Price elasticity of demand – how responsive a demand curve is to a change in priceo Price Elasticity = (% change in quantity) / (% change in price)

NOTE: price elasticity is not the same as the slope of the demand curve

If the change in quantity is greater than the change in price, it is to say that demand is elastic

o When ever the absolute value of elasticity is greater than one, demand is elastic

o On another note, when the change in quantity is less than the change in price, demand is said to be inelastic

Absolute value will be less than oneo When the change in quantity is equal to the change in price, demand is

said to be unit-elastico The steeper the demand curve, the less elastic demand is

Perfectly elastic – horizontal line, slope = 0 Perfectly inelastic – vertical line, slope is undefined

In determining price elasticity, there are 5 factorso Availability of close substitutes

More substitutes available means more elastic demando Passage of time

The more time that passes, the more elastic demand iso Necessities vs. luxuries

Demand curves for luxuries are more elastic than those of necessities

o Definition of the market The more narrowly defined market has more elastic demand

o Share of the good in a consumer’s budget The more a good has a share in a consumer’s budget, the more

elastic demand is Total revenue & price elasticity

o When demand is inelastic, revenue and price move together Increase in price = increase in revenue

o When demand is elastic, revenue and price move inversely Decrease in price = increase in revenue

Cross-price elasticity of demand – measures the effect on quantity demanded of one good due to a change in price of another good

o C.P.E. = (% change in quantity for good 1)/(% change in price for good 2)o Cross-price elasticity tells us some things about goods too, if CPE is:

Positive, then products are substitutes Negative, then products are complements Zero, then the products are unrelated

Income elasticity – measures how responsive demand is to a change in incomeo I.E. = (% change in quantity) / (% change in income)

o Like CPE, income elasticity can also tell us about goods, if IE is: Positive and <1, good is normal and a necessity Positive and >1, good is normal and a luxury Negative, good is inferior

Price elasticity of supply is calculated the same way as demand, the difference is the percentage change in quantity supplied instead of demanded

In the past 50 years, international trade has grown dude to falling costs in communication, travel, and shipping, along with changes in government policies regarding tariffs on imports

International trade is driven by comparative advantageo If one country can produce something at a lower opportunity cost than

another country, then it should specialize in production of that good and then trade with a country that is specializing in another good

o Autarky is the situation in which countries do not trade with one anothero Terms of trade is the ratio at which countries will trade imports and

exports There are three main reasons for lack of total specialization despite comparative

advantageo Not all goods and services are traded internationallyo Production of most goods involves increasing opportunity costso Tastes for products differ

There are 4 main sources for comparative advantageo Climate and natural resourceso Relative abundance of labor and capitalo Technologyo External economies - reduction in a firm’s costs that result from expansion

of the size of an industry Free trade occurs when there is no government restriction on importing and

exportingo However, governments usually restrict trade, and the restrictions come in

three main forms: Tariffs Quotas Voluntary export restraints

The World Trade Organization (WTO) was established in 1995 as a means of monitoring international trade

o Some are against it on grounds of anti-globalizationo An older argument against free trade is protectionism, the use of trade

barriers to protect domestic companies. Protectionism aims to protect 4 things:

Jobs Wages Infant industries

National securityo The US government also extends protection to domestic industry by

imposing tariffs on goods when it is believed that a country is dumping, selling a good below its cost of production

Utility is the measure of satisfaction one gains from consuming a producto Marginal Utility is the change in total utility received from consuming

one more unit of a good or serviceo When consuming multiple units of a good or service, utility received form

each unit usually decreases with each additional unit consumed, this is known as the Law of Diminishing Marginal Utility

To decide the optimal level of consumption (maximum utility) with a budget constraint, one should use the rule of equal marginal utility per dollar

o When consuming two goods, one should consume up to the point where the last unit consumed of each good gives equal increases in utility per dollar

When prices change, both the income effect and substitution effect take placeo Income effect - A decrease in price is essentially an increase in income,

causing people to consume more of one good (assuming it is a normal good)

o Substitution effect – a decrease in the price of as good will increase your marginal utility per dollar for that good by lowering the opportunity cost of consuming the other good

Sometimes, social factors play a role in decision makingo Along with social factors, celebrity endorsement also can affect purchaseso Network externalities are another reason people buy products that other

people are buying. A network externality is when the utility of a good or service increases with the number of people who use it

In recent years, behavioral economics has been an area of interest. Behavioral economics is the study of when people act in ways that are not economically rational. The main reasons for consumers acting economically irrational are:

o Ignoring nonmonetary opportunity costso Failure to ignore sunk costso Over optimism about future behavior

In economic terms, technology is the processes that a company uses to turn inputs into outputs

o A technological change is the ability to produce more outputs using the same number of inputs

In analyzing levels of production and production cost, time is split into short run and long run

o Short run – time period during which at least one of a companies inputs is fixed

o Long run – a time period long enough to allow a company to vary all of its inputs, adopt new technology, and increase/decrease the size of the physical plant

Total cost is the sum of the costs of all inputs used in production it is composed of two parts:

o Fixed costs – costs that remain constant as output changes (i.e. insurance)o Variable costs – costs that change as output changes (i.e. electricity bill)o TC = FC + VC

In examining opportunity costs, one should break it down to explicit and implicit costs

o Explicit costs – are those which involve moneyo Implicit costs – are those which are nonmonetary opportunity costs

A production function shows the inputs used by a company and the maximum attainable outputs with those inputs

o It can also show information on costs Average total cost is the total cost divided by the quantity of

output produced ATC = TC/Q

o Marginal product of labor is the additional output a company produces as a result of hiring one more worker

Average product of labor – total output divided by the number of workers

When MP > AP, then AP is increasingo Law of diminishing returns states that at some point in adding variable

input to the same fixed input will cause the marginal product of the variable input to decline

Marginal and average products of labor will affect costso Marginal cost – the change in a firm’s total cost from producing one

more unit of a good or service MC = (/\ TC)/(/\ Q) When MC is below ATC, ATC will fall, and vice-versa

Average fixed and variable costs can be calculated by dividing these costs by the output produced

o AFC = FC/Qo AVC = VC/Qo Similarly, ATC also equals the sum of the average fixed and variable costs

ATC = AFC + AVCo Three things to remember:

The curves for MC, ATC, and AVC are all U-shaped, MC crosses the other two curves at their lowest points

As output increases, AFC gets smaller and smaller As output increases, the difference between ATC and AVC

decreases

o It is important to note that in the long run all costs are variable, in the long run, TC=VC and ATC=AVC

A long run average cost curve shows the lowest cost at which a firm can produce a given quantity of output in the long run, when no costs are fixed

o Economy of scale – long run average cost decreases as output increases Minimum efficient scale – the level of output at which all

economies of scale have been exhaustedo Diseconomy of scale – long run average cost increases as output increaseso Constant return to scale – long run average cost stays the same as output

increases

A perfectly competitive market is one that meets 3 conditions:o There are many buyers and sellerso All firms sell identical productso There are no barriers to new firms entering the market

In a perfectly competitive market, prices are determined by the interaction of supply and demand, no single buyer or seller can affect the market price

o This makes buyers and sellers price takers The demand curve for a company in a perfectly competitive market is horizontal To maximize profit in a perfectly competitive market, one should produce to the

point where the difference between revenue and cost is the greatest o It is also where MC = MR

When looking at revenue, like most other things, we can look at average and marginal revenue

o Average revenue = TR/Qo Marginal revenue = /\ TR/ /\Qo In a perfectly competitive market, AR and MR are equal to the market

price

Another way to look at profit is as sucho Profit = (P – ATC) x Q

When P > ATC, firm is making a profit When P = ATC, firm is breaking even When P < ATC, firm is operating at a loss

Sometimes, firms may need to shut down in the short run when operating at a losso Some firms may continue to produce, others will temporarily stop

production During shutdown, a company is still responsible for fixed costs

If production will cause a loss greater than its fixed costs, the company will shut down

Sometimes production can lower a firms costs below its fixed costs, in this case, the company will continue to produce

In perfect competition, a company’s supply curve is the same as its MC curve

o NOTE: because production will cease when P < AVC, this is true only when price is greater than average variable cost

When other firms enter an industry, it reduces economic profitso Economic profit – a company’s revenues minus all costs, implicit and

explicito Entry of firms will cause the supply curve for that market to shift to the

right, thus lowering the market priceo Sometimes, consumers will no longer desire a product, causing the

demand curve to shift to the left The producers will move down the MC curve to a lower level of

output and suffer an economic loss Economic loss – a company’s revenue is less than its total

costs, including implicit ones This will also cause firms to exit the industry

In the long run, as firms exit an industry due to economic loss, the equilibrium price will be pushed back up to the point where a typical firm is breaking even, this is known as long run competitive equilibrium

o This will be the lowest point on a company’s ATC curve A long run supply curve will show the long run relationship between market

price and the quantity suppliedo It is a horizontal line representing where a typical firm breaks eveno It will be the minimum point on the ATC curveo A firm that has a horizontal long run supply curve is called a constant cost

industry Some have upward sloping curves, these are called increasing cost

industries Some have downward sloping curves, these are called decreasing

cost industries

Perfect competition causes productive efficiency in a marketo Productive efficiency – good or service is produced at the lowest possible

cost Perfect competition will also result in allocative efficiency

o Allocative efficiency – production reflects consumer preference, in particular, every good orservice is produced to the point where the last unit provides a marginal benefit to consumers equal to the marginal cost of producing it

Monopolistic competition – a market structure in which barriers to entry are low and firms compete by selling similar, but not identical, products

If a firm has the ability to affect the price of what it sells, its MR revenue curve will be below its demand curve

In monopolistic competition, Average revenue = price In monopolistic competition, a firm will produce where P > MC, profits will be

maximized at this pointo The amount of profit will be represented by Q(P-ATC)

Entrance of new firms will shift demand curves for any one firm to the left, along with making demand more elastic

o When the demand curve shifts to the point where it is tangent to the ATC curve, the firm is breaking even

Unless a monopolistically competitive firm can find ways to differentiate its products, or produce its products at a lower cost, it will lose all economic profits in the long run

Firms In monopolistic competition have excess capacity, if they increase output, they can produce at a lower average total cost

o These markets however are inefficient, achieving neither productive or allocative efficiency

How can a firm differentiate?o Marketing – all the activities necessary for a company to sell products to

a customer Brand management – the actions of a firm intended to maintain the

differentiation of a product over time Advertising Enforcement of trademarks

What makes a firm successful?o Value created to customers

Differentiation Producing at a lower ATC than competitors

o Marketingo Chance eventso

Oligopoly – a market structure in which a small number of interdependent firms compete

Oligopolies have 3 main barriers to entryo Economies of scaleo Ownership of a key input o Government imposed barriers

analysts use game theory to study oligopolieso Game theory is the study of how people make decisions in situations in

which attaining their goals depends on their interactions with otherso a payoff matrix can show the payoffs of every combination of business

strategies by different firmso Sometimes companies will collude, or agree to charge the same price or

otherwise not compete (ILLEGAL!)o ultimately, a manager will price products in order to maximize profit

relative to the prices of other companies, this is called using a dominant strategy

this is the main concept behind Nash Equilibrium (A Beautiful Mind)

Firms can maximize payoffs by cooperating, thus attaining cooperative equilibrium

o Contrarily, noncooperative equilibrium is when firms pursue their own interests

A cartel is a group of firms that collude to restrict output in order to increase prices and by extension, profits

A sequential game is when decisions follow the decisions of other competitorso Sequential games are used to analyze deterring entry and bargaining

between firms Five forces model shows competition in an industry

o Competition form existing firmso Threat of new entrantso Threat of substituteso Buyer powero Supplier power

Monopoly – the only seller of a good or service that doesn’t have a close substitute

Monopolies arise from 4 factorso Government blocks entry of more than one firm

Patents – grant legal protection for an invention for 20 years Copyrights – government granted exclusive right to produce and

sell a creation Granting public franchise – makes affirm the exclusive legal

provider of a good or serviceo One firm has control of a key raw materialo Network externalitieso A company is a natural monopoly – economies of scale are so large that

one company can supply the entire market at a lower ATC than 2 or more firms

Monopolies are price makers Monopolies will produce to the point where MR=MC, profit will be Q(P-ATC)

o Despite earning economic profits, a monopoly will not diminish these profits in the long run because no other firms are entering the industry

o Monopolies will produce less and charge a higher price than firms in perfect competition

Three effects of monopolieso Lower consumer surpluso Higher producer surpluso Deadweight loss

Also worth noting is that monopolies have market power, the ability to charge a price higher than the marginal cost

o In fact all markets aside from perfect competition have market power

This translates to the fact that there is some loss of economic efficiency in all markets

The US has many anti trust laws that it uses to stop monopolies and collusiono The government’s main concern is horizontal mergers, or mergers

between firms in the same industry, as these are more likely to increase market power, raise prices, and limit output

Conversely, a vertical merger is a merger between firms at different stages of production of a good

o The Federal Trade Commission (FTC) is very careful when approving mergers, two main points they look for

Definition of market Efficiency if merger happens

If it can be proven that a merger will make companies more efficient thus reducing costs and improving overall economic efficiency, despite increases in market power, merger will be approved

o The FTC has 3 guidelines for evaluating the impact of a merger Market definition

Start with a narrow definition of the marketo If prices increase by x% for certain companies and

profits increase, then that is the market, if profits decrease, broaden the market definition and repeat

Measure of concentration Firms merging in highly concentrated markets have a

strong possibility of increasing market powero Concentration is measured with the HHI index

which is calculated by adding the squares of each firm’s market share

Merger standards Using the HHI, merger is analyzed

o HHI < 1000 not concentratedo 1000 < HHI < 1800 moderately concentratedo HHI > 1800 highly concentratedo

According to the law of one price, identical products will sell for the same price everywhere

o Buying a product at a low price in one market in order to sell it at a higher price in another is known as arbitrage

o However, the law of one price only holds true when there are no transaction costs

Sometimes companies practice price discrimination, charging different prices to different customers for the same product when the price differences are not due to differences in cost. Successful price discrimination has 3 key factors

o Firm must have market powero Firm must know what prices consumers are willing to pay

o Firm must be able to segment market so as to prevent arbitrage When firms price discriminate, they charge customers with more elastic demand a

lower price and vice versa If a company can achieve perfect price discrimination (i.e. they can prevent

arbitrage) they can eliminate consumer surpluso If a monopolist is able to perfectly discriminate, it can convert into profit

what was once consumer surplus and DWL Some companies will price discriminate over time

o An example is the high price of new technology, and how the prices for that technology gradually fall over the years, in part to falling costs, but also in part to price discrimination

Under antitrust laws, price discrimination with the goal of reducing competition is illegal

Some companies use other pricing strategieso Odd pricing - .99 instead of .00o Cost plus pricing – a percentage markup on the cost of productiono Two part tariff – pay one price for the right to buy as much as you would

like of another product (i.e. Costco)