Chapter 7
The Analysis of Consumer Choice
The concept of utility When a consumer buys goods, that give him satisfaction, economists term this satisfaction utility. We cannot measure utility, but Francis Edgeworth (contributor to theory of economic behavior) imagined a device called hedonimeter which could capture consumer reaction for those goods. Total utility (TU) It is total number of units of utility that consumer gets from consuming a good or service. The total utility curve rises with the increase in the number of goods and services. Marginal utility (MU) It is the amount by which the total utility changes with the additional unit of good consumed. The slope of total utility decreases with the increase in the number of units so marginal utility curve falls downward (Law of diminishing marginal utility).
The Budget Constraint Consumer always behaves in a way that maximizes its utility, but it is constrained by the available income and the prices of the goods.
Marginal decision Rule The utility maximizing condition is MUxPx MUYPY
Problem of Divisibility To apply the above condition it is necessary that goods must be divisible, that is
available in small quantities, though in real world it is difficult to satisfy.
Deriving the Demand Curve The demand curve can be derived, by determining the quantities of goods (the quantity determined using the marginal decision rule) that consumer buys at each price.
Deriving the Market Demand Curve The market demand curve is the horizontal summation of all the individual demand curves.
Substitution and income effects When the price falls, the quantity demanded of the goods increases, this reaction has two effects i.e. substitution effect and the income effect. When the consumers consumption of a good changes in response to change in the price of good or service while the consumer income is adjusted so that the consumer can buy the original bundle of goods and services (income compensated price change). The substitution effect involves change in consumption works in an opposite direction to that of a price change. The size of substitution effect depends on the rate at which MU of good change due to change in the price. When the change in the consumption of a good is due to the change in the income because of a price change is called the income effect. The size of the income effect depends on how responsive the demand for good is to change in the income.
Normal good and Inferior good A normal good is the good whose consumption increases with the increases with the increases in income. The substitution effect and the income effect increases the quantity demanded. Inferior Goods An inferior good is the one whose demand decreases with the increase in the income. The substitution effect increases the demand whereas the inferior good decreases it.
Budget line The consumer budget constraint when graphically depicted is known as budget line. It shows the combination of goods that consumer can buy from the given budget. The horizontal axis is found by dividing the budget by the price of good X and the vertical axis by dividing the budget by the price of Good Y.
Indifference Curves Curves that shows the combinations of goods that give same utility are called indifference curves. Any point below and to the left of the indifference curve yield less utility compared to the right. Collection of indifference curves for a consumer illustrating preferences is called indifference map.
Curves, that is higher and to the right is preferred.
Utility Maximization Solution Two conditions- 1) the point must be attainable by the budget line. 2) The highest indifference curve is consistent with the above condition.
A change in the price would be shift the budget line and by tracing the quantity demanded we can derive demand curve.
Chapter 8
Production and Cost
Short Run It is the time period in which one of the factors of production is fixed as quantity.
Fixed Factor Of Production When the factor of production cannot be changed during a particular period is called fixed factor.
Variable Factor of Production A factor of production whose quantity can be changed during a particular period is called variable factor.
Short Run Production Function The relationship between the inputs and the output produced is called the production function. In this capital is the fixed factor and the labor is the variable factor.
Total Product (TP) TP shows the quantities of output produced with variable factor of production, while the other factor to be fixed.
Marginal Product (MP) It is the ratio of the change in the output to the change in the quantity of labor or capital. SlopeofthetotalproductcurveQL
Average Product (AP) It is the ratio of the output to the number of units of factor of production.
Relation between TP, MP and AP Marginal product rises with the increase in the slope of TP and vice versa. And reaches zero when TP is at its maximum value. MP intersects AP at the maximum point on the AP curve.
The MP experiences increasing returns initially when the output increase, but after a while the output starts decreasing i.e. decreasing marginal returns
Variable costs The cost of the variable factors of production is called the variable cost. Total variable cost is the cost that varies with the output.
Fixed Cost The cost of the fixed factors of production is called the fixed cost. And the total fixed costs is the one that does not change with the output.
When we add both the total variable and total fixed costs we get total cost.
Marginal cost is the change in the total output due to the additional unit of output a firm produces.
Average Costs is the total costs divided by the units of goods produced.
ATCAVCAFC AVCTVCQ AFCTFCQ
Relation between AC and MC MC intersects the AC and AVC at their minimum points. When the MC is below AVC and AC, AC and AVC slopes downward. And when the MC is above AC and AVC, they slope upward.
Long run The period in which both the factors of production of a firm are variable is called long run.
In the long run the firm chooses the factor mix using the marginal decision rule.
MPL PL MPKPK
Thus, a firm in the countries where labor is expensive uses capital-intensive production method whereas the countries with cheap labor use labor -intensive methods.
Costs in the long run The long run average costs, shows the firms lowest cost per unit where all the factors are variable. It is the envelope curve that surrounds various short run ATC.
Economies and Diseconomies of Scale A firm is said to have economies of scale when LRAC falls when firms expands and diseconomies when LRAC increases as firms expands. The economies of scale occur due to specialization and use of mass production methods. Whereas the management problems is the cause of the increasing cost in the long run. So initially the firm experiences economies of scale, but as the firm expands it starting facing the diseconomies too.
Chapter 9
Competitive Markets for Goods and Services.
Definition A perfect competition is an ideal market situation where there are large numbers of sellers selling the homogenous products at the same price.
Assumptions
1.Price takers No one can influence the price in the market every firm in the market is the price taker.
2.Homogenous Goods The goods sold in perfectly competitive market are same there are no brand preferences.
3. Large number of Buyers and sellers There are large numbers of buyers and sellers and nobody can influence the price no matter what quantity they buy.
4. Ease of entry and exit It is easy for the firms to enter and exit the market, which means greater degree of competition and sustainability of economic profits.
5. Complete information All the sellers have the complete information about the prices, technology of the good produced. Similarly, buyers also possess the complete information about the market.
6. AR MR curve Prices in the perfectly competitive market are determined by demand and supply curve. Price equals average revenue. And AR and MR curves are the horizontal line at the market price.
Equilibrium in the Short run There are two approaches to determine the equilibrium conditions of a perfectly competitive market. A) Total revenue and total cost approach. B) Marginal revenue and Marginal cost approach.
In the first approach the economic profit is the vertical distance TR and TC curve. And in the second approach the profit is maximized when MRMC.
Economic Losses in the short run In the short run the firm cannot shut down as it continues to pay for fixed costs.
Case1 Producing to minimize Economic Loss When the price is below ATC the firm continues to produce as it exceeds Average variable cost.
Case 2 Shutting down to minimize economic loss When the price falls below AVC it is advisable for the firm to shut down. The intersection of the minimum level of MC and AVC curve is called the shutdown point.
Marginal cost and supply The marginal cost curve above the AVC is the supply curve in the short run.
Economic and Accounting Concepts of profit Economic profit is the difference between revenue and cost. The implicit and explicit both costs are included in the computation of the economic profit where as only explicit costs are deducted to calculate accounting profit.
Long Run and Zero economic profits In the long run the economic profits are zero. As the profits will attract the firms in the industry till the profit is zero. Similarly firs exit until the loss is eliminated.
Figure Eliminating profits in the long run Figure Eliminating losses in the long
Entry, Exit, and Production Costs When the input prices change (increase, decrease or constant) with the entry or exit of firms the production costs also change (increases, decreases or constant). Therefore the long run supply curve slopes upward, downward or is horizontal.
Changes in the production costs A change in the production costs reduces the MC and AC, which help to earn economic profit. In the long run the supply curve shifts to the right and earns zero economic profit.
Change in the demand Change in the demand can be due to change in the preferences, incomes, and price of related good, population, or consumer expectations. An increase in the demand shifts the demand to right and price rises. And firm earns economic profit in the short run which is wiped in the long run by the entry of new firms in the industry.
Chapter 10
Monopoly
A monopoly is a market situation in which there is a single seller selling differentiated goods to large number of buyers at different prices.
Assumptions
1.Single seller.2. No close substitutes.3. Prohibitions on entry and exit in the industry.4.Price setter.5.Downward sloping demand curve.
Sources of monopoly power
1. Economies of scale A firm with the falling long run average cost throughout the range of outputs tends to monopolize the industry.
2.Location Central location in the market far from the competitors provides the monopoly power to the firm.
3.Sunk Costs Greater the costs to establish the business more difficult it is to enter the industry.
4.Restricted Ownership of raw materials and inputs.
5. Government Restrictions State and local governments provide franchises, patents etc that gives monopoly power to the firm.
Monopoly AR MR curves The monopoly faces the downward sloping demand curve that is it can sell additional units of output at lower prices only. The monopoly always sells at a price, which is in the elastic region of the demand curve as it increases the total revenue. Marginal revenue lies below the price i.e. additional units sold at lower prices. They are plotted at the midpoints of the respective intervals.
Monopoly Equilibrium A monopoly firm maximizes profit by applying the marginal decision rule i.e. MRMC. And the profit is the difference between price and average total cost, given by the shaded rectangle.
Efficiency, Equity, and Concentration of Power Since the monopoly charges the price greater than the marginal cost, the consumer gets less of the monopoly good or service than is economically efficient. Thus there is deadweight loss to the society. Moreover the consumer surplus is also reduced and transferred to monopolist (issue of equity). Besides the monopolist is free from the pressure of finding new products and thus consumer is left with fewer choices, higher costs and lower quality.
The Fragility of Monopoly power The potential for high profits continue to attract firms and break the insulation of the monopoly. But technological change constantly challenges the monopoly power.
Chapter 11
The World of Imperfect Competition
Monopolistic competition It is a market situation where there are large number of buyers and sellers selling differentiated products with easy entry and exit. Since the market sells differentiated products (differentiation on the basis of advertising, convenience of location, product quality or other factors) the firm faces downward sloping demand curve. And the MR curve lies below the demand curve.
Short run equilibrium The monopolistic competition market earns maximum profit at a situation where MRMC.
Long Run Equilibrium The existence of economic profits induces entry till the profits are wiped off.
Figure Short run equilibrium Fig Long Run equilibrium
Excess Capacity The price of variety A firm that produces to the left of the lowest point on its ATC curve has excess capacity.
Moreover the output produced is inefficient as firms charge more than the MC. But it wont increase the output, as revenue will decrease. Thus the inefficiency exist due to product differentiation,
Oligopoly It is the market structure, which is dominated by few firms, and each of which recognizes its own actions and reactions from the other firms. They produce both standardized and differentiated products.
Measuring Concentration in Oligopoly 1) Concentration Ratio, which reports the of output accounted for by the largest firm in the industry, Higher the concentration ration, the more the firms in the industry notices rivals behavior. 2) Herfindahl-Hirschman Index (HHI) It is calculated by squaring the share of each firm and then summing these values to get the index. The largest HHI is in the case of monopoly where one firm has 100 of the market.
The Collusion Model Economists have used various models to deal with the uncertain nature of the rivals. In this case the firms in any industry select the monopoly price and output to achieve the maximum profits, i.e. they collude.
In this case the profits are maximized if each produces half of the total output of the industry. a) Overt Collusion In this case firms openly agree on price, output to make maximum profits. The firms that coordinate their activities on the overt collusion are called cartel. The problem is that they are illegal and there is not enough inducement to join. b) Tacit Collusion An understanding through which firms limit their competition.
Game Theory and Oligopoly Behavior Game theory is an approach where the actions of others affect the outcome of its choice and its possible action. The outcome known as payoff, and the firm earns economic profit as a payoff.
Applications of Game theory 1) Prisoners Dilemma- It is a situation where two criminals are before a attorney. To get the confession the attorney places them in different cells and provides them with different strategies to come to a decision.
When the player best strategy is same regardless of other player, it is termed as dominant strategy and reaches dominant strategy equilibrium.
Advertising The monopoly, monopolistic competitive, and oligopolistic firms advertise a lot to earn maximum profits. It is always criticized that advertising lead to higher prices, as it is costly and creates barriers to entry. But at the same time it is defended as it provides useful information and encourages price competition.
Price Discrimination When the firm sells the same good to different customers at different prices, it is known as price discrimination. Conditions to be satisfied for price discrimination a) a firm should be able to set the price in the market. b) The customers should be easily segmented. c) The buyers should not be able to resell the goods at lower prices. A firm tries to sell the good at lower price where its demand is elastic and at higher prices where the demand is inelastic.
Chapter 12
Wages and Employment in Perfect Competition
In this model we study the labor market in perfect competition.
Assumptions 1 All the workers are identical.2.There is a single market for labor. 3.They earn the same wage W (equilibrium wage decided by the intersection of market demand and market supply) and the level of employment is L. 4.Workers and firms in the market are price takers, i.e. perfect competition prevails in the labor market.
Demand of labor Marginal decision rule The firm decides to employ additional labor only if additional unit of labor increases the output (MP) such that TR TC. And keeps on hiring till revenue (MRP) generated remains higher than the cost (MFC).
MRPMPMRor MRPMPAR (ARMR, under perfect competition)
Since the downward sloping portion of the MRPL exhibits the diminishing returns, hence considered as the demand curve for the model.
L(units of labor)OutputMP MRP013--1332020025623230 3762020049014140510010100
Any changes in the variables like technology, complementary or substitute factor of production, product demand etc. will correspondingly shift the demand curve for labor.
Supply of labor The supply of labor depends on how individuals tradeoff between work and leisure in the given 24 hours of the day. The more work a person does, greater his or her income but smaller the amount of leisure time. Therefore the opportunity cost of the leisure is the wages an individual can earn. Thus utility is maximized when (Utility derived from work should be equal to utility from leisure)
But the increase in the wages has both the positive (substitution effect) and the negative (income effect) effects on the supply of labor. Generally the supply curves for the specific labor markets are upward sloping, as mobility of labor stops it to react otherwise.
EQUILIBRIUM Wages in perfect competition is determined by the intersection of the demand and supply of labor. An individual firm takes the price as given (market wage), so the supply curve is horizontal and is also called the Marginal factor cost curve. Equating it to the marginal revenue product determines amount of labor to be employed by the firm.
Social problem Economists advise the solution of minimum wages where the less educated worker receives the wages decided by the government (generally higher than the equilibrium level) to narrow down the gap. This strategy increases the unemployment though provides high wages that continue to work. And the problem can be resolved if the less skilled workers are given support to enhance their skills through training workshops.
Chapter 13
Interest rates and the Markets for Capital And Natural Resources
Interest Rate is a mechanism through which financial investors are compensated for giving up the use of their funds for several years.
Relationship between interest rate and present value The value of the future amount if deposited today at a prevailing market interest rate is called the present value of that future value.
Demand for capital A firm uses demands additional units of capital, until the MRPMFC of capital. But the difference is that we need to determine the present value of MRP and MFC to calculate the demand foe capital.
Demand curve The demand curve shows the quantity of capital demanded at each interest rate. The demand curve is downward sloping curve. The variables that affect MRP, affect the demand curve of capital.
Theory of loanable funds The market in which borrowers and lenders meet is called the loanable funds market. We assume in the model that interest rate is same for firms and the consumers. The interest is determined by the intersection of demand and supply of the capital. Demand for loanable funds We assume in the model that interest rate is same for firms and the consumers. The interest is determined by the intersection of demand and supply of the capital. Supply of loanable funds Higher interest rates allow lenders to supply more funds in the market. The Equilibrium interest rate is determined by the intersection of demand and supply curves of loanable funds.
Figure Equilibrium under the loanable funds theory
Natural Resource and Conservation The stock of a natural resource is the quantity of the resource that is endowed by the nature is limited and used to produce flow of goods and services.
Case1 Future Generations and exhaustible natural resources The demand D for exhaustible resources id given by the MRP.S1 is the marginal factor cost of extracting the resources. At the equilibrium interest rate the quantity demanded in Q1.But if the interest rise the supply curve shifts to its right causing the price to fall (and thus consumed more today). Whereas a drop in the interest rate shifts the supply curve to left leading to increase in its price (preserving for the future).
Case2 Future Generations and Renewable resources The quantity of the renewable resource that can be consumed without reducing the stock is called the carrying capacity of the renewable resources. The efficient quantity of the renewable resource is determined at the intersection of demand and supply at pt. E, which is below the carrying capacity. Hence the resource will be available for future generations
Case3 Market of land Land is used for the space and its carrying capacity is equal to its quantity. The price of land is determined by the intersection of vertical supply curve (as land is fixed) and demand curve. The sum paid is economic rent (shaded area).
Chapter 16
Antitrust Policy and Business Regulation
Antitrust laws and their interpretation Antitrust policy is an attempt by the government to control the monopoly power and encourage competition in the market place. History of Antitrust policy After the industrialization movement U.S. firms saw the emergence of monopoly power that allowed the government to interfere and challenge these monopoly powers. a) The Sherman Antitrust Act 1890-the cornerstone of the antitrust policy. Its takes care of the activities of firms that is illegal in and of itself without regard to the circumstances under which it occurs. Two landmark cases in 1911 were Standard Oil and American Tobacco. In deciding emphasis was placed on the conduct and not the size of the firms. It also prevent price fixing in which two or more firms coordinate pricing policies. b) Federal Trade Commission formed in 1914 to investigate firms using illegal business practices. c) Clayton Ac t, 1914, aimed at preventing mergers. d) Celler-Kefauver Act 1950 extended to blocking of vertical mergers. Current Antitrust Policy Emergence of new firms is evidence of dynamism where it is not necessary foe an industry to be perfectly competitive rather they are contestable. So current guidelines uses HHI index (Herfindahl-Hirschman Index) to determine the concentration of oligopoly power.
If the post merger Herfindahl-Hirschman Index is found to beThen the Justice Department will likely take the following action.Unconcentrated (1,000)No challengeModerately concentrated (1,0001,800)Challenge if post merger index changes by more than 100 points.Highly concentrated (1,800)Challenge if post merger index changes by more than 50 points.Though the definition of market is itself difficult to value HHI.
Antitrust and Competitive a Global economy In 1997,The International Competition Policy Advisory Committee (ICPAC) was formed by Department of Justice to change the stringent antitrust laws as U.S. firms did not had competitive edge in the international trade. Since many Japanese and European firms cooperated and colluded for their projects. Antitrust policy and U.S. Competitiveness The NCRA (National Cooperative Research Act of 1984 provided simple registration for joint ventures. The Omnibus Trade and Competitiveness Act (OTCA) made unfair methods by foreign firms punishable under U.S. laws. Moreover WTO was formed in 1995 to supervise and discuss issues relating to world trade.
Regulation Protecting People from the market There are two types of regulatory agencies- a) one that protects consumer by limiting the market power abuse. b) Other to influence business decisions that affect consumer and worker safety. Theory of regulation seeks to find efficient market solutions. It says that firms need to be regulated to get the sure shot availability of certain goods. The Public Choice Theory of Regulation- it say that consumers are protected by controlling the decisions of the business. The approach is to determine how benefits are to be compared to its benefits.
Chapter 19
Inequality, Poverty, and Discrimination
Inequality a) How to measure it- the primary evidence of inequality is provided by the census data collected by the Census Bureau. Lorenz curve can represent the income distribution data graphically. The curve shows the cumulative share of income received by the individuals. The Lorenz curve would coincide with 45-degree line, if the households have the same income. But if the distribution were unequal the Lorenz Curve would be shaped like a backward L, with a horizontal line across the bottom of the graph and vertical line up to the right side. But the actual Lorenz curve lie between these two extreme. The ratio between the Lorenz curve and the 45-degree line and the total area under the 45-degree line is known as Gini coefficient, also used to measure inequality. b) Factors-the sharp increase in the number of families headed by the women, the increase in the use of computers, the demand for better communication skills in the workers (has created intellectual gap) has contributed to the problem of inequality.
Poverty a) How to measure it Absolute income test which sets a specific income level and defines a person a poor if his or her income falls below that level. And the other way to measure it is the relative test in which people whose income fall at the bottom the income distribution are considered poor. b) Characteristics of poor The six characteristics that describe a poor in U.S. constitute whether or not female, age, the level of education, whether or not the head of the family is working, the race of the household and the geography head of the family. c) Government Policies to alleviate poverty Government provides both cash and non- cash assistance to the poor people. The program called Temporary Assistance for Needy families (TANF) is a program funded by the federal government, which provides cash assistance to poor families. The Personal Responsibility And Work Opportunity Reconciliation Act Of 1996 passed by the federal government has proved to a major step in poverty removal.
Discrimination When people with similar characteristics experience different economic outcomes because of their race, sex, or other non-economic characteristics, it is termed as discrimination.
Becker got a Nobel Prize on the economics of discrimination. He suggested that discrimination is result of peoples preferences and if enough people have are discriminating its results can very well be seen in the market.
Suppose that employers have discriminatory attitudes and he assumes the black worker to be less productive than the white worker. So the demand for black would be lower than the white. Hence the black worker would get less of the work and lower wages. (LLB)
Graph
The most important federal legislation against discrimination was passed in 1964, The Civil Rights Act, which barred discrimination on the basis of race, sex, or ethnicity in pay, promotion, hiring, firing and training. The wage gap after this act has reduced a lot but still lot needs to be done.
Chapter 18 The Economics of the Environment
Maximizing the Net Benefits of Pollution Firms pollute the environment as it allows it to produce goods and services at lowest costs, thus we benefit from pollution. But the cost of pollution is spilled to everyone, which causes market failure leading to misallocation of resources. Therefore economists analyses an efficient allocation of the environment and find ways to find the solution for efficient pollution.
Pollution and Scarcity If an activity emits harmful by products then its emission is an alternative to some other activity, thus scarcity exists, when harm occurs.
The Efficient level of Pollution It is the level at which total benefits exceeds its total cost. To determine the total demand curve we determine the amount each person emits at various prices. And the marginal costs curves are determined by adding the individual MC curves vertically. The two curves intersect and determine the efficient level of emissions.
Property Rights and the Coase Theorem The prize winning economists Ronald Coase proposed that if the property rights are well defined and bargaining is costless the private market can achieve an efficient outcome of pollution. Though there are still problems relating to enforcement, monitoring etc. but still provides a great insight into the problem. The notion of harm is reciprocal one and the harmed could avoid it by adopting various ways.
The Measurement of Benefits and Costs Benefits the demand for emissions- It shows the quantity of emissions demanded per unit of time at each price. We estimate by knowing the how much emission of one more unit saves we can infer how much would they pay to dump it. Its interpretation from right to left is the marginal cost and marginal benefit of emissions when read left to right. Marginal costs of emissions It is the additional cost imposed by the each unit of the pollutant. When the read from right to left it is the marginal benefit curve for abating emissions. Efficient level of emissions and abatement the intersection of the two curves gives the efficient solution.
Alternatives in Pollution control a) Moral suasion-an effort to change people behavior by appealing to their moral sense, it is a widely used tactic to control pollution. b) Command and Control-government tells by how much or what method to use in emission. c) Incentive approaches- market like incentives that allow individual to determine the emission level like emission taxes, marketable pollution permits.