Utility

Utility
In economics we define utility as “satisfaction” or rather the satisfaction a consumer
receives from the consumption of a product over a given period of time. It can be loosely
translated into the satisfaction or happiness a consumer receives when he consumes a
product. Note that in reality satisfaction or happiness cannot be quantified. However, we as
economists will measure utility in a unit known as “Utils”.

Total Utility (TU): Total satisfaction received from the consumption of a good (or service)
within a given period of time.

Marginal Utility (MU): The additional satisfaction received from the consumption of one
extra unit.

Marginal Utility MUST always diminish. In fact, this is known as the Law of Diminishing
Marginal Utility (DMU). This law is the foundation for many economic theories.
All this law is stating is that additional units of a good consumed will give less and less
additional utility. MU MUST decline.

# Bars 0 1 2 3 4 5 6
TU 0 9 14 17 18 18 16
MU
Points to Consider:
• TU will always start at the origin. If zero units are consumed, then TU must be zero.
• MU ALWAYS slopes downwards. This is due to the law of DMU.
• TU MUST be maximum when MU is zero.
• In fact, as long as MU is positive, TU must increase. When MU is zero, TU is
maximum. When MU falls below zero then TU will start to fall.
• TU will increase at a decreasing rate due to the law of DMU (i.e. MU is downward
sloping)
• In fact, the slope of the TU curve is the MU curve! [Change in TU / Change in Q]

As mentioned before, utility cannot be measured as satisfaction cannot be quantified across

consumers. To get around this problem, economists decided to measure utility in monetary
terms. When utility is measured in monetary terms, the MU column becomes of tantamount
importance. In fact, the MU column starts to show us how much consumers are willing to
pay for subsequent units of a good. Note that consumers are willing to pay less and less for
subsequent units due to the law of DMU. Each additional unit consumed is giving less and
less satisfaction so consumers are willing to pay less and less.

Q MU (Willing Mkt P MCS

to pay) (Actually pay)

1 9 3

2 5 3

3 3 3

4 1 3

5 0 3

6 -2 3

The amount that consumers are willing to pay does not affect market price. Consumer
surplus is defined as the difference between what consumers are willing to pay and what
they actually pay for units of a good consumed. As can be seen above a consumer will only
consume 3 units of the good as for the 4th unit he is not willing to pay market price. At 3
units, total consumer surplus is maximised (6 + 2 + 0 = 8). If the 4th unit were to be
consumed it would take away from total consumer surplus (8 -2 = 6).
In fact, using this information, we can define what is known as a rational consumer. A
rational consumer is one who seeks to maximise his consumer surplus. As can be seen, this
means he will continue to consume up to the point where P = MU. As soon as P > MU a
rational consumer will not buy that unit as he is not willing to pay market price.
This can be shown on a diagram:

At a price of P, a rational consumer will consume Q units. Total consumer surplus is the area
above price but below the MU curve. The rational consumer consumes up to the point
where P = MU
At a price of P1, Q1 units are being consumed. If the price of this product rises to P2, a
rational consumer will now change the amount demanded to Q2, so as to maximise
consumer surplus. Similarly, at a price of P3, Q3 units of the good will be demanded.
As we keep changing price, we notice that the quantity demanded is being dictated by the
MU curve. In fact, the MU curve is showing us a unique relationship between Price and
Quantity Demanded. When we measure utility in monetary terms, and factor in the
rationality of consumers, the MU curve becomes the demand curve for a product. The law
of Diminishing Marginal Utility is indeed the basis for the downward sloping demand curve
and demand theory in general!
[PLEASE DO NOT WRITE THAT AN MU CURVE IS A DEMAND CURVE BECAUSE IT IS
DOWNWARD SLOPING!]

The Equi-Marginal Principle:

The equi-marginal principle deals with the concept of a consumer equilibrium. Consumers
have a fixed income and it is the goal of every rational consumer to try and maximise the
utility received from that given income. They will therefore choose that bundle/combination
of goods which gives then maximum utility from their given income.
The equi-marginal principle states that a consumer will get maximum utility from a given
level of income when he chooses that combination of goods where the utility gained from
that last dollar spent on each good is the same. He will choose that combination of goods
which equates relative prices to relative marginal utilities.

MUa = MUb = MUc = . . . . . . = MUn (where a-n are various g&s)

Pa Pb Pc Pn

Lets consider an example of two goods, a pizza and a movie.

Say the pizza is twice as expensive as a movie.

!" $
Therefore =
!# %

Currently, at present levels of consumption, say the MU gained from pizza is three times
that gained from movies.

&'" (
Therefore =%
&'#

&'" !"
What this means is that &'#
> !#

Even though the pizza is twice as expensive as a movie, it is currently giving the consumer 3
times as much satisfaction. Therefore the consumer will consume more of the pizza (and
less movies).
However, as more pizza is consumed, the MU of pizza has to fall (law of DMU) and as less
movies are consumed the MU of movies must rise.
Say now the consumer has consumed so may pizzas that the MU of pizzas and movies is the
same.
&'" %
=%
&'#

&'" !"
What this means is now <
&'# !#

The pizza is twice as expensive as the movie but giving the same amount of satisfaction. The
rational consumer will now cut back on pizzas and start consuming more movies.
In fact, the consumer will continue to alter his consumption of both goods until:
&'" !" $
= !# = %
&'#

Now, at current quantities consumed, the pizza costs twice as much as the movie but also
gives twice as much satisfaction. The consumer has no incentive to alter his behaviour or
switch any further between the products. This is the point of ‘consumer equilibrium’.
Relative prices and relative marginal utilities have been equated. This is the assertion of the
equi-marginal principle.

Note : some rearrangement of the above equation gives us the original equation from the
equi-marginal principle.

&'" !"
=
&'# !#

The equi-marginal principle states that a rational consumer will buy that quantity of each
good a --> n which satisfies the equation. Only then will he get maximum satisfaction from
given income.

Utility Practice MCQs

1)
2)

3)
Using the Equi-Marginal Principle to derive a Demand Curve:

MUa = MUb = MUc = . . . . . . = MUn (where a-n are various g&s)

Pa Pb Pc Pn

We can use the above equation to derive a demand curve for a product. Say we want to
derive a demand curve for good ‘a’. Currently, some quantity of good ‘a’ is being consumed
which is satisfying the EMP. Let us assume that the ratio which satisfies the equation is 3/1.
Further, the price of good a is currently $10. Therefore the consumer will find that quantity
of ‘a’ which is yielding an MU of 30. Say that is 5 units. We have just successfully generated
the first point on our demand curve.
Now say the price of ‘a’ increases to $15 ceteris paribus. What this means is, aside from the
price of ‘a’, the entire equation above remains constant. With the new price of ‘a’, the
current quantity of 5 with an MU of 30 will no longer satisfy the equation. (30/15 = 2/1 not
the required 3/1). The consumer is now adjust his behaviour to find a new quantity and
therefore a new MU of ‘a’ which once again satisfies the equation. In fact, he needs a
quantity of ‘a’ which yields an MU of 45. Say this happens at 3 units. He will cut back
consumption of this good to 3 units. We have successfully generated a second point on the
demand curve.
We can continue to change the price of this product and allow the above equation to
generate quantities which keep satisfying the EMP. In doing so, we generate an entire
demand curve for the product!

Note: Shapes and shifts of the demand curve can also be explained using DMU. Inelastic or
steeper curves show a rapidly diminishing MU while along flatter curves MU diminishes
more slowly. This is because with elastic demand the overall consumption of the good does
not change very much. Consumers are simply switching away from the substitute towards
this brand therefore overall consumption of the product is not changing too much.
Therefore MU will not change too much.
Similarly, an upward shift of the demand curve is showing more MU per unit consumed. A
very simple example would be an increase in demand for ice cream over the summer. The
utility per unit of ice cream consumed over the summer will be higher as compared to the
winter.
Limitations of Utility Theory:

1) Utility is a very transient concept. It changes from day to day or even from hour to
hour. It is hard to base an entire theory on a concept that keeps changing.
2) Essentially, utility is satisfaction and satisfaction simply cannot be quantified. We can
attempt to measure it in monetary terms but this does not change the fact that in
reality it cannot be measured.
3) Economists measure utility in monetary terms. When we do this we are making an
inherent assumption that money itself has a constant marginal utility. In fact, this is
not so. Money itself is subject to the law of DMU. As we earn more and more money,
the additional satisfaction gained from additional income will be less and less. A
thousand dollars given to a man earning $100 will mean more and give more
satisfaction than the same amount given to a man earning $1,000,000. If this is the
case, looking at the amount that consumers are willing to pay will not measure
relative utilities across different income groups. We are essentially basing our entire
theory of a foundation that is subject to the theory itself! If the foundation is not
solid, the entire theory can be called into question.
4) For consumer durables, utility may be hard to predict. They may assign too high or
too low a utility for a product before purchase. This will make the EMP somewhat
inaccurate.
5) Similarly, the quality of goods may change over time. Therefore the consumer may
want more or less of the good as a result. The assumption of ‘ceretis paribus’ cannot
always hold.
6) The equilibrium of a product may come at a decimal value of the good that is
impossible to buy! E.g 1.2 cars.
7) The law of DMU cannot explain special cases such as perfectly elastic or ineasltic
demand. These special cases do not have a root in utility theory.
8) Say we accept the theory itself and assume it is valid. The next question we need to
ask is if consumers indeed behave this way! Can we actually use this as a model or
prediction of consumer behaviour? Are consumers indeed rational? Do they actually
behave in a rational manner? Do they subconsciously follow the EMP when making
decisions? And finally what is the role of advertising?

Advertising and Rationality:

Informative advertising may allow the consumer to make a more informed and therefore
rational decision.
The goal of persuasive advertising is simply to convince the consumer to buy the product. In
this case, is a consumer behaving rationally when he is suddenly convinced to buy the
product? What is the explanation behind impulse buying? Is a consumer really rational if the
music playing in a store can influence his buying pattern? Consider why candy and
magazines are often placed in the front of the store. Even in shops such as H&M and Zara,
accessories are often kept where customers line up to pay. Why do you think this is so? How
does all of this affect the EMP and the concept of a ‘consumer equilibrium’?

The Paradox of Value - Diamonds vs Water:

Diamonds are a luxury and are extremely expensive while water is a necessity but relatively
cheap. Utility theory explains these different values placed on the product by looking at
Marginal Utility vs Total Utility. The total utility received by water over a lifetime is
extremely high but marginal utility is likely to be low due to the large amount consumed. For
an individual, the overall total utility from diamonds is lower than the total utility from
water in his lifetime, however the marginal utility from diamonds is high due to the
restricted amount consumed. The paradox of value explains that it is marginal not total
utility that makes a consumer allocate a value to the product.
 Budget Lines
A budget line shows different combinations of two goods that a consumer can buy Slope of the Budget Line: Y/Py = Px
with his given income. Y/Px Py
E.g. Y = $100 The slope of the budget line is the ratio of the prices.
Px = 20
A: consumer spends his entire income on good Y.
Py = 25 1) The price of X increases:
How many units can he buy?
Good Y Good Y
B: consumer spends his entire income on good X. When the price of X increases, the x intercept
How many units can he buy? Y/Py moves inwards.
Y/Py A C: some combination of good X and good Y that Why doesn’t the Y intercept change?
the consumer can buy using all his income.
E
The slope of the budget line will change as the
D: the consumer is not using his entire income. ratio of the prices has changed.
C
E: a combination of good X and good Y that is
D currently unattainable with given income
B
0
Y/Px Good X
0 Y/Px1 Y/Px Good X
 2) The price of Y decreases: 3) The price of the two goods remains the same but income increases:
Good Y
Good Y If income changes the budget line will shift in a
Y/Py1 parallel manner.
When the price of Y decreases, the Y intercept
moves outwards. Why is this so?
Y/Py
Why doesn’t the X intercept change? Y1/Py
Similarly the the price of both goods double the
The slope of the budget line will change as the budget line will shift inwards in a parallel manner.
ratio of the prices has changed. Why is this so?
Y/Px
0 Y/Px Good X 0 Y/Px Y1/Px Good X
 4) Income stays the same, the price of X increases by 20% and the price of Y 5) Income stays the same, Px increases, Py decreases
increases by 30 %
Good Y Good Y
Y/Py Y/Py
0 Y/Px Good X 0 Y/Px Good X
 Income and Substitution Effects
6) Finally lets consider a scenario where income is increasing and so is the price of As we know, the law of demand states that there is an inverse relationship between
Y. However Px is remaining constant. P and Qd. When the price of a good increases we know that Qd will fall. We are now
trying to analyse the exact reasons that cause Qd to fall. We will look at the change
Good Y Because we do not know the degree of increase in Qd and break it up into two different effects:
of Y and Py, there are 3 different scenarios that
can take place. (i) Income Effect: When the price of a good increases, a consumer’s real income
Y/Py 1) ↑Y > ↑ Py falls. They are unable to afford as much as he could before. As a result of this
2) ↑Y < ↑ Py they will have to cut back on quantity demanded.
3) ↑Y = ↑ Py (ii) Substitution Effect: When the price of a good increases, ceteris paribus, it
becomes relatively expensive as compared to its substitutes. Therefore,
consumers will have an incentive to substitute away from that good towards other
alternatives. This works to reduce quantity demanded.
Note: CAIE questions will require you to work
backwards from this information. You will need to Remember, these two effects are happening simultaneously with changes in price.
figure out what set of circumstances caused the The market registers an overall fall in Qd. We are simply looking under a microscope
budget line to change its position.
to see how much Qd is changing specifically as a result of each of these effects.
0 Y/Px Good X
For Normal Goods: Normal goods are defined as those whose demand has a For Inferior Goods: Inferior goods are defined as those whose demand has an
direct relationship with income. When the price of a normal good increases, both the inverse relationship with income. Remember though, these goods still have a
income and the substitution effect work in the same direction. They reinforce each downward sloping demand curve. When the price of an inferior good increases, the
other to reduce Qd. income and substitution effects work in opposite directions.
Say currently at a price of 10, 100 units are being demanded. The price of the good
increases to 15. Qd falls to 70 units. We can see that Qd has decreased by 30 units. The substitution effect still works to reduce Qd as before. Note however, that an
We are now trying to further subdivide this fall of 30 units into income and increase in price will reduce the real income of the consumer. This reduction in
substitution effects. income will, by definition, increase the demand for inferior goods! Therefore,
the income effect will actually work to increase Qd!
As mentioned before, inferior goods have downward sloping demand curves. This
means that the substitution effect will outweigh the income effect and there will be an
overall fall in Qd. It is important to remember that these two effects are happening
70 82 100 simultaneously and so the market will just record an overall fall in Qd.
In the above example, the substitution effect led to a reduction in Qd of 18 units, and
the income effect a further 12 units. This gives an overall fall in Qd of 30 units.
The magnitude of these effects determine how much Qd will change. Therefore, they
are essentially determining the elasticity of demand for this product.
Say currently at a price of 10, 100 units are being demanded. The price of the good
increases to 15. Qd in the market falls to 80 units. For Giffen Goods:
We are now trying to isolate income and substitution effects. The substitution effect
pushed Qd all the way down to 75 units. However the income effect increased Qd by A giffen good is a unique type of inferior good that has an upward sloping demand
5 units. So the overall effect in the market is a fall of 20 units as the income effect curve. As the price of this good increases, Qd actually increases as well. This
outweighed the substitution effect. phenomenon is found under conditions of extreme poverty such as the potato
famine of Ireland. What happens here is that consumers buy this product as their
staple diet and therefore spend a very large proportion of their income on this good.
When the price of the good increases, consumers are still forced to buy it as it is
their staple diet. Since they have very little money left over, there are unable to buy
anything else and so, therefore, end up buying more of the product due to necessity.
Consider a poor Irish family that eats potatoes 6 times a week and chicken once a
week. As potatoes become more expensive, they must continue to buy potatoes as
75 80 100
it is their staple diet 6 days a week. But now, they don’t have enough money left over
to buy chicken on the 7th day. Hence they must buy potatoes for that day as well.
The increase in price actually led to an increase in Qd.
In the case of a Giffen Good, the income effect will outweigh the substitution effect.
The substitution effect will work to reduce Qd and, much like an inferior good, the
income effect will work to increase Qd. However, in this case, the income effect
outweighs the substitution effect and there will be an overall increase in Qd.
85 100 110
 Indifference Analysis
An indifference curve shows various combinations of two goods between which the
consumer is indifferent. We can say that all these combinations yield the same total utility
to the consumer.

Pears Oranges
All these combinations yield the same amount of utility.
30 6
Note a trend with regards to Diminishing Marginal
Utility. Initially, the consumer is willing to give up 6
24 7
pears for just 1 orange as consumption of pears is high
(leading to low MU) and consumption of Oranges is low
20 8
(leading to high MU).
However, lower down the table the opposite holds true.
14 10 5 oranges are being given up for 2 pears. This is because
now, comparatively, the consumption of oranges is
10 13 higher.

8 15

6 20

We can also show indifference curves with a diagram. An indifference curve will bow in at
the origin.
Initially, at point A, the consumer is consuming a lot of pears and very few oranges. As a
result, the consumer is willing to sacrifice 6 pears for just one orange. This is due to the law
of DMU. As we have mentioned before, total utility must remain the same along each
indifference curve. Therefore, we can safely say that the utility to the consumer from 6
pears is equal to that of one orange. What we have derived is something known as the
“Marginal Rate of Substitution” (MRS). This simply tells us how much of one good is needed
to compensate for the loss of another in order to keep Total Utility the same.

At point A MRS is 6, as 6 pears are given up for 1 orange. Since TU is not changing, this
means that the MU from 6 pears is equal to the MU from 1 orange.
!"# %
=
!"$ &
Note that the MRS is the slope of the indifference curve. (change in y/change in x = 6/1 =6)
The slope of the indifference curve is very much dependent on utility, specifically marginal
utility.

Each indifference curve will always give the

same level of utility to the consumer. Every
combination of goods along a specific
indifference curve all have the same level of
total utility.
However, indifference curves that are further
out indicate a higher level of utility for the
consumer. As we move away from the
original, each indifference curve is showing a
higher level of utility.

TU3 > TU2 > TU1

This is known as an Indifference Map

Every rational consumer would want to be on the highest possible Indifference Curve. It is
simply the consumers income that is a barrier in reaching this point. This can be represented
by adding a budget line to an indifference map.

Now that we have factored in a budget line to represent the consumers budget constraints,
we can see that the consumer is unable to reach IC3. Points ‘a’ , ‘b’ and ‘c’ are all attainable
to the consumer. However the consumer will choose point ‘c’ as this point is on a higher
indifference curve and therefore by definition will yield a higher level of total utility.
It follows that a rational consumer will choose that combination of ‘x’ and ‘y’ where the
budget line and indifference curve are tangential. This will ensure the highest possible utility
from given income.

At a point of tangency, the slope of the budget line and indifference curve must be the
same.

!"' )'
Therefore : = )(
!"(

But this is just the same Equimarginal Principle as before! Indifference analysis allows us to
come the conclusion of a consumer equilibrium without ever having to quantify utility! We
simply need consumers to be able to order their preferences!
Using Indifference Analysis to show income and substitution effects:

1) Normal Good: As mentioned before, for a normal good income and substitution
effects will work in the same direction.
Initially the consumer is at equilibrium at point ‘A’. Say the price of good X increases
ceteris paribus. The budget line will pivot inwards. The consumer will now have to
establish a new equilibrium at the point where the new budget line is tangential to
the highest achievable indifference curve. Say this happens at point ‘B’. Qd of X has
fallen from Qx1 to Qx2 as a result of the price increase. We will now attempt to isolate
the income and substitution effects within this change in quantity. To do so, we will
have to shift the new budget line up in a parallel manner. We then mark the point
where this new budget line is tangent to the original indifference curve. By shifting
the new budget line upwards in a parallel manner, we are essentially removing the
income effect of this price change by theoretically giving the consumer enough
income to get back on his original indifference curve. Hence any change in quantity
now MUST be due to the substitution effect. The only reason he has changed his
position on the indifference curve is due to the new, higher price of good X. Say this
is at point Qx3. Therefore Qx1 to Qx3 is the substitution effect and the remainder Qx3 to
Qx2 is the income effect.
2) Inferior Good: As mentioned before, for an inferior good income and substitution
effects will work in the opposite direction but the substitution effect outweighs the
income effect.
Initially the consumer is at equilibrium at point ‘A’. Say the price of good X increases
ceteris paribus. The budget line will pivot inwards. The consumer will now have to
establish a new equilibrium at the point where the new budget line is tangential to
the highest achievable indifference curve. Say this happens at point ‘B’. Qd of X has
fallen from Qx1 to Qx2 as a result of the price increase. We will now attempt to isolate
the income and substitution effects within this change in quantity. To do so, we will
have to shift the new budget line up in a parallel manner. We then mark the point
where this new budget line is tangent to the original indifference curve. By shifting
the new budget line upwards in a parallel manner, we are essentially removing the
income effect of this price change by theoretically giving the consumer enough
income to get back on his original indifference curve. Hence any change in quantity
now MUST be due to the substitution effect. The only reason he has changed his
position on the indifference curve is due to the new, higher price of good X. Say this
is at point Qx3. Therefore Qx1 to Qx3 is the substitution effect and the remainder Qx3 to
Qx2 is the income effect.
[Note in this case Qx3 lies outside the initial fall in quantity demanded.]
3) Giffen Goods: As mentioned before, for a Giffen Good, income and substitution
effects will work in the opposite direction but the income effect outweighs the
substitution effect.
There will be an overall increase in quantity demanded with a rise in the price of the
good.
Remember for a Giffen Good there is a direct relationship between price and
quantity demanded. Increases in price will increase quantity demanded while
reductions in price will actually reduce quantity demanded as now the consumer’s
real income has risen enough to allow him to purchase more attractive alternatives.

Price Change Type of Good Y and Sub Effects Overall D Demand

Rise Normal S¯ Y¯ Fall
Rise Inferior S ¯ Y ­ (S>Y) Fall
Rise Giffen S ¯ Y ­ (Y>S) Rise
Fall Normal S­ Y­ Rise
Fall Inferior S ­ Y ¯ (S>Y) Rise
Fall Giffen S ­ Y ¯ (Y>S) Fall
Although Indifference Analysis allows us to get around the problems of measuring utility, it
still may have some limitations. Consumers may not be able to construct imaginary bundles
of goods between which they are indifferent, unless they actually consume the goods.
Similarly, consumer durables such as computers and phones which are bought infrequently,
will not have any direct trade-off. Nevertheless, it does offer an elegant solution when
attempting to explain consumer behaviour.

As mentioned before, the rationality of consumers must also be taken into consideration. It
is for this reason that a new branch of economics known as ‘Behavioural Economics’ was
introduced.

Behavioural Economics

Both traditional Utility Theory and Indifference Analysis are rooted in the assumption that a
consumer will act rationally. That is to say, they:

i) Try and maximise their own personal utility.

ii) Have all the information required to them to make an informed decision.
iii) They analyse the costs and benefits of each action.
iv) They always make decisions at the margin.
v) Adhere to ‘ceteris paribus’ i.e. their preferences remain fixed.

It is quite obvious that consumers may not always behave in the ways mentioned above.
They may act ‘irrationally’ when looked at from the point of view of traditional economic
models. Such behaviour may include automatically renewing an existing car insurance when
a cheaper one is available or keeping funds in a particular bank when another is offering a
higher rate of interest.

Behavioural Economics attempts to combine aspects of sociology and psychology in

conjunction with economics to better understand human behaviour. Below are some
insights into this field.

Bounded Rationality and Heuristics: In reality, a consumer may not have either the time or
the ability to go through all the volume of information required to make a rational decision.
Therefore, we can say that an individual’s ability to make rational decisions is limited by the
quantity of information available to them and their ability to absorb and interpret it within
the timescale required. This is known as ‘Bounded Rationality’. It may help explain, like in
the example given above, why consumers tend to stick with a bank or insurance company
instead of trying to find a better deal. They may believe that the opportunity cost in terms
of time, financial costs and potential earnings lost will offset any gains or savings received.
This leads to ‘satisficing’ verses ‘optimising’ behaviour. They may stick to actions or
decisions that are ‘good enough’.

Behavioural Economics claims that individuals tend to use ‘Heuristics’ when making
decisions. These are rules of thumb or mental shortcuts used in order to speed up the
decision making process. These include:
 • Anchoring: Using the first bit of information received when making a decision. This
first bit of information is known as the ‘anchor’.
• Availability: Basing decisions on the easiest bit of information to recall. This
emphasises the importance of the way and order in which information is presented
to an individual.
• Representativeness: Basing decisions on past experience or assumptions. This can
also lead to stereotyping and therefore misinformation or irrational decisions. For
example, if a person has only met low income individuals from a certain location,
they may assume that everyone from that area must be of a low socio-economic
status.

Framing: The way information is presented to an individual may result in different decisions
being made by that individual. For example, an individual is more likely to buy an item if it is
marked down from $500 to $350 than if it was initially priced at $350! It is for this reason
that retail shops often raise the price of a product and then offer a 50% discount! It makes
the item seem more attractive to the consumer. What this implies is that that way an issue
or choice is presented or ‘framed’ may affect the decision made by an individual. This would
obviously affect the concept of ‘rational’ decision making.

The Endowment Effect: This refers to the fact that individuals often require more to give up
goods that they already own (their endowment) versus how much they would be prepared
to pay for these goods in the first place. Take the example of a coffee mug. Studies showed
that consumers often demanded up to twice the amount to part with their coffee mug as
compared to how much they paid for it in the first place! This endowment effect seems to
be related more to the fear of loss than the value or attractiveness of the good itself. This is
known as ‘Loss Aversion’.

Loss Aversion: Evidence shows that individuals appear to give greater weight to the
possibility of losses as opposed to gains even if the probability of either occurring is the
same.

Certainty versus Uncertainty: it is for the above reason that individuals may choose a less
attractive but certain outcome, over an outcome that may be far more lucrative but has an
element of uncertainty attached to it. This explains, for example, why individuals may prefer
a low yield investment to one that has a larger gain but also a possibility, albeit low, of
losses.

Too Much Choice: Although we often think of competition driven choice as a good thing for
consumers, studies have shown that too much choice may actually work against, rather than
for, the interest of the individual. When confronted with too many choices, individuals may
end up getting frustrated and make irrational choices or, in some cases, no choice at all!

Herd Instinct and Competition: People tend to have a ‘herd mentality’ when making
decisions and therefore may end up purchasing products simply because others are doing
so. Similarly, the desire to compete and keep up with others may drive the purchase of
expensive luxury items.
The fact that consumer’s behaviour may not always be traditionally rational has many policy
implications. Governments and other agencies can ‘nudge’ consumers into making different
decisions based on how the information is presented or, as mentioned above, framed.
“Nudge Theory” is defined as an attempt by the government (and other economic agents)
to alter the behaviour of consumers in some way. When it is the government using ‘nudge
theory’ they will attempt to make individuals behave in a way that is more beneficial to
them. Campaigns such as “Smoking Kills” is an example of nudge theory used by the
government.

Another example of ‘Nudge Theory’ is when individuals have to ‘opt out’ rather than ‘opt in’
for a particular scheme which is beneficial to them. Studies have shown that if participating
in a scheme (such as a pension) is the default position, less people will ‘opt out’ of the
scheme. However, if individuals had to click on a button to ‘opt in’ to the pension, less
people would have participated!

Proponents of Behavioural Economics claim that these insights are very useful as they
explain how individuals behave in reality, as opposed to traditional economic models. This
can help shape policy decisions as well as marketing decisions by firms, hence preventing
errors in prediction. However, there are some who claim that behavioural economics cannot
be completely relied on as some data collected may be experimental in nature (surveys and
college students) and therefore may not represent the decision making abilities of a large
proportion of the population. Similarly, it ignores the fact that consumers may learn from
earlier mistakes and may therefore end up making more rational decisions when faced with
similar circumstances in the future. Nevertheless, it is a useful branch of economics which is
gaining a fair amount of popularity.
Background to
Market
Structures
 Efficient Resource Allocation
Efficiency: The relationship between scarce inputs and outputs. This has to do with how the 3
basic questions are answered.

There are two types of efficiency that we need to consider:

Productive efficiency: This is when production is achieved at the lowest possible cost. Given
inputs need to produce maximum output or alternatively given output must be produced with
minimum inputs. If this is not the case we say the firm has not achieved productive efficiency.
At this point we must note that there is a difference between productive efficiency and
technical efficiency. Say I have 5 workers and 1 machine and they are producing 100 units. They
are producing as much as they can and are making maximum output. They are technically
efficient. But this does not mean the firm is productively efficient! If that same output, 100
units, could be made at a lower cost with 2 machines and 4 workers then the firm was not
productively efficient before. Productive efficiency takes into account the combination of FoPs
as well. Remember for productive efficiency the least cost method of production must be
employed. Workers are at their ‘highest possible average productivity’.

(This will be at the minimum point of a firm’s ATC curve)

Allocative Efficiency: Allocative efficiency has to do with what the resources are producing.
There are three different ways of looking at allocative efficiency. One is to look at whether firms
are producing what people want. It would be allocatively inefficient to produce something for
which there is no demand. [This is also known as ‘Social Desirability’]. Another measure of
allocative efficiency is that of Pareto Optimality. Pareto Optimality means that “no one can be
made better off without making someone else worse off”. Only if Pareto Optimality is achieved
can allocative efficiency be achieved (all resources need to be fully employed). This is Allocative
Efficiency on a macro-economic level.

The last way to achieve allocative efficiency is to produce at that point where P=MC. Here we
assume that the price of the good reflects its worth to society while the marginal cost
represents the cost to society of producing that good. Remember this cost is also an
opportunity cost as those very resources could have been producing another good had they not
produced this good.

Now: If P>MC this means that society values this good more than it costs to produce. The
production of this good should increase.

If P˂MC this means that there is an overallocation of resources. Society would rather these
resources produce something else as they do not value the good as highly.
This leaves P=MC as the socially optimal level of production. REMEMBER if firms produce where
P=MC it means that allocative efficiency has been achieved on a micro economic level.

We can now also include the concept of static and dynamic efficiency.

Static Efficiency: This is efficiency at a point in time. Can more be produced NOW if resources
were allocated differently? Both Productive and Allocative Efficiency are examples of static
efficiency. They answer questions such as whether a country reached its PPC.

Dynamic Efficiency: This is efficiency over a period of time. A country’s decision to produce
capital instead of consumer goods is dynamically efficient. Dynamic Efficiency is defined as the
greater efficiency that results from improvements in technical or productive efficiency over a
period of time. This could happen as a result of R&D, invention and innovation. Existing capital
can become more productive, hence increasing productive potential and output in the long run.

Efficiency and the PPC:

All points on the PPC are both productively and allocatively efficient (think Pareto Optimality).
Points inside the PPC are neither productively or allocatively efficient. WHY?

The combination of Productive and Allocative Efficiency is known as Economic Efficiency. The
following are reasons why economic efficiency may not be achieved:

1) Lack of competition: Firms will produce less output and push up prices hence not
allowing for allocative efficiency. Similarly, firms may not use least cost method of
production leading to productive inefficiency [Monopoly]. Unions may also ask for
higher wages once again pushing up costs of firms.
2) Externalities: Whenever externalities are present- both positive and negative- there can
never be allocative efficiency. This is because prices are sending an incorrect or
incomplete signal. The allocation of resources is being done without considering the
externality.
3) Missing markets: Public goods will never be provided by the free market and therefore
allocative efficiency cannot be reached without government intervention.
4) Factor immobility will make it hard to achieve both productive and allocative efficiency.
If FoPs cannot easily be transferred from one field to another, the market may not
always be able to produce what people want. Similarly, if one industry closes down
while another opens up, FoPs may be less productive in the new industry for some
period of time. (This is basically asking how easy it is for countries to move onto their
PPCs or even from one point to another on their PPCs).
5) When there is an unequal distribution of income it is hard to reach allocative efficiency.
Is it allocatively efficient to produce an additional designer handbag while people are
starving in the country? The market will only produce for those who have the money to
buy goods and services. As the result the needs of the underprivileged may go
unnoticed.
6) The last point has to do with static versus dynamic efficiency. If there are many small
firms in an industry instead of one large firm, this may be an example of static efficiency
but dynamic inefficiency. One large firm could have achieved lower costs than many
small firms due to Economies of scale.
 The Production Function
There are 4 factors of production (FoPs) that combine together to produce an output. There
FoPs are considered inputs used to produce an output. We can define a production function
as the relationship between the amount of factors used and the amount of output
generated over a given period of time.

TPP = f (F1 , F2 , F3 , … , Fn) where F1 to Fn are various FoPs.

For now we will consider just two FoPs – labour and capital.
Therefore,

TPP = f (K, L)

Difference between the Short Run and the Long Run:

We first need to distinguish between fixed and variable factors of production. A fixed factor
is defined as one that cannot be increased (or decreased) for some period of time. On the
other hand, a variable factor can easily be increased (or decreased) immediately. Using
these definitions, we can now distinguish between the short run and the long run.

Short Run: There is at least one fixed factor of production.

Long Run : ALL factors of production are variable.

Note that the short run is NOT some pre-determined amount of time. In fact, it will vary
from firm to firm depending on how long it takes each firm to increase its fixed FoP. The
short run can vary from a few months to many years depending on each firm.

The Short Run:

In the short run, production is subject to the Law of Diminishing Returns (LDR). This is also
known as the law of diminishing marginal returns as well as the law of variable proportions.

This law states that as more and more of a variable factor is used with a given amount of a
fixed factor, there will come a time when additional units of the variable factor will add less
and less to total output than the previous units.

!" %!"
Some equations: TP = f (K,L) AP = #$ MP = %#$

Note: Since Q simply means total output we use Qv to denote quantity of the variable factor.

MP is simply the extra output produced by hiring an additional unit of the variable factor.
Therefore, simply, the law of diminishing returns is telling us that at some point MP MUST
start to fall.
Lets use an example of a farm with land as the fixed factor and labour as the variable factor.

# of workers TP AP MP
0 0
1 3
2 10
3 24
4 36
5 40
6 42
7 42
8 40

Where does LDR set in?

Why?

Diagrams of TP, AP and MP

Some Important Facts:

1) TP must start at the origin

2) As long as MP is increasing, TP will increase at an increasing rate.
3) When DR sets in, MP will start to fall
4) When MP starts to fall, TP will start increasing at a decreasing rate.
5) TP is max where MP is 0. As long as MP is positive, TP must rise. When MP is 0, TP is
max. When MP becomes negative, TP must fall.
6) There is a relationship between marginals and averages. As long as marginal is above
average, average must rise. If marginal falls below average, average must fall. This
applies to MP and AP as well. As long as MP is above AP, AP must rise (it does not
matter if MP itself is increasing or decreasing – it just has to be above AP). As soon as
MP falls below AP, AP must fall. Therefore MP MUST cut AP at its maximum point.
7) The slope of the of the TP curve is the MP curve!

Remember for MCQs about short run diagrams we must look out for 2 things:
(i) Is diminishing returns being satisfied? (Is MP going down?)
(ii) Does the above math hold?

REMEMBER: Diminishing Returns is a purely short run phenomenon as it requires the

presence of a fixed factor. In the long run, all FoPs are variable.
The Long Run:

In the long run we CANNOT have diminishing returns as all FoPs are variable. There is NO
fixed factor. The firm is free to choose any quantity/combination of all FoPs.
Consider a firm that has 5 machines. Say it takes 2 years to order and receive a new
machine. For 2 years, this firm will be in the short run. It may hire as many workers as it
wants but it is bound by its 5 machines. It is interesting to consider that the long run isn’t
actually a chronological time period but rather a decision made by the firm. If the firm
decides to order 3 extra machines it knows it will take 2 years for those machines to be
delivered. It is in the short run for 2 years. HOWEVER, once the 3 extra machines are
delivered it is back in the short run again now with 8 machines!!! The long run is simply a
decision made by the firm. Once the decision is made and the fixed factor is altered, the
firm will be back in the short run with a new quantity of the fixed factor.

In the short run we have diminishing returns but in the long run we have Returns to Scale.
Returns to Scale looks at what happens to output if we increase inputs by a certain
percentage. For example, if we double all inputs, will output exactly double, more than
double or less than double.

Say we double inputs:

1) Increasing Returns to Scale: Output will more than double ( % increase in output > %
increase in inputs)
2) Constant Returns to Scale: Output will exactly double (% increase in output = %
increase in inputs)
3) Decreasing Returns to Scale: Output will less than double (% increase in output < %
increase in inputs)

You will be asked to identify these 3 concepts in MCQs

Output Capital Labour

100 5 10
200 8 16
300 14 28
400 20 40
500 26 52

How do we know we are in the long run?

(The trend is usually increasing returns then, constant (if at all), then decreasing)
Optimal Factor Combination:

For every given level of output, there will be more than one combination of labour and
capital that can be used to produce it. Any given level of output (say 100,000 units) can be
made with a multitude of factor combinations (say 10 machines and 100 workers or 15
machines and 60 workers). Which combination should the firm choose? Clearly it would
want the least cost combination of factors. In fact, optimal factor combination will come
about when this following equation is satisfied. (Does this look familiar?!)

!"# !"% !"& !"(

= = =⋯=
"# "% "& "(

Where k to n are all various FoPs.

We need to equate relative productivity to relative prices of these factors. The last dollar
spent on each factor should yield the same extra product. If there are various combinations
that the firm can use to produce a given level of output, then the firm should use that
combination which satisfies the above equation. Only then will it be using the least cost
method of production and will be productively efficient. The firm will strive to reach
productive efficiency for every level of output in the long run. Every level of output should
be produced using the least cost method of production.

One inherent problem with this process is that we have to predict future factor prices.
Decisions made, even in the long run, will be based on given factor prices. (Say the firm
decides to use a labour intensive method of production in the long run as labour was cheap
when the decision was made and then workers decide to unionise)

Two Other Time Periods:

1) The Very Short Run: All FoPs are fixed

2) The Very Long Run: The state of technology is allowed to change. We are now able
to change both the quantity and quality of FoPs. The entire family of product curves
will shift upwards.
 Costs
Explicit Costs: These are the costs of factors of production not owned by the firm. Money
actually changes hands. Examples would include electricity, wages, raw materials etc.

Implicit Cost: These are the costs of factors of production owned by the firm. There is no
direct payment of money. It is simply an opportunity cost. Eg: if a piece of land is owned by
the entrepreneur and subsequently used for a business, then rent will be part of an implicit
cost. Similarly, if an individual quits his job and starts his own business, his previous salary
would be an implicit cost to the firm. This would be how the owners time would be valued.

Accountants only look at explicit costs of production while superior economists (!!) will
consider both implicit and explicit costs of production. Say an individual is earning Rs
100,000 at a bank. She decides to leave her job and start her own business. This business
gives her a revenue of Rs 900,000 and bears an explicit cost of Rs 800,000. An accountant
would say her profit is Rs 100,000. However, an economist would actually consider her
profit zero! This is because the implicit cost of 100,000 would also be taken into
consideration. She is no better off than she was in her next best alternative!

Let us consider a few scenarios:

TR = 900,000
TCimplicit = 100,000

1) TCexplicit = 800,000
TCecon = 900,000
!"## = 100,000
!)#*+ = 0

2) TCexplicit = 750,000
TCecon = 850,000
!"## = 150,000
!)#*+ = 50,000

3) TCexplicit = 850,000
TCecon = 950,000
!"## = 50,000
!)#*+ = −50,000 (Loss)

Historic Costs/Sunk Costs:

This is a cost of production that cannot be recovered. Even if the business closes down, this
cost cannot be even partially recovered by the firm. Advertising is a good example of a
historic cost as it is an intangible service that cannot be resold. A machine, however, can be
sold off if the business decides to shut down.
Types of Costs:

A firms costs of production are basically dependant on its inputs (FoPs used by the firm).
Specifically, they will depend on:
(i) The price of inputs (FoPs)
(ii) The productivity of FoPs.

A Fixed Cost can be defined as the cost of fixed factors of production. This type of cost will
not vary with the level of output produced by the firm. Even at an output level of zero, the
firm will incur these costs. These are also known as “overhead costs” or “unavoidable
costs”. Rent is a great example of a fixed cost. If the firm has rented a premises for 5 years,
it will have to continue to pay rent for that time period even if it chooses to cease
operations.

A Variable Cost is the cost of variable factors of production. These costs will vary directly
with output. There will be no variable costs at zero levels of output. They are also known as
“direct costs’ or “avoidable costs”.

TC (total cost) = FC + VC

ATC (average total cost) or AC (average cost) = TC/Q

AFC (average fixed cost) = FC/Q

AVC (average variable cost) = VC/Q

Therefore, AC can also be written as AC = AFC + AVC

Marginal Cost can be defined as the cost of producing an additional unit or one extra unit.

∆1/
./ =
∆2

Marginal cost is, by definition, a variable cost. This is because fixed costs cannot change.
Therefore MC is only looking at changes in the variable costs of production.

EG: FC = 200
VC of 10 units =100
VC of 11 units = 110

Calculate MC.

Change the level of FC and see if there is any change in MC.

This shows that MC is ENTIRELY independent of FC and only dependent on VC.
Short Run Cost Curves:

Total Cost Curves:

Notice the shape of the curves.
-TFC is constant as it does NOT vary
with output.
-VC increases at a decreasing rate and
then increases at an increasing rate. It
eminates from the origin.
-The TC curve follows the shape of VC.
We simply shift up the VC curve by the
amount of TFC to get TC. TC will start
from TFC.

The Total Variable Cost (VC) curve, and therefore the Total Cost curve, get their shape from
the production curves we studied earlier. This is because, as mentioned before, a firms costs
will depend entirely on the quantity and productivity of factors of production. While TP is
increasing at an increasing rate, TC will increase at a decreasing rate. As soon as diminishing
returns sets in, TP starts increasing at a decreasing rate (as each worker is now becoming
less productive). Therefore, TC will start increasing at an increasing rate. Note however, that
while TP can fall, TC/VC will never fall with increases in output.

Average/Marginal Cost Curves:

Average Fixed Cost (AFC) is always

downward sloping. We are
dividing a fixed amount by an
increasing quantity. At very high
levels of output, AFC will be
aysmptotic to the x axis.
While MP is increasing, this means that each additional worker hired is adding more to
output than the previous worker. Therefore the additional cost of producing extra units will
go down. In other words, as long as MP is rising, MC must fall. When MP is maximum, MC
will be minimum. When DR sets in, MP will start to fall and therefore MC will start to rise.
MC is like a mirror image of MP! It gets its shape from the MP curve – more specifically from
the law of diminishing returns.

Similarly, the Average Variable Cost (AVC) curve will get it shape from the Average Product
curve. (Note AVC and AP will have an inverse relationship NOT AC and AP. This is because AC
includes a fixed costs which is independent of productivity). As long as AP is rising, AVC is
falling. When AP is maximum, AVC is minimum. When AP starts to fall, AVC will start to rise.

AC will lie above AVC. In fact, to get AC

we simply add the AFC and AVC curves
at each and every level of output.
We observe that AC and AVC get
closer to each other as output
increases. This is because AFC keeps
decreasing as output increases. This
means we are adding smaller and
smaller amounts to AVC to get AC as
output increases.
Note: MC cuts both AVC and AC at
their minimum points due to the
relationship between marginals and
averages.
The whole family of Average/Marginal Cost Curves:

An exercise to clarify the above concepts:

capital labour TP AP MP TFC TVC TC AFC AVC AC MC

5 0 0 300
5 1 100 300 100
5 2 250
5 3 400
5 4 500 400
5 5 560

Write out all equations before you start:

Capacity in the Short Run:

In the short run, capacity is defined as that level of output that corresponds to minimum
SRAC (short run average cost). It is NOT the maximum amount a firm can produce, but
rather that quantity that the firm can produce at the lowest cost. The firm can produce
more than Qc but it will have to bear a higher cost per unit in the short run.

Long Run Cost Curves:

In the long run there are no fixed factors and all FoPs are variable. We cannot have
diminishing returns as there is no fixed factor of production. What we have in the long run
are economies of scale, constant returns, and diseconomies of scale. Economies of scale will
come about when the firm is experiencing increasing returns to scale while diseconomies of
scale corresponds to decreasing returns to scale.
In the long run, we have a long run average cost curve (LRAC) which shows us the average
cost of producing a unit of output in the long run. Economies of scale will cause LRAC to fall
while diseconomies of scale will cause LRAC to rise. Constant returns leads to a horizontal
LRAC.

(Note when drawing LRMC, make sure its mathematically correct)

As mentioned earlier, economies of scale has to do with the concept of ‘increasing returns
to scale’. As output is expanded, cost per unit of output will decrease. Conversely, smaller
and smaller amounts of factors of production are needed per unit of output

Reasons for Economies of Scale:

There are a number of possible Economies of Scale that may be available to a firm.

1) Technical Economies: These include

• Economies of increased dimensions: the larger contains are, the more

volume they can hold. For example, if we simply double the lengths of a cubic
container, the volume will go up by 8 times that amount. Therefore, the cost
in relation to volume is lower, leading to lower costs for the firm. Also, more
volume is being transported per truck/driver.
• Division of Labour: If output per worker goes up, cost per unit goes down.
Larger organisations can take advantage of division of labour and assembly
line work leading to mass production.
• Large and Specialised Capital Equipment: The larger the production process,
the larger, better and more specialised the capital equipment used can
become. This will lead lower per unit costs. Small firms may be unable to
afford such a high initial cost, and may not have enough output to justify it.
• Research and Development: Larger firms have funds available for R&D. this
may lead to cost saving technological progress and innovation.

2) Financial Economies: Larger organisations have access to a greater amount of funds

at lower rates of interest. They can also raise money through the issuance of shares.

3) Marketing Economies: Large firms may get some financial advantage through the
bulk buying of raw materials. Similarly, large supermarket chains get products from
suppliers at lower prices per unit as compared to small local stores. In addition, their
marketing and advertising budgets are spread over a much larger output therefore
leading to a lower cost per unit. They may also have their own distribution channels
and transport for their goods.

4) Managerial Economies: Larger companies can afford highly qualified specialist staff
and can also introduce specific departments to deal with HR, Administration etc. This
may increase productivity and therefore output, hence lowering cost per unit.

5) Risk-Bearing Economies: As companies grow in size, they are able to diversify into
other related or non-related areas of production. This allows a company to spread
risks therefore reducing the risk associated with operating in a single market. If any
one area is not doing well, profits from other enterprises can be used. Similarly, the
collapse of any one market will not affect the firm too much.
 6) Economies of Scope: When a firm produces a range of products, advertising and
distribution costs can be spread. For example, transportation costs will be lower
when one firm is transporting a whole range of products to a given destination as
opposed to just one. Also common raw materials can be used for a variety of
products. Similarly, advertising can create brand loyalty for a brand name, which will
then spill over to all its products.

Economies of scale cannot go on forever. When firms become too big, costs per unit of
output may start to rise. Factors of production may become less productive. This is known
as Diseconomies of Scale. It has to do with ‘decreasing returns to scale’.

Reasons for Diseconomies of Scale :

1. Management problems may occur when a firm becomes too large. Problems in
communication, coordination etc
2. As further and further specialization takes place, the morale of workers may fall and
they may become disgruntled. This is known as ‘alienation’. As a result, productivity
may be lower.
3. Complex Interdependencies of Mass Production : As the production process is
further and further divided within the firm and perhaps even across firms (vertical
integration) a hold up in any one part of the production process will cause massive
disruptions throughout the firm. E.g. if the production process is divided into 3
stages, a hold up in stage 2 will render production in stages 1 and 3 useless.

External Economies of Scale: These are benefits that a firm may receive not due to any
of its own decisions, but rather due to the industry as a whole growing in size. This
means that the firm itself need not expand, but rather the expansion of the industry has
lowered costs for the firm. As an industry expands, labour with specific skills become
more abundantly available, special raw materials may be easily found, markets for
finished products as well as financial services may now be easier to locate. Transport
and infrastructure may also improve in that area.

This is basically when a town starts to grow around an industry and will therefore
specifically cater to that industry. A computer company setting up in Silicon Valley may
face lower costs due to the ease of availability of specific factors of production.

In addition, external economies of scale also explain why shops of the same nature often
locate right next to each other. One often finds jewellery shops, clothing stores and car
showrooms, for example, all on the same road. This is due to the fact that consumers
would be inclined to go to a location where they have a choice of the item they are
looking for. One would rather go to a location where there are several sellers as
opposed to a location where there is only one seller and therefore limited choice. Firms
are therefore benefiting from their location as opposed to their decision to, for example,
expand.
 Remember, these are benefits that a firm will accrue not due to its own production
process or decisions, but rather external factors such as growth of the industry and
location.

Similarly, there can also be external diseconomies of scale. If an industry grows too
much, labour and raw materials may start to become scarce and hard to come by. This
would drive up costs of the firm. Additionally, external costs of production in the form of
pollution may increase in the area, negatively impacting local residents and employees.
This may lead to litigation against the firms. Remember, once again, it is not the size of
the firm but rather the size of the entire industry growing too big which is driving up
costs for the firm.

Assumptions behind LRAC:

1) Factor prices are not changing along the curve. Any benefit that the firm may accrue
due to bulk buying has already been taken into consideration in the shape of the
curve. The curve does NOT slope upwards due to increasing factor prices. In fact, any
change in factor prices will shift the entire curve.
2) The state of technology is held constant throughout the curve as well as the quality
of all FoPs. Internal economies and diseconomies of scale occur with given
technology and given FoPs.
3) EVERY POINT on the LRAC uses the least cost method of production. For every level
of output shown, there can be NO cost lower than that dictated by the LRAC. Costs
cannot fall below LRAC. Every point on the LRAC adheres to the equation

.34 .35 .36 .3+

= = =⋯=
34 35 36 3+

In the long run, we will always have productive efficiency. Every point on the LRAC is
productively efficient. Even if the firm is experiencing diseconomies of scale, it is still being
efficient and using the least cost method of production for that level of output. Its just that
the costs of the least cost method of production are increasing.

Relationship between SRAC and LRAC:

The assumption behind LRAC is that all FoPs are variable. Say 100 units in the long run can
be produced at the least cost method of production with 5 units of capital and 3 of labour.
There HAS to be an SRAC where the fixed factor capital is 5 units (as each SRAC is drawn
keeping in mind some quantity of the fixed factor). This SRAC will be tangent to the LRAC at
the point of production of 100 units using 5 k and 3 L. It will lie above the LRAC at all other
points. Similarly, another SRAC with a capital quantity 7 will be tangent to the LRAC at one
point and lie above it at all other points.

In fact, each SRAC is tangent to the LRAC at one point and lies above it at all other points.
(Note: SRAC can NEVER fall below LRAC as we have already assumed that LRAC shows the
least possible cost of producing that level of output).
An LRAC is sometimes called an “envelope curve” which hosts a family of SRAC curves.

This whole family of curves may shift upwards and downwards if there is a change in factor
prices or technology.
For example, an improvement in technology (the very long run) may shift the entire family
of curves downwards – while an increase in oil prices will push the entire family upwards
(changes in factor prices).
Any change apart from the quantity of factors used will shift the entire family of curves.
 Revenues
Total Revenue can be calculated by multiplying the price of a good by the number of units
sold.

TR = P x Q

Average Revenue would be the revenue per unit sold. This is just the price of the unit! Price
and average revenue are the same thing!

AR = TR/Q = P

Marginal Revenue is the revenue generated by the sale of an additional unit

∆%"
!" =
∆&

There are two types of firms we will consider:

1) The firm is a Price-Taker:

This is when a firm does not set its own price for its product but rather accepts market price
as a given. This is very common in, say, agricultural markets. An individual farmer does not
set his own price for a crop but rather accepts the price set by the market. What this means
is, at a predetermined market price, the farmer will consider the demand for his product
infinite.

Note that the horizontal demand curve is also the AR and MR curve.
Also note that the TR curve emanates from the origin and is linear.
 2) The firm is a Price-Setter (Price-Maker)

In this case, the firm will experience a regular downward sloping demand curve for its
product.

Q P = AR TR MR
1 9
2 8
3 7
4 6
5 5
6 4
7 3

Note that the MR curve lies below the demand curve/AR curve for every subsequent
unit sold. This is because price must be lowered to sell these subsequent units. So when
price is lowered, it is also lowered for previous units that could have been sold at a
higher price.
If the firm was selling only 1 unit, it would have sold that unit for $9. However, if the firm
wants to sell 2 units, it must lower the price of both units to 8. The firm is losing some
revenue from selling the previous unit for $1 less. This is why MR lies below price.

For a downward sloping demand curve, the MR curve will always lie below the demand
curve.
 Profit
There are two ways to calculate profit:

1) Using TR and TC

As the name suggests, the easiest way to calculate profit is TR-TCC

! = #$ − #&

Q TR TC !
0 0 6
1 8 10
2 14 12
3 18 14
4 20 18
5 20 25
6 18 36
7 14 56

How do we know that we are in the short run?

What is profit maximising level of output?

Note: There is a difference between revenue maximisation and profit maximisation.

Consider the following diagram for MCQs.
2) Using Marginal Revenue and Marginal Costs (important):

Where MR and MC (MR=MC) intersect is the profit maximising level of output (q*) for
every firm. At output levels below q*, additional units produced are adding more to
revenue than they are to costs (MR>MC). Therefore they are adding positive amounts to
profit. Similarly, after q*, units produced are adding more to costs than they are to
revenue (MC>MR). It therefore concludes that a profit maximising firm would not
produce these units. We can thus conclude that profit maximisation takes place at the
level of output where MR=MC.
At this point, we can say that marginal profit is zero and therefore total profit is
maximised.

NOW, please note that a profit maximising firm will ALWAYS produce at q*. It does not
make any sense for the firm to produce at any other point if its aim is profit
maximisation. [q* is the first point we will identify on all future diagrams].

However, the kind of profit the firm will make at q* will depend on the positions of the
AR and AC curves. This will determine whether the firm will make an Abnormal Profit, a
Normal Profit or a Loss.

1) Abnormal/Supernormal/Pure/Economic Profit:

This occurs when AR > AC at q*

If AR > AC then AR x Q > AC x Q therefore TR >TC

Carefully consider the following diagram and draw it step by step as dictated.
2) Normal Profit or Zero Economic Profit:

This occurs when AR = AC at q*

Carefully consider the following diagram and draw it step by step as dictated.

Note: Always make sure AC is tangent to AR at q* and above it at all other points.
If a firm is earning normal profit, it means that FoPs are earning as much as they would have
in their next best alternative. All implicit costs of production have been taken into
consideration and the firm is earning nothing over and above this amount (remember, as
mentioned before, the firm will still be making an accounting profit – just not an economic
profit).

3) Loss Minimisation

This occurs when AC>AR at q*

What this means is that this firm is currently incapable of making a profit. q* goes
from being a point of profit maximisation to a point of loss minimisation. Note, the
firm is unable to make a profit – if it tries to produce at a point other than q* then its
losses will be greater.

Carefully consider the following diagram and draw it step by step as dictated.

Under conditions of loss minimisation the firm may not necessarily shut down. The firms
decision to shut down will be determined by the position of AVC relative to AR. Remember,
as this is the short run, the firm will incur a fixed cost whether it stays open or shuts down.
At zero levels of output there is still a fixed cost of production.
If, at q*, the firm is able to cover all its variable costs and is able to contribute some amount
to its fixed costs then it is loss minimising to stay open. This is the case when AR>AVC.
However, if at q* the firm is not even able to cover its variable costs then it would incur a
further loss by staying open (fixed costs + additional variable costs). This is the case where
AVC>AR.
Finally, if AR=AVC then the firm will incur the same loss whether they stay open or shut
down. This could be called the ‘shut-down point’ of production. The firm will make the
decision to stay open or shut down depending on how it feels about its future prospects.
Carefully consider the following diagram and draw it step by step as dictated.

Remember: in this case the firm is ONLY ever able to make a loss. There is no chance of
profit. It now needs to decide whether to stay open or shut down in the short run.

Q) Under which conditions will the firm stay open in the short run [12]
• Abnormal profit
• Normal profit
• Loss if AR > AVC or AR = AC
 Market
Sructures
 Market Structures

The one assumption that we make is that all firms, no matter which type of market
structure they operate in, are profit maximisers. The goal of each firm will be profit
maximisation.

There are 4 types of markets that we will consider:

1) Perfect Competition
2) Monopoly
3) Monopolistic Competition
4) Oligopoly

On a spectrum diagram, each market structure will be placed like so:

Depending on which market structure the firm operates in, it will behave differently, make a
different type of profit and have different short and long run conditions.
 1) Perfect Competition

Here are the assumptions associated with Perfect Competition:

1) There are a large number of buyers and sellers. Each firm is too small to affect
market price. Market price will be determined by forces of demand and supply. The
individual firm will accept market price as given. Each firm is a price taker. What this
means is that each firm faces a horizontal demand curve for its product.
2) Products are homogenous (identical). What this means is that it is impossible for
consumers to differentiate between the product of different firms. (e.g an unmarked
bunch of bananas or an unmarked kg to sugar)
3) There is freedom of entry and exit in this market. Firms are free to come and go from
this market. There are no barriers to entry. But, entry and exit is a purely long run
phenomena. The number of firms in the short run remains fixed.
4) There is perfect information. Producers know about methods of production used by
other firms and consumers are well aware of the market price of the product.
Perfect information on the part of the producer ensures that firms are identical and
using the same methods of production.

Good examples of perfectly competitive market structures are unmarked fruits and
vegetables. Agricultural markets often tend to follow a perfectly competitive model.

Relationship between Short Run and Long Run conditions in Perfect Competition:

In the short run, firms can either make an abnormal profit, a normal profit or a loss.
However, depending on these short run conditions there will either be entry, exit or no
change in the long run.

Short Run Long Run

Abnormal Profit Entry
Normal Profit No change
Loss Exit

These changes ensure that firms will only ever make normal profit in the long run.
In the case of abnormal profit, entry will take place until all abnormal profit is eaten away.
Similarly, in the case of a loss, firms will leave until remaining firms are making normal
profit.

Let us look at short run diagrams and their associated long run conditions:
 (i) The firm is making normal profit in the short run:

Market price and quantity is determined by market forces of demand and supply. The firm
accepts market price as given and therefore has a horizontal demand curve at ‘P’. This
horizontal demand curve shows that the firm is very small (q) as compared to the entire
market (Q). The individual firm is unable to affect market price and has to accept it as given.
The firm profit maximises by using the formula MR=MC and produces at q*. in fact, as all
firms are identical, the output level of every firm will be q*.
In order to show normal profit, we need AR = AC at q*. REMEMBER, AC will be tangent to AR
at q* and lie above it all other points. Also, MC cuts AC at its minimum point.

Note that as the firm is making a normal profit in the short run, there will neither be entry
nor exit in the long run.

(ii) The firm is making abnormal profit in the short run:

[Market price and quantity is determined by market forces of demand and supply. The firm
accepts market price as given and therefore has a horizontal demand curve at ‘P’. This
horizontal demand curve shows that the firm is very small (q) as compared to the entire
market (Q). The individual firm is unable to affect market price and has to accept it as given.
The firm profit maximises by using the formula MR=MC and produces at q*. in fact, as all
firms are identical, the output level of every firm will be q*.]
Abnormal profit is calculated by looking at the difference between AR and AC at q*.
Now, this abnormal profit in the short run will lead to entry in the long run.

Entry is shown by a rightward shift of the market supply curve. This starts to push down the
market price of the product. In fact, entry will continue and market price will keep falling
until all firms are making normal profit. Price will fall to P’ ensuring that all existing firms are
making normal profit.
Note that while the output of the industry has increased, the output of individual firms has
gone down. This is because there are now more firms in the market.

(iii) The firm is making a loss in the short run

[Market price and quantity is determined by market forces of demand and supply. The firm
accepts market price as given and therefore has a horizontal demand curve at ‘P’. This
horizontal demand curve shows that the firm is very small (q) as compared to the entire
market (Q). The individual firm is unable to affect market price and has to accept it as given.
The firm profit maximises by using the formula MR=MC and produces at q*. in fact, as all
firms are identical, the output level of every firm will be q*.]
Loss is calculated by looking at the difference between AC and AR at q*. Now this loss will
lead to exit in the long run.

Exit is shown by a leftward shift of the market supply curve. This starts to push up the
market price of the product. In fact, exit will continue and market price will keep rising until
all firms are making normal profit. Price will rise to P’ ensuring that all remaining firms are
making normal profit.
Note that while the output of the industry has decreased, the output of individual firms has
increased. This is because there are now less firms in the market.

A complete Long Run diagram for a firm under Perfect Competition:

At q* D= P= AR =MR=MC =SRAC =LRAC !!!

Points to consider:
It is a combination of freedom of entry and exit as well as perfect knowledge that ensures
that all firms under perfect competition will only ever make normal profit in the long run.
[Abnormal profit will attract new firms while losses will encourage firms with the most
depreciation of capital to exit].
This also implies that if a firm is making an abnormal profit or loss under perfect
competition we know it HAS to be in the short run. This type of information can be tested in
MCQs. (Answers may include: a fixed factor is present or diminishing returns is being
experienced as both of these are short run phenomena).

Short Run Supply Curve Under Perfect Competition:

At a price of P, the firm will profit maximise and produce quantity q where MR=MC. If price
increases to P1, the firm will shift production to q1. Similarly at P2, the profit maximising
firm will produce quantity q2. What we are noticing is that whenever price changes, the
amount the firm produces will be dictated by its MC curve. In fact, the MC curve is showing
a unique relationship between price and the quantity supplied by the firm. This unique
relationship is commonly known as a supply curve!! Just the way diminishing marginal utility
was the basis for a downward sloping demand curve, the law of diminishing returns is the
basis for the upward sloping supply curve!
However, if price falls to P3 (below AVC) this firm will cease production in the short run as it
is unable to cover even its variable costs of production (AR < AVC). Therefore we can say
that for firms under perfect competition, their supply curve is their MC curve above AVC.
Long Run Industry Supply Curve (LRISC) under Perfect Competition:

We are trying to determine the relationship between price and supply in the long run. The
question we are asking is whether the expansion of the industry will lead to more being
supplied at a higher, lower or the same price. Essentially, we are looking at the role of
external economies of scale!

There are three scenarios we will consider:

1) Constant Industry Costs:

Initially the firm is making normal profit at point ‘a’. A sudden increase in demand pushes up
the price to P1 and now the firm is making an abnormal profit as shown by point ‘b’. This
abnormal profit is purely a short run phenomenon. In the long run entry will take place and
the market supply curve will shift outwards till all firms are making normal profit once again.
This occurs at point ‘c’. The line connecting points ‘a’ and ‘c’ is the LRISC. It shows the
relationship between price and quantity supplied by the industry in the long run.

Note that in this case, price fell back down to P. The line connecting ‘a’ and ‘c’ is horizontal.
This is because the entry of new firms did not in any way affect the cost structure of existing
firms. The AC curves of existing firms did not shift at all. A horizontal LRISC shows us that in
this market quantity will always eventually be supplied at the same price. Any increases in
price are a purely short run phenomenon. Price will always fall back down in the long run.
 2) Decreasing Industry Costs (External Economies of Scale):

Initially the firm is making normal profit at point ‘a’. A sudden increase in demand pushes up
the price to P1 and now the firm is making an abnormal profit as shown by point ‘b’. This
abnormal profit is purely a short run phenomenon. In the long run entry will take place and
the market supply curve will shift outwards till all firms are making normal profit once again.
This occurs at point ‘c’. The line connecting points ‘a’ and ‘c’ is the LRISC. It shows the
relationship between price and quantity supplied by the industry in the long run.

Note that in this case, price fell down to P2. The line connecting ‘a’ and ‘c’ is downward
sloping. This is because the entry of new firms positively affected the cost structure of
individual firms as a consequence of external economies of scale. The AC curves of existing
firms shifted downwards due to the costs benefits associated with an expanding industry. A
downward sloping LRISC shows us that in this market more will eventually be available to
the consumer at lower and lower prices. This phenomenon is common in markets such as IT,
technology and cell phone service providers. They are often able to provide more at lower
prices due to technological advancements with the passage of time and growth of the
industry.
 3) Increasing Industry Costs (External Diseconomies of Scale)

Initially the firm is making normal profit at point ‘a’. A sudden increase in demand pushes up
the price to P1 and now the firm is making an abnormal profit as shown by point ‘b’. This
abnormal profit is purely a short run phenomenon. In the long run entry will take place and
the market supply curve will shift outwards till all firms are making normal profit once again.
This occurs at point ‘c’. The line connecting points ‘a’ and ‘c’ is the LRISC. It shows the
relationship between price and quantity supplied by the industry in the long run.

The difference here is that as market supply increases due to the entry of new firms, each
firms AC curve is pushed up due to external diseconomies of scale. Normal profit now comes
at a price of P2 which lies between P and P1. The line joining ‘a’ and ‘c’ will be upward
sloping. In the long run, increased output of this good will happen at higher and higher
prices due to unavailability of resources.

Shapes of the three types of LRISCs:

Perfect Competition and Internal Economies of Scale:

Internal economies of scale are benefits that a firm accrues from growing in size. As such,
the market structure Perfect Competition does not allow for internal economies of scale.
This is because an important assumption of PC is that firms must be small and must remain
‘price-takers’. The minute a firm grows large enough to experience EOS, it will gain market
power and no longer be a price taker. It follows that it will no longer be operating under the
parameters of perfect competition! Therefore Perfect Competition excludes the notion of
internal economies of scale.

An Analysis of Perfect Competition: Pros and Cons

Advantages:

Perfect Competition is often considered an ideal situation for the following reasons:

1) Under perfect competition P=MC. This is the condition for allocative efficiency. In
fact, perfect competition is the only market structure where allocative efficiency is
achieved without government intervention.
2) There is a lot of competition amongst firms which forces firms to be efficient. If firms
are not efficient they will make a loss and be driven out of business.
3) The desire for abnormal profit may encourage firms to develop new technology.
(Note: due to perfect information this technology will eventually be copied)
4) Due to the homogenous nature of the product, there is no need for advertising. This
will keep costs and therefore prices low for the consumer. Also, as resources are not
diverted toward advertising, they may be free to produce other useful goods and
services (opportunity cost).
5) In the long run firms are at the bottom of both SRAC and LRAC. They use the least
cost of all the least cost methods of production! They are always at capacity in the
long run.
6) Low average costs curve along with a combination of no abnormal profit will keep
prices low for the consumer.
7) Any increase in demand is met only with a short run increase in prices. In the long
run prices will always fall.

Under Perfect Competition we say there is ‘Consumer Sovereignty’. The consumer has the
power. Prices are at the lowest possible and firms are only able to make normal profit in the
long run. They are price takers.

Disadvantages:

1) There may not be an incentive to develop new technology as firms know they will be
copied and earn normal profit in the long run. As a result they may consider an
 investment in technology a waste of money. The family of LARC and SRAC curves
may never shift downwards.
2) Even if firms did want to invest in technology they may not have the means to do so.
If they are only ever making normal profit, they may not have the funds to invest in
R&D.
3) There will be a lack of variety for the consumer due to the nature of a homogenous
product.
4) Under perfect competition firms will never truly be able to achieve internal
economies of scale. Economies of scale are the benefits a firm accrues from
becoming large. Under PC firms remain small and have no market power. If a firm
becomes large enough it will gain some market share and will no longer be operating
under conditions of perfect competition.
2) Monopoly
A monopoly is a sole provider of a good in the market. We need to distinguish between
competition in the overall market and monopoly power. A firm may face competition in
some markets and enjoy monopoly power in others. This is particularly pertinent in
pharmaceutical markets as well as the travel industry.

Demand Curve under a Monopoly:

Under a monopoly there is no distinction between the firm and the market. There is only
one firm in the market and therefore we do not need to distinguish between a firm and a
market demand curve. The demand curve facing the firm is simply the market demand
curve for the product. This curve is likely to be highly inelastic as there is only one provider
of this product and therefore no substitutes are available. However, it won’t be completely
inelastic as the industry itself may have substitutes. For example, if an airline carrier is the
sole provider of air travel between cities ‘A’ and ‘B’, it is technically a monopoly for that
sector and will have an inelastic demand curve. However, air travel itself has many
alternatives such as cars, trains and buses so the demand curve cannot be completely
inelastic.

One of the most important features of a monopoly are “Barriers to Entry”. In order for a
monopoly to retain its monopoly status, it must put up barriers to entry high enough so as
to discourage new firms from coming into the market.

Barriers to Entry:

1) Natural Monopoly – Economies of Scale:

We say a firm is a natural monopoly when it has a constantly downward sloping
LRAC curve. This firm is able to achieve unlimited economies of scale. Such industries
are characterised by very high fixed costs (start up costs) but very low marginal
costs. If more than one firm enters the market, ‘duplication of resources’ will take
place.
In this market, it is beneficial for one firm to service the entire market. Quantity Q1
can be made at an AC of AC1. However, if a second firm enters and takes away half
the market, average cost per firm will rise to AC2. It is actually in the benefit of
consumers to have just one firm in the market. Note however, that such a firm needs
to be heavily regulated by the government to make sure consumers are not taken
advantage of.
2) Product Differentiation and Brand Loyalty:
This is when a firm is able to differentiate its product and create brand loyalty to
such an extent that consumers start to associate the brand with the actual product.
Other firms can technically enter this market but consumers themselves will be
unwilling to switch. E.g. Pampers, Strepsils, Vicks, Panadol, Surf

3) Established Monopolies:
Established monopolies tend to have lower costs, more R&D as well as a better
knowledge of the market. Additionally, they are likely to have years of abnormal
profit at their disposal. What this means is that new firms without all the above at
their disposal can easily get pushed out of the market through, say, a price war.

4) Control of Vital Inputs (Vertical Integration Backwards):

If a firm has control of vital inputs, it can prevent other firms from entering the
market by denying them access to necessary inputs. This would be the case if, for
example, one company such as DeBeers buys all the diamond mines in Africa.

5) Control of Major Outlets (Vertical Integration Forwards):

Similarly, firms can try and control major outlets. This would prevent other firms
from getting their product to the market. For example, why is it that we can either
get Coke or Pepsi at all major fast food joints but not both? Why do companies send
their fridges to major department stores?

6) Legal Protection:
Patents, Copyrights and Trademarks legally allow a company to become a monopoly.
These are given to allow for innovation and R&D. A company is more likely to invest
in the research required for a new product or medication if it knows it can enjoy
monopoly profits for years to come. The average duration or protection is 10 years
but may even go up to 25.
[Patent: Product and production process; Copyright: Intellectual property;
Trademark: Logos]

7) Mergers/Takeovers:
Firms can get monopoly status by merging with or taking over other smaller firms.
(Note such mergers and acquisitions must be approved by the government if the
resulting firm becomes a monopoly).

8) Aggressive Tactics:
Larger firms sometimes drive smaller firms out of business through aggressive tactics
such as price and advertising wars. Additionally, larger firms may use location tactics
to drive smaller independent firms out of business. E.g. Starbucks and Barnes and
Nobles.

9) Illegal Harassment:
This is quite self-explanatory! Do some research on firms such as Microsoft.
Profit Maximisation Under Monopoly

It is generally accepted that a monopolist will enjoy abnormal profits as he is the sole
provider of a product and faces no competition. Additionally, he will face a rather inelastic
demand curve for his product.

A profit maximising
monopolist will charge
a price P for quantity Q*
sold.
He will make an
abnormal profit
indicated by the shaded
area.

The monopolist is able to enjoy this abnormal profit both in the short run as well as the long
run due to the existence of barriers to entry. Changes in demand conditions or cost
structure will affect the amount of profit made.

No Supply Curve Under Monopoly:

A supply curve necessarily needs to show a unique relationship between price and quantity
supplied. Under a monopoly we have no such unique relationship. The same quantity can be
sold at two different prices depending on demand conditions.

Initially the demand for the product is D1

and a price of P1 is being charged for Q*.
If demand falls to D2 and MR2 cuts MC at
the same point, then Q* will now be sold
at a price of P2.
This shows us that the same quantity
CAN be sold at two different prices under
different demand conditions.
There is no UNIQUE relationship
between price and quantity supplied and
hence no supply curve under a
monopoly.
Disadvantages of a Monopoly:

Monopolies are often considered to be against the public interest. There is producer
sovereignty as opposed to consumer sovereignty. There is a general perception that
monopolies will exploit consumers through higher prices and lower output.

1) Higher price and lower output as compared to Perfect Competition in the short run:

In the short run, the MC

curve is the supply curve
under PC.
The monopolist will produce
at Qm with a price pf Pm
while the perfectly
competitive market will
produce at Qpc at a price of
Ppc (where demand = supply)

The diagram clearly shows how a monopolist charges a higher price and produces a lower
output as compared to a perfectly competitive market. We can also consider this concept
from the point of view of allocative efficiency. Allocative efficiency is achieved when P=MC.
This is the exact same point that production would have taken place in a perfectly
competitive market. The profit maximising monopolist will necessarily produce at a level of
output less than the allocatively efficient one.
Note: if a monopolist if forced to produce at ‘A’ we call it ‘Marginal Cost Pricing’ (for MCQs)

2) Higher price and lower output as compared to Perfect Competition in the long run:
Even if perfectly competitive firms enjoy abnormal profits in the short run due to
increased consumer demand, they will return to normal profit in the long run (due to
the entry of new firms). Prices will always fall in the long run under perfect
competition. There is no such guarantee under a monopoly as there are significant
barriers to entry. The monopolist can maintain higher prices in the long run as well.

3) A monopolist may have no incentive to be efficient as he is facing no competition.

There is no guarantee he will use the least cost method of production. This is known
as ‘X’ inefficiency.

4) Much like PC, there will be no product variety or choice for the consumer nor any
real incentive for the monopolist to improve his product.

5) Monopolies, as mentioned before, are often considered unfair and against the public
interest. The monopolist enjoys massive profits while low income earner may be
 unable to afford the good. Also, some barriers to entry used may negatively impact
small firms.
Advantages of Monopoly:

1) Lower price and higher output as compared to Perfect Competition:

Monopolies are often able to achieve economies of scale. This would push down their
cost structures as compared to firms under PC. Mass production may allow the
monopolist to charge a lower price for a higher level of output as compared to a
perfectly competitive market.

Under PC the firm will produce

at point ‘A’ where demand =
supply. However, when many
small firms are wiped out and
replaced by one large firm, the
cost structure of that large firm
may be lower (due to EoS).
The MC curve of this large
monopolist will be MCm. This
profit maximising monopolist
will produce at Qm and charge
Pm (point ‘B’)

The profit maximising monopolist is charging a lower price and producing a higher quantity
as compared to a perfectly competitive market as a result of economies of scale. This is a
benefit of mass production.
Note: the best outcome would be if, now, the monopolist was forced to adopt marginal cost
pricing. We would get the benefits of mass production alongside reaching the point of
allocative efficiency! This is point ‘C’ on the diagram.

2) The monopolist may have an incentive to be efficient as this would push down his
costs and allow him to earn an even larger amount of abnormal profit both in the
short run as well as the long run.

3) Years of abnormal profit will give monopolies a large budget for R&D. Additionally,
the monopolist may try and better his product for increased sales and therefore
more profit.

4) There is likely to be a lot of innovation under a monopoly. As mentioned before, the

firm will have the budget for R&D, and barriers to entry such as patents will
encourage monopolists to develop new products and production techniques.
 Price Discrimination:
Thus far, we have been studying a single price monopolist. This monopolist will charge just
one price in the market. We must also consider a monopolist who ‘price discriminates’ i.e.
charges more than one price for his product in the market.
A firm is said to be price discriminating when it charges different consumers different prices
for the same product. Remember, in order for price discrimination to be taking place, costs
of production must be the same. Different consumers are being charged different prices
even though costs of production are not changing.

There are three types of price discrimination that we must consider:

1) First Degree or Perfect Price Discrimination:

This is when the producer attempts to charge each consumer the maximum amount
they are willing to pay. Each consumer will be charged a different price. Examples
include auctions or any situation where the price is not fixed and a consumer can
bargain.
If perfect price discrimination is practiced properly, the producer will be able to
extract all the consumer surplus.

2) Second Degree Price Discrimination:

This is when consumers pay different amounts according to quantity consumed (not
important)

3) Third Degree Price Discrimination:

This involves putting consumers into separate markets and charging a different price
in each market. This is the most common type of price discrimination practiced.
Examples include student discounts and different prices based on age as well as
gender. Bus fares are lower for children under 15; movie tickets and entrance tickets
for amusement parks are cheaper depending on age.

Conditions Necessary for Price Discrimination:

1) The firm must be able to set its own price. It cannot be a price taker. Price
discrimination is most commonly found under monopolies and oligopolies.
2) There cannot be resale from a lower price market to a higher price market.
3) The firm needs to identify the consumers from each market and figure out how
much they are willing to pay.
4) Elasticities must be different in each market, otherwise price discrimination is
pointless. If both groups of consumers have the same elasticity for the product, then
they will be willing to pay the same amount and so therefore there would be no
need for price discrimination.
Reasons for Price Discrimination:

Firms price discriminate as this will increase their total revenue.

Initially the firm was selling

entire quantity Q at a price of
P. Its revenue is OPEQ.
Now say it price discriminates
and sells half its quantity (Q/2)
at a price of P1 and half at
original price P.
As we can see, this causes an
increase in total revenue of
the rectangle PP1AB.

Note, the more prices a producer charges, the greater the addition to his revenue.

Notice now that if perfect price discrimination is in effect, and there are an infinite number
of prices being charged, the addition to revenue will be the entire consumer surplus!
Profit Maximising Price and Quantity under Price Discrimination:

1) First Degree Price Discrimination:

In this case, the
demand/average revenue curve
will also be the marginal revenue
curve! This is because we no
longer need to lower price on
previous units in order to sell an
additional unit. We are charging
different people different prices
and so therefore there is no
need to lower prices for
everybody when selling
additional units.

The price discriminating monopolist will continue to profit maximise and produce where
MR=MC. They will produce quantity Qe. What price do you think they will charge? In fact,
they will charge every price between P and Pmax!
Notice how under conditions of perfect price discrimination the condition of allocative
efficiency is being met! Marginal cost pricing is taking place and the firm is producing an
allocatively efficient level of output.

2) Third Degree Price Discrimination:

Consider users in two markets A and B. Note that the demand curve in each market has a
different elasticity (and has its own corresponding MR curve). We can sum up the demand
curve in market A and the one in market B to form a market demand and MR curve for the
product. We now equate the MC curve of the firm with the market MR curve to establish
profit maximising quantity.
We now take this MC and drag it back to each individual market and establish quantity sold
by equating MR and MC in each market. (Essentially, we are selling a profit maximising level
of output in each market). Now we simply go up to the demand curve in each market to set
price. Note that price is different in each market based on elasticity. Markets with inelastic
demand will have a higher price set as consumers are willing to pay more.
Arguments for and against price discrimination:

Against For
• Price discrimination is often • Allocative efficiency under perfect
considered unfair as different price discrimination is achieved.
consumers are paying different • The good may become available to a
prices. wider variety of consumers.
• The firm has the ability to exploit • Very low income consumers may be
consumers and charge higher prices able to get a service they could not
in areas where it is a monopoly. otherwise afford. E.g.lawyers and
• In the case of perfect price doctors who do pro bono work.
discrimination the firm is able to • Local and international markets may
extract all the consumer surplus have different prices. A local
leaving consumers with none. monopoly could break into an
international market by charging a
lower price abroad. The opposite of
this may also hold true. Locals could
be charged less for a product that is
sold abroad at a higher price.
• Increased revenue for the producer
which may lead to increased R&D
and innovation.

People often look down upon price discrimination as the word ‘discrimination’ has a lot of
negative connotations. However, as we can see, price discrimination may actually be more
beneficial than harmful. It allows the product to reach a larger variety of consumers.

Q) Why might a firm choose to price discriminate and what consequences might this have
on the market?

Q) Discuss how and why a firm may choose to price discriminate.

 Imperfect Competition:

On one end of the spectrum we have perfect competition and on the other end, in direct
opposition to this, we have a monopoly.

All market structures that lie on the spectrum diagram come under the realm of ‘Imperfect
Competition’. We will put these market structures into two rough categories:

(i) Monopolistic Competition

(ii) Oligopoly

3) Monopolistic Competition
This market structure is towards the competitive end of the spectrum.

Assumptions:
1) There are quite a large number of small firms, but perhaps not as many as under
perfect competition.
This gives rise to our second assumption.
2) The assumption of independence: This assumption states that when a firm is making
decisions, it cannot factor in the reaction of all its rivals as there are too many to
consider. The firm works ‘independently’ when making decisions. Remember, the
firm will factor in the reaction of the market, but not of individual rivals.
3) There is a somewhat differentiated product which allows the firm to have a
downward sloping demand curve. What this means is that firms have control over
their own price and can increase price without losing all their customers. (This would
be a result of brand loyalty).
However, this demand curve is likely to be rather elastic due to the amount of
competition prevalent.
4) There is freedom of entry and exit – but, once again, this is a long run phenomenon.
5) The assumption of symmetry: This assumption states that if a new firm enters the
market, all existing firms will be equally affected. The entry of a new firm will not
cause any one firm to shut down. The new firm will steal customers away equally
from all existing firms.

Good examples of industries that are characterised by monopolistic competition include

small food chains (boat basin), hairdressers/barbers, tailors and small supermarkets/corner
shops.
Short run Equilibrium under Monopolistic Competition:

In the short run under monopolistic competition, the firm can either make an abnormal
profit, a normal profit or a loss. However, the most likely situation is that the firm is making
an abnormal profit.

Long Run Equilibrium under Monopolistic Competition:

Abnormal profit in the short run will lead to entry in the long run. The law of symmetry
states that all firms will be equally affected by the new entrant. Due to the increase in
competition now present, the demand curve of each individual firm will shift inwards and
become more elastic. It will shift inwards as each firm is losing customers, and will become
more elastic due to the increased competition. This will happen until all firms are making
normal profit.
Limitations of Monopolistic Competition:

1) The assumption of symmetry can often be challenged. For example, a firm may have
some sort of a location advantage and therefore can continue to charge higher
prices. In this case, the entry of a new firm may not affect the demand curve/profit
levels of this firm.
2) Advertising and brand loyalty will play a role in this market structure. In fact, this is
the first market structure we have seen where advertising plays a useful role. If a
firm advertises enough and instils brand loyalty into its consumers, the entry of a
rival firm may leave the demand curve for this firm unchanged. In fact, the purpose
of advertising is to push the demand curve out and make it more inelastic. This can
exactly outweigh the effects of entry!
3) There is no assumption of perfect information so potential entrants may not know
about abnormal profits being earned. Additionally, a firm may have a cost advantage
over others which allows them to retain abnormal profit in the long run.

Comparison with Perfect Competition:

Firms under perfect competition reach the minimum point of both SRAC and LRAC in the
long run. They will always produce at capacity (that quantity that corresponds to minimum
average cost per unit) in the long run. Under monopolistic competition however, long run
equilibrium comes on the downward sloping portion of AC. It comes at a level of quantity
less than capacity. We say there is ‘excess capacity’ under monopolistic competition. Firms
do not reach the minimum point of LRAC in this market structure.

It is interesting to note that monopolistic competition is a market structure where there are
a large number of firms but each firm is producing less than the allocatively efficient
amount. Consumers will pay a higher price for slightly less output as compared to perfect
competition. However, we can counter this argument by looking at the advantages of
product differentiation. Consumers may be willing to pay this higher price in return for a
variety of products. The benefits of product differentiation may outweigh the slightly higher
price. Additionally, firms under monopolistic competition may have more of a scope for
economies of scale as compared to perfectly competitive firms.
When compared to a monopoly, firms under monopolistic competition will have a greater
output at a lower price, however the monopolist will have a greater scope for economies of
scale and R&D.

4) Oligopoly
An oligopoly is described as a market structure where a few large firms (between 2-10)
dominate the market. If there are just two firms, then we say a duopoly is present. There
are just two assumptions that we make in this market structure.

1) The assumption of Interdependence: Since there are such few firms under an
oligopoly, we can make the assumption of interdependence. Each firm will take into
account the reaction of its rivals when making its own decisions. Similarly, each firm
will be looking at the action of its rival and reacting accordingly. No firm can afford to
ignore the actions and reactions of its rivals. This is also known as being ‘mutually
dependent’.
Note though, that the reaction of rival firms has to be predicted. It is possible that a
rival does not behave as the firm expected. It is for this reason that there is no
concrete theory of oligopoly. Unlike other market structures, we cannot say with
certainty that a firm will behave like so.

2) Barriers to Entry: Much like a monopoly, there are also barriers to entry in this
market structure. However, they are not as high as they were under a monopoly as a
few firms have managed to enter the market. We can add two additional barriers to
entry unique to oligopoly.

(i) Advertising: It is interesting to consider the role of advertising in this market.

Of all the market structures, advertising will play the largest role under
oligopolies. These are firms that are likely to have a large amount of
abnormal profit and, therefore, have the means for huge and extensive
advertising budgets. In addition to the means, they also have the largest
incentive for advertising as compared to the other market structures.
Empirically, we see the most advertising done under conditions of oligopoly.
The question we must ask ourselves, is the reason for such a heavy emphasis
on advertising. Economic theory has taught us that the purpose of advertising
is to increase the demand for a firms product and make it more inelastic. But
when we consider firms such as Coke and Pepsi, we notice that there is
already a huge demand for these products. In fact, in relation to the amount
spent on advertising, sales do not increase by very much as a result of these
campaigns. Consumers who prefer Coke will stick to coke no matter how
many amazing Pepsi ads they see! So why then do these firms continue to
advertise?
The answer lies in the notion of barriers to entry. A new entrant will find it
exceedingly hard to enter a market where existing firms are already
 advertising so heavily. The budget needed to compete on this huge scale may
be beyond the capabilities of a new firm. Similarly, consumers are constantly
seeing these products advertised extensively so may be unwilling to give a
new entrant a chance.

(ii) Brand Proliferation: This is when a firm floods the market with different
brands/types of its own product. These brands may actually end up
competing with each other. However, this does act as a barrier to entry. One
way of understanding this would be to look at the toothpaste industry. There
are just a few major toothpaste companies present in the market (Colgate,
Crest, Sensodyne, Aquafresh and perhaps a few more). However, we notice
that each company will release a variety of toothpastes. We will see Colgate
regular, whitening, extensive clean, multipurpose to name a few. If we think
about it, all these types of toothpaste are essentially doing the same thing. If
each company just released one type, consumers would still be getting the
product they need. So why release so many?
This is, of course, partly a response to consumer taste. BUT, it also acts as a
barrier to entry for new firms. If 4 firms release one type of toothpaste only
we can assume that each has ¼ of the market. A new entrant can hope to
achieve up to 1/5th of market share. However, if each of these four firms are
releasing six to eight types of toothpaste, the new entrant has a lot more
competition. They would be unnoticeable on the shelf amongst all the
toothpastes present!
The cereal industry is similar to this too. Each company produces a large
variety of cereal. As mentioned before, this is a response to consumer taste.
However, it will also act as a barrier to entry as all the flavour profiles have
been covered by existing firms!

Oligopolies may go in either one of two directions. An oligopolistic market can either be
competitive or collusive. Firms can recognise their interdependence and choose to collude
with one another. They may agree upon pricing, output, market share, advertising standards
or any other factor they choose. Collusion will be beneficial for the industry as a whole.
On the other hand, oligopolists may decide to compete with one another. Their aim would
be to appropriate as much market share as possible and hence increase their own profits.
Competition may be both price and non-price. Non price competition will include negative
advertising about each others products as well as any USP, promotion or bundling of the
goods they sell.

Oligopolies

Collusive Competitive
Collusive Oligopoly

Overt Collusion:

When firms overtly collude, they essentially act like one firm (i.e. a monopoly). An overt
collusive agreement is known as a ‘cartel’. If firms have formed a cartel, they will act like a
monopoly and set monopoly prices in the market. In order for a cartel to be successful, the
product should be standardised if not homogenous. (Homogenous refers to exactly identical
unmarked products while standardised means of the same quality). OPEC is a great example
of an international oil cartel while cement producers in Pakistan also formed a cartel.

Say 5 firms form a cartel.

The MC curve would be the
sum of individual firms’ MC
curves.
Profit maximisation would be
the same as that of a
monopoly. They would
consider the market demand
(and MR) curve for their
product and profit maximise as
if they were one firm.

Note that market price and quantity is set as if the market was dictated by a monopoly. Each
individual firm now becomes a price taker (just like perfect competition). Once market
quantity is decided, it has to be distributed amongst the firms. This could be an equal
distribution or one based on the size of each firm. It could also be done according to
previous market share held by each firm prior to the cartel being formed. The firms may also
decide to use non price competition to determine market share but this would be an
unlikely scenario as the firms are openly colluding!

Tacit Collusion:

These are basically unwritten rules of collusive behaviour. There is no formal collusive
agreement such as a cartel. Firms are just choosing not to compete with each other and are
tacitly colluding in different ways. Remember, a lack of competition is collusion! There are
several ways that tacit collusion may take place.

(i) Dominant Firm Price Leadership

In this model, there is one dominant firm who sets the price in the market and all other
firms accept this price as given. They choose not to compete with the price leader, and
simply set the same price in the market.
Under this model, the leader will extract for himself a demand curve for his product
specifically. The diagram shows the market demand curve for the product and the
supply curve of all other firms. This supply curve is obtained through a horizontal
summation of the MC curve of all other firms. Now using these two curves, we will
attempt to pull out, from market demand, the demand curve for the leaders product
specifically. We do so by subtracting the supply of all other firms from market demand.

At P1, the market demand is being

met by supply of all other firms.
Therefore, the demand for the
leaders product is zero.
At P2, no other firm is supplying
therefore the leader has the entire
market demand to himself.
By connecting these two points, we
can extract the leader’s demand
curve.
(Distance ‘a’ will always equal to
distance ‘b’)

In order to find equilibrium in this market, we now look at the leaders corresponding MR
and MC curves. The interaction of MR and MC gives us QL and the leader goes up to his
demand curve to set the price in the market. At this price, market demand will be Qm
and the amount supplied by followers will be Qf as dictated by their supply curve.
(Remember, QL + Qf = Qm, as we got QL by subtracting Qf from Qm!)
Remember, this is a model of price leadership and all other firms in the market will simply
follow the leader. What this means is that all other firms are essentially, once again, price
takers! (Like perfect competition)
It is also possible that the MC curve of the leader lies above the supply curve of all other
firms. In the earlier diagram its seems like the leader has a huge cost advantage over his
competitors. Economies of scale have allowed him to gain leadership status through lower
costs and sheer size.
However, in the diagram below, it would appear that the leader is not the largest provider in
the market. The combined market share of all other firms is greater than that of the leader.
We can see that Qf > QL. His leadership status could be the result of being the oldest and
most established firm in the market.

A simpler model of Dominant Firm Price Leadership:

In this model we do not extract the leaders demand curve. Instead, the leader simply
assumes a certain percentage of the market (e.g. 50%). The leaders demand curve would
simply be 50% of the market demand curve. Now the leader will profit maximise looking at
his corresponding MR and MC curve and set price in the market. At this price, market
demand is Qm. He will provide quantity QL (as per profit maximisation) and the followers
will supply the difference (Qm – QL).

(ii) Barometric Firm Price Leadership

This is when there is no single firm which is the price leader in the market. Rather, all firms
will follow the price change made by any one firm as it would benefit the industry as a
whole. There is no standard practice as to which firm would make the initial change. The
behaviour of banks often comes under the model of barometric firm price leadership.

(iii) Rules of Thumb

Often firms that wish to collude will simply use some simple rules of thumb to avoid direct
competition. Remember: Any lack of competition is collusive behaviour.

• Average Cost Pricing: This is when firms decide to charge a price a certain percentage
above average costs. E.g. 15% above AVC. This would mean that firms that are
producing the same product and would have roughly the same AC would be charging
the same price. This is particularly relevant during periods of inflation.
• Price Benchmarks: This is when firms have some predetermined benchmarks. When
costs etc rise, they simply go from one benchmark to another. E.g. $9.99 to $11.99
• Advertising: Sometimes firms collude on the basis of advertising. They can decide not
to insult each other’s products or may even collude not to mention certain things at
all. E.g. Safety in airlines!

Factors Favouring Collusion:

In order for collusive behaviour to be successful, firms need to be able to identify each
other, perhaps establish some sort of leader and need to be able to trust each other.
Collusion will be easier if:

1) There are a few firms who are well known to each other.
2) They are open with each other about costs and production methods.
3) Firms have similar cost structures and production methods. They will therefore want
to change prices at the same time and by the same percentage.
4) Products are similar (standardized). This will make a common price easier to set.
5) There is some dominant firm.
6) There are significant barriers to entry. This is so that there is no disruption of the
collusive agreement by a new entrant.
7) There is a stable market. If the market is unpredictable then it will be hard to reach a
collusive agreement. There will be a lot of temptation to cheat to maintain sales.
8) There is no government to prevent collusion. Collusive behaviour is actually illegal as
it acts against the public interest!
In most market situations only a few of the above factors will be present. Therefore,
competition will be more likely. There is likely to be a BREAKDOWN OF COLLUSION.

Breakdown of Collusion - Incentives to Cheat:

Let us use the example of a cartel, which is a formal collusive agreement. As mentioned
before, the cartel will act like a monopoly and set monopoly price and quantity in the
market. Even though this benefits the industry as a whole, individual firms will have an
incentive to cheat. (Remember, in this model individual firms are price takers).

Say there are 5 members of a

cartel.
The cartel sets a market price
of 10 and a market quantity of
1000.
Each firm accepts this price of
10 and produces 200 units
each.

Now, there are 2 ways that this firm can have an incentive to cheat.

(i) The firm can accept the cartel price as given and choose to profit maximise
according to its own MC curve. Even through the industry is profit maximising, it
does not necessarily mean that each firm is producing at the profit maximising level
of output.
Since each firm is a price taker, it faces a horizontal demand curve at the cartel set
price. Currently, each firm is supplying 200 units. It may decide to profit maximise
and sell 400 units in the market.

If enough firms do this, market output will increase and market price will have to fall. There
will be a breakdown of collusion.
(ii) A firm may decide to directly undercut the market price set by the cartel. It may
simply look at its own demand and MR curve and set its own profit maximising price
and quantity. This would lead to a direct breakdown of collusion.

Smaller firms are likely to cheat by trying to sell a few extra units at market price. They are
too small to want to start a full blown price war as they are unlikely to succeed against
larger firms. On the other hand, a large firm is much more likely to directly undercut the
cartel price as it is capable of stealing market share.

Either way, each firm has a strong incentive for personal gain. Although collusion benefits
the industry as a whole, competition is much more likely to take place. This is best explained
through John Nash’s Game Theory.

Game Theory:

John Nash developed Game Theory to explain how even though collusive behaviour will
benefit all players, more often than not there is a breakdown of collusion. Each player has a
“dominant strategy” to cheat. This is best explained through the ‘Prisoner’s Dilemma”.

Prisoner A

Confess Don’t Confess

Prisoner B Confess A : 6 years A : 12 years

B : 6 years B : 3 months

Don’t Confess A : 3 months A : 2 years

B : 12 years B : 2 years

Lets say there are two prisoners A and B. The police has caught them on a minor crime such
as a speeding ticket but wants to convict them of a major crime that they know they have
committed. They want to get the prisoners to confess to the major crime. What the police
can do is construct a set of pay offs that will encourage the prisoners to confess to the
crime.
Each prison has two options – to confess or not to confess. We need to learn how to read
this table. The first box refers to the situation where both players have confessed to the
crime. In this case, each prisoner will get 6 years in jail. The top right box refers to a
situation where A is refusing to confess and B has confessed to the crime. In this case, B
comes out in 3 months, while A is blamed for the entire crime and gets 12 years in jail. The
bottom left box is the opposite of this. And finally, the bottom right box is where neither
player confess. In this case, each prisoner will go to jail for 2 years. As we can see, this box
represents the best outcome for both players. This would be the ‘collusive outcome’.
However, we will see that each player has a ‘dominant strategy’ to cheat and break the
collusive agreement.
Let us look at this set of payoffs from A’s point of view. If A believes that B has confessed to
the crime, it is in his best interest to also confess. That way, he gets 6 years instead of 12.
Similarly, if A believes that B has not confessed to the crime, it is still in his self-interest to
confess, as now he gets 3 months instead of 2 years in jail. We say that player A has a
‘dominant strategy’ to confess – no matter what he believes B is doing, it is in his best
interest to confess to the crime. The same holds true for B.
The ‘Nash Equilibrium’ in this game is where both players confess. We can predict the
outcome of this game even before it has been played! Even through the collusive outcome
is better for both players, there is such a strong incentive to cheat and break the collusive
agreement that the outcome of the game will be non-collusive.

We can apply this concept to an Oligopoly. Say there are two firms who can set two prices,
$7 and $10. $10 would be the collusive price while $7 would be the competitive price. The
payoffs given are profit levels the firm can achieve.

Firm A

10 7

Firm B 10 A : 12 m A : 15 m
B : 12 m B:6m

7 A:6m A:9m
B : 15 m B:9m

The above game shows that although collusion will benefit the industry as a whole (top left
box), each firm will have a ‘dominant strategy’ to cheat and break the collusive agreement.
Nash equilibrium will be where both players break the collusive agreement and undercut
the agreed upon price. It is much more likely that this collusive oligopoly will end up
becoming a competitive one.
Competitive Oligopoly

As shown by Game theory, collusion will often fail as firms have an incentive to cheat and
break the collusive agreement. Under oligopoly, there is no fixed rule for competition. Firms
may choose to compete through price wars or even non-price competition. Non-price
competition, as mentioned before, will include advertising, product development and
differentiation, R&D to name a few.
If firms engage in a price war, then they will constantly try and undercut the price set by
their rivals in order to gain market share. In fact, Game Theory shows us that producers
would want to keep lowering prices in order to gain more profit.
However, if we look at competitive oligopolistic markets, we tend to notice the
phenomenon of “price stickiness”. Prices in such markets tend to remain stable. This price
stickiness can be explained using a ‘kinked’ demand curve.

Kinked Demand Curve

The Kinked Demand curve is based on the concept of interdependence (each firm will
consider the reaction of its rival when considering its own actions) between firms. Say we
take the example of two firms – Coke and Pepsi. The current price of a can of Coke is ‘P’. if
Coke decides to increase its price, ceteris paribus, it knows that Pepsi will not follow suit.
This is because Pepsi recognises that Coke is a rival company and therefore can steal away
customers from Coke as a result of their, now, relatively lower price. Coke will lose a large
customer base due to this increase in price. They will not, however, lose all their customers
due to the presence of brand loyalty. This leads to an elastic demand curve above price ‘P’.
On the other hand, if Coke decides to lower its price, it knows that Pepsi will definitely
follow suit as they know they will lose customers to Coke if they don’t do so. This is, once
again, a recognition of the interdependence between competitive firms under an oligopoly.
As a result of both firms decreasing their price, neither firm will gain that many more
customers. This leads to an inelastic demand curve below price ‘P’.

This interdependence between firms is giving us a demand curve which is ‘kinked’ around
current price and quantity. We are already seeing the origins of ‘price stickiness’ as the firm
will not have an incentive to either raise or lower prices.
Deriving the MR curve for a Kinked Demand Curve and Subsequent Profit Maximisation:

In order to derive the MR curve for a kinked demand curve, we simply elongate the two
separate demand curves. We get D1 as an elastic demand curve and D2 as an inelastic
demand curve. Each of these demand curves will have a corresponding MR curve.

Now, till quantity ‘Q’, we are on D1 and therefore MR1. After quantity Q, we are on D2 and
therefore MR2. Notice that there is a vertical segment at Q between MR1 and MR2. When
we draw the final MR curve, it will be disjointed at quantity ‘Q’. The vertical line that
connects the two MR curves will be part of the final collective MR curve that we draw for
the kinked demand curve.

This vertical segment of the MR curve explains ‘price stickiness’. Between ‘a’ and ‘b’, the MR
curve is vertical. This implies that for any MC curve that lies between ‘a’ and ‘b’, profit
maximising price and quantity will not change! Even in the face of rising costs, this
oligopolistic producer will be reluctant to increase prices. For a significant period of time
prices in this market will remain sticky.
Note however, if costs increase too much, prices will rise in the market and we will generate
a new kinked demand curve around a new price and quantity.

Remember, we are explaining price stickiness under the model of a profit maximising
competitive oligopolist. Price stickiness does happen and is expected under collusive
oligopolies, but the theory of competition and Game Theory would suggest otherwise in the
presence of competition. The kinked demand curve attempts to explain why, even in the
face of direct competition, we still see somewhat stable prices in the market.

Although the kinked demand curve is a very useful theory for explaining price stickiness, it
may have a few limitations:

(i) It does not explain how initial price and quantity were set in the market. Our
entire demand curve is contingent on this initial price and quantity already being
set in the market. We cannot derive a kinked demand curve without knowing
initial P and Q. However, the theory fails to tell us how P and Q were established.
(ii) It is also possible that a competitive oligopolist faces a regular downward sloping
demand curve and is holding prices constant for other reasons such as brand
loyalty and customer relations. In this case, the oligopolist is no longer profit
maximising but rather working with some other objective.

Concentration Ratio

The concentration ratio is a ratio that indicates the size of firms in relation to their industry
as a whole. It is the percentage of market share taken up by the largest firms. Low
concentration ratio in an industry would indicate greater competition among the firms in
that industry, compared to one with a ratio nearing 100%, which would be evident in an
industry characterized by a true monopoly.
We could look at a 3 firm concentration ratio (market share of 3 biggest) or a 5 firm
concentration ratio.
Concentration ratios are used to determine the market structure and competitiveness of the
market. For example, an oligopoly is often defined when there is a 5-firm concentration
ratio of greater than 50%

The Formula for the concentration ratio is:

Total sales by the specified number of largest firms/Total industry sales x 100

Importance of concentration ratios :

Concentration Ratios can be used to:

Determine the degree of competition. If the five-firm concentration ratio rises from 40% to
60%, this is an indication of a fall in competitive pressures. It could lead to higher prices for
consumers
Indicate monopoly power. In the UK, the legal definition of a monopoly is a firm with more
than 25% market share. Any firm over this threshold has an important market position.

Regulatory oversight. If there is a three-firm concentration ratio of over 80%, then there is
greater scope for collusion and abuse of monopoly power. In this kind of industries, the
government may need to use a regulator to check monopoly power isn’t being abused. For
example, the government has a regulator for railways, electricity and gas – where the
market is dominated by a few large firms.

An MCQ:
5

8 In September 2008 Google introduced its Chrome web browser. The table shows the market
percentage (%) share of different web browsers between September 2008 and June 2014.

% share in % share in
web browser
September 2008 June 2014

Internet Explorer 67.2 21.0

Firefox 25.8 17.9
Safari 3.0 10.3
Opera 2.8 1.8
Chrome 1.0 45.5
others 0.2 3.5

What can be concluded from the table about the change in market concentration ratios between
2008 and 2014?

5-firm 3-firm
concentration concentration
ratio ratio

A fell fell
B fell rose
C rose fell
D rose rose

9 A firm incurs both fixed and variable costs of production. It is currently producing at the level of
output which minimises its average total cost.

What effect will a small reduction in output have on the firm’s marginal and average variable
costs?

average
marginal cost
variable cost

A fall fall
B fall rise
C rise fall
D rise rise
 Other Objectives of Firms

One similarity that ran though all market structures is that each firm is a profit maximiser.
Although this would seem like a logical objective for the firm, there are many extenuating
factors to consider.

First and foremost, is a firm ACTUALLY able to profit maximize? Profit maximization means a
firm must produce where MR=MC. This is easy to comply with in theory, but in reality may
not be as simple. Although its own cost structure is easily available to a firm, demand and
revenue curves are simply a projection. A firm can in no way derive an EXACT demand curve
for its production (The MR curve is derived from the demand curve). As a result the profit
maximizing quantity may be IMPOSSIBLE to actually calculate. What this means is that even
if profit maximization is an objective a firm may not have the necessary information to
profit maximize.

Additionally, as we will see below, firms often have many objectives apart from profit
maximization.

Other objectives of firms will include:

1) Sales revenue maximization: This is when firms aim to maximize revenue as opposed to
profits. This will happen at the point where MR=0 therefore TR is maximum. The reason
for this is that some firms feel that performance is judged by sales as opposed to profits.
Sales managers have an incentive to try and maximize sales as they get commissions
based on sales figures. These firms will still be making a profit but may not be profit
maximizing. They will be profit satisficers (explained below). It is interesting to note that
firms with this objective will tend to spend more on advertising as compared to a profit
maximizing firm. Advertising increases sales as well as costs but these firms will focus
more on the increase in sales.

2) Predatory pricing to remove competition (discussed previously). This is when a firm

slashes prices, sometimes even below costs, to drive competitors out of business. The
firm will sustain a temporary loss to ensure future market share.

3) Charity. This includes NGOs and other charitable organizations which do not have a
profit motive.

4) Satisficing Profits: There are usually many stakeholders in every firm, all of whom need
to be kept sufficiently happy. There may be a separation of ownership and control i.e. a
 company may be owned by a family or directors, but run by professional managers etc.
There are also workers and shareholders to please. Often profit maximization is not the
goal of every firm. As long as they are earning a level of satisficing profit (somewhere
between normal and abnormal profit but not a loss), the conflicting objectives of the
various stakeholders may be satisfied. Workers may demand a more than optimal wage,
shareholders have to be kept happy with some level of dividends and managers may
focus on sales as opposed to profits. Satisficing profit would be a viable alternative to
profit maximization.
[This theory implies an inherent assumption of imperfect information as indicated by
the principal- agent problem where people (principals) cannot ensure that their best
interests are being served by the agents hired. In today’s complex and modern economy
people have to employ others (agents) with specific knowledge and skills to carry out
certain tasks. (E.g. if you hire a travel agent to book your holiday, you cannot ensure
that you are getting the best possible deal). These ‘agents’ may prefer other alternatives
to profit maximization while all the while ensuring a level of satisficing profits.]

5) Firms may sacrifice short run profits to achieve long run profit maximization. E.g.
policies to increase the size of the firm as well as market share may involve heavy
advertising as well as investment in R&D. This would increase costs in the short run but
may allow for increased profits in the long run. (Note: this is a very elusive concept as
there is no certainty about long run consequences of today’s actions. This objective can
be abused as almost any policy can be undertaken with the aim of long run profit
maximization).

6) Average cost pricing (discussed previously). This is usually prevalent in times of inflation
where costs keep rising. It is also found commonly as a means of collusion between
oligopolists. Firms just add on a certain percentage to their average costs when setting
price. E.g. price is set as 10% above AC. This 10% serves as profit for the firm.

7) Growth maximization: The firm may strive to increase its market share and become a
large corporate player. Growth is an important objective for the firm.
The firm may be able to achieve growth through internal expansion. This is when a firm
increases its sales as well as its productive capacity. This may happen through extensive
advertising as well as investment in R&D. It can be funded through borrowing, giving out
of less dividend to shareholders, new issue of shares as well as through dipping in to a
pool of previous profits collected. Remember, the firm may not be traditionally profit
maximizing while it does this, but it does need to retain some level of satisfactory profit.
 The firm may also grow in size through diversification. This is when a firm has interests
in varied fields. A good example is the company Virgin owned by Richard Branson.
Virgin’s interests include planes, trains, cars, finance, music, mobile phones, cinemas,
radio, publishing and even space travel. Diversification not only allows a firm to grow
larger, but also allows it to spread risks as well as use profits from one part of the
company to another.
A firm may also achieve growth through mergers. This is when a firm buys or takes over
another firm. Mergers may be horizontal, vertical or lateral in nature. Mergers allow for
growth as well as economies of scale.
Another way for a firm to achieve growth is by going global. This may involve opening
factories abroad to take advantage of cheaper labor conditions or perhaps just merging
or forming alliances with already existing firms. With the trend towards free trade,
multinational companies are playing a larger and larger role in today’s economic
environment.

Role of Advertising:
Advertising will play a role in most market structures. Under conditions of Oligopoly the role of
advertising is most pronounced. In fact, this emphasis on advertising is sometimes presented as
a critique of large firms. We must consider the effect on advertising in the economy.

Advertising and the public interest:

Benefits:

1) It gives information to the consumer

2) It can be used for the introduction of new products. It allows other firms to break into
existing markets
3) If advertising brings about an increase in sales then this could lead to economies of scale
and a long run reduction in costs.

Costs:

1) It may mislead the consumer

2) It creates wants and therefore encourages scarcity
3) It makes people materialistic
4) It uses up resources that could be used towards the production of other more important
goods and services.
5) It raises costs and therefore may raise price for the consumer.
 6) It acts as a barrier to entry for new firms
7) Unsightly billboards etc may generate negative externalities

Survival of Small Firms

Economies of scale focus on the importance of being large. As firms grow they accrue
certain benefits based on their size. With the onset of the business world as we know it
today there is an emphasis on being large. More and more markets are being taken over by
massive corporations that can provide the good at lower and more affordable prices. Small
businesses are often finding themselves driven out of the market by corporate giants. E.g.
Starbucks driving out small independent coffee shops; Barnes and Nobles forcing smaller
book shops to shut down; Small independent oil companies facing threats from oil giants.
Does this imply that all firms must grow? Is there no role any more for the small firm? Can
small firms survive despite the current trend towards size and globalization? Although in
most markets firms are getting larger and larger, there is still a role for small firms in today’s
day and age.

1) They cater to niche markets such as antiques and expensive jewelry.

2) There may be limited demand which is the economic limit to specialization and growth.
3) One-man businesses with limited capital tend to remain small as they provide a
personalized service. E.g. tailors, hairdressers etc
4) Skill based work such as arts and crafts.
5) Some small firms are protected by the government through grants and subsidies. E.g.
organizations that help impoverished women.
6) Some products cannot be mass produced such as specific prescription glasses.
7) Some small firms may be needed to provide services to large firms. E.g. a small company
provides cars for hire to larger corporations.
8) Goods that have snob appeal will never be mass produced such as Ferrari and Chanel.
9) There is an argument that small firms may be more efficient as they can respond better
to changing market conditions
10) All firms must start from humble beginnings.

This information may be used in questions that ask why some firms choose to remain small
while others grow in size. The benefits of economies of scale must be given as well as reasons
why firms may remain small.
 Contestable Markets

Theory of Contestable Markets

Contestable Markets is an alternative theory to traditional market structures. Market structures

focus on the number of firms present in the market and claim that firms make price and
quantity decisions accordingly. Contestable Markets challenge this tradition theory by saying
that the number of firms actually present is not the sole decider. In fact, the theory claims that
what is crucial in determining price and quantity is not whether the industry is actually a
monopoly or characterized by competition, but rather whether or not there is a real threat of
competition. Potential competition plays as much of a role in determining price and quantity as
does actual competition.

For example, say a firm is the only firm in a market so it can be characterized as a monopoly.
But if this firm knows that with just a little effort another firm can enter and take over some
share of the market, it is more likely that this monopolist will behave and price more like a
competitive firm. The threat of competition will have the same effect as the actual presence of
competition. This applies to situations such as the canteen at Cedar. Currently the canteen has
a monopoly in food services at Cedar. But the company knows that if it does not provide good
services and reasonable prices, it may be replaced entirely by a new service provider. It is the
threat of competition and not actual competition present that is determining the behavior of
the firm.

Perfectly Contestable Markets

In a Perfectly Contestable Market, the cost of entry and exit by potential entrants is zero and
entry can be made rapidly. As a result normal profit will always prevail as if there is a hint or
possibility of abnormal profit, entry will ensue.

What this implies is that in perfectly contestable markets price will always be low because all
firms are making normal profit. There will also be efficiency in production. In short, no matter
the number, all firms will behave like perfectly competitive firms.

Contestable Markets and Natural Monopolies

In a market characterized by a natural monopoly there is only room for one firm. However
there is still room for this market to be contestable. If a natural monopoly is inefficient,
there is always a threat that a new firm can enter and replace the existing one. Example
PTCL is a natural monopoly, but if they are pricey and inefficient, the government may
replace them entirely with another telephone company. Natural monopolists, knowing this,
will behave more efficiently.

Concept of Costless Exit

‘Sunk Costs’ not only act as a barrier to entry, but also as a barrier to exit. If sunk costs are
high, firms will think twice about shutting down as they have already invested so much
money. The market cannot be perfectly contestable. However, as exit costs get lower and
lower the market becomes more and more contestable.

It is interesting to note that large established firms tend to have lower exit costs. They are
able to diversify and enter different markets as the cost of this entry (and therefore exit)
can be funded from other areas. In addition, equipment and capital bought can be
transferred to other areas of production.

Hit and Run Competition

In markets where there are low entry and exit costs, we might find the phenomena of hit
and run competition. This is when firm enter the market during a period of high demand
and leave afterwards. A good example would be roadside stalls during ramzan. There is a
temporary increase in the demand for certain food products and as a result people enter
this market to take advantage of this. Builders after a natural disaster as well as rival postal
companies during Christmas time are also good examples. In all these cases, entry has
taken place just to take advantage of a temporary increase in profits. As soon as demand
falls back down, these firms will leave the market.

Oligopoly and Contestable Markets

The lower the barriers to entry an oligopolist faces, and therefore the more contestable the
market is, the more likely there is to be competition as opposed to collusion. The threat of
entry and competition will not allow firms to collude as the new entrant will disrupt the
collusive agreement. Contestable oligopolies will be characterized by competition as
opposed to collusion.

To Sum Up:

If a market is contestable, Oligopolists and Monopolists will keep normal profit to avoid
entry by potential competition (both local and foreign). They do not want potential
competition to become real competition in the market. As a result firms behave as though
they were competing under conditions of perfect competition. This benefits consumers as
price will be low and quantity greater and it also benefits the government as they no longer
need to regulate monopolies! Even a sole firm in the market will not price or behave like a
monopoly. Contestable Markets is an alternative theory to profit maximization stating that
there is no link between price and quantity and the number of firms in the market. Looking
at the number of firms actually present in the market is not a determinant for a firm when
making price and quantity decisions.
Labour
Markets
 Theories of Wage Determination: The Labour Market

In this chapter we will discuss wage differentials, inequalities and the types of markets that
labour may face.

As with market structures we will start with the assumption of a perfectly competitive labour
market and eventually relax these assumptions to offer a more realistic view of how wages are
indeed determined.

A perfect labour market assumes that everyone is a wage taker. This includes both workers and
firms. This is a situation that is not uncommon. There is often a ‘going rate’ for certain
professions such as assembly line workers, cooks, porters etc. Both the employer and the
employee are aware of this wage rate as well as the availability of jobs and the productivity of
labour. This brings us to our second assumption of perfect knowledge. In addition to this, a
perfect labour market is one where there is freedom of entry and exit. There are no
restrictions on the movement of labour from one field to another or one location to another.
Workers are both occupationally and geographically mobile. Unions, Professional Associations
and the Government do not impede the movement of labour. Much like before, the assumption
applies to the long run as it may take time for labour to move from one occupation/location to
another. Finally, we assume that labour is homogenous. This means that all workers of a given
category are identical in terms of productivity. It does not mean that sweepers are
homogenous to doctors but rather that all sweepers are homogenous as well as all doctors.

Under perfect competition the market wage rate is determined by forces of demand and
supply. This wage rate set is then accepted by firms and workers alike.

We will now attempt to present a theory explaining the demand for labour

Demand for Labour

When a firm is deciding an optimal number of workers the hire, it will use a theory similar to
that of profit maximization. When a firm was deciding whether or not to produce an additional
unit of output it looked at the cost of producing that output (MC) versus the revenue gained
from the sale of that additional unit (MR). In fact, the firm uses the same logic when it is
deciding whether or not to hire an additional worker.

The “MC” of the additional worker is simply the wage rate it has to pay that worker (which in
the case of Perfect Competition is constant). However the “MR” of an additional worker, ie the
amount they are adding to a firm’s revenue, is far more complicated.
The extra revenue generated for the firm by hiring an additional unit of labour is known as the
Marginal Revenue Product of Labour (MRPL). This is calculated by multiplying the Marginal
Physical Product of Labour (MPPL or simply MPL) by the Marginal Revenue gained by selling
those units (MR)

MRPL = MPPL x MR

If a firm hires a worker who produces 100 units and each of those units add $2 to revenue then
essentially the worker has added $200 to the firm’s revenue!

What will this MRPL curve look like? Well, it will follow the shape of the MP curve! This is
because the curve will simply expand when we multiply it by a constant MR.

We will now return to the earlier principles of profit maximisation.

As long as the additional worker hired adds more to the revenue of the firm than he does to
cost, the firm will hire the worker. To rephrase: As long as MRPL is greater than the Wage rate
the firm will hire the worker. However, when MRPL falls below the Wage rate then the
additional worker is adding more to cost than to revenue to the firm will not hire this worker.

Let us now do a both a number and a diagrammatic analysis of this concept:

At wage rate ‘W’, ‘Q’ number of workers will be employed.

Now, lets start changing wage rates and see what happens! We notice that for each and every
wage rate, the number of workers that the firm employs is determined by its MRPL curve. In
fact, the MRPL curve is showing us a unique relationship between wage rates and the number
of workers the firm ‘demands’. In essence, the MRPL curve is simply the Demand Curve for
Labour! (as it tells us the number of workers the firm will employ at each and every wage rate!)

The MRPL curve beautifully sums up the theory of the demand for labour. Labour is a derived
demand ie the demand for labour is derived from the demand for the goods and services that
labour produces. We don’t demand workers for the sake of workers! We demand them for the
goods and services they produce. This part of the demand for labour is reflected in the ‘MR’
part of the equation. Additionally, we demand workers based on the productivity of workers
themselves. The more productive workers become, the more demand will increase. This is
reflected in the MPP part of the equation. The equation completely embodies the two distinct
reasons that form the basis of a firm’s demand for labour
 MRPL = MPPL x MR

There is also something known as Value of the Marginal Product of Labour (VMPL). This is
simply MPPL multiplied by Price (as opposed to MR). Note that if there is perfect competition in
the goods as well as the factors market MRPL = VMPL [Use this info for MCQs]

To Recap:

MRPL = MPPL x MR (revenue received from hiring an extra worker)

VMPL = MPPL x P (same as MRPL in the case of PC in the goods market)

A firm hires labour based on the principles of profit maximization. The firm will continue to hire
workers until MRPL = MCL (which is just wage rate set by the market). Changing the wage rate
shows us that the firm will hire workers as dictated by the MRPL curve showing a relationship
between wage rate and quantity of labour hired. Hence we can conclude that the demand
curve for labour is the MRPL curve.

Determinants of the Demand for Labour:

1) Wage rate: This will determine the firms position on the demand curve for labour. This
has to do more with quantity demanded as opposed to demand.
2) Productivity of labour (MPPL): This determines where the actual demand curve for
labour will be. Changes in MPPL will shift the entire demand curve.
3) Demand for the product that labour is producing: any ↑ in demand for the product =>
↑P => ↑MR => ↑MRPL. This will again affect the position of the demand curve and any
change will lead to a shift of the demand curve.

(Summary : ∆ wages => movement. ∆ productivity/demand for final product => shift)

Note: The demand for labour is based both on the productivity of labour as well as the demand
for the final product that labour is producing (derived demand)
Determinants of the Elasticity of the Demand for Labour (with respect to wages):

1) The more elastic the demand for the good that labour produces, the more elastic the
demand for labour will be. This is because labour is a derived demand.
2) If the firm can substitute labour with other factors and vice versa with relative ease,
then the demand for labour is likely to be elastic. For example, if wages fall the firm will
hire more workers in place of other factors and vice versa.
3) Elasticity of supply of complementary factors: If labour has a complementary factor and
wage rates fall, the firm will hire more labour if the complementary factor is easily
available. If not then this decrease in wage rates will not increase employment too
much.
4) Elasticity of supply of substitute factors: If substitute factors are not readily available,
then an increase in wage rates may not affect demand greatly. If they are then Qd of
labour will fall drastically.
5) Wages as a proportion of total costs: If wages are a large proportion of total costs then
demand is likely to be elastic and vice versa.
6) Time Period: The longer the time period considered, the more elastic demand will be.
The firm will have time to adjust to changing market conditions.

The Demand for Labour (MRPL theory) on its own is an incomplete theory. It is only half the
story! Wages are determined by both demand and supply factors. We also need to study the
Supply of Labour if we are to figure out how wage rates are determined and why differentials
may exist.

Supply of Labour

The supply of labour is the number of hours supplied by an individual worker.

Work is done at the expense of leisure. Therefore the opportunity cost of work is leisure.

There is a Marginal Disutility of Work (MDW). The more the hours worked, the greater the
MDW that sets in. As work hours increase, a lot more leisure has to be given up and work
itself may become more tedious and boring etc. This increasing MDW leads to an upward
sloping supply curve of labour. Workers will need to be paid more in order for them to work
more hours and sacrifice leisure. (This is the reason that overtime pays are higher than
standard rates of pay)
So far we have established that the supply curve of labour is likely to be upward sloping. In
fact, at very high levels of wages, this supply curve may even bend backwards. There are
two opposite forces at work:

1) Substitution Effect: As wage rates increase, the opportunity cost of leisure becomes
greater and greater – leisure becomes more expensive. As a result an individual worker
will substitute income (work) for leisure. The substitution effect of an increase in wages
is to increase the number of hours supplied by an individual worker.
2) Income Effect: As wage rates rise a lot, workers now feel that they can maintain the
same standard to living with fewer hours worked. They may now cut back hours worked
to increase leisure time. The income effect of an increase in wages is to reduce the
number of hours supplied by an individual worker.

At lower wage rates, the substitution effect outweighs the income effect. As wage rates
increase workers have an incentive to increase the number of hours worked. BUT, at very
high wage rates the income effect outweighs the substitution effect. Individual workers will
cut back number of hours worked in favour of leisure as they can now maintain the same
lifestyle even if they do so. This leads to a backward bending supply curve of labour. At very
high wage rates, the number of hours supplied by an individual worker actually decreases.
(Think about the implication on tax policies)

0 – W1 : Substitution effect outweighs income effect

W1 onwards : Income effect outweighs substitution effect.

 Market Supply Curve of Labour:

This is just upward sloping (does not bend backwards). As wage rates increase, more and
more people would be attracted into this industry and supply will increase. The position
of the curve will depend on

1) The number of qualified people available.

2) Non wage benefits of the job.
3) Non wage benefits in other jobs.

Any change in wage rates leads to a movement along the same supply curve while a change in
other factors will lead to a shift of the supply curve.

Elasticity of the Market Supply Curve of Labour:

The question we are asking is whether an increase in wages will attract a lot more workers into
the industry. This will depend on the difficulty of changing jobs as well as the time period
considered. Therefore the answer to this will depend on both the geographical and
occupational mobility of labour. The more mobile labour is, the more elastic supply will be.
Similarly, the longer the time period considered, the more elastic supply will be.

Supply is likely to be more elastic when:

• Alternative jobs are in the same location

• Alternative jobs require similar skills
• There is good information.

Economic Rent and Transfer Earnings

Earnings of FOPs can be split into two categories:

Transfer Earnings: This is the minimum amount that a factor must earn to prevent it from
moving to an alternative use. It is what labour must be paid to persuade it to stay in its present
job.

Economic Rent: Anything earned over and above transfer earnings. It is the excess a factor is
paid over its transfer earnings.

Example: Say I would transfer to Lyceum if my salary fell to 60,000 a group. I currently earn
80,000 a group. In this case my transfer earnings would be 60,000 and my economic rent would
be 20,000.

Total Earnings – Transfer Earnings = Economic Rent

Start at point ‘a’. Start to ↑ W. This will attract more people into the market. This increase in
wage is just enough to attract the additional workers into the market therefore for these new
entrants the wage rate is all transfer earnings. But, for workers already in the market the
increase in wages gives rise to economic rent. They are now getting more than the minimum
amount required to keep them in the market.

For each worker economic rent is the difference between wage rate and the point on the
supply curve where they entered the market.

The more inelastic the supply curve, the more the economic rent and the less the transfer
earnings. Need to increase wages A LOT to get new workers so therefore existing workers get a
lot more economic rent.

Elastic Supply => lower ER , ↑ TE

Inelastic Supply => higher ER , ↓ TE

Perfectly inelastic supply curve : All Economic Rent (e.g. sports stars and singers etc)

Perfectly elastic supply curve : All Transfer Earnings.

Quasi Rent: In the long run supply becomes more elastic. Economic rent can get eaten away by
new workers entering the market. If economic rent was just a short run phenomenon due to
lack of available labour and skill then it is known as quasi rent.
 Different Labour Market Conditions

1) Perfect Competition (Both in the factors and the goods market)

This is the traditional theory of wage determination.

Assumptions : As before

Equilibrium wage rate is determined by market forces of demand and supply. At this wage rate
the individual employer can hire as many workers as he wants. The supply of labour facing the
individual firm is perfectly elastic. (He cannot get workers for wage rates less than We and
would obviously be unwilling to pay more than We). The firm hires workers according to its own
demand curve.

Similarly, an individual worker can supply as many hours as he likes at this equilibrium wage
rate. What this means is that as far as the individual worker is concerned, the demand for his
services is infinite at market wage. He will supply the number of hours dictated by his own
supply curve.

Remember the position of the demand and supply curves is what sets wage rates in a perfectly
competitive market. Therefore wages will be higher in those professions where there is a high
demand and low supply (e.g. doctor) and lower in those professions where there is a lower
demand and relatively higher supply (e.g. sweeper). Apply this to the question of whether
workers are paid according to their productivity. If productivity is high then MRP is high and so
too will demand be high and therefore a higher wage rate! So yes, the essence of labour theory
takes into account the productivity of a worker.

However, as mentioned before, this is just half the theory. The position of the supply curve
plays an important role in the determination of the wage rate. Changes in the supply of labour
will affect the wage rate and this would be unrelated to the productivity of labour (think day vs
night guards).

Perfect competition does not necessarily imply income equality. What it does guarantee is that
all of a particular kind of labour will be paid the same but there will still be differences in wages
across professions. Even within Perfect Competition wage differentials may exist due to the
fact that

• Some jobs may be risky and unpleasant and therefore need to offer a higher rate of
compensation. This may be both in terms of timing as well as dangerous work
conditions. AS mentioned before this has to do with supply conditions (Apply this to the
question: Are workers always paid according to their productivity)
• The very real fact is that there may be unequal ownership of factor endowments i.e. a
difference in the quality of FOPs in terms in intelligence, strength, ability etc. This is
challenging the theory itself.
• Different jobs will require different skills which implies that there may not always be
perfect factor mobility (even in the long run).

This is basically saying that demand and supply conditions are different in different markets
leading to wage differentials across markets.

Long Run under Perfect Competition: As mentioned before there is freedom of entry and exit
under a perfectly competitive labour market as well as no restrictions to the movement of FoPs.
What this implies is that, in the long run, there will be perfect wage equality! Wage differentials
across occupations will disappear and, in the long run, all wages will be identical. This is
because people in low paying professions will leave to join higher paying professions. As a
result the supply curve in the low paying profession will shift inwards while the supply of high
paying professions will increase. This will work to equate wages!! Although this sounds
farfetched, traces of this theory can be seen in developed countries. Why is a plumber in the UK
paid more than the same plumber in a country like Pakistan?

Profits under Perfect Competition:

W = MRPL (= VMPL) of the last worker hired. But all pervious workers are getting a wage rate
lower than their MRPL. They are adding more to revenue than to costs. This is a surplus for the
firm and translates into normal profit for the firm.
Imperfect Markets

We will now start to relax the assumptions made earlier and look at a more realistic view of
labour market conditions. There will now be

1) Restrictions on the movement of factors such as trade unions

2) Imperfect information
3) Other forces at play such as discrimination

There are a few different situations that we will consider

a) The firm may be a monopoly or oligopoly in the goods market (but still PC in labour
market).

b) The firm may be a monopsony i.e. the sole employer of labour (if there are a few
employers it is known as an oligopsony)
c) Workers may have market power such as a union. In this case workers are acting like
monopolists
d) A bilateral monopoly. This is when a union monopolist faces a monopsonist employer.

2) Firm with market power in the goods market (monopolist) but perfect competition in
the factors market. (Mostly for MCQs. No need to use in answer question)

This is a situation where the firm is a monopolist in the goods market but has to compete
for workers in the factors market. E.g. a monopolist who hires assembly line workers.

Now P ≠ MR. In fact, P > MR therefore VMPL > MRPL

 At Q1, VMPL > W. Workers are not being paid according to the value of the goods and
services that they are producing. The monopolist can afford to give them more but he does
not. This could be considered monopoly exploitation. Alternatively, the monopolist could
hire up to the point Q2 but again he chooses not to. If a lot of the goods markets are
characterised by monopolies then this ↓ output => ↓ DL => ↓ W. (But remember there is
always scope for economies of scale and therefore an ↑ output!)

[This is not too important as it does not apply to wage differentials]

3) Monopsony (Market power in employing Labour)

This is an alternate theory to traditional theories of wage determination (perfect competition)

If one (or a few) firms employ a certain kind of labour then that firm is going to be a wage
maker. E.g. if Cedar is the only school in Karachi then it will be the sole employer of teachers
and will have control over wage rates.

In fact, a monopsonist will face an upward sloping supply curve of labour. If the firm wants to
hire more workers, it must increase wage rates to attract more workers into this industry from
other professions. On the other hand, if it wants to reduce the number of workers it is free to
reduce wage rates.

ACL = TCL /#workers = W

Also, MCL > ACL. This is because as the firm hires more workers it must increase wage rates for
all existing workers as well. Therefore the marginal cost of the additional worker will not just be
the wage rate of the additional workers but rather the wage rate plus the increase in wages of
previous workers.
Now, the firm will profit maximise at quantity Q1 where MRPL is equal to MCL. But, it will set a
wage as dictated by the supply curve of labour. It will set a wage rate W1. This is also an
example of exploitation of labour. W ˂ MRPL of even the last worker employed. Under
conditions of perfect competition, wage rates would have been W2 and quantity of labour
employed would have been Q2. The monopsonist is taking advantage of his market power.

4) Labour with Market Power : Unions and Minimum Wage Legislations (in a competitive
labour market)

The power of the trade union will differ depending on the market structure the employer is
working under. If the employer is working under conditions of perfect competition or
monopolistic competition in the goods market then the firm is only making normal profit. If
unions try and increase wages, some firms will go bankrupt and leave the market. This will
reduce supply and increase price, therefore allowing remaining firms to pay the higher wages.
But this will cause unemployment as now there are fewer firms and less output.

If unions increase wages to W2 then employment will fall to Q2. There will be a surplus of Q3 –
Q2 number of workers who are ready to work but there are no jobs available for them. The
union must make sure that these unemployed workers do not try and undercut the union wage.
They may force the firm to only hire union workers.

If the union doesn’t want to cause unemployment, it may strike a ‘productivity deal’ with the
firm. This is when workers agree to increase productivity (output/worker) with an increase in
wages. This will shift the MRPL and therefore demand curve to the right leading to a higher
wage with no unemployment.

Remember the union has two considerations. If it wants to maximise employment it will stick to
a wage of W1. If it wants to increase wages for remaining workers, it will push wages up as
much as possible.
The government setting a minimum wage would have similar consequences. Remember the
minimum wage has to be above market wage in order for it to be effective.

5) Bilateral Monopoly : Firms and Labour with Market Power.

This is the case where a union monopoly faces a monopsonist employer. Ironically, when a
union faces a powerful employer they have more of a chance to increase wages without
causing unemployment.

No union: Wage will be set at W1 and quantity employed will be Q1

The union will want to increase wages. Now the firm will have to pay this higher wage or it will
have no workers. Say unions demand a wage rate of W2. For workers up to Q2, W2 is above the
supply curve and therefore more than the workers were will initially willing to work for. As a
result, the firm is able to easily hire quantity Q2 number of workers without increasing wage
rates any further. But after Q2, once the firm hits its supply curve once again (point x), if the
firm wants to hire additional workers it will have to increase wage rates to attract more
workers.

In fact, the firm is now operating along a NEW supply curve which is horizontal till point x and
then rejoins the old supply curve after that. If the supply curve is horizontal till point x then so
too must be the Marginal Cost curve.

The firm will profit maximise at the point where MRPL = MCL. This will happen at a wage rate of
W2 will an employment level of Q1. The union has succeeded in increasing wages without
causing any unemployment!
How to use this information!

If a question comes linking wages to productivity or asks about wage differentials then one
could say that the very same worker with the very same productivity will be paid different
amounts based on the labour market structure he is operating in.

Additionally, one must consider the role of discrimination. If an employer discriminates based
on race, gender of ethnicity he is no longer paying a worker according to his productivity.
Remember though, discrimination is hard to prove. Perhaps the white candidate is truly better
for the job because of his background, education and world exposure. If so, even if an
intelligent black man is applying for the job the employer may be looking for more than raw
intelligence.

Discrimination Diagrams:
Market Failure
 Externalities and Market Failure

Background:

Define Marginal Benefit (MB) as the additional benefit gained from some activity. An MB curve
will be downward sloping like a demand curve.

Define Marginal Cost (MC) as the additional cost of some activity (this could be an opportunity
cost). An MC curve will be upward sloping like a supply curve.

If MB is greater than MC then additional units of the activity are adding more to benefit than to
cost so the activity should be continued. If MC is greater than MB then additional units of the
activity are adding more to cost than to benefits so the activity should be cut down. It can
therefore be concluded that a “rational consumer” will consume or partake in an activity till
MB=MC. This is known as the point of “private efficiency”.

Define Marginal Social Benefit (MSB) as the additional benefit gained by society from some
activity and Marginal Social Cost (MSC) as the additional cost bourn by society from some
activity. It therefore concludes by the above argument that the point of “social efficiency” will
be where MSB=MSC.

Externalities:

Externalities are the external effects (on other people) of an action. They are known as third
party effects. If the actions of either a producer or a consumer affect other people, we say that
externalities are present.

Externalities can be both positive or negative. Example: Smoking has negative externalities
while vaccinations have positive externalities. A positive externality is known as an external
benefit while a negative externality is known as an external cost.
Externalities can be further divided into externalities of production and externalities of
consumption. Externalities of production will affect MC and MSC while externalities of
consumption will affect MB and MSB (Discussed in detail in the subsequent 4 cases)

We can now define the social costs of an action as private costs + externalities and the social
benefits of an action as the private benefits + externalities.

Remember if MSB=MB then there are no externalities of consumption

MSC=MC then there are no externalities of production.

For understanding MCQs:

We have already established that the point of social efficiency is where MSB=MSC. It is
important to remember that at this point there can be no additional net benefit to society.
Additional units consumed will take away from net benefit- net benefit is maximum.

THEREFORE at this point the difference between TOTAL SOCIAL BENEFIT and TOTAL SOCIAL
COST will be MAXIMUM. This is very important for solving MCQs.

Social Benefit [Total] = Private benefit + external benefit

Social Cost [TOTAL] = Private cost + external cost

The 4 Cases:

1) External costs of production (MSC>MC): this is when the production of some good
generates negative externalities. This could be pollution by a factory. Every time a unit
of this good is produced, society bears an additional burden in the form of pollution.
Social cost is greater than private cost.

As a result of this negative externality there is currently overproduction of this good from
society’s point of view.

2) External benefits of production (MSC˂MC): this is when the production of some good
generates positive externalities. This could be R&D undertaken by a firm. Other firms
and the community as a whole benefit from the firm ‘producing’ this good. The private
cost of the good is higher than the social cost. The firm incurs a cost but society
benefits.

As a result of this externality there is underproduction of this good.

 3) External costs of consumption (MB>MSB): these are negative externalities of
consumption. Examples include smoking, littering and any action that affects others
adversely. Here the private benefit is going to be greater than social benefit as every
time this activity is undertaken the individual gets a benefit but the benefit to society
goes down due to the negative externality.

There is currently overconsumption of the good. Society would benefit if consumption is cut
back.

4) External benefits of consumption (MSB>MB): these are positive externalities of

consumption. The consumption of these goods affects other people in a positive way.
External benefits are present. Examples include education, vaccinations, using public
transport etc. Social benefit will be greater than private benefit as the consumption of
this good generates positive externalities.

There is currently underconsumption of this good. We would like more people to partake in
these activities.
Recap:

1) MSC > MC. External costs of production: Currently overproduction of the good.
2) MSC ˂ MC. External benefits of production: Currently underproduction of the good.
3) MSB ˂ MB. External costs of consumption: Currently overconsumption of the good.
4) MSB > MB. External benefits of consumption: Currently underconsumption of the good.

MSB=MB means no externalities of consumption while MSC=MC means no externalities of

production.

Market Failure:

The free market relies on the price mechanism to allocate resources. Prices and profits act as a
signal to consumers and producers and therefore play a vital role in allocating scarce resources.
BUT when externalities are present, these prices and profits do not represent the true cost to
society. When there are external costs/benefits of an action then the signals sent by prices and
profits will become distorted.

E.g.: If a chemical company dumps toxic waste in a river it is cheaper for the company to do so,
but costly to society. MSC>MC. This reduction in cost incurred by dumping the toxic waste
allows the company to charge a lower price for its product and therefore encourages
demand/production. If the externality was taken into consideration then ↑ cost => ↑ P => ↓
Demand/Production.

Now consider a water company that uses that river as a source for drinking water. This
company will now need to spend more money to purify the water and remove dangerous
chemicals before selling it. Costs will be higher and so too will prices. This will lead to a lower
demand for the product. Without the presence of the externality more clean drinking water
would have been demanded/consumed.

It is clear to see that an externality can have far reaching effects – not only in the market that
the externality is present in but also in other related markets. The greater the externality, the
greater the market failure and the less that prices and profits are acting as an accurate signal
for the allocation of resources.

In the above 4 cases the presence of overconsumption/production and

underconsumption/production is showing the market failure. Every time there is market failure
present the government needs to intervene and bring society to the point of social efficiency.
Government Policies to correct for Market Failure:

1) Regulation: The government can put in place laws to regulate pollution levels or ban
certain polluting activities altogether. E.g. cars need to meet certain requirements in
terms of the fumes they emit into the atmosphere. Regulation is easy and cheap (the
govt merely needs to pass a law) but there are certain drawbacks:
(i) What is the right level of regulation? The laws passed may be too stringent or too
lax. There is some optimal level of pollution which the govt may not be able to
correctly estimate. It is too costly to remove pollution altogether. What this means is
that if firms are required to have zero level of pollution than this may require the
use of a lot of financial resources and man power which will then have an
opportunity cost to society.
(ii) Different firms may experience different costs when trying to reduce pollution. E.g.
there are two firms A and B emitting the same number of fumes into the
atmosphere. Say the govt passes a law that every firm has to reduce emissions by
25%. It costs firm A $2m to reduce emissions but costs firm B $8m to reduce
emissions by the same amount. If both firms are forced to do this then the total cost
to society is $10m. But if firm A reduces emissions by 50% then the total cost to
society would be $4m. The same reduction in emissions could have been done for a
much lower cost.

2) Property Rights: Without government intervention, property rights are not fully
allocated. An individual owns his home but no one owns the atmosphere or a lake. The
govt could extend property rights. This would mean
• The water company could sue the chemical company (from earlier e.g.)
• Workers can sue employers for pollution in work atmospheres (asbestos)
• Local residents can sue a polluting firm if they are getting sick from the fumes.

When property rights are extended we have ‘internalised the externality’. This is
good because there is a direct transfer of resources from those who pollute to those
who suffer. The govt does not have to get involved or assess the cost of the
externality. But there are still some drawbacks:

(i) The externality may be in a different country. E.g. Pakistan cuts downs trees
and forests. This causes global warming.
(ii) There is a burden of proof needed that it was indeed the externality that
caused the damage. In the case of workers mentioned above, the workers
need to prove that it was bad working conditions that got them sick. This is a
long and expensive legal process.
 (iii) The monetary value of the externality needs to be assessed. This is by far the
most complicated part of externalities. A money value needs to be attached
to the externality and both parties will have an incentive to either underplay
or overplay the financial burden of the externality.

3) Taxes and Subsidies: Goods which generate negative externalities can be taxed. This
would ↑ COP => ↑ P => ↓ Demand => ↓ Output => ↓ Externality. Similarly goods that
generate positive externalities could be subsidised. Once again, the problem that may
arise is deciding the correct amount of tax and subsidy.

4) Permits: The government can issue permits to pollute. This is a four step procedure:
(i) The government decides the optimal level of emissions into society.
(ii) It then issues permits to pollute, the total of which add up to the above figure.
(iii) These permits are allocated between firms based on size, current levels of
pollution, production processes etc.
(iv) NOW, firms can trade permits between themselves for money. If a firm is easily
able to reduce emissions drastically, it can sell its excess permits for money to
those firms that find it very costly to reduce pollution.

Public, Merit and Demerit goods

There are a category of goods that are either underproduced or not produced at all by the
private sector. These are public and merit goods.

Public Goods: Public goods have two essential characteristics

(i) Non rivalry in consumption

(ii) Non excludability

Non rivalry: If a private good (such as a Snickers Bar) is consumed by a person, it necessarily
means that that good cannot be consumed by anyone else. There is rivalry in consumption. But
certain goods have non rivalry in consumption such as street lights. The ‘consumption’ of a
street light by one person does not in any way diminish its consumption by another.

Non Excludability: This is when you cannot provide a good to one person without it being
consumed by others. A good example is defence. If a country has a defence sector, it cannot
stop anyone from being protected, even those who have not paid for it. If the good or service is
provided to even one person it automatically becomes available to everyone.
 The combination of non rivalry and non excludability gives rise to something known as the ‘free
rider problem’. This is when no individual would be willing to pay for such goods as they would
be able to reap the benefits of the good without actually paying for it. The free rider is happy to
allow others to pay for the good while he benefits from its consumption.

Public goods are socially desirable but privately unprofitable. Because of the free rider problem
the private sector would be unwilling to provide these goods. This is market failure to the
extreme as society wants these goods but no one is willing to provide them. There is a lot of
external benefit as compared to private benefits. These goods will ONLY be provided by the
public sector i.e. the government.

Examples of PURE public goods (non rival and non excludable): Streetlights, Defence, Roads

Some goods may be rival but non excludable (e.g. public library or swimming pool) or
excludable but non rival (e.g. TV broadcasts). These may also be considered public goods but
they are not pure public goods.

Merit Goods: These are goods that generate a lot of positive externalities. They are goods for
which MSB>MB or MSC˂MC. These goods are provided by the private sector, but they are
underprovided by the private sector. For example, we do have private hospitals and schools
(merit goods) but there should be more of these goods so that healthcare and education is
available to everyone. The government needs to step in and either directly provide these goods
and services or subsidise the production of these goods and services.

Demerit Goods: These are goods that generate negative externalities of consumption
(MB>MSB). Good examples are drugs, alcohol and cigarettes. These goods are currently
overproduced/consumed by the private sector. The government needs to intervene in the
market for such goods and reduce consumption. It may regulate consumption through (i) ban
(ii) taxes (iii) legislature (e.g. smoking illegal in certain areas) (iv) advertising campaign against
the product

Summary of Different Types of Goods:

Private Good : Rival, Excludable [Therefore provided by the private sector for profit motive]

Public Good : Non Rival, Non Excludable, [Therefore provided solely by the public sector]

Merit Good : A lot of positive externalities, [Provided by both the private and public sector]

Demerit Good: A lot of negative externalities, Govt intervention necessary in these market
Sources of Market Failure:

1) Externalities (diagrams done) and Public Goods

2) Monopoly
3) Monopsony
4) Indirect Taxes and Subsidies

Consider the following diagrams and the subsequent Deadweight Loss

 Asymmetrical Information and Moral Hazard:

Asymmetrical information causes market failure as one economic agent has more information
than another, enabling them to use that information to exploit the other. Due to this
asymmetrical information and unequal knowledge, advantage will lie in the hands of the
economic agent with the complete information.

One such application of this theory is that of Akerlof’s Lemons. He used the second-hand car
industry in America to show how asymmetrical information can lead to a market with adverse
selection of low quality products, which may eventually lead to a collapse of the market.

Consider a second-hand market which has two types of cars – peaches and lemons. Peaches are
of good quality and therefore worth $20,000 while lemons are of inferior quality therefore
worth $10,000. The problem that arises is that while the seller knows the quality of the car, the
buyer has no idea whether it is a peach or a lemon! This is an example of asymmetrical
information.

The buyer would be willing to pay $20,000 for a peach and $10,000 for a lemon, but he has no
idea which is which. Therefore, to hedge his losses, he would offer about $15,000 for a
particular car. Now, the seller would only accept this price if he was offering a lemon for sale!
Therefore, what we would notice, is that the market would be taken over by lemons and
peaches would no longer be offered for sale! This is known as adverse selection. Ultimately, the
market may end up collapsing as now buyers are aware that there are only lemons for sale. As
can be seen, asymmetrical information that persists will end up leading to market failure.

One way to solve this problem is by providing better information to consumers. This can be
done through a process called ‘signalling’. Car dealers could send ‘signals’ to potential buyers
about the quality of cars through offering guarantees, warranties as well as providing
information about previous servicing done to the car. An economist named Michael Spence
applied this theory to the job market by analysing how candidates ‘signal’ to potential
employers about their abilities, dedication and job suitability by obtaining expensive, high-level
qualifications.

Asymmetrical information may go the other way too. In the market for insurance companies, it
is the buyer or customer who has better information about himself in terms of health, lifestyle,
driving habits etc. The insurance company cannot assess this information simply by looking at a
candidate. An economist named Joseph Stiglitz showed how insurance companies try to
mitigate this risk through a process called ‘screening’. This involves customers providing
detailed histories of their driving histories and health conditions. Additionally, a variety of
different policies can be offered which will reveal the risk category of the individual. For
example, a low risk individual would be likely to choose a policy with a low premium but higher
excesses/deductibles as they know they will not be making claims often.

Moral Hazard:

This occurs when economic agents such as individuals and organisations increase their
exposure to risk once insured as they know that someone else will bear the cost of that risk.
The behaviour of the agent will change as a result of this knowledge. For example, if a
government pledges to support small businesses that are losing money, these businesses may
start to take greater risks than they would have otherwise. This is a type of market failure as the
insured agent may not take optimal or rational decisions as they know they do not have to bear
the cost.

Note: This is similar to the principal – agent problem in the sense that the interests of the
parties involved may not be aligned.

One possible solution is to develop a reward based scheme in which the objectives of both
parties line up closer to eachother.

Government Policies to achieve Efficient Resource Allocation and correct Market Failure

We have already studied these over the course of the AS and A2 syllabus. Therefore, please find
them here in point form to help with written questions.

• Indirect taxes (both specific and ad valorem)

• Subsidies
• Price Controls (maximum prices, minimum prices/wages, buffer stock schemes)
• Production Quotas (for demerit goods and polluting firms)
• Prohibitions and licences
• Regulation and deregulation (to allow for greater competition)
• Pollution permits
• Property rights
• Provision of information
• Direct provision of goods and services
• Behavioural insights and ‘nudge’ theory
 Government Failure in Microeconomic Intervention:

Government Failure is when intervention by the government leads to a measure of economic

inefficiency that would not have existed in a free market. It is the failure of the government to
achieve its desired objective.

This may happen as a result of:

1. Lack of Complete Information: A good example of this are laws/taxes that may be too
stringent or too lenient. In the case of negative externalities there is no way for a
government to assess the monetary value of the externality.

2. Problems of Incentives: Extremely high tax rates could lead to a disincentive to work, or
possible tax evasion. Similarly, a mixture of progressive taxation and means tested
benefits could lead to a ‘poverty trap’. This occurs when, after a certain level of income,
benefits are removed and taxes start to set in. Essentially, for some period of time, the
individual is actually worse off as a result of an increase in income. Such individuals may
keep themselves below the poverty line by not taking on extra work, as they end up
worse off if they do so.
Additionally, the provision of benefits to achieve income equality and reduce poverty
may lead to ‘welfare dependency’.

3. Problems of Distribution: Some well-intended regulations like a tax on polluting firms

will end up increasing costs of production for that firm and therefore prices in the
market. This increase in prices will affect lower income groups more than higher income
groups. This may lead to an increase in inequality in the distribution of income.

4. Moral Hazard: As mentioned before, government support of certain industries may

make them more inefficient and more likely to make poor decision as they know the
government will offer them financial support.

5. Political Interference and Regulatory Capture: this is when the government decisions
may be influenced by political gain and the regulation of industries may end up being
sub par.

As a consequence of this type of government failure, price signals may end up being distorted
and there may be a less that efficient allocation of resources. For example, a failing industry
being propped up by the government means that resources are being wasted on an industry
that is clearly not efficient. Additionally, the public sector may not let go of extra workers who
are essentially redundant as they do not want to add to the problem on unemployment. This,
once again, leads to an inefficient use of resources.

Similarly, high progressive taxes to create income equality may lead to a disincentive to work as
well as a possible ‘brain drain’ and capital outflow to other countries.

Government action, no matter how well meaning, may end up leading to a net loss in welfare in
society. A reliance on the free market may have led to a better allocation of scarce resources.

Nationalisation and Privatisation:

Nationalisation is when a private sector firm is transferred into public ownership and is
controlled and operated by the government.

Advantages of Nationalisation Disadvantages of Nationalisation

Possible economies of scale which leads to Lack of incentive to be efficient as there is no

lower price and higher output profit motive

Monopoly power that the private sector may Lack of innovation due to the lack of
have had will be removed competitive pressures

No profit motive would lead to lower prices, Actions taken could be for political gain as
higher output and more employment opposed to economic theory

Duplication of resources will not take place A potential loss making enterprise that the
government must support

Negative externalities can be controlled and Mismanagement may end up with the
positive externalities can be encouraged consumer worse off than before

Protection of strategic industries

A possible revenue source for the

government
Privatisation is when there is a transfer of ownership of an industry and its assets from the
public to the private sector.

Advantages of Privatisation Disadvantages of Privatisation

A higher degree of efficiency in terms of A public sector monopoly could be replaced

resource allocation due to profit motive by a private sector monopoly which would
charge higher prices . There may, therefore,
be a need for heavy regulation and a
regulatory body

A massive inflow of funds for the In the case of a natural monopoly,

government when the industry is sold duplication of resources could take place

The consumer will receive a better product Increased unemployment as redundant

or service due to profit motive workers are laid off

Possible lowering of price due to efficiency Negative/positive externalities may not be

and competition taken into consideration

Larger role of the private sector which may A one-time inflow of funds is all the
pave the way for increased investment and government will get. A possible long term
economic growth revenue stream for the government will no
longer exist
 Equity and
Redistribution
of Income and
Wealth
 Equity and Redistribu0on of Income and Wealth
Equity refers to the idea of fairness, jus3ce or impar3ality. On the other hand, equality refers
to a situa3on where everyone is on the same level in terms of opportuni3es, income, wealth
and responsibili3es.

As can be seen, equality may be hard to achieve as it is almost impossible to ensure that
everyone has the exact same amount. Therefore, governments try and maintain a target for
equity. The redistribu3on of income through progressive taxes cannot be equal but it can be
made more equitable – i.e. more just and fair. Similarly, subsidies and maximum prices are
also levied for this goal.

Remember, there will always be a trade-off between equity and efficiency (efficiency can be
defined as the best possible use of resources or the least cost method of produc3on). The
more efficient a system becomes, the less equitable it is likely to be.

Difference between Absolute Poverty and Rela7ve Poverty

Absolute Poverty: This type of poverty occurs when the resources required for minimum
physical health are lacking. This includes limited access to food, clothing and shelter. The
World Bank defines the interna3onal poverty line as US$ 1.90 a day (calculated at
purchasing power parity exchange rates). This makes comparisons across countries easier as
it is a standard that does not change with 3me.

Rela7ve Poverty: This is a type of poverty that measures a situa3on of low income rela3ve
to other people in the country. It is a condi3on where household income is a certain
percentage below the median income of a country. For example, we could say that a
households income is 50% less than the median income of people in that country.

The Poverty Trap:

A combina3on of progressive marginal rates of taxa3on and means tested benefits may give
rise to a poverty trap. This occurs when, aVer a certain level of income, benefits are
removed and taxes start to set in. Essen3ally, for some period of 3me, the individual is
actually worse off as a result of an increase in income. Such individuals may keep themselves
below the poverty line by not taking on extra work, as they end up worse off if they do so.

Policies to achieve Equity and Equality:

1. Negative Income Tax: The negative income tax is a way to provide people below a
certain income level with money. In contrast to a standard income tax, where people
pay money to the government, people with low incomes would receive money back
from the government (as opposed to food stamps etc).
 Theoretically, this would work by giving people a percentage of the difference
between their income and an income cutoff, or the level at which they start paying
income tax. For instance, if the income cutoff was set at $40,000, and the negative
income tax percentage was 50 percent, someone who made $20,000 would receive
$10,000 from the government. If they made $35,000, they would receive $2,500
from the government. (This is different from a universal basic income in which
everyone, regardless of income level, receives the same amount of money from the
government).

This structure is designed so that people who work will always make more than
people who don’t, which would ideally incentivize people to work. This effectively
aims to get rid of the poverty trap.

2. Universal and Means Tested Benefits:

Universal Benefits : these are available to everyone regardless of income level. E.g.:
The NHS in the UK

Social Security in the US

Means tested benefits : These are benefits received on the basis of low income
levels. In order to qualify for these benefits the recipient has to be below a certain
income level:
E.g : Unemployment Benefits

Food Stamp Programs

Medicaid
Benazir Bhutto Income Support Scheme

Note in both cases there has been NO EXCHANGE OF GOODS AND SERVICES. Citizens
are eligible for these types of benefits without having to do any work to receive
them.

The Lorenz Curve and Gini Coefficient

In the diagram below, we plot % of popula3on (from poorest to richest) against % of income.
As can be seen, the 45o line is the line of complete income equality. 10% of the popula3on
has 10% of income ; 50% of the popula3on has 50% of income and so on. We now look at
each country’s line of income distribu3on (known as its Lorenz Curve) in comparison to this
line of complete equality. The lower the line is, the more unequal the distribu3on will be.
The difference between the 450 line and the country’s Lorenz curve is called the inequality
gap.

From this we can calculate a Gini Coefficient. The formula for the Gini Coefficient is

!
!+#

The higher the value of the Gini Coefficient, the more unequal the distribu3on of income in
country is. 0 would be complete income equality while 1 would be complete income
inequality.

Rank these 4 countries on the basis of income inequality:

Country Gini Coefficient

Thailand 0.864
Solvakia 0.498
Costa Rica 0.750
Iceland 0.256