economics chapters 1-11

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Economics: Chapter 1-7

Lecture #1: Economic Issues and Concepts

1. Economics: Comes in whenever more of one thing (goods or services) means less than another.

2. Macro – Economics: Is the study of the determination of economic aggregates such as total output, total employment, the price level, and the rate of economic growth.

3. Micro – Economics: The study of the causes and consequences of the allocation of resources as it is affected by the workings of the price system and government policies that influence it.

4. Opportunity Cost: The benefit given up by not using resources in the best alternative way.

Economic Problems:1. Scarcity (production resources not enough goods or services as desired) implies that choice must be made and making choices implies the existence of costs.2. Choice

Types of Resources:

1. Natural Resource i.e. land, lakes, forests, etc.2. Manmade Resources i.e. capital and physical3. Human Resources i.e. labour force

Economists refer to resources as factors of production; outputs are goods (tangibles), or services (intangibles). Technology is the knowledge we use to transform resources into goods and services.

The following questions must be asked…What will be produced?How will it be produced?For whom will it be produced? Resource allocation determines the quantities of various goods that are produced Three broad groups of decision makers: consumers, producers, and government; in order to

achieve their objectives, maximizing consumers and producers make marginal decisions.

Production Possibilities Boundary: Represents scarcity, choice, and opportunity cost. Scarcity is indicated by the unattainable combinations outside the boundary, choice is

determined by the need to choose among the alter. Opportunity cost is shown by the negative slope of the boundary.

The Flow of Income and Expenditure:

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Individuals own factors of production; they sell the services of these factors to producers in factor markets and receive payment in return.

Producers transform factor services into goods and services, which they then sell to individuals in good markets, receiving payment in return.

Production and Trade: Production usually displays two characteristics noted long ago by Adam Smith:

Specialization and division of labour. Specialization is the allocation of different jobs to different people. It is more efficient then

self-sufficiency because: Individual abilities differ (comparative advantage) and focusing on one activity leads to improvements.

Specialization must be accompanied by trade.

Types of Economic Systems: There are three pure types of economic systems; 1. Traditional, 2. Command and 3. Free-

market. Every economy is a mixed economy, and combines significant elements of all three systems. Governments intervene to: correct market failures, provide public goods, and offset the

effects of externalities. Markets often work well, but sometimes government policy can improve the outcome for society as a whole.

Lecture #2: Economic Theories, Data, and Graphs:

1. Normative Statements: Depend on value judgements and opinions they cannot be settled by resource to facts.

2. Positive Statements: Do not involve value judgements. They are statements about what is, was or will be.

3. Theories: Consist of a set of definitions about variables; a set of assumption; and a set of prediction or hypotheses.

Variables:1. Endogenous Variables: Value is determined within the theory 2. Exogenous Variables: Influences the endogenous variable but is determined outside the theory i.e. state of weather is dependent on the endogenous variable.3. Assumptions: Concerns motives, directions of causation, and the conditions under which the theory is meant to apply.

Types of assumptions include…1. Motives: individuals strive to maximize utility, while firms, are assumed to maximize profits.

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2. Direction of Causation: When the amount of eggs that producers want to supply is assumed to increase when the price of their chicken feed falls, the causation runs from the price of chicken feed to supply of eggs.3. Conditions of Application: Utilized to specify the conditions under which a theory is meant to hold i.e. a theory that assumes there is no government Is not meant literally, it means the theory is applied to where governments are not involved.4. Predictions: The propositions that can be deducted from it or “hypotheses.”

Slop of a straight line:

DeltaC/Delta I = mI+b

Types of Economic Systems: Traditional: Is one in which behaviour is based primarily on tradition, custom, and habit. Command: Economic behaviour I determined by some central authority, usually the

government, which makes most of the necessary decisions on what to produce, how to produce it, and who gets it.

Free-Market: The decisions about resource allocation and made without any central direction. Instead, they result from enumerable independent decisions made by the individual producers and consumers.

Mixed: Economics that are fully centrally planned or wholly free-market such as a mixture of central control and market determination with a certain amount of traditional behaviour.

Lecture #3: Demand, Supply, and Price:

1. Quantity Demanded: the total amount that consumers desire to purchase in some time period, quantity demanded is a flow, as opposed to stock. Quantity bought or exchanged refers to actual purchases. Ceteris Paribus: price of the product and quantity demanded are negatively related.

2. Quantity Supplied: The amount of a product that firms desire to sell in some time period. Ceteris Paribus: the price of the product and the quantity supplied are positively related.

3. Equilibrium Price: Every buyer finds a seller and every seller finds a buyer; is the only price that will last and is that price at which the amount willingly supplied and the amount willingly demanded are equal.

4. Absolute Price: Is the amount of money that must be spent to acquire one unit of that product.

5. Relative Price: is the price of one good in terms of another.

6. Ceteris Paribus: Assumption is assuming that all variables are constant.

7. Disequilibrium: Whenever there is either excess demand or excess supply in a market, that market is said to be in a state of disequilibrium and the market price will be changing.

Shifts in Demand and Supply Curves:

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A rightward shift indicates an increase in demand A leftward shift indicates a decrease in demand. A change in variable other than price will shift the demand curve: household income, price

of other products, distribution of income or population, taste/preferences, and expectations about the future.

A change in demand is a change in quantity demanded at every price, a change in quantity demanded refers to a movement from one point on a demand curve to another point.

A change in supply is a change in the quantity that will be supplied at every price; a change in quantity supplied refers to a movement from one point on a supply curve to another point.

A change in any variable other than price will shift that supply curve to a new position; price of inputs, technology, number of suppliers, and prices of other products affect this shift.

Laws of Supply and Demand:

1. An increase in demand causes an increase both the equilibrium price and quantity.2. A decrease in demand causes a decrease in both equilibrium price and quantity.3. An increase in supply causes a decrease in the equilibrium price and an increase in the quantity.4. A decrease in supply causes an increase in the equilibrium price and a decrease in the quantity.

Three conditions must be satisfied in order for price determination in a market to be well described by the demand-supply model:1. Large number of consumers; each one small relative to the size of the market.2. Large number of producers; each one small relative to the size of the market.3. Producers must be selling “homogenous” versions of the product.

Lecture #4: Elasticity:

Price elasticity of demand: A measure of the responsiveness of quantity demanded to a change in the commodities own price.

Price elasticity of supply: Measures the responsiveness of the quantity supplied to a change in the products price; supply tends to be more elastic in the long run than in the short run because it usually takes time for producers to alert their productive capacity in response to price changes.

Inferior Goods: A good for which quantity demanded falls as income rises, its income elasticity is negative.

Normal Goods: A good for which quantity demanded rises as income rises, its income elasticity is positive.

N = Percentage change in quantity demanded _______________________________

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Percentage change in price

Demand is said to elastic when quantity demanded is very responsive to change in the products own price, and demand is inelastic if quantity demanded is very unresponsive to changes in its price.

Demand elasticity tends to be high when there are many close substitutes; the length of time interval considered, whether the good is a necessity or a luxury, how specifically the product is defined.

The elasticity of supply depends on how easily firms can increase output in response to an increase in the product’s price this depends on; the technical ease of substitution in production, the nature of production costs, and the time span under consideration.

Lecture #5: Markets in Action:

Partial – Equilibrium Analysis: The study of a single market in isolation, ignoring events in other markets. General equilibrium analysis is the study of all markets together; is appropriate when the market being examined is small relative to the entire economy.

Government Controlled Prices: Policies that attempt to hold the price of some good or service at some disequilibrium price of some good or service at some disequilibrium value a value that could not be maintained in the absence of the government’s intervention.

A binding price floor is set above the equilibrium price; a binding price ceiling is set below the equilibrium price.

Binding price floors lead to excess supply and binding price ceilings lead to excess demand; price ceilings government has three main objectives 1. Restrict production, 2. Keep specific prices down, and 3. Satisfy (normative) notions of equity.

Rent Controls: A form of price ceiling; the major consequence of binding rent controls is a shortage of rental accommodations and the allocation of rental housing by seller preferences. I.e. a housing shortage, alternative allocation scheme in black markets, and illegal schemes like “key money” effects.

Market Efficiency:

Demand curves show consumers’ willingness to pay for each unit of the product. The area below the demand curve shows the overall value that consumers place on quantity.

Supply curves represent the lowest price producers are prepared to accept in order to produce and sell each unit.

For any given quantity exchanged of a product, the area below the demand curve and above the supply curve shows the economic surplus governed by the production and consumption of those units.

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Economic surplus is a common measure of market efficiency; maximize when the quantity exchanged is determined by the intersection of the demand/supply curves.

Policies that intervene with the free/competitive markets i.e. price floors/ceilings and production quotas generally lead to a reduction in the total amount of economic surplus generated in the market.

Lecture #6: Consumer Behaviour:

Utility: The satisfaction or well-being that a consumer receives from consuming some good or service; economists assume that in making their consumer decisions consumers are motivated by maximizing their “utility.”

Marginal Utility: The additional satisfaction obtained from consuming one additional unit of a commodity.

Total Utility: The total satisfaction resulting from the consumption of a given commodity by a consumer.

Real Income: Income expressed in terms of the purchasing power of money income; that is, the quantity of goods and services that can be purchased with the money income.

Substitution Effect: The change in quantity of a good demanded resulting from a change in its relative price (holding real income constant)

Increases the quantity demanded of a good whose (relative) price has fallen and reduced the quantity demanded of a good whose (relative) price has increased. This alters relative price and the consumer’s real income.

Consumer Surplus: The difference between the total value that consumers place on all units consumed by a commodity and the payment that the actually make to purchase that amount of the commodity.

The value placed by a consumer on the total consumption of some product can be estimated in two ways: The valuation that the consumer places on each unit may be summed, and the consumer may be asked how much he or she would be willing to pay to consume the total amount if the alternative were to consume none.

Income Effect: Leads consumers to buy more of a product whose price has fallen provided that the product is a normal good.

Giffen Good: An inferior good for which the income effect outweighs the substation effect so that the demand curve is positively sloped.

Income: the “purchasing power” essentially when prices go up your pay cheque may not change but you will buy less of the good with your pay cheque.

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Diminishing Marginal Utility:

Ceteris paribus, the utility that any consumer derives from successive units of a particular product is assumed to diminish as total consumption of the product increases that is marginal utility falls as the level of consumption rises.

Maximizing Utility:

A utility-maximizing consumer allocates expenditures so that the utility obtained from the last dollar spent on each product is equal. Economists assume that consumers seek to maximize their total utility subject to the constraints they face such as income and the market prices of various products.

For two products, X and Y, for utility-maximizing condition is:

Mux = MUy__________ Px Py

Conspicuous Consumption Goods:

Does this behaviour violate our theory of utility maximization?

Some products are consumed because they have “snob appeal” the high price confers status on its purchase:

Snobs would still buy more at a lower price as other people thought they had paid a high price; the theory of the “leisure class”

Even if such consumption exists, it is unlikely that the “market” demand curve is positively sloped.

The Paradox of Value:

Early economists encountered the paradox of value; water is cheap but “invaluable” whereas diamonds are very expensive but mostly unnecessary.

We must distinguish total value (area under the curve) from marginal value (height of the curve).

Lecture #7: Producers in the Short Run

Dividends: Profits paid out to shareholders of a corporation.

Bond: A debt instrument carrying a specified of interest payments, and usually a date for redemption of its face value.

Organizations of Firms:

1. Single Proprietorships: Have all of the control, one individual, provides a service or product such as cutting grass, creating apps for apple, etc.

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2. Ordinary Partnerships: Involves two individuals whom are equally responsible for the business.

3. Limited Partnerships: Develops a formal structure through the government, the firm has taken on their firm legally by paying taxes. They have limited liability; risking only the money they have invested.

4. Corporations: Have a limited liability; people sue the corporation as a whole not the individual.

5. State owned “crown” Corporations: Examples include Via Rail, Post Offices and etc. Completely controlled by the government and everything is regulated by the government.

6. Non-Profit operations: No profits involved, helps community.

Goals of Firms:

1. Firms are assumed to be profit maximizers, individuals believe that firms are not maximizing their profits as much as they need to.

2. Each firm is assumed to be single, consistent, decision-making unit.

3. It is not socially responsible to maximize profits; a “good” firm would spend money for environmental and waste management resources and give back to the community through foreign aid, housing and etc.

Production:

Intermediate Products: All outputs that are used as inputs by other producers in a further stage of production.

Firms use four types of inputs for production:1. Intermediate products2. Inputs provided directly by nature.3. Inputs provided directly by people, such as labour services.4. Inputs provided by the service of physical capital (machines).

Production Function: A functional relation showing the maximize output that can be produced by any given combination of inputs; relates inputs to outputs, it describes the technological relationship between the inputs that a firm uses the output that it produces. Function notation is: q=f(L,K)

Costs and Profits:

Economic profit includes both implicit and explicit costs; whereas accounting profits include only explicit costs.

Economic Profit: the difference between the resources received from the sale of output and the opportunity cost of the inputs used to make the output negative economic profits are called economic losses.

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Accounting Profits = Revenue – Explicit Costs Economic Profits = Revenue – (Explicit + Implicit Costs) =

Accounting Profits – Implicit cost

Time Horizons for Decision Making:

Short Run: A period of time in which the quantity of some inputs cannot be increased beyond the fixed amount that is available; is a length of time over which some of the firm’s factors of production are fixed, typically capital is fixed.

Long Run: The length of time over which all of the firm’s factors of production can be varied, but its technology is fixed.

The Very Long Run: The length of time over which all of the firm’s factors of production and its technology can be varied.

Total Product: is the total amount of output that is produced during a given period of time.

Average Product: Is the total product divided by the number of units of the variable factor used to produce it (usually thought of as labour). The marginal product of labour is given by:

MP = DeltaTP _______ DeltaL

Marginal Product: Is the change in total product resulting from the use of one additional unit of labour.

Law of Diminishing Returns: The hypothesis that if increasing quantities of a variable factor are applied to a given quantity of fixed factors; the marginal product of the variable factor will eventually decrease. States that if increasing amounts of a variable factor are applied to a given quantity of a fixed

factor (holding the level of technology constant), eventually a situation will be reached in which the marginal product of the variable factor declines.

Total Cost: The total cost of producing any given level of output; it can be divied into total fixed cost and total variable cost.

Total Fixed Cost: All costs of production that does not vary with the level of output.

Total Variable Cost: Total costs of production that vary directly with the level of output.

Average Total Cost: Total costs of producing a given output divided by the number of units of output, it can also be calculated as the sum of average fixed costs and average variable costs.

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Average Fixed Cost: Total fixed costs divided by the number of units of output.

Average Variable Cost: Total variable costs divided by the number of units of output.

Marginal Cost: The increase in the total cost resulting from increasing output by one unit.

TC = TFC + TVC

ATC = AFC + AVC

Capacity: The level of output that corresponds to the minimum short-run ATC is the capacity of the

firm. Capacity is the largest output that can be produced without encountering rising average cost

per unit. A firm that is producing at an output less than the point of minimum ATC is said to have

excess capacity.

Lecture #8: Producers in the Long Run

Cost Minimization: An implication of profit maximization that firms choose the production method that produces any given level of output at the lowest possible cost.

Long Run Minimization: If it is possible to substitute one factor for another to keep output constant while reducing total cost, the firm is currently not minimizing its costs. The firm should substitute one factor for another factor as long as the marginal product of the one factor per dollar spent on it is greater than the marginal product of other factor per dollar spent on it.

MPK/Pk = MPl//PL

Principle of Substitution: The principle that methods of production will change if relative prices of inputs change, with relatively more of the cheaper input and relatively less of the more expensive input being used; profit maximizing firms will react to changes in factor prices by changing their methods of production.

Long – Run Average Cost Curve: The curve showing the lowest possible cost of producing each level of output when all inputs can be varied; the LRAC curve is the boundary between costs levels that are attainable, with known technology and given factor prices, and those that are unattainable.

Economies of Scale: Reduction of long run average costs, resulting from an expansion in the scale of firms operations so that more or all inputs are being used.

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Increasing Returns: A situation in which output increases more output than in proportion to inputs at the scale of firms production increases. A firm in this situation is a decreasing cost firm.

Minimum Efficient Scale: The smallest output at which LRAC reaches its minimum. All available economies of scale have been realized at this point.

Constant Returns: A situation in which output increases in proportion to inputs at the scale of production is increased. A firm in this situation is a constant cost firm.

Decreasing Returns: A situation in which output increases less than in proportion to inputs as the scale of a firms production increases. A firm in this situation is a constant cost firm.

The Relationship between Long-run and Short-Run Costs:

- No short run cost curve can fall below the long run cost curve bc the LRAC curve represents the lowest attainable cost for each possible output.

- Each SRATC curve is tangent to the LRAC curve out the level of output for which the quantity of the fixed factor is optimal and lies above it for all other levels of outputs.

- A rise in factor price shifts LRAC curves upward, a fall in factor prices or a technological improvement shifts LRAC curve downward.

Three Influences

1. New techniques (Process Innovation)

2. Improved Inputs

3. New products (Product Innovation)

- The development of new products is a crucial part of the steady increase in living standards.

- Faced with increases in the price of an input, firms may either substitute away or innovate away from the input or do both over different time horizon.

Lecture #9: Competitive Markets

Market Structure: All features of a market that affect the behaviour and performance of firms in that market, such as the number and size of sellers, the extent of knowledge about one another’s actions, the degree of freedom of entry, and the degree of product differentiation.

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Market Power: The ability of a firm to influence the price of a product or the terms which it is sold. The more market power the firms have the less competition in the market structure.

Perfect Competition: A market structure in which all firms in an industry are price takers and in which there is freedom of entry into and exit from the industry.

Homogenous Products: In the eyes of purchasers, every unit of the product is identical to every other unit.

1. All the firms in the industry sell an identical product; economists say that the firms sell a homogenous product.

2. Consumers know that nature of the product being sold and the prices changed by each firm.

3. The level of each firms output at which its long run average cost reaches a minimum is small relative to the industry total output.

4. The industry is characterized by freedom of entry and exit, existing firms cannot block the entry of new firms, and there are no legal prohibits or other barriers to entering or exiting the industry.

Price Taker: A firm that can alter its rate of production and sales without affecting the market price of its product.

Marginal Revenue: The change in a firms total revenue resulting from a change in it sales by one unit.

Should the firm’s product at all?

1. If the firm produces nothing, must pay its fixed costs.

2. If the firm decides to produce, must also pay the variable cost of production.

3. Receives revenue from sales, a firm should produce only if at some level of output, TR exceeds TVC.

- A firm should produce only if at some level of output, price exceeds AVC.

- At the shutdown price the firm can just cover its average variable cost, and so is indifferent between producing and not producing.

Shut Down Price: The price that is equal to the minimum of firm’s average variable costs. At prices below this, a profit maximizing firm will shut down and produce no output.

Profit Maximization for a Competitive Firm:

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- The market determines the equilibrium price. The firm then picks the quantity of the output that maximizes its own profits.

- The profit maximizing level of output is the point at which price (marginal revenue) equals marginal cost.

Alternative Short-Run Profits of a Competitive Firm:

- Positive profits means that this firm is earning more than it could in its next best alternative venture, since p > ATC, the firm makes positive economic profits equal to the blue area.

- The typical firm maximizes its profits by producing at q star.- But if p < ATC, the firm suffers losses equal to the red shaded area.- The typical firm is just covering its costs, p = ATC, there is zero economic profit.

The Effect of New Entrants Attracted by Positive Profits:

1. Positive profits attract new firms.

2. Entry leads to an increase in supply and a decline in price.

3. Positive profits are eroded.

Long Run Decisions: Entry and Exit

- If existing firms have positive economic profits, new firms have an incentive to enter the industry.

- - If existing firms have zero profits, there are no incentives for new firms to enter, and no incentives for existing firms to exit.

- If existing firms have economic losses there is an incentive for existing firms to exit the industry.

- In the long run equilibrium, all existing firms: must be maximizing their profits, are earning zero economic profits, are not able to increase their profits by changing the size of their production facilities.

Declining Industries:

- What happens when a competitive industry in LR equilibrium experience a continual decrease in demand?

- The efficient response is to continue operating with existing equipment as long as variable costs of production can be covered. As demand shrinks, so will capacity.

- Antiquated equipment in a declining industry is often the effect rather than the cause of the industry’s decline.

Changes in Technology:

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- Suppose technological development reduces the costs for newly built plants, new plants will earn economic profits; expand industry output and drive down price.

- The price will fall until it is equal to the SRATC of the new plants. Old plants may continue, but will earn losses. They will eventually exit. I.e. companies that produce record players or obsolete technologies.

Lecture #10: Monopoly, Cartels, and Price Discrimination

- A monopolist I the sole producer of the product that it sells, the demand curve it faces is simply the market demand curve for that product.

- The market demand curve shows the quantity that the monopolist will be able to sell at each price.

- Unlike a perfectly competitive firm, a monopolist faces a negatively sloped demand curve.

TR = P X Q AND AR = TR/Q = PXQ/Q = PMarginal Revenue: The monopolists’ marginal revenue is less than the price at which it sells its output. Thus the monopolist MR curve is below its demand curve.

MR = TR/QShort – Run Profit Maximization:

Rule 1) the firm should not produce at all unless price (average revenue) exceeds average variable cost.

Rule 2) if the firm does produce, it should produce a level of output such that marginal revenue equals marginal cost.

No Supply Curve for a Monopolist:

- A monopolist does not have a supply curve because it is not a price taker; it chooses its profit maximizing price quantity combination from among the possible combinations on the market demand curve.

Competition and Monopoly Compared:

- A perfectly competitive industry produces a level of output such that price equals marginal cost. A monopolist produces a lower level of output with price exceeding marginal cost.

- A monopolist restricts output below the competitive level and thus reduces the amount of economic surplus generated in the market. The monopolist therefore creates on inefficient market outcome.

- Entry barriers and long-run equilibrium, if monopoly profits are to persist in the long run, the entry of new firms into the industry must be prevented.

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Entry Barrier: Any barrier to the entry of new firms into an industry, an entry barrier may be natural or created.

Natural Monopoly: An industry characterized by economists of scale sufficiently large that only one firm can cover its costs while producing at its minimum efficient scale.

Cartel: An organization of producers who agree to act as a single seller in order to maximize joint profits i.e. gas and oil prices.

Effects of Cartelization: The profit maximizing cartelization of a competitive industry will reduce output and raise price from the perfectly competitive levels.

Enforcement of Output Restriction: Cartels tend to be unstable because of the incentives for individual firms to violate the output restrictions needed to sustain the joint profit maximizing monopoly price.

Restricting Entry: If price differences reflect cost differences, they are not discriminatory. When price differences are based on different buyer’s valuations of the same product, they are discriminatory.

Price Discrimination: The sale by one firm of different units of a commodity at two or more different prices for reasons not associated within differences in cost.

When is Price Discrimination Possible:

1. Market Power

2. Identification of consumer’s different valuations

- 1. Same consumer might be prepared to pay a different price for each unit of the goods.- 2. Consumers of one particular type may be prepared to pay more for the good than

consumers of a different type (segmenting the market).- 3. Whenever the same product is being sold at different prices, there is an incentive for

buyers to purchase the product at the lower price and re-sell it at the higher price which is called “arbitrage.”

Handle Pricing: Handle Pricing exists when firms create an obstacle that consumers must overcome in order to get a lower price. Consumers then assign themselves to the various market segments, those who don’t want to jump the hurdle and are willing to pay the high price, and these who choose to jump the hurdle in order to benefit from the low price.

Price Discrimination and Firm Profits: For any given level of output, the most profitable system of discriminatory prices will always provide higher profits to the firm than the profit-maximizing single-price.

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Price Discrimination and Output: A monopolist that price discriminates among units will produce more output than will a single price monopolist.

Price Discrimination and Consumers Welfare: There is no general relationship between price discrimination and consumer welfare. Price discrimination usually makes some consumers better off and other consumers worse off.

Lecture #11: Imperfect Competition and Strategic Behaviour

Industry Concentration: An industry with a small number of relatively large firms is said to be highly concentrated. A formal measure of such industrial concentration is given by the concentration ratio.

Concentration Ratio: The fraction of total market sales or some other measure of market activity controlled by a specified number of the industry’s largest firms. We measure whether an industry has power concentrated in the hands of only a few firms or dispersed over many.

Firms Choose their Products:

- Most firms in imperfectly competitive markets sell differentiated products. In such industries, the firm itself must choose which characteristics to give the products that it will sell.

- Differentiated Product: A group of commodities that are similar enough to be called the same product but dissimilar enough that all of them do not have to be sold at the same price.

- Price Setter: A firm that faces a downward sloping demand curve for its product, it choses which price is set.

- Firms choose their prices in market structures other than perfect competition, firms set their prices and then let demand determine sales. Changes in market conditions are signalled to the firm by change in the firm’s sales.

Monopolist Competition: Market structure of an industry in which these are many firms and freedom of entry and exit but in which each firm has a product somewhat differentiated from the others giving it some control over its price.

Assumptions of Monopolist Competition:

1. Each firm produces one specific brand of the industry’s differentiated product. Each firm thus faces a demand curve that although negatively sloped, is highly elastic because competing firms produce close substitutes.

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2. All firms have access to the same technological knowledge and so have the same cost curves.

3. The industry contains so many firms that each one ignore the possible reaction of its many competitors when it makes its own price and output decisions. In this respect, firms in monopolistic competition are similar to firms in perfect competition.

4. There is freedom of entry and exit in the industry if profits are being earned by existing firms; new firms have an incentive to enter. When they do, the demand for the industry’s product must be shared among more brands.

Excess Capacity theorem: The property of long run equilibrium in monopolistic competition that firms produce on the falling portion of their long run average cost curves. This results in excess capacity, measured by the gap between present output and the output that coincides with minimum average cost.

Oligopoly: An industry that contains two or more firms, at least of which produces a significant portion of the industry’s total output; these firms often make strategic choices they consider how their rivals are likely to respond to their own actions.

- Temporary changes in demand lead to more price volatility in competitive markets- Permanent changes in demand lead to similar adjustments in both market structures- Is an important market structure in modern economies because there are many industries in

which the MES is simply too large to support many competing firms.- Often grow through mergers or by driving rivals into bankruptcy. - Process increases the size and market share of survivors and possibly reduces the extent of

competition in the market.- The challenge for public policy is to keep oligopolies competing and using their competitive

energies to improve products and reduce costs.

Game Theory: The theory that studies decision making in situations in which one player anticipates the reactions of other players to its own actions.

When game theory is applied to oligopoly:

- The players are firms- Their game is played in the market- Their strategies are their prices or output decisions- The payoffs are their profits

Is used when...

1. How firms interact when they charge different prices for their differentiated products.

2. How firms interact when the decision is whether to develop a new product.

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Collusion: An agreement among sellers to act jointly in their common interest, collusion may be overt or covert explicit or tacit.

Explicit Collusion: In order for firms to ensure that they will all maintain their joint profit maximizing output is to make an explicit agreement. Cooperation among cartel members allows them to restrict output and raise prices and increasing the cartel member’s profits.

Tacit Collusion: Collusive behaviour that affects prices is illegal, a small group of firms that recognize the influence that each has on the others may act without any explicit agreements to achieve the cooperative outcome.

1. Common interest in cooperating to maximize their joint profits at the cooperative solution.

2. Each firm is interested in its own profits, and any one of them can usually increase its profits by behaving competitively.

Nash Equilibrium: Is an outcome in which each firm is doing the best it can give what the other firm is doing; is a rational decision in making the absence of cooperation, and no firm has an incentive to unilaterally alter its own behaviour.

Cooperative outcome: If two firms in this duopoly can cooperate the payoff matrix shows that their highest joint profits will be earned if each firm produces on half of the monopoly output. Gives an incentive to cheat and produce two thirds of the monopoly output.

Types of Competitive Behaviour:

- Firms may compete for market share- Firms may offer secret discounts to increase sales- Firms may use innovation and attempt to gain advantage over rivals in the very

long run.

Predatory Pricing: A firm will not enter a market if it expects continued losses after entry, existing firms can create such an expectation by keeping prices below their own costs until it he entrant goes bankrupt, the existing firm loses profits but it also discourages potential future rivals.

The Importance of Entry Barriers: In the absence of natural entry barriers, oligopolistic firms must create entry barriers if they are to earn profits in the long run.

Brand Proliferation as an Entry Barrier: A large number of differentiated products leaves small market share available to a new firm. This is one explanation for many varieties of a product being produced by the same firm.

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Advertising as a Barrier to Entry: Heavy advertising can force an “outside” firm to spend heavily on its own advertising, if the “outside” firm had a low MES, the new advertising costs may result in a much higher MES which deters entry.

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economics chapters 1-11

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