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SENIOR OUTCOMES SEMINAR

(BU385)

ECONOMICS

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BASIC CONCEPTS IN ECONOMICS I

•Opportunity costs

•Equilibrium of supply (QS) and demand (QD)

•Price elasticity of demand

•Marginal costs, revenues, and profits

•Economies of scale and scope

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BASIC CONCEPTS IN ECONOMICS I

•Sunk costs and entry barriers

•Profit maximization by a competitive firm

•Profit maximization by a monopoly and oligopoly

•Pricing policies

•Externalities

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A rational (reasonable) decision suits interests of the decision maker.

The opportunity cost of the rational decision is the value of the next best alternative that is sacrificed because of this decision

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Essence of the opportunity cost:

• Under scarcity, no gains without pains, i.e. each gain involves some loss

• The value of the gain is determined by a ratio between its market price and the market price of the sacrificed next best alternative option.

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Illustrative example:

P(gain)=absolute market price of gain in $$P(loss)=absolute market price of sacrificed best alternative option in $$

RATIO P(gain)/P(loss) IS A RELATIVE PRICEWHICH DETERMINES

THE TRUE VALUE OF THE GAINS

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Equilibrium of QS and QD is a price P* such that QS(P*)=QD(P*)

Follows from QS=g(P*) & QD=f(P*)

Prices are information signals that pushQS and QD

towards equality

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Equilibrium of QS and QD is a price P* such that QS(P*)=QD(P*)

P

QD, QS

P1

P2

Surplus at P1

Deficit at P2

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Shifts of DD curves

P

QD, QS

Rightward:Population upIncomes up

Leftward:Population downIncomes down

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Shifts of SS curves

P

QD, QS

Rightward:Size of industry upTech progress upRelative prices of inputs down

Leftward:Size of industry down Relative prices of Tech progress down inputs up

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Elasticity of demand with respect to changes in prices:η = ΔQD/QD : ΔP/P = ΔQD/ΔP ×P/QD

,

ΔQD/QD percentage changesΔP/P percentage changes

η is the key measure of sensitivity of demand to

changes in prices

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Elastic demand curve: η>1Inelastic demand curve: η<1Unit-elastic demand curve: η=1

P

QD 450

η>1 (luxury)

η=1

η<1 (necessities)

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P

QD

P1

At P1, η=0

QD

P

At any P, η=∞

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Marginal costs (MC) are costs of producing an additional unit of output

Suppose 50 units are already producedTC:= Total cost

MC (of the 51th unit)= TC (of 51 units)- TC (of 50 units)

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In certain business environments, volume of production at MC=AC

is an optimum position

MC

Volume

MCAC

MC=AC

?

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Fixed costs (FC) are incurred no matter how much units are produced

Variable costs (VC) increase as a volume of production increases

This distinction is the key to understanding why some firms are better off after M&A

and other are better off without M&A

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Scale = volumes of produced homogeneous (the same type) output

Scale + Scope = volumes of produced

homogeneous and heterogeneous outputs

Scope = volumes of produced heterogeneous (different types) outputs

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Economies of scale (ES) are changes in efficiency

due to changes in volumes of output

Decreasing EC

Scale

AC

Constant ES

Increasing ES

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Increasing ES: costs of additional units of output go down

due to rationalization of operations

fixed costs per unit decrease

Decreasing ES: costs of additional units of output go up

due to increasing difficulties of managing added operations

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Sunk costs are costs that cannot be recouped

Barriers to entry into an industry or market

are costs that outsiders should incur to become insiders

Higher barriers to entry

Bigger market power

of insiders

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Economic profit =accounting profit – profit from the next best alternative use of capital

Bigger market power

of insiders

Higher economic profits

of insiders

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Zero economic profit at time t:

there does not exist an alternative investment option that will lead to a

higher accounting profit at time t

In an industry with zero economic profit,

insider firms prefer to stay put

since nowhere

they could get a higher profit

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• Numerous firms are price takers: their individual decisions to change volumes of outputs have no influence on prices. Such (small) firms have horizontal DD curves

• Such firms can sell any quantities of their outputs at going market prices

Perfect competition is idealized model = benchmark:

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Perfect competition:

• The firm should stop increasing/ decreasing its outputs when its economic profit becomes zero, i.e.

MC = MR = P, where MR is marginal revenue.

• Any firm can freely exit or enter the industry

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Monopoly:

• A firm that can influence prevailing market prices by changing its outputs

Such firm has a downward-sloping DD curve

• Creates entry barriers for potential competitors

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Essence of monopoly:

• Chooses levels of outputs such that its economic profit is greater than zero:

MC = MR < P.

Economic profit from production of additional unit of output is

MC = P – MC.

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Two types of monopoly

Pure monopoly: a one-firm industry

whose product has no close substitutes

Natural monopoly: a one-firm

industry because this firm has enormous economies of scale (ES). Such ES need gigantic size=scale.

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• Freedom of exit and entry

Monopolistic competition:

• Numerous small firms

• Each firm produces slightly different product. Apart of this difference, the product has many close substitutes

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Monopolistic competition:

• Economic profit slightly higher than zero

MC=MR <P

higher: a firm exercises small market power due to unique distinction in its product

slightly: many close substitutes, i.e. tough competition

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• A bulk of the business in industry carried by a few large firms

Oligopoly:

• Products are close substitutes so competition is tough

• May have economic profit slightly higher than zero

MC=MR <P

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Pricing policies

Cost-based pricing: cost +target profit. Not enough flexibility to speedily adjust to changes in market situations.

Utility-based pricing: a firm adjusts prices to attract maximum consumers and then ruthlessly cut cost to make sales profitable.

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Pricing policies

Price discrimination: different prices to different customers for the same products

Price leadership: one firm sets the price for the industry and the other follow.

Premium-based pricing: extracting additional payment for unique qualities of a product

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Externalities are any costs or benefits generated by one firm/person that

affect another firm/person

Imposition of external costs detrimental externality

Imposition of external benefits beneficial externality

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Examples of externalities

Private goods are products and services whose consumption is

excludable and rival,e.g. good food at graduation party

Public goods are products and services whose consumption is

nonexcludable and nonrival,e.g. national defense

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Examples of externalities

Mixed goods:• Excludable but nonrival consumption, e.g. cable TV.• Nonexcludable but rival consumption, e.g. public park.