Post Grad Diploma Class 2 Elasticity The beauty

Post Grad Diploma - Class 2 Elasticity The beauty of Marginal Cost and Marginal Revenue Accounting and Economic Profits Different types of Markets

The elasticity of demand • Price elasticity of demand is a measure of how much the quantity demanded of a good responds to a change in the price of that good. • Price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in price.

Computing the price elasticity of demand • The price elasticity of demand is computed as the percentage change in the quantity demanded divided by the percentage change in price. Price elasticity of demand = Percentage change in quantity demanded Percentage change in price

Computing the price elasticity of demand • Example: If the price of an ice cream cone increases from $2. 00 to $2. 20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand would be calculated as (ignoring the negative sign):

The variety of demand curves • Inelastic demand – Quantity demanded does not respond strongly to price changes. – Price elasticity of demand is less than one. • Elastic demand – Quantity demanded responds strongly to changes in price. – Price elasticity of demand is greater than one.

The variety of demand curves • Perfectly inelastic – Quantity demanded does not respond to price changes. • Perfectly elastic – Quantity demanded changes infinitely with any change in price. • Unit elastic – Quantity demanded changes by the same percentage as the price.

The price elasticity of demand (a) Perfectly inelastic demand: elasticity equals 0 Price Demand $5 4 1. An increase in price. . . 0 100 Quantity 2. . leaves the quantity demanded unchanged. Copyright© 2003 Southwestern/Thomson Learning

The price elasticity of demand (b) Inelastic demand: elasticity is less than 1 Price $5 4 1. A 22% increase in price. . . Demand 0 90 100 2. . leads to an 11% decrease in quantity demanded. Quantity

The price elasticity of demand (c) Unit elastic demand: elasticity equals 1 Price $5 4 Demand 1. A 22% increase in price. . . 0 80 Quantity 100 2. . leads to a 22% decrease in quantity demanded. Copyright© 2003 Southwestern/Thomson Learning

The price elasticity of demand (d) Elastic demand: elasticity is greater than 1 Price $5 4 Demand 1. A 22% increase in price. . . 0 50 100 Quantity 2. . leads to a 67% decrease in quantity demanded.

The price elasticity of demand (e) Perfectly elastic demand: elasticity equals infinity Price 1. At any price above $4, quantity demanded is zero. $4 Demand 2. At exactly $4, consumers will buy any quantity. 0 3. At a price below $4, quantity demanded is infinite. Quantity

Total revenue and the price elasticity of demand • Total revenue is the amount paid by buyers and received by sellers of a good. • Calculated as the price of the good times the quantity sold. • TR = P x Q

Total revenue Price $4 P × Q = $400 (revenue) P Demand 100 0

Elasticity and total revenue along a linear demand curve • With an inelastic demand curve, an increase in price leads to a decrease in quantity that is proportionately smaller. Thus, total revenue increases.

Price How total revenue changes: inelastic demand Price An Increase in price from $1 to $3 … … leads to an Increase in total revenue from $100 to $240 $3 Revenue = $240 $1 Demand Revenue = $100 0 100 Quantity Demand 0 80 Quantity Copyright© 2003 Southwestern/Thomson Learning

Elasticity and total revenue along a linear demand curve • With an elastic demand curve, an increase in the price leads to a decrease in quantity demanded that is proportionately larger. Thus, total revenue decreases.

Price How total revenue changes: elastic demand Price An Increase in price from $4 to $5 … … leads to an decrease in total revenue from $200 to $100 $5 $4 Demand Revenue = $200 0 50 Revenue = $100 Quantity 0 20 Quantity Copyright© 2003 Southwestern/Thomson Learning

What are costs? According to the law of supply, firms are willing to produce and sell a greater quantity of a good when the price of the good is high. This results in a supply curve that slopes upward.

What are costs? The firm’s objective The economic goal of the firm is to maximise profits.

Total revenue, total cost, and profit Total revenue is the amount a firm receives for the sale of its output. Total cost is the amount a firm pays to buy the inputs into production. Profit is the firm’s total revenue minus its total cost. Profit = total revenue − total cost

Costs as opportunity costs A firm’s cost of production includes all the opportunity costs of making its output of goods and services. A firm’s cost of production include explicit costs and implicit costs. • Explicit costs are input costs that require a direct outlay of money by the firm. • Implicit costs are input costs that do not require an outlay of money by the firm.

Economic profit versus accounting profit Economists measure a firm’s economic profit as total revenue minus total cost, including both explicit and implicit costs. Accountants measure the accounting profit as the firm’s total revenue minus only the firm’s explicit costs.

Economic profit versus accounting profit When total revenue exceeds both explicit and implicit costs, the firm earns economic profit. Economic profit is smaller than accounting profit. For a business to be profitable from an economist’s standpoint, total revenue must cover all the opportunity costs, both explicit and implicit.

Economists versus accountants How an economist views a firm How an accountant views a firm Economic profit Accounting profit Revenue Implicit costs Explicit costs Revenue Total opportunity costs Explicit costs Copyright © 2004 South-Western

Production and costs • The production function: The production function shows the relationship between quantity of inputs used to make a good and the quantity of output of that good.

The production function • Marginal product: The marginal product of any input in the production process is the increase in output that arises from an additional unit of that input.

The production function • Diminishing marginal product is the property whereby the marginal product of an input declines as the quantity of the input increases. • Example: As more and more workers are hired at a firm, each additional worker contributes less and less to production because the firm has a limited amount of equipment.

Hungry Helen’s Cake Factory Output (quantity of cakes Marginal Number of produced per product of hour) labour workers 0 1 0 50 50 40 2 3 4 90 120 140 30 20 10 5 150 Cost of factory Total cost of inputs (cost of factory + cost of Cost of workers)

Hungry Helen’s production function Quantity of output (cookies per hour) Production function 150 140 130 120 110 100 90 80 70 60 50 40 30 20 10 0 1 2 3 4 5 Number of workers hired

The production function Diminishing marginal product The slope of the production function measures the marginal product of an input, such as a worker. When the marginal product declines, the production function becomes flatter.

From the production function to the total-cost curve The relationship between the quantity a firm can produce and its total costs determines pricing decisions. The total-cost curve shows this relationship graphically.

Hungry Helen’s cake factory Number of workers Output (quantity of cakes Marginal produced per product Cost of hour) of labour factory Cost of workers Total cost of inputs (cost of factory + cost of workers) 0 0 50 $30 $ 0 $30 1 50 40 30 10 40 2 90 30 30 20 50 3 120 20 30 30 60 4 140 10 30 40 70 5 150 30 50 80

Hungry Helen’s total-cost curve Total cost Total-cost curve $80 70 60 50 40 30 20 10 20 30 40 50 60 70 Quantity of output (cookies per hour) 80 90 100 110 120 130 140 150 Copyright © 2004 South-Western

The various measures of cost • Costs of production may be divided into two types: − fixed costs and − variable costs.

Fixed and variable costs Fixed costs are those costs that do not vary with the quantity of output produced. Variable costs are those costs that do vary with the quantity of output produced.

Fixed and variable costs Total costs: Total fixed costs (TFC) Total variable costs (TVC) Total costs (TC) TC = TFC + TVC

Thirsty Thelma’s Lemonade Stand Quantity of lemonade (bottles Total per hour) cost Fixed cost Variable cost Average fixed cost Average variable cost Average total cost Marginal cost 0 $3. 00 $ 0. 00 — — 1 3. 30 3. 00 0. 30 $3. 00 $0. 30 $3. 30 $0. 30 2 3. 80 3. 00 0. 80 1. 50 0. 40 1. 90 0. 50 3 4. 50 3. 00 1. 50 1. 00 0. 50 1. 50 0. 70 4 5. 40 3. 00 2. 40 0. 75 0. 60 1. 35 0. 90 5 6. 50 3. 00 3. 50 0. 60 0. 70 1. 30 1. 10 6 7. 80 3. 00 4. 80 0. 50 0. 80 1. 30 7 9. 30 3. 00 6. 30 0. 43 0. 90 1. 33 1. 50 8 11. 00 3. 00 8. 00 0. 38 1. 00 1. 38 1. 70 9 12. 90 3. 00 9. 90 0. 33 1. 10 1. 43 1. 90 10 15. 00 3. 00 12. 00 0. 30 1. 20 1. 50 2. 10

Average costs • Average costs can be determined by dividing the firm’s costs by the quantity of output it produces. The average cost is the cost of each typical unit of product.

Average costs • Average costs Average fixed costs (AFC) Average variable costs (AVC) Average total costs (ATC) • ATC = AFC + AVC

Average costs

Marginal cost • Marginal cost (MC) measures the increase in total cost that arises from an extra unit of production. Marginal cost helps answer the following question: How much does it cost to produce an additional unit of output?

Marginal cost

Thirsty Thelma’s cost curves Costs $3. 50 3. 25 3. 00 2. 75 2. 50 2. 25 MC 2. 00 1. 75 1. 50 ATC 1. 25 AVC 1. 00 0. 75 0. 50 AFC 0. 25 0 1 2 3 4 5 6 7 8 Quantity of output (glasses of lemonade per hour) 9 10 Copyright © 2004 South-Western

Big Bob’s Bagel Bin Bagels (per hour) Total cost Fixed cost Average Variable fixed cost Average variable cost Average total cost Marginal cost 0 $ 2. 00 $ 0. 00 — — 1 3. 00 2. 00 1. 00 $2. 00 $1. 00 $3. 00 $1. 00 2 3. 80 2. 00 1. 80 1. 00 0. 90 1. 90 0. 80 3 4. 40 2. 00 2. 40 0. 67 0. 80 1. 47 0. 60 4 4. 80 2. 00 2. 80 0. 50 0. 70 1. 20 0. 40 5 5. 20 2. 00 3. 20 0. 40 0. 64 1. 04 0. 40 6 5. 80 2. 00 3. 80 0. 33 0. 63 0. 96 0. 60 7 6. 60 2. 00 4. 60 0. 29 0. 66 0. 95 0. 80 8 7. 60 2. 00 5. 60 0. 25 0. 70 0. 95 1. 00 9 8. 80 2. 00 6. 80 0. 22 0. 76 0. 98 1. 20 10 10. 20 2. 00 8. 20 0. 82 1. 02 1. 40 11 11. 80 2. 00 9. 80 0. 18 0. 89 1. 07 1. 60 12 13. 60 2. 00 11. 60 0. 17 0. 97 1. 14 1. 80 13 15. 60 2. 00 13. 60 0. 15 1. 05 1. 20 2. 00 14 17. 80 2. 00 15. 80 0. 14 1. 13 1. 27 2. 20

Big Bob’s cost curves (a) Total-cost curve Total cost TC $18. 00 16. 00 14. 00 12. 00 10. 00 8. 00 6. 00 4. 00 2. 00 0 2 4 6 8 10 12 14 Quantity of output (bagels per hour) Copyright © 2004 South-Western

Big Bob’s cost curves (b) Marginal- and average-cost curves Costs $3. 00 2. 50 MC 2. 00 1. 50 ATC AVC 1. 00 0. 50 AFC 0 2 4 6 8 10 12 14 Quantity of output (bagels per hour) Copyright © 2004 South-Western

Typical cost curves Three important properties of cost curves Marginal cost eventually rises with the quantity of output. The average-total-cost curve is U-shaped. The marginal-cost curve crosses the averagetotal-cost curve at the minimum of average total cost.

Economies and diseconomies of scale • Economies of scale refer to the property whereby long-run average total cost falls as the quantity of output increases.

Economies and diseconomies of scale • Diseconomies of scale refer to the property whereby long-run average total cost rises as the quantity of output increases. • Constant returns to scale refers to the property whereby long-run average total cost stays the same as the quantity of output changes.

Average total cost in the short and long run Average total cost ATC in short run with small factory ATC in short run with medium factory large factory ATC in long run $12, 000 10, 000 Economies of scale 0 Constant returns to scale 1, 000 1, 200 Diseconomies of scale Quantity of cars per day Copyright © 2004 South-Western

The four types of Markets Perfect Competition Monopoly Oligopoly Monopolistic Competition

Perfect Competition Monopolistic Competition Oligopoly Monopoly Firms Large number Large Number Small Number One Products Identical Differentiated Similar. Differentiated No close substitutes Barriers to entry and exit No barriers Freedom of entry and exit Some barriers to entry Effective barriers to entry Control over market price No Control Small Control Substantial control Significant control.

Perfect Competition A perfectly competitive market has the following characteristics: There are many buyers and sellers in the market. The goods offered by the various sellers are largely the same. Firms can freely enter or exit the market.

What is a competitive market? As a result of its characteristics, the perfectly competitive market has the following outcomes: The actions of any single buyer or seller in the market have a negligible impact on the market price. Each buyer and seller takes the market price as given.

In a competitive firm Total revenue for a firm is the selling price times the quantity sold. TR = (P Q) Total revenue is proportional to the amount of output.

Average Revenue = Price

Marginal Revenue Marginal revenue is the change in total revenue from an additional unit sold. MR =DTR/DQ

Revenue of a competitive firm Quantity (Q) 1 lawn Price (P) Total revenue (TR = P X Q) Average revenue (AR = TR/Q) Marginal revenue (MR = ΔTR/ΔQ) $20 $20 - 2 20 40 20 $20 3 20 60 20 20 4 20 80 20 20 5 20 100 20 20 6 20 120 20 20 7 20 140 20 20 8 20 160 20 20

Profit maximisation The goal of a competitive firm is to maximise profit. This means that the firm will want to produce the quantity that maximises the difference between total revenue and total cost. Marginal Revenue = Marginal Cost

Profit maximisation Quantity (Q) Total revenue (TR) Total cost Profit (TC) (TR – TC) Marginal revenue (MR = ΔTR/ΔQ) Marginal cost (MC = ∆TC/∆Q) 0 lawns $0 $ 10 –$10 - - 1 20 14 6 $20 $4 2 40 22 18 20 8 3 60 34 26 20 12 4 80 50 30 20 16 5 100 70 30 20 20 6 120 94 26 20 24 7 140 122 18 20 28 8 160 154 6 20 32

Profit maximisation Costs and Revenue The firm maximises profit by producing the quantity at which marginal cost equals marginal revenue. MC MC 2 ATC P = MR 1 = MR 2 AVC P = AR = MR MC 1 0 Q 1 QMAX Q 2 Quantity Copyright © 2004 South-Western

Profit maximisation When MR > MC, increase Q When MR < MC, decrease Q When MR = MC, profit is maximised

To shut down or to exit? Shut Down – Short run decision to not produce anything Permanent exit – Long run decision to exit the market. Most firms cannot avoid fixed costs in the short run Firms Decision to Shut Down Total Revenue < Total Variable Cost Price < Average Variable Cost Firms Decision to Exit Permanently Total Revenue < Total Cost Price < Average Total Cost If this is the exit then Price > ATC – is the entry

The competitive firm’s short run supply curve Costs If P > ATC, the firm will continue to produce at a profit. Firm’s short-run supply curve MC ATC If P > AVC, firm will continue to produce in the short run. AVC Firm shuts down if P < AVC 0 Quantity

Profit (a) A firm with profits Price MC ATC Profit P ATC P =

Loss (b) A firm with losses Price MC ATC P P = AR =

The long run: Market supply with entry and exit Firms will enter or exit the market until profit is driven to zero. In the long run, price equals the minimum of average total cost. The long-run market supply curve is horizontal at this price.

Competitive firms and zero profit Profit equals total revenue minus total cost. Total cost includes all the opportunity costs of the firm. In the zero-profit equilibrium, the firm’s revenue compensates the owners for the time and money they expend to keep the business going.

Monopoly A monopoly is a price maker Competitive market P=MC Monopoly P> MC The monopolist profit is not unlimited because of the demand curve Why monopolies arise Simply its due to the barriers of entry Monopoly resources – a key resource used for production is owned by one firm (Diamonds) Government regulation – the government gives a single firm the right to produce some good or service (railways) The production process – economies of scale so the costs are much lower in one firm over the others.

Economies of scale as a cause of monopoly Cost Average total cost 0 Quantity of output

Monopoly production and pricing decisions Monopoly is the sole producer faces a downward-sloping demand curve is a price maker reduces price to increase sales Perfect Competition is one of many producers faces a horizontal demand curve is a price taker sells as much or as little at same price

Demand curves: Competitive and monopoly firms (a) A Competitive firm’s demand curve Price (b)

A monopoly's revenue Quantity of water (Q) Price (P) Total revenue Average revenue (TR = P X Q) (AR = TR/Q) Marginal revenue (MR = DTR/DQ) 0 litres $11 $0 — — 1 10 10 $10 2 9 18 9 8 3 8 24 8 6 4 7 28 7 4 5 6 30 6 2 6 5 30 5 0 7 4 28 4 – 2 8 3 24 3 – 4

Demand marginal-revenue curves Price $11 10 9 8 7 6 5 4 3 2

Profit maximisation A monopoly maximizes profit by producing the quantity at which marginal revenue equals marginal cost. It then uses the demand curve to find the price that will induce consumers to buy that quantity.

Profit maximisation for a monopoly Costs and revenue 2. . and then the demand curve shows the price consistent with this quantity. B Monopoly price 1. The intersection of the marginal-revenue curve and the marginal-cost curve determines the profit-maximizing quantity. . . Average total cost A Demand Marginal cost Marginal revenue 0 Q QMAX Q Quantity Copyright © 2004 South-Western

A monopoly's profit Profit equals total revenue minus total costs. Profit = TR − TC Profit = (TR/Q − TC/Q) Q Profit = (P − ATC) Q

The monopoly’s profit Costs and revenue Marginal cost Monopoly E price B Monopoly profit Average total D cost Average total cost C Demand Marginal revenue 0 QMAX Quantity Copyright © 2004 South-Western

The inefficiency of monopoly Price Deadweight loss Marginal cost Monopoly price Marginal revenue 0

The inefficiency of monopoly The monopolist produces less than the socially efficient quantity of output.

Price discrimination is the business practice of selling the same good at different prices to different customers, even though the costs for producing for the two customers are the same.

Price discrimination Examples of price discrimination movie tickets store brands airline prices discount coupons quantity discounts

Between monopoly and perfect competition Types of imperfectly competitive markets Oligopoly only a few sellers, each offering a similar or identical product to the others Monopolistic competition many firms selling products that are similar but not identical

Monopolistic Competition A monopolistic competitive firm is inefficient. Average total cost is not at a minimum. There is a lot of information for the consumer to collect and process to make the best decisions. Advertising increases cost but advertising is essential to differentiate.

Markets with only a few sellers Characteristics of an oligopoly market Few sellers offering similar or identical products. Interdependent firms. Best off cooperating and acting like a monopolist by producing a small quantity of output and charging a price above marginal cost.

The demand schedule for water Quantity (in litres) Price Total revenue (and total profit) 0 $120 $ 0 10 1100 2000 30 90 2700 40 80 3200 50 70 3500 60 60 3600 70 50 3500 80 40 3200 90 30 2700 100 20 2000 110 10 1100 120 0 0

A duopoly example Price and quantity supplied The price of water in a perfectly competitive market would be driven to where the marginal cost is zero: P = MC = $0 Q = 120 Litres The price and quantity in a monopoly market would be where total profit is maximised: P = $60 Q = 60 Litres

A duopoly example Price and quantity supplied The socially efficient quantity of water is 120 litres, but a monopolist would produce only 60 litres of water. So what outcome then could be expected from duopolists?

Competition, monopolies, and cartels The duopolists may agree on a monopoly outcome. Collusion is an agreement among firms in a market about quantities to produce or prices to charge. Cartel is a group of firms acting in unison.

Game theory and the economics of cooperation Game theory is the study of how people behave in strategic situations. Strategic decisions are those in which each person, in deciding what actions to take, must consider how others might respond to that action.

Game theory and the economics of cooperation Because the number of firms in an oligopolistic market is small, each firm must act strategically. Each firm knows that its profit depends not only on how much it produces, but also on how much the other firms produce.

The prisoners’ dilemma provides insight into the difficulty in maintaining cooperation. Often people (of firms) fail to cooperate with one another even when cooperation would make them all better off.

The prisoners’ dilemma Kelly’ s decision Confess Kelly gets 8 years Remain silent Kelly gets 20 years Confess Ned gets 8 years Ned’s decision Kelly goes free Ned goes free Kelly gets 1 year Remain Silent Ned gets 20 years Ned gets 1 year

The prisoners’ dilemma The dominant strategy is the best strategy for a player to follow regardless of the strategies chosen by the other players. Cooperation is difficult to maintain, because cooperation is not in the best interest of the individual player.