival of the new entrant.To maximise market
share, a firm will produce the output level where price is equal to average cost, assuming it wants to
make at least normal profit.

Sales Revenue Maximisation

A firm may seek to maximise sales revenue. For example, in many large firms today, there is a
separation between ownership and management. Although it may be in the interest of the shareholders
to have the management maximise profit and hence dividend, it may be in the interest of the
management to maximise sales revenue if it is the key performance indicator. To maximise sales
revenue, a firm will produce the output level where marginal revenue is equal to zero.

Long-run Profit Maximisation

A firm may seek to maximise long-run profit. For example, one of the potential problems of a
monopoly maximising profit is that the profit-maximising price may attract potential firms to enter the
market. If this happens, the profit of the firm will fall in subsequent periods. Therefore, to maximise
long-run profit, the firm may need to practise limit pricing which is a pricing strategy where a
monopoly charges a price below the profit-maximising price with the objective of preventing potential
firms from entering the market. In this case, although profit will not be maximised, long-run profit
may be maximised.

Note: Student should not confuse limit pricing with predatory pricing. Limit pricing is a pricing
strategy where a monopoly charges a price below the profit-maximising price with the objective of
preventing potential firms from entering the market. Predatory pricing is a pricing strategy where an
oligopolist charges a price below the profit-maximising price with the objective of driving competitors
out of the market.

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