Microeconomics - IntroductionEconomics involves the choices
people make when matching their limitless needs and wants with a
scarcity of resources. The word "economics" is derived from the
Greek words "oikos", which means house, and "nomos", which means
manager. So the term originally referred to management of the
household. Today, the term has been broadened to refer to firms and
all of society.
Another way of looking at economics is to consider the field as
a set of tools for analyzing people and groups and the choices that
they make. Accountants are trained to render an account of
financial activity for a company. Lawyers are trained into a
certain mode of thinking so as to resolve issues in a legal
framework. Similarly, economists are trained to use a set of tools
and principles to analyze why individuals, firms, governments and
other groups behave as they do.
ModelsEconomists often use models, which are representations of
what the economist wishes to analyze. If, for example, an economist
wishes to analyze the behavior of a labor union, the economist will
not try to include every possible aspect and piece of data about
labor unions in his or her model. Important factors will be focused
on, such as wages, benefits, alternative jobs, etc. Hopefully the
economist's model will include all of the important variables and
will give little or no weight to less critical variables.Most
economic analyses include the phrase "everything else is remaining
the same", so attention can be focused on the variables specified
by the model. Of course, this assumption is rarely true in real
life. If one were trying to analyze federal deficits and interest
rates, for example, there would be plenty of change during the time
period analyzed.
The CFA Level I ExamThe economics portion of the CFA Level I
exam touches on a wide range of economic theory. The material
covered would normally be taught in senior (or graduate level)
microeconomic, macroeconomic, money and banking, and international
trade courses. You will need to understand all of the material
presented here in order to successfully answer all of the questions
given. There will be a few questions that require the solution of
equations, particularly with regards to foreign exchange.
This section focuses on preliminary economic concepts you should
know for your upcoming exam. Note that your upcoming CFA Level 1
exam will not test directly on these basic concepts, but CFA
Institute notes that you should have a basic understanding of these
topics to ensure success on the more challenging topics that lie
ahead.
Microeconomics - Supply and DemandWhat is
Microeconomics?Microeconomics is the branch of economics which
looks at choices made by narrowly defined units, such as individual
buyers/consumers, and firms that produce goods.
Two of the most important principles used by economists are
theLaw of Supply and theLaw of Demand:
Law of SupplyThe law of supply says that, all other things
remaining equal, as the price of a good increases (decreases), the
quantity of that good supplied will increase (decrease).
Law of DemandThe law of demand states that, all other things
remaining equal, as the price of a good increases (decreases), the
quantity of that good demanded will decrease (increase).
Economists often use graphs as a way to demonstrate what is
being discussed. The laws of supply and demand can be represented
by a simple graph such as the one below.
Figure 3.1: Law of Supply and Demand
In figure 3.1, we can see that at the price of $1, the suppliers
are willing to provide one million widgets (Point A), while the
quantity demanded will be much higher - eight million (Point
B).
At a higher price, such as $5, suppliers will be willing to
provide six million widgets (Point D), while the quantity demanded
is only one million (Point E).
Finally, at the price of $3, the quantity demanded is equal the
quantity supplied (Point C). This price is also referred to as the
"market clearing" or equilibrium price because no suppliers are
left with the desire to provide goods at that price and no buyers
are left wishing to purchase the goods at that price either.Look
Out!Note that supply and demand curves depict a quantity supplied
or a quantity demanded at a particular price, all other things
remaining equal.
Change in Consumer Preference.Suppose there was a significant
change in consumer preferences. For example, consumers suddenly
have an increased desire for corn. This change in taste may be due
to a new health study touting the benefits of corn, alternative
grains such as wheat may have gotten more expensive, or corn
growers may have conducted an effective advertising campaign.
Regardless of the reason, the increase in demand results in a
greater quantity demanded at particular price levels. This is an
example of a demand shift.
Figure 3.2: Shift in the Demand Curve
In the graph above D0represents the original demand curve, while
D1shows the new demand curve. Note that at a particular price
level, such as $4, the quantity demanded increases from three
million to five million.
Suppose something happens where the quantity of a good supplied
changes at many particular price levels. For example, technological
changes might occur whereby computer memory manufacturers would be
able to produce a particular type of memory at a lower cost. So for
many price levels, the quantity suppliers are willing to provide
will increase. This situation could be diagrammed as below:
Figure 3.3: Shift of the Supply Curve
S0represents the original supply curve, while S1represents the
new supply curve. At the price of $30 per 256MB chip, the quantity
supplied will increase from three million to four million units per
month.
Supply and Demand MovementsChanges in quantity demanded strictly
as a function of price are referred to as movement along a demand
curve. A shift of the entire demand curve is referred to as a
change in demand; this could be due to any factor(s) that affects
demand, other than price.
Changes in quantity supplied strictly as a function of price are
referred to as movement along a supply curve. A shift of the entire
supply curve is referred to as a change in supply; this could be
due to any factor(s) that affects supply, other than price.Demand
Curve ShiftsSome of the factors that can cause a demand curve to
shift include:1. Change in income- If consumer incomes increase, we
might reasonably expect that demand for some luxury goods will
increase.2. Change in preferences/tastes- If a product becomes more
(less) liked, the quantity demanded will increase (decrease).3.
Change in prices of goods that are complimentary- If the price of
gasoline goes up substantially, the demand curve for large SUV's
should shift down.4. Changes in prices of goods that are
substitutes- If the price of pork increases (decreases), demand for
beef would likely increase (decrease).5. Advertising- An effective
advertising campaign could increase the quantity demanded of a
particular good. It could also decrease the demand for a competing
good.6. Expectations- If consumers expect a good to become more
expensive or hard to get in the future, it could alter current
demand7. Shifts in market demographics -As segments of the
population age or their composition changes, their demands also
change. Because segments are not equally distributed that is, there
are not a consistent number of people in every age category larger
segments have a more noticeable impact on demand. The baby boomers
are an excellent example of this.8. Distribution of income- For
example, if the rich get richer, and the poor get poorer, demand
for luxury goods could increase.
Supply Curve ShiftsFactors that would cause a shift in the
supply curve include:1. Cost- An increase in crude oil costs for a
plastic manufacturer would shift the supply curve up and to the
left. Changes in technology can dramatically decrease costs.2.
Government tax policy- Increases in business taxes will cause the
supply curve to shift up and to the left. A government subsidy to
producers will cause more supply to be available - the supply curve
will shift down and to the right.3. Weather/climate- Changes in
weather and/or climate will especially influence agricultural
product supply.4. Prices of substitute products- If farmers can
grow wheat instead of corn, and the price of wheat goes up, then
the supply curve for corn will shift up and to the left as more
farmers switch from corn to wheat.5. Number of producers- As the
number of firms/individuals producing a product increases, we would
expect more supply to be available.Short- and Long-Run Market
EquilibriumIn the short run, market equilibrium is achieved when
the quantity demanded is equal to quantity supplied and the market
clears. The market is said to be cleared because there is no
additional quantity supplied, or quantity demanded, at the market
clearing price.
However, that particular market price may not lead to
equilibrium in the long run. In the short run, producers do not
have time to fully adjust to current market conditions. Some
current producers may not be making a profit or covering all their
costs at the current market price. Producers in that situation will
consider leaving the industry, or at least will not allocate
further capital to that industry. If producers are making profits,
then we would expect more resources to be allocated to the industry
such as the building of additional factories. In the long run, all
factors of production can be varied.
Long-run equilibrium is something we expect the market to move
towards over time.The process could take years. It actually may
never be achieved because demand and supply curves are constantly
shifting.
Suppose there is an increase in demand, as shown by the graph
below.
Figure 3.4: Effects of a Shift in Demand
D0is the original demand curve, and D1is the new demand curve.
The market equilibrium price will increase from P0to P1, at least
in the short-run. The quantity will also increase from Q0 to
Q1.Over time, in a market economy, two forces will come into
play:1. Buyers will have an incentive to search for substitutes,
thereby decreasing their purchase of the original good; this effect
will tend to lower the quantity demanded and the market price2.
Suppliers will have an incentive to supply more of the good, and
more resources will be allocated towards production of this good;
this effect will tend to increase the quantity and lower the market
priceShortages and Surpluses and their Effect on Equilibrium
Prices.A "shortage" exists when the quantity demanded at the
current price is greater than the quantity supplied. In the case of
shortage, we would expect the market price to go up. In this case,
less motivated buyers do not purchase the good and producers have a
strong incentive to supply more at the higher market price. This
process will continue until the quantity demanded is equal to the
quantity supplied.A "surplus" exists when the quantity supplied is
greater than the quantity demanded. In this case, we would expect
the market price to go down. The lower market price entices more
consumers into buying, but lower profits create an incentive for
producers to reduce the quantity supplied.
Invisible Hand PrincipleMarket prices deliver information to
producers on how to allocate capital and other resources. Prices
tell producers about consumer needs and wants by showing them how
much consumers are willing to pay for a particular good or service.
Prices also inform consumers by sending signals about how much of a
given product is available.
These market prices act as an "invisible hand" that pushes
self-interested individuals toward the correct allocation of
resources, benefitting both the individuals and society as a whole.
No one person is consciously making these decisions.
Microeconomics - Price ElasticityNow that you have completed the
basics, let us move onto the various learning outcomes on
Microeconomics you should look to know for your upcoming exam.
Price ElasticityIn general, theelasticityof a particular
variable is the percentage change in quantity demanded or supplied,
divided by the percentage change in the variable of concern. This
ratio is often called the elasticity coefficient.
Price elasticityis defined as the percentage change in quantity
demanded divided by the percentage change in price.
The price elasticity of demand can be expressed as:Formula
3.1
Example: Price ElasticityWhere Epis the price elasticity
coefficient, %Q represents the percentage in quantity, and %P
represents the percentage in price. If the price of gasoline goes
up by 50%, and the quantity demanded decreases by 20%, the price
elasticity of gasoline would be:
Ep=% Quantity=-20%= -0.4% Price +50%
Typically, the negative sign is ignored and we would say that
the price elasticity of gasoline is 0.4.
To calculate elasticity we must first have data for quantities
purchased at different prices. Suppose that the price of a good
goes from P0to P1, and that we have data for the change in quantity
demanded, which goes from Q0to Q1. The calculation is typically
made by dividing the actual change by the average(or midpoint) of
the beginning and ending values. Suppose that the quantity demanded
of a good goes from 10 to 14. The percentage change in quantity
demanded could be expressed as:
(Q0- Q1)=4= 0.3330.5(Q0+ Q1) 0.5(24)
That number would be multiplied by 100 to get the percentage
change, which in this case would be 33.3%.Similarly, the percentage
change in price can be expressed as:
(P0- P1)x 1000.5(P0+ P1)Look Out!Sometimes the denominator used
for these percentage change calculations is simply the original
value (P0 and Q0). Because the CFA text uses the midpoint method,
unless the exam has instructions to the contrary, it would be safer
to use the midpoint method.
The full elasticity calculation can be simplified by canceling
out the 0.5 (one-half) and 100. The more simplified expression can
be stated as:
Example:Suppose, to continue the example given above, that the
change in quantity demanded for the good (10 to 14) was in response
to a price decrease from $8 to $7. In that case, the elasticity
would be expressed as:
(10 - 14) / (10 + 14)=-4 / 24=-1/6=-15= -2.5(8 - 7) / (8 + 7) 1
/ 15 1/15 6
Alternatively, the elasticity could have been calculated as: -4
divided by half of 24, which is equal to -0.333, over 1 divided by
half of 15, which equals 0.1333.
So the elasticity would be -0.333 over 0.133 = - 2.5, the same
answer as above.
The following definitions apply to calculations of price
elasticity:
1)If Ep> 1, Demand iselastic. The percentage change in price
will produce a greater percentage in quantity demanded. If the
price goes up, then total revenues will go down. If the price goes
down, then total revenues willincrease.
2)If Ep< 1, Demand isinelastic. The percentage change in
price will produce a lower percentage in quantity demanded. If the
price goes up, then total revenues will go up. If the price goes
down, then total revenues will decrease. Put simply, these changes
will be less drastic than if demand is elastic.
3)If Ep= 1, Demand has unitary elasticity. A percentage in price
will produce the exact same percentage change in quantity.
Therefore, changes in price will no have effect on total
revenues.If demand is elastic for a product, then a small change in
price will cause a large change in quantity demanded. If the demand
for a product is inelastic, even a large change in price might
cause little change in quantity demanded.
Microeconomics - Elasticity of DemandDeterminants of price
elasticity include: Availability of substitutes - if substitutes
are plentiful, then demand should be elastic. Relative percentage
of expenditure - if an item takes up a considerable proportion of a
consumer's income, then demand should be elastic; if it takes up a
very small amount, then demand should be expected to be inelastic.
Amount of time - consumers can make more adjustments to prices
changes over time and, therefore, demand tends to be more elastic
as time passes. Necessities or luxuries - demand for necessities
will tend to be inelastic, while demand for luxuries will tend to
be elastic.Cross Elasticity of DemandCross elasticity of demand
relates the percentage change in quantity demanded of a good to the
percentage change in price of a substitute or complementary good.
Examples of complementary goods would include peanut butter and
jelly, and large SUVs and gasoline. The cross elasticity of demand
will be positive for a substitute, and negative for a complement;
i.e. demand for a substitute (complement) will go up (down), if the
price of the substitute (complement) goes up.
The following formula can be used to calculate cross-elasticity
of demand:Formula 3.2
Where: CEpis the cross-price elasticity coefficient,%Q
represents the percentage change in quantity demanded, and%P
represents the percentage change in price of the substitute or
complement.
Income ElasticityIncome Elasticityis defined as the percentage
change in quantity demanded divided by the percentage change in
income. The calculations are similar to those for price elasticity,
except that the denominator would include a change in income
instead of a change in price.
Usually the amount of goods purchased will be positively
correlated with income; if consumers' incomes go up (down), more
(less) goods will be purchased. Any good with a positive income of
elasticity of demand is said to be a normal good. Luxury goods have
high income elasticity (greater than one). The proportionate amount
of spending for those goods will go up as incomes increase.
The amount spent on some goods decrease as incomes goes up. Such
goods are referred to as inferior goods. Examples of inferior goods
include margarine (inferior to butter) and bus travel (inferior to
owning a vehicle).Microeconomics - Elasticity of SupplySupply
elasticityis defined as the percentage change in quantity supplied
divided by the percentage change in price. It is calculated as per
the following formula:
Formula 3.3
The calculation of elasticity of supply is comparable to the
calculation of elasticity of demand, except that the quantities
used refer to quantities supplied instead of quantities
demanded.Factors that influence the elasticity of supply include
the ability to switch to production of other goods, the ability to
go out of business, the ability to use other resource inputs and
the amount of time available to respond to a price change.
Over a short time period, firms may be able to increase output
only slightly in response to an increase in prices. Over a longer
period of time, the level of production can be adjusted greatly as
production processes can be altered, additional workers can be
hired, more plants can be built, etc. Therefore, elasticity of
supply is expected to be greater over longer periods of time.
We would expect the supply elasticity of wheat to be very high
as farmers can easily switch land that is used for wheat over to
other crops such as corn and soybeans. On the other hand, an oil
refinery cannot easily switch its production capacity over to
another product, so low oil-refining margins do not reduce the
quantity supplied by very much. Due to high capital costs, higher
refining margins do not necessarily induce much greater supply. So
the supply elasticity for oil refining is fairly low.Microeconomics
- Marginal Benefit and Marginal CostWithin this section we will
focus on determining the difference between marginal benefit and
marginal cost, as well as how to calculate the efficient
quantity.
Consumer ChoiceEconomic analysis generally assigns the following
properties to consumers: Consumers make rational decisions. If two
products are of equal benefit to a consumer, then he or she will
choose the cheaper product. If two products are the same price, the
consumer will choose the one that provides the higher benefit.
Limited income enforces choice. Consumers have to make choices as
to what goods will be purchased or not purchased. Purchasing one
item means that less funds are available to purchase other items.
Substitution of goods. Consumers can achieve satisfaction, which is
generally referred to asutility, with many choices. The
satisfaction and cost of a cheeseburger can be evaluated in
comparison to other goods - such as hot dogs. TheLaw of Diminishing
Marginal Utility. This law refers to marginal utility, which
describes the increase in satisfaction from consuming one
additional unit of the good. The Law of Diminishing Marginal
Utility states that as each additional unit of a good is consumed,
the amount of marginal (incremental) utility will
decrease.Economists believe that consumers make decisions at the
margin; i.e. should one more unit of the good be obtained or not?
The consumer will compare the additional (marginal) utility to be
achieved by consuming one more unit of the good, to the additional
(marginal) utility that must be given up (buying power) in order to
obtain the good. At any particular price, the consumer will
continue to buy units of the good as long as the marginal benefit,
as expressed by maximum willingness to pay, exceeds the price. The
marginal benefit indicates, in dollar terms, what the consumer is
willing to pay to acquire one more unit of the good; it can also be
related to the height of an individual's demand curve. Another
implication of the Law of Diminishing Marginal Utility is that the
height of the demand curve will fall as more units of the good are
consumed.
Another implication of marginal utility theory is that for
consumers to maximize utility, the following relationship
holds:
MUa=MUb=MUc= and so on...PaPbPc
MU refers to marginal utility of the good, P represents the
price of the good, and the subscripts indicate a particular good.
The last unit of each good purchased will provide the same marginal
utility per dollar spent on that good.The term marginal cost refers
to theopportunity costassociated with producing one more additional
unit of a good.Opportunitycost is a critical concept to economics -
it refers to the value of the highest value alternative
opportunity. For example, in examining the marginal cost of
producing one more bushel of wheat, that number could be expressed
as the dollar value of corn or other goods that could be produced
in lieu of more wheat.
Marginal benefit refers to what people are willing to give up in
order to obtain one more unit of a good, while marginal cost refers
to the value of what is given up in order to produce that
additional unit. Additional units of a good should be produced as
long as marginal benefit exceeds marginal cost. It would be
inefficient to produce goods when the marginal benefit is less than
the marginal cost. Therefore an efficient level of product is
achieved when marginal benefit is equal to marginal cost.
Consumer Surplus and Marginal BenefitConsumer surplusrepresents
the difference between what a consumer is willing to pay and the
actual price paid. If a consumer is willing to pay $5.00 for a
gallon of gasoline, and the actual price is $3.00, then there is a
consumer surplus of $2.00 with the purchase of that gallon of
gasoline. The value to the consumer, or marginal benefit, is $5.00.
Value is calculated by getting the maximum price that consumers are
willing to pay.
We expect consumers to continue purchasing units of a good as
long as the marginal benefit exceeds the price paid; i.e., as long
as there is a consumer surplus to be achieved.
Microeconomics - Market EfficiencyMarginal (orOpportunity) Cost
and the Minimum Supply PriceThe supply curve (see figure 3.3)
represents the quantities of a particular good that producers are
willing to supply at various price points. For any particular
quantity, the height of the supply curve represents the minimum
price that suppliers of a good must get in order to supply the
additional unit. That minimum supply price must cover the increase
in total costs, or marginal cost, of producing the additional unit.
The opportunity cost represents the value of other goods that may
have been produced with the resources used. Producers must receive
a price at least equal to their opportunity cost.
Producer surplus is defined as the difference between what a
producer actually receives (which will be the market price) for a
product and the producer's minimum supply price (marginal cost) for
that product. If a producer is willing to provide a unit of a good
for $3.00, and actually gets $4.00, then the producer would have
$1.00 of producer surplus.
Consumer Surplus, Producer surplus, and Equilibrium.We expect
consumers to keep consuming additional units of a good until the
marginal benefit no longer exceeds the price, or there is no longer
an increase in consumer surplus. Producers will continue to provide
additional units of a good up to the point where the market price
no longer exceeds their minimum supply price.
The marginal benefit for all people in a society can be
described as the marginal social benefit. Similarly the marginal
costs for all producers in a society of a good can be described as
the marginal social cost. At market equilibrium, the marginal
social benefit of consuming an additional unit of a good is just
equal to the marginal social cost of producing the additional
unit.
In the figure 3.5 below, the triangle defined by the points
P2PmQmrepresents consumer surplus, while the triangle defined by
points P1PmQmrepresents producer surplus.
Figure 3.5: Consumer and Producer Surplus
How Resources Move Toward Their Most Efficient AllocationIn
economics, a market is efficient if the maximum amount of goods and
services are being produced with a given level of resources, and if
no additional output is possible without increasing the amount of
inputs. Efficient markets ensure optimal resource utilization by
allowing for price to motivate independent actors in the economy.
If buyers and sellers are free to choose how to allocate resources,
prices will direct resources towards those who value them most and
can utilize them most effectively.
Suppose consumer preferences change so that good A is now more
desired than good B. We would expect the price of good A to shift
higher and the price of good B to shift lower. This in turn will
induce the production of additional units of good A and the
devotion of more input resources to good A, while similarly
decreasing production of B and its associated input resources.
In the real world today we have seen higher oil prices stimulate
more drilling for oil and more investment in oil substitutes. The
wage rates of mainframe programmers in the United States has
decreased over the last several years in comparison to the year
2000, as there less of a need for their services. The lower wage
rates have induced more mainframe programmers to retrain themselves
with other computer skills, or to leave the field.
Obstacles to achieving efficiency include:
Price Ceilings/Floors- Sometimes governments impose price
ceilings, which define a maximum price, or price floors, which
define a minimum price. Effective price ceilings or floors prevent
normal market equilibrium.Public Goodsare goods available to
everyone, even if they don't pay. Examples include police
protection and public parks. One reason competitive markets don't
produce the optimum amount of a public good is due to the
"free-rider" problem: those who don't pay get a "free ride" with
regards to getting the benefit.
Externalitiesreflect costs and benefits not borne by the person
or firm making the economic decision, which are imposed on or
granted to others. Runoff from large cattle feedlots can damage
nearby farms, and this potential cost may not be considered by
feedlots when they look at their supply curve. A landowner who
chooses not to develop her land may benefit several other homes for
purposes of flood control. The benefit to others may not be taken
into account when deciding to develop the land.
Taxeslead to lower quantities produced, higher prices for buyers
and lower effective prices for sellers.
Subsidiesincrease the quantity produced, lower prices for buyers
and increase seller prices.
Quotaslimit the quantity that can be produced.
High transaction costsreduce the price that customers are
willing to pay and increase supplier costs, leading to an
equilibrium quantity that is lower than either party would desire
absent the higher costs.
Asynchronous informationcreates a perceived cost for buyers and
sellers if they cannot adequately evaluate a proposed transaction.
Drug companies can charge premium prices for pharmaceuticals due in
part to the established evidence that the drug works. Auto makers
entering new markets often have to offer lower prices and/or better
warranties because customers do not have sufficient information
about the new brands.
Discriminationdeprives market participants of the ability to
conduct business at prices that otherwise be acceptable to them.
Businesses that discriminate against certain types of job-seekers
may have to pay more for labor, while customers that discriminate
against a business may have to pay more for goods.
Amonopolymeans that only one firm can provide a certain good or
service. A monopolist will charge a higher price and produce a
lower quantity in comparison to a competitive market.
With the exception of the above-mentioned obstacles, a
competitive market will use resources efficiently. Goods are
produced up to the point where the marginal benefit is equal to the
marginal cost, and the sum of consumer and producer surplus is
maximized.
Although price is the dominant means of allocating resources in
a market economy, it is not the only way for markets to allocate
resources. A command economy relies upon a central planning
authority to allocate resources. Markets can also allocate
resources by majority rule (citizens vote on the desired allocation
of resources), lottery, or force and theft.
The Fairness Principle, Utilitarianism, and the Symmetry
PrincipleEconomists often like to examine the "fairness" of a
situation or economic system. Ideas about fairness can be lumped
into one of two categories:
"Results" must be fair. "Rules" must be fair.
Utilitarianism, which is a moral philosophy developed in 18thand
19thcentury Great Britain, posits that an action is correct if it
increases overall happiness for the performer of the act and those
affected by the act. Utilitarians argued that income should be
transferred from the rich to the poor until complete equality was
achieved.
One problem with utilitarianism is the tradeoff between fairness
and inefficiency. An effort to transfer wealth by heavily taxing
rich people will decrease incentives for people to save money or
work hard. This can lead to inefficient uses of capital and labor.
Another source of inefficiency is the administrative cost of
transferring money from the rich to the poor.
Thesymmetry principleis based on the intuitive principle that
people in similar situations should be treated the same. From an
economic perspective, we would like to achieve equality of
opportunity. The symmetry principle adheres to the viewpoint that
"rules" must be fair.
Microeconomics - Price Ceilings and FloorsPrice CeilingsIf the
price ceiling is above the market price, then there is no direct
effect. If the price ceiling is set below the market price, then a
"shortage" is created; the quantity demanded will exceed the
quantity supplied. The shortage may be resolved in many ways. One
way is "queuing"; people have to wait in line for the product, and
only those willing to wait in line for the product will actually
get it. Sellers might provide the product only to family and
friends, or those willing to pay extra "under the table". Another
effect may be that sellers will lower the quality of the good sold.
"Black markets" tend to be created by price ceilings.
Figure 3.6: Effect of Price Ceilings
Figure 3.6 illustrates the shortage that occurs when a price
ceiling is imposed on suppliers. Consumers demand QDwhile Suppliers
are only willing to supply QS. If the price ceiling is set above
the equilibrium; consumers would demand a smaller quantity than
suppliers are producing.
Economic Efficiency: Black Vs. Legal MarketsLegal systems
provide various benefits to economic systems.
Economic efficiency may be said to occur when an action creates
more benefits than costs. Legal systems help economic systems
become more efficient by reducing risks to economics participants.
Risk represents a cost that must be compensated for by higher
charges.One risk reduced by government regulation is theft.
Government protects the property rights of owners so that they can
benefit from the assets they own and use them in an efficient,
economic manner. Participants in a "black market system" face a
high risk of theft in their transactions as well as exposure to
other forms of violence.
Governments often also provide a regulatory framework for the
safety of products. In a market operating within a legal system,
purchasers of drugs have a reasonable expectation about the quality
of the drugs and the expected benefits of the drugs. Participants
in a black market for drugs will have incomplete information about
the quality of drugs purchased and, therefore, appropriate
decisions are more difficult to make.
Price Floors.When a "price floor" is set, a certain minimum
amount must be paid for a good or service. If the price floor is
below a market price, no direct effect occurs. If the market price
is lower than the price floor, then a surplus will be generated.
Minimum wage laws are good examples of price floors. In many
states, theU.S. minimum wage law has no effect, as market wage
rates for low-skilled workers are above theU.S.minimum wage rate.
In states where the minimum wage is above the market wage rate, the
law will increase unemployment for low-skilled workers. Although
some low-skilled workers will get higher pay, others will lose
their jobs.Microeconomics - Effect of Taxes on Supply and
DemandTaxes reduce both demand and supply, and drive market
equilibrium to a price that is higher than without the tax and a
quantity that is lower than without the tax.
Actual and Statutory Incidence of TaxTax authorities usually
require either the buyer or the seller to be legally responsible
for payment of the tax.Tax incidenceis the way in which the burden
of a tax is shared among the market participants ("who bears the
cost?"). Taxes will typically constitute a greater burden for
whichever party has a more inelastic curve e.g., if supply is
inelastic and demand is elastic, the burden will be greater on the
producers.
Suppose that a state government imposes a tax upon milk
producers of $1 per gallon.
Figure 3.7: Incidence of Tax
Figure 3.7 shows the original price for milk was $2 per gallon.
After imposition of the tax, the supply curves shift up and to the
left. Consumers pay $2.60 per gallon. Sellers receive $1.60 per
gallon after paying the tax. So sixty cents of the tax is actually
paid by consumers, while forty cents is paid by the milk
producers.
The triangle ABC above represents thedeadweightloss due to
taxation, which occurs because now there are fewer mutually
beneficial exchanges between buyers and sellers. Deadweight loss
stems from foregone economic activity and is a loss that does not
lead to an offsetting gain for other market participants; it is a
permanent decrease to consumer and/or producer surplus.
Elasticity of Supply and Demand and the Incidence of TaxIf
buyers have many alternatives to a good with a new tax, they will
tend to respond to a rise in price by buying other things and will,
therefore, not accept a much higher price. If sellers easily can
switch to producing other goods, or if they will respond to even a
small reduction in payments by going out of business, then they
will not accept a much lower price. The incidence of the tax will
tend to fall on the side of the market that has the least
attractive alternatives and, therefore, has a lower
elasticity.Cigarettes are one example where buyers have relatively
few options; we would therefore expect the primary burden of
cigarette taxes to fall upon the buyers.
Asubsidyshifts either the demand or supply curve to the right,
depending upon whether the buyer or seller receives the subsidy. If
it is the buyer receiving the subsidy, the demand curves shifts
right, leading to an increase in the quantity demanded and the
equilibrium price. If the seller receives the subsidy, the supply
curve shifts right and the quantity demanded will increase, while
the equilibrium price decreases.
Aquotalimits the amounts of a good that can be produced. If the
quota is greater than what would be produced under normal market
conditions, then it will have no effect. If the amount is less,
than the market equilibrium that is achieved will be at a higher
price than what would occur without the quota, as consumers will be
willing to pay more.
Making a good or service illegally impacts demand, supply and
market equilibrium by imposing a cost (prosecution and punishment)
on the buyer or seller (or both) of the good/service. Quantities of
illegal goods will always be less than if they were legal, but the
impact on price is determined by whether the buyer or seller (or
both) is punished. If the only the buyer is penalized, the
equilibrium price will be lower; the risk of punishment is regarded
by buyers as a cost, and reduces the price they will pay to the
seller. If the seller is penalized, the equilibrium price will be
higher as the cost of punishment is factored into the seller's
cost. Prices will remain relatively unchanged if the risk and cost
of punishment is shared equally.Microeconomics - Opportunity
CostsExplicit CostsExplicit costs reflect monetary payments made to
resource owners. Examples include wages, lease payments and
interest payments.
Implicit Costs.Implicit costs are those associated with
resources used by the firm, but with no direct monetary payment.
For example, there may not be an explicit monetary payment
associated with the work efforts of a sole proprietor; however,
there is an implicit cost associated with those work efforts as the
sole proprietor could earn wages elsewhere. For a firm's capital,
there is an implicit cost involved as the firm could be getting
interest or earning a rate of return elsewhere. The implicit cost
associated with the highest-valued alternative opportunity is
referred to as theopportunity cost.
On the reverse side, particularly for an individual, there may
be forms of implicit ("psychic") revenues; for example, a person
may particularly enjoy "being his own boss".
Economic ProfitEconomic profit is equal to total revenues less
both implicit and explicit costs. For a firm to stay in business,
both implicit and explicit costs must be covered. If firms are
receiving a negative economic profit in a market, they will leave
that market. A normal profit rate exactly covers wage costs and the
competitive rate of return on capital.Accounting Profits.Accounting
profits are generally higher than economic profits, as they omit
certain costs, such as the value of owner-provided labor and the
firm's equity capital.
When calculating "economic profit", explicit and opportunity
costs are taken into account.
Example:Suppose someone owns and runs a candy store that grosses
$20,000 per month and has operating expenses of $14,000 per month.
The store owner particularly enjoys socializing with the customers;
this aspect of the business provides a comfort to the owner which
is worth $2,000 a month to her. The owner could receive $3,000 a
month in interest with the capital that is tied up in the store's
inventory. She could earn $5,000 a month at a different job.
An income statement would show an accounting profit of $6,000 a
month:
Explicit Revenues$20,000
Explicit Costs$14,000----------Accounting Profit$ 6,000
Answer:The economic profit, which should determine the economic
decision, would be calculated as follows:
Explicit Revenues$20,000
Implicit Revenue(value of socialization)$ 2,000- - - - -
-Economic Revenues$22,000Explicit Costs$14,000
Implicit Costs:Value of owner's labor$5,000Required rate of
return oninventory investment$3,000- - - - - -Economic
Profit($2,000)
From an economic viewpoint, keeping the candy store open does
not make sense. The implicit value of enjoying being with the
customers is not of sufficient value in comparison to the fact that
the store owner could make more money by working elsewhere and
employing the capital elsewhere.
Microeconomics - Achieving Economic & Technological
EfficiencyFirm ConstraintsConstraints on a firm include:
Information- firms will not have complete information regarding
strategies of competitors, ethics of their workers, customer buying
plans, forthcoming technologies and many other factors that affect
firm profitability. Acquiring relevant information can be costly,
so benefits and costs of acquiring information must be weighed.
Market- prices firms charge will be impacted by the offerings of
other firms. Firms are in competition with other firms for
resources such as employees and raw materials. Market constraints
limit what firms can charge and enforce pricing on the input side.
Technology- economists view technology as the methods and processes
that firms use to produce goods and/or services. There is a
"technology" associated with any business, and the set of available
technologies will limit what a firm can do and impact its
profit.Technological vs. Economic EfficiencyTechnological
efficiency relates quantities of inputs to the quantity of output,
while economic efficiency relates the dollar value of inputs to the
dollar value of output. A firm would be operating with
technological efficiency when it produces a certain level of output
with the least amount of input. Economic efficiency would be
achieved when a certain level of output is produced with the lowest
cost of inputs.
Suppose there are two available methods to produce widgets, one
that is highly automated with industrial robots, and a mostly
manual one that requires significantly more workers. The automated
method costs $50,000 per month to produce 1,000 widgets over a
monthly period, using three robots and one worker. The manual
method costs $40,000 per month to produce 1,000 widgets over the
same time period, with 10 workers that have a minimal amount of
tools. We can't say that either method is technologically
inefficient - the automated method requires fewer workers, while
the manual method requires less capital for the same quantity of
output. However, we can say that the manual method is economically
efficient, since it produces 1,000 widgets at the lower cost.
Ways to Organize ProductionThere are two broadly defined methods
of organizing production. A command system utilizes a hierarchical
organization whereby commands flow down from the top of the
organization. Armies typically are organized by this method. An
incentive system tries to provide market-like incentives to each
layer of the organization. Sales organizations predominantly use
incentive systems. Incentives also can be provided to personnel,
such as assembly line workers, by relating pay to certain
production targets.
The Principal-Agent ProblemThe principal-agent problem is an
example of incomplete and asymmetric information. Principal-agent
problems occur when the principal (buyer) has less information than
the agent (supplier). For example, a patient at a hospital has much
less information about the medical treatments being conducted than
the doctors. The patient would prefer to have the illness resolved
at the lowest possible cost to him. The doctors may be facing
pressures or may be influenced by incentives that are not in the
best interests of the patient. It is difficult for the patient to
judge the quality of his or her own treatment.Owners (shareholders)
of firms face similar problems. The owner (principal) compensates
an agent (an employee) to perform acts that are useful to the
principal, costly (or otherwise undesirable) to the agent, and
where performance is costly or difficult to observe. Because of the
difficulty/cost of observing the work, the principal finds it
difficult to assess the agent's competence and achievements and
adjusting compensation accordingly. Likewise, there is an inherent
conflict of interest at work the principal seeks to gain maximum
output for minimum compensation, while the agent seeks to maximize
compensation and minimize output.
A firm can reduce principal-agent problems by giving the agent
an ownership stake in the enterprise, incentive compensation and/or
a long-term employment contract. These serve to give the agent a
vested interest in the overall health of the enterprise and align
the interests of the principal and the agent.
Types ofBusiness Firms:
ProprietorshipsProprietorships are businesses owned by a single
individual (or sometimes a family). Risks and rewards for the
business are the responsibility of that one individual. Note that
the sole proprietor is legally responsible for the debts of the
business.
PartnershipsPartnerships are businesses that have two or more
people acting as co-owners of the business. Agreements are made
beforehand as to how to share the risks and rewards. As with
proprietorships, owners are personally responsible for all debts
associated with the business. Law firms and accounting firms are
organized often as partnerships.
CorporationsCorporations are businesses that have been granted a
charter so that they are recognized as separate legal entities.
Individuals in a corporation are not subject to the liabilities of
the firm; the most that they can lose is the amount they invested.
Taxes are paid, assets are acquired and contracts are entered into
n the name of the corporation. Corporations generally have easier
access to capital than proprietorships or partnerships.
Major factors promoting cost efficiency and customer service
within the corporate world include:
1.The threat of takeover-Inefficient corporate management can
attract the interest of outsiders, who will try to take over of the
corporation with the intent of running the corporation more
efficiently, so as to increase shareholder value. The takeover
company most likely would remove the current management. The threat
of such a takeover gives management an incentive to serve the
interests of corporate shareholders.
2. Competition for capital and customers- Poor management will
tend to drive the price of a company's stock down, which will tend
to make raising more capital difficult. An efficient and/or
innovative management will tend to cause the price of a company's
stock to go up, which will make raising additional capital easier.
The corporation's products must be competitive, in terms of both
price and quality, in order to attract customers. The production of
inferior goods will tend to drive customers away, which will
decrease corporate revenues. Therefore, competitive forces tend to
limit the ability of management to serve their own needs in lieu of
stockholder and customer needs.
3. Management compensation -Compensationcan be set up so that
management incentives are in line with those of the corporation.
For example, a significant amount of executive compensation can be
in the form of stock options, which are of value only when a
certain stock price is met.
Microeconomics - Types of Markets & Concentration
MeasuresPrice Taker MarketsA purely competitive (price taker)
market exists when the following conditions occur:
Low entry and exit barriers - there are no restraints on firms
entering or exiting the marketHomogeneity of products - buyers can
purchase the good from any seller and receive the same goodPerfect
knowledge about product quality, price and costNo single buyer or
seller is large enough to influence the market price
Sellers must take the existing market price and they will adjust
the quantity of their products so as to maximize profit at the
market price. Because sellers must take the current market price, a
purely competitive market also is called a "price takers"
market.
Price-Searcher MarketsPrice-searcher markets are characterized
by:
1.Barriers to Entry2.Firms in the Markets that have
Downward-Sloping Demand Curves
While perfectly competitive markets have a homogeneity of goods,
price-searcher markets have a differentiation of goods. The
differentiation could be in the form of location, taste, packaging,
design, quality and many other factors. Some textbooks use the
phrase "monopolistic competition" to describe markets where each
firm has something unique about its product while facing
significant competition. A good example would be a gas station.
Although there are many competing gas stations, an individual gas
station is the only one at its particular location and, therefore,
to some degree it has a monopoly or is a sole seller. The CFA text
prefers the term "competitive price searcher".
Firms in a price-searcher market with low barriers to entry have
some flexibility to raise prices, as they will not lose all their
customers if they do so. For example, if Valvoline raises the price
of its motor oil, some people will be willing to pay the price for
the motor oil they prefer. However, rival firms such as Pennzoil or
Castrol also provide similar motor oils. As Valvoline raises its
prices, many customers will switch to rival suppliers. The demand
curve faced by firms in competitive price search markets, such as
motor oil, will be highly elastic.
Firms in price-searcher markets with low barriers to entry face
competition from existing suppliers and potential new entrants. If
economic profits are being made in the market, then more firms will
be expected to enter the market. Price searchers can set their
prices, but the actual quantities sold will depend upon market
forces.
MonopolyMonopoly refers to a "single seller". The single seller
will have a market with no well-defined substitute. The monopolist
does not need to worry about the reactions of other firms. Utility
companies are often monopolists in particular markets.
ConcentrationConcentrationwithin an industry refers to the
degree to which a small number of firms provide a major portion of
the industry's total production. If concentration is low, then the
industry is considered to be competitive. If the concentration is
high, then the industry will be viewed as oligopolistic or
monopolistic. Government agencies such as the U.S. Department of
Justice examine concentration within an industry when deciding to
approve potential mergers between industry firms.The most common
measure of concentration is thefour-firm concentration ratio, which
is defined as the percentage of the industry's output sold by the
four largest firms. An industry with a four-firm concentration
ratio of forty percent is generally considered to be
competitive.
TheHerfindahl-HirschmanIndex (HHI)calculates concentration
ratios by squaring the market share of the fifty largest firms in
an industry. The formula can be expressed as follows:
Formula 3.4
HHI = s12+ s22+ s32+ ... + sn2
(where snis the market share of the ithfirm).
A monopoly would have the largest possible value - 1002= 10000.
The HHI for a highly fragmented industry would be close to zero.
The Justice Department generally considers an industry with an HHI
above 1800 to be highly concentrated.
Limitations of Concentration MeasuresConcentration ratios have
some of the following limitations:
Foreign production concentration ratios often fail to fully
incorporate the revenue from foreign companies, thus overestimating
the concentration of a domestic industry and underestimating the
impact of foreign goods on competition.
Ease of entry an industry may have relatively few participants,
but low barriers to entry. In such cases, a concentration ratio
will overstate the power of current suppliers.
Elasticity of demand concentration ratios do not factor in the
elasticity of demand and the availability of substitutes. Many
highly-concentrated industries (metals, airlines, et al) are
constrained by the availability and cost of substitute products and
services.
Imprecise definitions a narrowly-defined industry will appear to
be more concentrated than a more broadly-defined industry. Suppose
we were looking at concentration within the shoe industry. Should
the market be simply "shoes", or do we break that down further into
"athletic shoes", "men's shoes", "children's shoes", etc.?
Coordinating Economic ActivityEconomic activity can be
coordinated by markets or by individual firms. A firm organizes
input production factors so as to produce and market goods and/or
services.
Auto manufacturers are actually assemblers of cars - most the
parts in a car are produced by hundreds of component suppliers.
This is an example of market coordination. If General Motors
decides to coordinate all activities associated with brake
components, then the coordination is being done by that firm. A
firm will decide to coordinate a particular type of economic
activity when it can do so more efficiently than what is provided
by the market.
Firms can be more efficient than markets due to:
Economies of scope- this applies when a firm hires specialized
resources that can produce a broad range of goods and services. For
example, a person with a difficult to diagnose medical condition
would probably be sent to a hospital, which will have a broad range
of medical specialists and diagnostic equipment.
Economies of scale- for many types of goods, per unit production
costs decline as larger volumes of output are produced by an
individual firm.
Team productioncan often lower production costs.
Transaction costsare often reduced when economic activity is
coordinated by a firm. Suppose you want to perform a major
remodeling of your house. If you decide to coordinate the work
yourself, you will have significant transaction costs associated
with hiring qualified personnel such as plumbers and carpenters,
monitoring their work, negotiating contracts with them, finding
suitable building materials, arranging for delivery of materials
and coordinating work schedules of the various subcontractors. If
you hire a building firm or general contractor to coordinate the
work, they probably will have lower transaction costs because they
already will have knowledge of suitable subcontractors in the area
and how best to get building materials. By hiring a general
contractor, you will reduce your transaction costs by only having
to negotiate one contract.Microeconomics - Modifying OutputThe
"Short Run"The short run is a time period so short that the firm
cannot alter some production factors (typically these factors
include the size and/or number of plants, the technology used,
equipment and the management organization). Those factors are
sometimes referred to collectively as the "plant". The firm usually
can increase output in the short run by adding variable inputs.
Labor is the most common variable input.
The "Long Run"In the long run, firms have sufficient time to
adjust to any and all production factors. Factories can be
expanded, shrunk, demolished or built. The firm can leave or enter
an industry.
Suppose a car manufacture decides to build a new plant to build
SUVs. This would be an example of a decision made in the long run.
If that manufacturer decided to expand output by having employees
work overtime, then that would be an example of a short-run
decision.Look Out!Differences between the "short run" and the "long
run", and the concept of economic profit are critical to
understanding economics!
Total Product:The total product is the total quantity of goods
produced, in association with specified levels of input. Marginal
Product:The marginal product is the change in output that occurs
when one more unit of input (such as a unit of labor) is added.
Average Product:The average product is the total product divided by
the number of input units, usually a variable input such as
labor.Example:Suppose only one worker was present at an assembly
plant and that workerhad to do all functions of the plant - order
and stock supplies, assemble the good, provide maintenance for the
factory, prepare the good for shipping, etc. If a second worker is
added, there may be a larger increase in productivity, as the two
workers can allocate the tasks according to their abilities, and
lesstime will be lost going to and from various locations in the
plant.
A possible schedule of plant output could be as follows:
In this example, hiring the fourth worker increases output by
110 units, which is not as large as the increase created by hiring
the third worker.
The cost of all production factors is equal to the firm's total
cost (TC). Total fixed costs (TFC) include all fixed costs, while
total variable costs (TVC) include the cost of all variable inputs
such as labor. Marginal cost is the increase in costs associated
with producing additional output. At some point in time, marginal
costs will begin to increase because each additional worker
contributes less to total output. The average fixed cost (AFC) is
the fixed cost per unit of output, while the average variable cost
(AVC) specifies the variable cost per unit of output. AFC and AVC
combined are equal to the average total cost (ATC). As production
increases, average fixed cost (total fixed cost divided by
quantity) will decrease. When marginal cost exceeds average total
cost, average total costs will go up, at which point the firm must
receive higher prices if higher production is to occur.
The table below assumes that the firm has fixed costs of $1,000
per day, each worker is paid $200 per day, and each unit produced
has variable material costs of $1 per unit.
From the table above we can see that both average total cost and
marginal cost initially decrease as production increase, but both
start going up at certain levels of production.
Microeconomics - Marginal and Average Total Cost CurvesCost
CurvesThe short-run marginal cost (MC) curve will at first decline
and then will go up at some point, and will intersect the average
total cost and average variable cost curves at their minimum
points.
The average variable cost (AVC) curve will go down (but will not
be as steep as the marginal cost), and then go up. This will not go
up as fast as the marginal cost curve.
The average fixed cost (AFC) curve will decline as additional
units are produced, and continue to decline.
The average total cost (ATC) curve initially will decline as
fixed costs are spread over a larger number of units, but will go
up as marginal costs increase due to the law of diminishing
returns.
The graph below illustrates the shapes of these curves.
Figure 3.8: Cost Curves
Diminishing Returns and Diminishing Marginal Product of
CapitalThe law of diminishing returns states that as one type of
production input is added, with all other types of input remaining
the same, at some point production will increase at a diminishing
rate.
There may be levels of input where increasing inputs causes
production to go up at an increasing rate. However, according to
the law of diminishing returns, at some point production will go up
at a decreasing rate.The marginal product of capital is the
increase in total output associated with an increase in capital,
while holding the quantity of labor constant. Capital is also
subject to the law of diminishing returns.
Economies of ScaleEconomies of scale mean that goods can be
produced at a lower cost per good, as the quantity produced
increases. Large-scale factory operations can permit the most
efficient specialization of machinery and labor. Average fixed
costs will decline as costs such as advertising can be spread
across more and more units.Diseconomies of ScaleDiseconomies of
scale occur when per unit costs go up as output is increased. A
typical reason given is bureaucratic inefficiencies - more
attention may be given to administrative rules as opposed to
innovation. Worker motivation is also more difficult as the number
of employees increases.
When economies of scale occur, the long-run average total cost
(LRAC) curve will be declining; with diseconomies of scale, the
LRAC curve will be rising.
Figure 3.9: Long Run Average Total Curve
Microeconomics - Perfectly Competitive MarketsA purely
competitive (price taker) market exists when the following
conditions occur: Low entry and exit barriers - there are no
restraints on firms entering or exiting the market Homogeneity of
products - buyers can purchase the good from any seller and receive
the same good Perfect knowledge about product quality, price, and
cost No single buyer or seller is large enough to influence the
market priceSellers must take the existing market price; if they
set a price above the market price, no one will buy their product
because potential buyers simply will go to other suppliers. Setting
a price below the market price does not make any sense because the
firm can sell as much as it wants to at the market price; selling
below the market price will just reduce profits.
Because sellers must take the current market price a purely
competitive market is also called a "price takers" market.
The firm can sell as much as it can produce at the existing
market price, so demand is not a constraint for the firm. Revenue
will be simply the market price multiplied by quantity
produced.
Maximizing Profit in Perfect CompetitionA price taker can sell
as much as it can produce at the existing market price.
Sototal revenue(TR) will be simply P Q, where P = price and Q =
quantity sold.
Marginal revenue(MR), the increase in total revenue for
production of one additional unit, will always be equal to the
market price for a price taker.
If the market price of a good is $15, and a firm produces 10
units of a good per day, then its total revenue for the day will be
$15 10 = $150. The marginal revenue associated with producing an
eleventh unit per day would be the market price, $15; total revenue
per day would increase from $150 to $165 (11 $15).
Marginal costs will vary, depending upon the quantity produced.
We would expect the firm to increase input up to the point where
marginal cost is equal to the market price. In the short run, a
firm will produce as long as its average variable costs do not
exceed the market price. If the market price is less than the
firm's total average cost, but greater than its average variable
cost, then the firm will still operate in the short run. Its losses
will be lowered by producing, since nothing can be done about fixed
costs in the short run. Over the long run, the firm will need to
cover all of it costs if it is to keep on producing.If the market
price at least covers the firm's variable costs, it may make sense
to keep on operating. Any price in excess of the average variable
cost will at least help to cover the fixed cost. Unless the firm
decides to completely leave the business, it will come out ahead by
continuing to operate.
If the market price is below the firm's average variable cost,
it will not make sense for the firm to operate as it will lose even
more money. If the firm believes that business conditions will
improve, it will temporarily shut down. Seasonal businesses such as
ski resorts or restaurants located by vacation areas will shut down
temporarily at certain times. Manufacturers temporarily might shut
down a factory and plan to reopen the factory when business
conditions improve.
When Does a Firm Maximize Profit in Perfect Competition?Profit
() is equal to total revenue minus total cost. We can express this
mathematically by stating: = TR - TC
In terms of calculus, we can state that profit will be maximized
when the first derivative of the profit function is equal to
zero:
d=dTR-dTC= 0dQdQdQ
We also can rearrange the terms to state that profit
maximization occurs when:
Formula 3.4
dTR=dTCdQdQ
The term on the left represents the change in revenue from
producing one more unit, which is called marginal revenue. The term
on the right represents the change in total costs resulting from
producing one more unit, which is marginal cost.
The firm's profit will be maximized at the level of output
whereby the marginal (additional) revenue received from the last
unit produced is just equal to the marginal (additional) cost
incurred by producing that last unit. Maximum profit for the firm
occurs at the output level where MR = MC.
For a firm operating in a competitive environment, the marginal
revenue received is always equal to the market price. Therefore a
firm operating under perfect competition will always produce at the
level of output where the marginal cost of the last unit produced
is just equal to the market price.The following equation will
hold:Formula 3.5MR = MC = P
Exam Tip!You do not need to know calculus for the CFA level I
exam. Just make sure you understand the relationship above.
Microeconomics - Effects on Equilibrium in the Short and Long
RunThe Firm vs. the Industry's Short-Run Supply CurveA company will
continue to produce output until marginal revenue (MR) is equal to
marginal cost (MC).
In other words, the condition for maximum profit occurs where:MR
= MC
Another condition for profit to be maximized, because it is
possible that MR=MC at a point where MC is falling, is that the
marginal cost curve must be rising. Therefore, the supply curve for
a competitive firm will be that part of the marginal cost curve
which lies above the low point of the average cost curve. The
supply curve slopes upward because marginal costs increase with the
greater quantity supplied in the short run. With a competitive
market, the supply curve will be a summation of the individual
firms' supply curves.
Long-Run Effects on EquilibriumIn the short-run, increases
(decreases) in demand in a competitive market will cause prices and
output to increase (decrease).
In the long-run, increases (decreases) in demand in a
competitive market will cause increases (decreases) in output.
Initially, markets with an increase (decrease) in demand will have
firms experiencing economic profits (losses). Over time, markets
with firms experiencing economic profits (losses) will have
additional firms enter (existing firms will exit) the market, and
prices will decrease (increase) towards previous levels. If cost
conditions remain the same, then prices will revert to what they
were before the increase (decrease) in demand.
If the market price falls below a firm's average total cost, the
firm will incur economic losses. The firm may be able to lower its
average total cost by changing to a different plant size. Suppose a
firm increases its plant size, and lowers its average total costs.
If other firms follow, then the industry supply curve will shift to
the right. This will result in lower prices and less economic
profit.If a firm does not expect market conditions to improve then
it may decide to go out of business. This would be the preferred
option as, by selling out, neither fixed nor variable costs would
be incurred.
Impact from Changes in TechnologyThe impact of a permanent
change of demand on price and output for a market will be
influenced by the cost structure of suppliers in the market. The
long-run market supply curve in a competitive industry will depend
on the returns to scale.
For a constant-cost industry, if demand increases, then firms
temporarily will make a profit as price will go above the minimum
needed for the firms to stay in business. This will cause firms to
expand output or new firms to enter the industry. Because costs are
constant in the long run, the long-run supply curve will be
horizontal. In the graph below, as demand shifts from D1to D2, over
the long run quantity will increase from Q1to Q2. However, price
will remain the same.
Figure 3.12: Long Run Supply: Constant Cost Industry
For an increasing cost industry, if demand increases, firms will
need higher prices over the long run in order to justify higher
levels of production. For example, prices for raw materials used in
the industry may go up with higher levels of production, which will
force the long-run supply curve to slope upward.
Figure 3.10: Long Run Supply: Increasing Cost Industry
For a decreasing cost industry, if demand increases, in the long
run firms can provide more output at lower prices. The need to
produce larger quantities of goods and services in response to
increased demand induces technological change, which lowers costs
for the producer and these savings are passed on to consumers in
the long run.
Figure 3.11: Long Run Supply: Decreasing Cost Industry
Microeconomics - Characteristics of MonopoliesA monopoly is the
single seller of a good for which substitutes are not readily
available. There should be high barriers to entry; i.e. other firms
cannot enter the market easily and provide the good.
Monopolies often are created due to legal barriers. Patent laws
grant inventors the exclusive right to produce and sell a product
for a period of time (typically 17 years in theUnited States).
Licensing restrictions often limit who is allowed to provide a good
or service in a particular geographic area.
In some instances, economies of scale exist so that there is a
tendency toward a natural monopoly - one firm can provide the good
most efficiently. One traditional example is the distribution of
electrical power to a local community. Duplication of power lines
within a community would increase overall costs. With natural
monopolies, government policy to encourage more entrants may not
make sense.
To some degree, natural monopolies occur in the computer
industry, where customers want to adhere to a common standard. The
common standard for personal computer operating systems is provided
by Microsoft. Alternative operating systems for personal computers
(such as LINUX) do not make sense for most consumers, so Microsoft
has considerable monopoly power.
The Monopolist and Profit MaximizationThe monopolist has control
both over the quantity produced and price charged; it also faces
the entire demand curve for the good produced. Therefore, it will
face a downward-sloping demand curve. It follows the general rule
for profit maximization, MR = MC. As the monopolist does not know
exactly how much consumers are willing to buy at particular prices,
it must "search" for the optimum price.
Figure 3.12: Monopolist Profit Maximization
As shown in the graph above, a monopolist facing demand curve
D0will produce quantity Q0and the price charged will be equal to
P0.
What happens if the monopolist later faces a demand curve such
as D1? In that case, the monopolist cannot cover costs and will go
out of business.
Microeconomics - Inefficiencies of MonopoliesMonopolies vs.
Perfect CompetitionsA market characterized by monopoly has only a
single seller, while a perfectly competitive market has many
sellers. There are high barriers of entry with the monopoly, but
little to no barriers to entry in the perfectly competitive market.
Because the product of a monopolist cannot be substituted readily,
the monopolist can set a higher price and still get sales. The
seller in a perfectly competitive market cannot get a higher price
because potential buyers always can get the product from other
sellers.
Major inefficiencies associated with monopolies include:
Allocative inefficiency- prices will tend to be higher, and
output lower, than what would exist in a market with low barriers
to entry. Prices will tend to be higher than both marginal costs
and average total cost.
Weakened market forces- when consumers of a product have many
alternatives, producers must serve their customers efficiently in
order to stay in business. If consumers can't purchase competitive
products easily, the monopolist doesn't need to worry a lot about
losing customers when poor service or a poor quality good is
provided.
Rent or favor seeking- firms and/or individuals will put a great
deal of effort into obtaining or maintaining high entry barriers;
by doing so, they hope to achieve monopoly-type profits. Such
efforts enrich some people, at the expense of many others.
Price DiscriminationPrice searchers effectively price
discriminates among their customers when they are able to:a)
Identify sub-groups which have different elasticities of demand,
andb) ensure that the customers cannot resell the good.A common
example is airline travel. Travelers who plan in advance will have
higher elasticity of demand than travelers who must travel within a
short period of time.With price discrimination, some consumers pay
higher prices than they would if there was a single price. However,
many in the group paying lower prices will now be getting something
they otherwise would not have purchased. Universities are
increasing their use of price discrimination. Tuition rates for
students without financial aid are increasing greatly while the
average price charged is not going up as much because more
financial aid is being offered. The colleges reap high revenues
from wealthy families who can afford to pay high tuition while more
students from lower-income families can now attend college.
In general, higher output will occur with price discrimination.
Furthermore, there may be some businesses that could not exist
without price discrimination. For example, a dentist in a small
town may not have a viable business without performing price
discrimination.
As price discrimination increases output and gains from trade,
it reduces allocative inefficiency. Firms that successfully price
discriminate will benefit by getting higher revenues.
Why Do Monopolies Exist?If a natural monopoly is to exist, the
government can regulate the price and output. In the graph below,
the monopolist would prefer to charge price P1 and Q1 to maximize
profits. A regulatory agency will often set the price at P2. At
this price, the monopolist receives enough to cover costs and, in
effect, it receives a competitive rate or return of its capital.
The benefits to society from the increased production outweigh the
increased costs to the monopolist.
Figure 3.13: Results of Regulating Price and Output
Microeconomics - Monopolistic CompetitionA firm engaged in
monopolistic competition which is considering reducing prices in
order to increase total revenue has two conflicting factors to
consider. Reducing prices will increase the quantity of a good
sold, but the reduction in price will also apply to quantities of
the good that would have been sold at a higher price.
The price searcher can maximize profit by adjusting output and
the price until marginal revenue is equal to marginal cost. Notice
that the marginal revenue curve lies below the firm's demand
curve.
Figure 3.15: Marginal Revenue Curve In Monopolistic
Competition
The phrase "contestable markets" describes markets where there
are few sellers, but they behave in a competitive manner because of
the threat of new entrants. For instance, an airline may serve a
particular route exclusively, but does not charge excessive prices
because those prices would entice additional airlines to offer that
route.
Government regulation is often used to keep new firms out of
markets. Economists generally favor deregulation as this helps to
keep prices low.
Prices over the long run in a competitive market will move to
the lowest point of the firm's average total cost curve. We then
have allocative efficiency because desired goods are produced at
the lowest possible cost.Because price searchers face
downward-sloping demand curves, the price they charge will exceed
the firm's marginal cost. The price charged and the quantity
produced will not be where the firm minimizes average total costs.
Figure 3.16 illustrates these points.
Figure 3.16: Monopolistic Competition: Low Barriers to Entry
The monopolistic competition market, in comparison to a purely
competitive market, will have a higher price and lower output. Some
argue that this is a good trade-off, as consumers benefit from
having a variety of goods. Advertising would be not be used by
price-takers, but is used by price-searchers; as the cost of
advertising is ultimately borne by consumers, it is an argument
against the price-searcher market. If barriers to entry are low,
firms still have an incentive to produce efficiently, use resources
only if they add value and innovate by altering their products or
offering new products. Entrepreneurs may have more incentives with
price searcher markets, while if markets are contestable, prices
will not be excessively higher than those in competitive
markets.
Product Development and Marketing in Monopolistic
CompetitionFirms engaged in monopolistic competition invest in
product development and marketing so as to differentiate themselves
from other firms in the industry. By doing so, they hope to gain
more monopolistic pricing power. Since advertising increases costs,
it will shift supply curves up and to the right. Ultimately, over
the long run, consumers pay for the advertising in the form of
higher prices.In comparison to the pure competitive market, prices
will be higher and quantities produced will be lower when there is
monopolistic competition. However, there will be a greater variety
of goods. This may be a worthwhile tradeoff.Microeconomics -
OligopoliesWhat is an Oligopoly?Oligopoly refers to a market with
"few sellers". Oligopolies interact among themselves. When an
oligopolist changes a price, it must take into account how other
firms in the industry will respond. Within an oligopoly, the
products can be similar or differentiated. Oligopoly markets have
high barriers to entry.The Prisoner's DilemmaThe "prisoners'
dilemma" was first described in the field of "game theory", which
is a branch of applied mathematics and economics dealing with
choices made under conflict and uncertainty. Suppose that the
police believe Dave and Henry have committed a felony, but the
evidence is weak. The police have placed Dave and Henry in jail, in
separate cells. The police need the confession of at least one of
the prisoners in order to get a felony conviction. If neither
prisoner confesses, then the police can only convict them on a
minor charge with a three-month prison term. Each prisoner is
offered the following deal: if one testifies against the other
while the other remains the silent, the one who testifies will not
be convicted of anything, while the one who remains silent will go
to jail for 20 years. If both confess, then each will receive a
five-year jail term.To sum up the situation:
The optimum result for the two together is to stay silent, in
which Dave and Henry will each get only three months prison time.
However, each prisoner does not have knowledge of what the other
prisoner will do. The most rational response from the individual is
to confess. If the other prisoner stays silent, then that person
gets off free; if the other prisoner confesses, then the prison
term will be less (five years vs. 20 years).
The prisoners' dilemma illustrates a situation in which
individuals arrive at a non-optimal solution, due to a lack of
cooperation and trust. A similar situation occurs with oligopolies.
If firms within an oligopolistic industry have cooperation and
trust with each other, then they can theoretically maximize
industry profits by setting a monopolistic price. Firms would then
have to figure out how to fairly divide up the profits.If
oligopolies collude successfully, they will set price and output
such that MR = MC for the industry overall. In figure 3.17 on the
following page, this is depicted as Pa and Qa. Without collusion,
firms will lower prices to attract more customers. Gradually, the
price and output will move to Pband Qb, which is identical to what
would be achieved with a competitive market.
Figure 3.16: Oligopolist Profit Maximization
Oligopolies have strong incentives to collude because while
acting together, they can restrict output and set prices so that
economic profits are earned. The individual oligopolist has an
incentive to cheat because the firm's demand curve is more elastic
than the overall market demand curve. By secretly lowering prices,
the firm can sell to customers who would not buy at the higher
price, as well as to customers who normally buy from the other
firms.
Oligopolistic agreements tend to be unstable due to these
conflicting tendencies.
Obstacles to collusion within oligopolies include:
Low Entry Barriers- Particularly as time goes on, more firms
will be attracted to the potential economic profits, which will not
be sustainable. For example, the OPEC's raising of oil prices
during the 1970s and early 1980s enticed more non-OPEC producers to
produce more. The market share of OPEC producers was drastically
reduced and they had to reduce prices in order to gain market
share. In the long run, cartels are not usually successful at
raising prices.
Antitrust Laws- these laws prohibit collusion. Although firms
may make secret agreements, those agreements will not be
enforceable in a court of law.
Unstable Demand Conditions- These conditions will make collusion
more difficult, as firms are more likely to have disagreements as
to what is the best direction for the industry. Some may expect
large increases in demand, while others may disagree and prefer
that industry capacity remains the same.
Increasing Number of Firms- An increasing number of firms in an
oligopolistic industry will make agreements harder to discuss,
negotiate and enforce. Differences of opinion are more likely. As
the number of firms in the industry increases, the industry will
behave more like a competitive market.
Difficulties with Detecting and Stopping Price Cuts- These
difficulties will undermine effective collusion. Sometimes
oligopolistic firms will cheat by enacting quality improvements,
easier credit terms and free shipping. If quality changes can be
used to compete, collusive price agreements will not be
effective.Microeconomics - ConclusionWithin this Section we have
focused on the basics of microeconomics, the properties of demand
and supply, price takers and searchers, and demand and supply for
resources and capital. For a quick review, we've summarized the
characteristics of the various market types below.