Assumptions under the law of demand

- The income effect

As the price of a product falls, the real income (macro: disposable income) of customers
increases. They are able to buy more products at lower prices. In other words, real income
increases when prices fall, as customers are able to purchase more goods and services with
the income they currently have.
Real income -> The amount consumers can buy
- The substitution effect
As the price of a good or service falls, more customers are able to buy the product, so
choose this over the rival or substitute products that they might have previously bought.
Essentially, the substitution effect causes consumers to replace higher priced products with
lower priced ones.
- The law of diminishing marginal utility
As individuals consume more of a particular good or service, the utility gained from the
additional unit of consumption declines, so customers will only purchase more at lower
prices.
Assumptions under the law of supply
- The law of diminishing marginal returns
: describes how the output is affected when a firm uses more variable inputs (factors of
production) while maintaining at least one factor of production as fixed in the short run.

Topic 6 Critique of the maximizing behaviour of consumers and producers (HL)

Rational consumer choice:

-> refers to the decision-making process based on the assumption that people make choices
that result in the optimal level of benefits (utility).
-> the basis of most introductory and mainstream economic theories.
-> examples are the law of demand

Assumptions:
Consumer rationality:
-> it is assumed that consumers will make rational choices by using rational calculations or
considerations to make sensible choices that align with their own best interests

Utility maximization:
-> Consumers will try to maximise their satisfaction/utility/benefit when consuming a
good/service

Perfect information:
->This exists when all stakeholders in an economic transaction have access to the same
knowledge
->referring to equal and easy access to information (eg. prices, product specifications and
information about alternative products) available on the market

Behavioural economics - limitations of the assumptions of rational consumer choice:

-> the study of economic theory (economic decision-making) with the use of psychology
-> it challenges the assumption that actors always make rational choices with the aim of
maximising utility
-> acknowledges the power of social conformity on decision-making, because humans are
social beings whose behaviour is clearly influenced by the behaviour of others in society,
including peer pressure and the desire to conform to social norms.

Limitations:
1. Biases-Rule of thumb
-> where consumers will make their decision based on the information available to them
and it will act as a point of comparison
Eg. Intuition (直觉): choosing the middle-priced option when a consumer is facing similar
products with different prices
Common sense: buying more when there is a sale as goods are cheaper
2. Biases - Anchoring and framing
-> Where consumers will make their decision based on pre-existing information and it will
act as an anchor to the consumer
-> when an idea or a value is firmly anchored in a person’s mind, it can lead to automatic
decisions and behaviours
Eg. Placing too much emphasis on the first information found when making decisions
Relying too much on pre-existing information
-> Consumers might make different decisions based on how the information is presented
Eg. Changing the wording of a choice
➢ Option A: hamburger with 9% fat
➢ Option B: 91% fat-free hamburger
3. Availability Bias
-> Consumers might make decisions based on how likely an event happened
Eg.
➢ Overestimating the probability of something happening in future because…
- A similar event has happened recently
- People are too emotional about the previous event
-> Consequence is that people become poor at estimating probability and risks, such as
overestimating the likelihood of shark attacks/aircraft accidents
4. Bounded (restricted) rationality
-> Where consumers cannot make the best decision, instead consumers will go for a
satisfactory decision due to limited constraints (Eg. lack of information, limited time…)
Examples of restrictions on people’s ability to make rational decisions:
➢ Cognitive biases
➢ Limited availability of information
➢ Inaccuracy of information
➢ Limited time available to make a decision - summer sale, discounts
➢ Computation weaknesses (not good at calculating costs/benefits)
➢ Limited ability to process and evaluate large amounts of data involved in
decision-making - contract signing
5. Bounded self-control
-> Consumers might not be able to stop the consumption of a good/service due to
limited self-control
Eg.
➢ Consumers may have a limited ability to stop eating junk food or quit smoking, even
though they know these consumption acts do not maximise their utility
 -> emotions take over and we might do something irrational by justifying that we are worth it
right now
6. Bounded selfishness
-> Consumers will also care for others instead of maximising their self-interest
-> This often results from people’s perception of fairness, which involves treating people
equally in a reasonable way, giving others respect and time, sharing with others, and not
taking advantage of others
Eg.
➢ Donating to charities, helping a stranger, young children sharing food with other
children
7. Imperfect information
-> Where stakeholders have unequal access to the information of a good/service
-> Consumers may make ‘wrong’ decisions (such as irrational choices) if they possess
imperfect information
Eg.
➢ Consumers may misunderstand or be unaware of the true costs/benefits of a good
(such as the nutrition of some food or side-effects of a medicine)
➢ The seller of a financial product may mislead buyers about the true level of risks, as
the buyers often have little knowledge about it

Behavioural economics in action

1. Choice architecture
-> it suggests that the decisions we make are affected by the layout, sequencing, and range
of choices that are available (ie. how choices are presented) eg.layout of supermarkets and
calorie counts on restaurant menus
-> Choice architecture can be done in different ways, such as default choices, restricted
choices and mandated choices

A choice architect is an individual or organization responsible for shaping the context in

which people make decisions. It could be a parent, teacher, colleague, friend, employer, the
media, or a government official who organizes the context in which people make choices
based on the simplified design of different options being presented to them.

Default choices:
-> a choice is made by default (consumers will have to actively tick off/select another option)
Eg. the company can send promotional emails to me
-> occurs when a person is automatically signed up into a system, it is the given decision of
the economic agent if no action is taken
-> this can be used to encourage individuals to act in a certain way, as more people tend to
choose the default choice
E.g
➢ Employees are more likely to join the pension scheme if they are automatically
enrolled in it
➢ Countries that require people to opt-out of organ donations generally have a much
higher proportion of the population willing to donate than countries who ask people to
opt-in
Opt-in: people have to fill in a form and check a box to choose to donate their organs
Opt-out: people who don’t want to donate their organs have to essentially fill out a form to
“opt-out”; by default they consent to donate their organs

Restricted choices:
-> a choice that is limited by the government or an authority
-> due to the existence of bounded rationality, when the number of choices is large, it may
lead to poor decisions made by consumers. Consumers will often find it easier to make a
decision effectively under restricted choices
Eg.
➢ People being restricted to a limited number of choices of schools in their local area
➢ Policy requiring energy companies to simplify their pricing structures and restrict the
number of options offered to consumers

Mandated choices:
-> a choice between alternative that is made compulsory by the government or an authority
-> when people are required to make an advanced decision and declare whether they wish
to participate in a particular activity
Eg.
➢ “I agree with the terms & conditions” - consumers must select this option before
proceeding
➢ People in the state of Montana are asked whether they want to be an organ donor or
not when they sign up for or renew their driver’s licence => the state achieved a 82%
donation rate
Nudge Theory
-> generally used to describe situations where nudges (prompts, hints) are used to improve
the life and wellbeing of people and society
Consumer nudges:
-> where consumers behaviour can be influenced by small changes/suggestions & positive
reinforcement
-> nudges attempt to change consumer behaviour in ways that comply with desirable social
norms, to increase social welfare
-> nudges are also used in government policies to change people’s behaviour in a
predictable manner without removing their freedom of choice. The use of nudges is an
alternative to using laws to ban or restrict certain activities.
Eg.
➢ Displaying social trust - showing feedback from peers is one of the strongest
nudges. Companies often display positive reviews next to their products to
encourage people to buy

Business objectives
Measuring revenues and costs
● Total revenue (TR) - selling price (P) x Quantity sold (Q)
● Average revenue (AR) - revenue per unit of output sold (=price of the output)
Total revenue/Quantity = PxQ/Q = P = AR
● Marginal Revenue - extra revenue for selling one more unit of output
∆Total revenue/∆Quantity = Total revenue (new - original) /Quantity (new - original)
● Total Cost (TC) - total production cost of all inputs
● Average Total Cost (ATC)/Average Cost (AC) - production cost per unit of output
 Total Cost/Quantity
● Marginal Cost (MC) - the extra cost to produce one additional unit of output
∆Total Cost/∆Quantity - Total Cost (new - original)/Quantity (new - original)

Measuring profits
● Economic Profit - the difference between total revenue and economic cost (total
opportunity cost)
Total Revenue = Total Cost = positive #

Main business objective: Profit maximisation

-> A firm will try to maximise their profit (the difference between total revenue and total cost
is the largest)
-> when marginal cost (MC) = marginal revenue (MR)
Reasons for the objective:
➢ Reinvesting in the company (eg.financing for research and development)
➢ Allowing higher reward (more dividends) for shareholders and attracting more
investors
➢ Enabling higher salaries and better employment opportunities for workers, important
for staff motivation, loyalty and productivity
➢ Lowering the risk of being taken over

Alternative business objectives

1. Corporate social responsibility (CSR)
-> Corporate action/practice to avoid socially undesirable activities (the business will
consider the other stakeholders when making business decisions)
-> refers to committing to ethical objectives to benefit both internal and external
stakeholders, not just to the owners/shareholders of the business
Eg.
➢ Avoidance of polluting activities
➢ Support for human rights (eg. avoid exploitation of labour)
➢ Donations to charities
➢ Art and athletics sponsorship
Reasons for the objective:
● Due to the general public’s increasing awareness of economic, social and
environmental effects of corporate activities
● Promote company image

2. Market share (sales maximisation/Revenue maximisation/ (PxQ)

-> market share refers to a firm’s portion of the total value of sales revenue in a particular
industry, calculated by
= (Firm’s total sales revenue/Industry’s total sales revenue) x 100
-> this occurs when a firm attempts to sell as much as it can without making a loss, to
achieve rapid growth of its market share
-> to become the market leader = more market power
Reasons for the objective:
➢ Brand loyalty, which leads to ongoing or repeat sales and customers being less
sensitive to higher prices being charged
➢ Economies of scale - these are cost-saving benefits due to the firm’s larger scale
operations
➢ Higher profits as the firm accounts for more of the market’s overall sales
➢ Driving away competitions by forcing rivals out of business
➢ Greater marker power: enables the firm to raise prices and make more profit in the
long run
➢ Sales can be identified and measured more easily than profits over the short run, and
increased sales target can be used to motivate employees
➢ Rewards for managers (eg. bonuses) are often linked to increased sales

3. Satisficing
-> a goal of firms to achieve satisfactory results, rather than pursue a single maximising
objective/result
-> it is a mix of the words “satisfy” and “suffice”
-> a firm tries to achieve satisfactory rather than optimal results
Reason for the objective:
➢ Firms may have many different goals, some of which may conflict, and achieving one
goal could give rise to a significant sacrifice of other objectives. Therefore, firms may
prefer a strategy that makes compromises among different objectives and achieves a
satisfactory outcome with respect to all
Eg.
● Maximising profit and improving welfare of employees, since the workers and
managers prefer sufficient profit to ensure there is job security but do not want to
overwork

4. Growth
-> a firm aims to maximise its growth
-> refers to increasing the size and scale of operations of a firm
-> the firm may be willing to make lower levels of profit in order to maximise growth
It can be measured through an increase in the firm’s:
- Sales revenue and/or profits
- Product range (the different products sold by a business)
- Number of employees
- Number of stores/outlets
- Volume of output and/or production capacity
- Value of its assets or the capital invested
Reason for the objectives:
➢ Economies of scale (enjoying lower average costs)
➢ Greater market power to influence prices
➢ Reducing dependence on a single product or market through diversification
➢ Lower risks: less affected during economic downturn; less likely to be taken over
➢ Benefiting both owners and managers
Firms can grow in several ways, including:
- Mergers and acquisitions 收购
 - Market penetration growth strategies, which require firms to focus on increasing the
sale of existing products in existing markets existing customers
- Market development growth strategies, where a firm sells its existing products in new
markets (new group of customers)
- Product development growth strategies, where a firm introduces new products in
existing markets, so it targets new products at existing customers
- Diversification growth strategies, which involve firms producing and selling
completely new products to new customers

10 markers:
1. Describe how bound rationality, bounded self-control, and bounded selfishness
may influence consumers when making consumption choices.

Define: bound rationality, bounded self-control, bounded selfishness, rational consumer

choice theory

2. Explain how the following goals of firms may influence firms' behaviour -- profit
maximization, corporate social responsibility, and satisficing.

Importance of PED for firms and government decision-making

-> informs business decision makers about the effect of price changes on sales revenue
(PxQ)
-> Government uses PED values to determine taxation policies. Eg.on inelastic product, the
tax has to be sufficiently high to discourage consumption, while generating a lot of tax
revenue for the government

-> Consumers pay most of the tax burden, producers absorb the remainder of the tax
burden, combined areas show the tax revenue collected by the government
-> The huge increase in price does little to reduce the consumption of cigarettes but collects
a lot of tax revenue for the government
-> this knowledge of PED also informs the government that the significant increase in price
does little harm to the cigarette manufacturing firms and jobs in the industry
Changing PED along a straight-line downward sloping demand curve (HL)
- The value of PED increases as the price of the product rises (vice cersa). This occurs
because customers will be more responsive to changes in prices at higher levels
(when the price accounts for a greater proportion of consumers’ income)
- The value of PED at the mid-point along a linear demand curve is equal to 1.0
 - At all prices above Pe, PED is greater than 1 (price elastic). When prices become too
high, the Qd drops to 0 (PED = infinity)
- At all prices below Pe, the PED value will be below 1.0 as customers are far less
sensitive to reductions in price.

Reasons why the PED for primary

commodities is generally lower than the
PED for manufactured products (HL)
Due to the main determinants of PED for
primary products:
- Lack close substitutes. Eg. few
alternatives for coal, crude oil, gold, metal
ores and rice.
- Are essential (necessities) for production, so their demand is relatively price
inelastic
- The proportion of income spent on primary products is relatively low. The price
of primary commodities used for production tends to account for a smaller proportion
of overall costs of production, as labour and capital costs tends to be higher
- The time needed to grow and harvest/extract primary commodities is a lot
longer than the process to manufacture goods. The shorter the time period under
consideration (使用的时间）, the lower the value of PED.

PED for Manufactured products:

- Have many substitutes eg.different makes and models of cars, laptops and watches
- The degree of necessity is lower, as customers might be able to use their existing
manufactured (eg.furniture) for longer in response to higher market prices/switch to
cheaper alternatives.
- Take up a larger proportion of consumers’ income -> relatively price elastic
- Can be used continuously over a long period of time -> high PED

Importance of YED for Firms and the Economy (HL)

For firms:
-> Useful to decide what to produce in the future
Reason: YED affects how the Qd of a good changes as income changes.
1) If there’s economic growth -> income increase -> firms should focus on producing
luxury good
2) If there’s recession -> income decrease -> firms should focus on producing inferior
goods
-> firms selling income inelastic products tend not to be so affected by fluctuations in the
business cycle.
For economy:
Changes in economy’s structure over time
Primary sector:
-> relatively income inelastic, people do not demand much more following an increase in real
income or significantly less when real income falls
-> is only likely to grow only slowly as real incomes in the economy increase over time
-> countries that rely on the exports of primary commodities lack the economic growth and
development of countries that rely on the export of manufactured goods
Secondary sector:
-> higher YED value
-> As standards of living rise, there tends to be a more than proportionate increase in the
demand for manufactured goods
-> Hence, the secondary sector grows much more rapidly than the primary sector as real
incomes increase
Tertiary sector:
-> relatively high YED value
-> As standards of living rise, the demand for banking, education, and leisure and tourism
increase by a larger percentage than the increase in real income
However, firms and the economy suffer suffer during an economic recession as customers
are highly responsive to the fall in their real income

-> YED has an important effect on the allocation of resources within an economy as it
determines the nature of sectoral change as the country develops

-> developing countries: most of the production is related to primary sector (eg.farming and
mining)
-> developed countries: most of the production is related to the tertiary sector (tourism and
banking)
Reasons:
● The low YED of primary products implies that the growing income of an economy will
lead to a less than proportionate increase in demand for these products
● There is a relatively more rapid growth in secondary sector than in primary sector, as
demand for manufactured goods rises at a faster rate
● Growth of the tertiary sector is the fastest, as YED of services is highest among the
three.

PES for primary commodities and manufactured products (HL)

-> PES for primary products is relatively low owing to the comparatively long time it takes to
increase primary sector output
-> PES for manufactured products is generally higher because many of these can be mass
produced in shorter time periods
5 determinants:
● Time - The output of primary sector products tends to take a relatively long time, so
supply is fixed in the short run. Hence, the supply of primary products is relatively
price inelastic.
● Inventory (stocks) - primary output are perishable and can easily become damaged.
Hence, it can be difficult to hold stocks of primary products for any significant period
of time.
● (Marginal) costs - The additional costs of supplying an extra unit of mass products
products is very low. With mass production, output is continuous with large numbers
of identical goods being produced. Therefore, it is relatively easy to produce more
 without having to increase price as supply is highly elastic. / in the primary sector,
producing an extra unit of primary product would contribute to the higher price
needed to ensure firms have an incentive to produce additional units.
● Capacity - Capital intensive output in the secondary sector means it is relatively easy
to increase output, whereas production tends to be land/labour-intensive in the
primary sector. Land is fixed in supply - once fields have been planted for the season,
the capacity is effectively fixed.
● Substitution (of factors of production) - Capital equipment used in manufacturing is
more flexible and adaptable than resources used in the primary sector. Machinery
can be easily and quickly adjusted to mass production, but capital tends to be more
specialized in the primary sector.

Market failure - market power (HL)

:the ability of a firm to manipulate the market price of a good or service, the firm can affect
the market outcomes by restricting output to raise price above the marginal cost

Perfect competition:
It is a market structure where there is an intensive degree of competition, with no individual
firm being large enough to influence the price or quantity traded.

Characteristics:
- Price taker - firms having no market power, hence unable to influence their price.
- Many firms - large # of firms and consumers in the market
- Perfect information - Buyers and sellers have full perfect knowledge of products
and prices in perfectly competitive market
- Freedom of entry and exit (no barriers of entry)
- Homogenous products - supply products that are identical rather than differentiated

In reality, there are no firms or industries that can fit these assumptions perfectly.
Eg. market stall vendors selling fruits and vegetables -> can have several mango vendors in
the market but the size of the mangoes may vary, therefore the price will differ -> if there is
branding, then the mangoes are no longer homogeneous but heterogeneous. -> not possible
to test perfect knowledge since consumers do not know the of the mangoes at every fruit
stall in the market

Real-world example:
Markets that sell fresh fruit and vegetables, where the demand is highly price elastic
because:
- firms sell homogeneous products (carrots/oranges from one vendor are no different
from those sold by other firms in the same market).
- No individual firm is large enough to influence market supply or market price -> firms
are price takers.
- Relatively easy for firms to enter/leave the market
Monopoly:
Is a market structure where there is a single supplier of a particular good or service, thus
having the power to influence the market supply and price.

In the case of a monopoly, the substitution effect (law of demand) is not present, as it is the
only firm in the market

Characteristics:
● Price setter - a single or dominant firm that has significant market power enabling it
to manipulate its prices as it has significant control over market supply
● A single/dominant firm
● High barriers to entry - prevents new firms trying to enter the industry in an attempt
to compete for market share
- Branding - a monopoly, especially one that has operated for a long period of
time, has such as large amount of brand awareness that if a new firm was
to enter the industry, it would be very challenging and expensive for it to
advertise enough to compete with the existing brand. Well established market
leaders also enjoy customer and brand loyalty.
- Legal barriers (legal reasons why firms can not enter the market) - there can
be licenses or health and safety requirements. In some cases, the
government grants the right for only one firm to operate in the market, as in
the case of natural monopolists/legal monopolies. Monopolists can also
create artificial barriers to entry by protecting their intellectual property
rights through the use of copyrights, trademarks and patents.
- Anti-competitive practices - some monopolies may take measures or
engage in practices that prevent other firms from entering their market.
Eg.the use of limiting price strategy means a monopolist deliberately sets the
price of their good or service below the price at which it would be possible for
a new entrant to sell it. -> reduces the contestability (竞争性）of the
monopoly’s market.
- Domination of resources - where all the resources that are required are
currently being used by the monopolist. Eg.gold or diamond mining in some
countries; all areas that are rich in gold and diamonds have already been
mined or are under the ownership of a dominant firm already, such as De
Beers - the world’s largest diamond exploration company.
- Economies of scale - cost-saving benefits of lower average costs of
production brought about by an increase in the volume of production. There
may not be enough demand in the market for a new firm to achieve the
necessary economies of scale to compete. -> any potential entrants will have
higher costs and not be able to compete with the more efficient monopoly. ->
prevent a firm from joining the market in the first place. The monopolist can
also create barriers to entry by investing in the latest innovations and
technologies. By exploiting (剥削) technical economies of scale, the higher
set-up costs can deter firms from trying to enter the market.
● No close substitutes - firms are able to supply a unique good or service can charge
higher prices and control market supply. Eg.the demand for veterinary services is
highly price inelastic owing to the high willingness to pay and because there are no
 close substitutes. -> Enjoy price inelastic demand -> charging a higher price earns
them more revenue owing to the lack of substitutes

While monopolists have the ability to control market supply, they can not control market
demand. If prices rise too high, customers will switch to or seek alternatives. Hence,
monopolists must lower prices if they want to sell more.

Monopolistic competition:
A market structure in which many firms exist, but each firm has only a small degree of
market power.

Characteristics
- Many firms - as they do not produce or sell homogeneous products, each firm has a
small degree of market power. By supplying differentiated products, monopolistically
competitive firms have the ability to determine price, although this is only to a small
extent owing to the large number of firms in the market. Eg.local hairdressers, fast
food restaurants.
- Free entry - any firm is free to set up in the market and compete with the existing
firms. If there are more profitable industries to operate in, firms are free to leave the
industry without incurring any major costs.
- Product differentiation - Have the ability to differentiate their goods or services.
Eg.brand name ->>> accounts for the differences in price in monopolistically
competitive markets, rather than the ability to exploit consumer surplus as in the case
of monopoly market. ->>> restaurants offer something different (eg.different cuisines)
and have some degree of uniqueness, but they are all essentially competing for the
same customers in the local area.

Rational producer behaviour - profit maximization >> acts as an

incentive or reward for entrepreneurship

Total revenue: overall amount of money received by a firm from selling its entire products
=PxQ

Average revenue: TR/Q = (P x Q)/Q = P

Economists refer to cost in terms of the cost of production, whereas price is the value paid
by the customers for the purchase of a good or service

Fixed cost: expenses do not change with the level of output, such as rent, insurance,
premiums, management salaries, loan interest repayments and advertising costs.
- Total fixed cost (TFC): sum of production costs that do not change with the level of
output / AFC x Q
- Average fixed cost (AFC): fixed costs per unit of output / TFC/Q
Variable cost: Cost directly linked to the level of output. Hence, they continuously rise if
output increases, such as wages and raw material costs.
- Total variable cost (TVC): production costs incurred directly from the output of a
particular good or service. / AVC x Q
- Average variable cost (AVC): incurred for each unit of output of a good or service /
TVC/Q

Total Costs (TC) = TFC + TVC

Average Costs (AC/ATC) = TC/Q

Profit = TR - TC

Marginal Revenue:
The additional revenue received from the sale of an extra unit of output
MR = ΔTR/ΔQ

Marginal Cost:
The additional cost of producing an extra unit of output
MC = ΔTC/ΔQ

Profit maximisation is reach when MR = MC

- If MR > MC, firms should increase its output
- If MR < MC, firms should decrease its output

Economic costs are the explicit and implicit costs of all resources used by a firm in the
production process.
Explicit costs include the accountable costs related to the output of a product
i.e.cost of factors of production
Implicit costs are the opportunity costs of the output (the income from the best alternative
forgone)

Abnormal profit (economic profit)

:profits that is greater than normal profit, thereby creating incentives by producers to
increase their profit
-> it may also attracts potential rivals to enter the market
-> AR > AC
-> a firm is said to earn economic profit from a particular economic activity only when it
experiences a profit greater than its next best alternative forgone (implicit costs)

Normal profit
:amount of profit needed to generate production of a good or provision of service
-> without normal profit, there is no incentive for firms to produce
-> AR = AC
-> If a firm earns zero economic profit, this means it earns normal profit but not earn any
abnormal profit. Hence, zero economic profit does not mean the firm earns zero profit, it can
still cover all production costs (explicit + implicit)
Losses
:when a firm experiences negative economic profit
- TC > TR
- AR < AC
- While it is possible for a loss-making firm to remain operational in the short run, this
is not sustainable. Firms need to pay their suppliers, workers, and financiers so must
generate surplus revenues in order to continue to be operational in the long run

Degrees of market power

Refers to the ability of firm to manipulate the price of a good or service by manipulating the
level of supply and/or demand for the product.

Perfect competition: price is determined by price mechanism

P = AR = MR

The profit maximising firm produces Q* output (MR = MC). As price (w) is greater than than
the short run average cost, the firm makes abnormal profit as shown by the shaded area
(x,y,w,z). This means that the firm is earning more profit in this market than it could in its next
best alternative.
Profit maximization in the long run
In the long run -> can only earn normal profits (zero economic profit)

The perfectly competitive firm initially operates at Q1, earning abnormal profit at a market
price of P1. However, owing to a lack of barriers to entry and the presence of perfect
knowledge, other firms will be able to enter the industry quickly. Hence, the market supply
will increase (S1 -> S2). This will lead to a reduction in the price to P2 (determined by price
mechanism). Therefore, the existence of new entrants in the industry will shift the D=AR=MR
curve lower because firms have to take (accept) the lower market price until they reach the
minimum efficient scale (occuring at the lowest point on the LRAC curve). This results in the
new profit maximizing output of Q2, which occurs at the point of normal profit for the firm.
Firms will still stay in the market since it still earns zero economic profit (earning as much
profit as its next best alternative) If market price were to fall below the lowest part of the
LRAC curve, then the firm is going to begin making a loss. This would mean that the firm no
longer enjoys as much profit as it could in its best alternative forgone. A rational firm would
therefore leave the industry in the long run if faced these conditions. This would then lead to
a fall in the market supply, causing the D=MR=AR curve to rise owing to the resulting higher
market price.
Hence in the long run, perfectly competitive firms can earn only normal profits (AR=AC). As
these firms are also profit maximizers, they produce at the output level where MR=MC.
->MR=MC=AR=AC

Meaning of allocative efficiency:

Refers to making the best use of an economy’s scarce resources thereby ensuring the
maximum possible ratio of natural output to total factor inputs, thereby minimizing/eliminating
resource waste.
-> Occurs when P=MC (the price that consumers are willing and able to pay matches that of
the producers) or MSB = MSC, generating maximised social surplus
-> Allocative efficiency occurs when the perfectly competitive firms produce Q* units of
output, where P=MC=MR=LRAC
- profit maximization (MC=MR)
- Allocative efficiency (P=MC)
- Cost minimization (MC=LRAC)
Therefore, firms competing in perfectly competitive markets are unique in being able to profit
maximize without compromising allocative efficiency.
This is arguably the most socially desirable outcome as individuals can consume goods and
services at the firms’ cost of production (which makes allowances for earning normal profit).
In the long run, this means that firms in perfect competition sell their goods and services at a
profit (=opportunity cost).
-> Productive efficiency in the LR (this occurs when the output level where average costs
are minimized, where MC=AC. Hence there is no wastage or unemployment of scarce
resources)
Key advantage:
- economic efficiency where firms are allocatively efficient in both SR and LR, while
productive efficiency in LR
- Healthy competition can ensure consumers get the right products at the right price in
an efficient way
Limitations
- Few industries, if any, actually fit the model in the real world. For instance, branding
means that most products are heterogeneous in reality and it is not possible for
consumers to have perfect information about all prices for all products.

Monopoly
The monopolist has significant market power as it controls enough of the market supply so
can charge higher prices. -> Price maker
Profit maximising point: MC=MR
-> If this firm were to produce less than Qpm (MR > MC), while it may still earn a profit, it
would have forgone the sale of goods or services. In other words, the firm would have
accumulated greater economic profit from the sale of these units.
-> If this firm were to produce more than Qpm, it would be producing units where the MC >
MR. >>> loss
As the monopolist enjoys market power, its price is set higher than the marginal costs of
production (P=AR>MC), enabling the firm to enjoy abnormal profit.
Unlike firms operating in perfect competition, firms operating in imperfect competition face a
downward sloping demand (D=AR) curve.
AR = D as it is assumed there is a single supplier, that is, the firm is the industry. The AR = D
curve is downward sloping because the monopolist must reduce price in order to sell more
output. The gradient of the linear MR curve is twice that of the linear AR curve, because for
the AR to fall continually, the MR must fall at a faster rate.

Profit maximizing monopolist will supply when MR=MC, at Qpm and charge a price of Ppm,
while average costs are AC1. As the firms’ AR > MC at this level of output, abnormal profit is
earned (as shown by the red shaded area).

PED will change along a linear demand curve.

MR = 0 at the midpoint of the AR curve for the monopolist. To the left of the mid-point of the
AR curve, demand is relatively price elastic. The monopolist will not ordinarily choose to
operate on the inelastic half of its AR curve because MR will be negative. Profits can not be
maximized when MR < 0.

A monopolist might earn only normal profit in the short run (occurs when AC=P). This could
happen if the monopolist reduces price as a deliberate deterrent to potential entrants to the
market. However, as the monopolist does not face any real competition, it is rational to
assume the profit maximizing monopolist will raise its price above above its average cost of
production in the long run, so that P=AR>MC, and AR > AC.

Monopolist may also make a loss if AC>P in SR. In LR, it would suggest that the monopolist
is not covering its implicit costs, meaning that it could make more profit by pursuing the next
best alternative forgone - making it irrational to stay in this market in the LR.

Allocative inefficiency (market failure) and welfare loss in a monopoly

Disadvantages:
-> Not reaching productive efficiency (AC = MC). A profit maximising monopoly lacks
incentives to operate at the lowest point on its AC curve. Instead, the rational supply
maximizing monopolist will limit market supply (to Qpm), enabling it to charge a higher price
(Pm) than would be the case in perfectly competitive markets (Ppc).

-> Not reaching allocative efficiency (AR = MC). Owing to the lack of competition, P>MC.
For a perfectly competitive firm, the output would be higher at Qpc and price would be lower
at Ppc. The resulting welfare loss (combined loss of consumer and producer surplus) is
shown by the red shaded area. >>> At the profit maximizing output (Qpm), consumers pay
more for a lower amount of output. This is not a socially desirable outcome owing to
restricted output and higher price in comparison with perfect competition.

Advantages:
- As a monopolist controls the market supply, it can achieve high economies of
scale. -> sell large quantities and at lower average prices. (applicable to natural
monopoly) A monopolist, rather than many small but highly competitive firms, is more
likely to have the financial ability to fund research and development (R&D) from
its economic profits. R&D helps to create new innovations (new commercially
viable plans, products and processes), thus improving the production capacity
and international competitiveness of the economy.

Natural monopoly
: occurs when the market can sustain only one firm in a profitable way.
- Tends to exist when the industry can tolerate only one supplier in order to avoid
wasteful competition and to maximize the economies of scale to operate in a
sustainable way
- Because such industries have high set-up costs, fixed costs and sunk costs
(irreversible costs upon exit of the industry), which need to be covered by sufficient
revenues to ensure supply of the good or service. >> meaning that one provider
would need all of the volume to achieve such economies of scale
Eg.postal services, gas pipes, telephone lines, electricity cables and railway tracks
- Trying to artificially increase competition in such industries actually creates a
potential loss of efficiency as new entrants would mean a wasteful deplication of
scarce resources
eg.MTR, significant LRAC exist >> high fixed and sunk costs that are involved with building
an underground railway network. It is only after a considerable quantity of consumers that
economies of scale (Q1) can begin to be enjoyed. If another firm was to enter the industry
and compete, MTR’s demand curve would shift inwards from AR=D1 to AR=D2, and it would
no longer have enough commuters to cover its LRAC. >> Only sustainable for one firm to
operate profitably in this market.

Monopolistic competition
:market structure where there are many firms but each firm has only a small degree of
market power. >>> able to earn some economic profit, although it is also possible for firms in
monopolistic competition to earn normal profit or losses (in the short run).
- Firms operating in monopolistic competition have less market power due to many
substitutes being available >> face a more price elastic demand curve compared
with firms operating in monopoly industries.
SR:

As a profit maximizer, the firm operates at the output level (Q*) where MC=MR. Its price (P*)
at this level of output is greater than the average cost of production (AR = P>AC), so the firm
earns abnormal profit as shown by the shaded area.

However, in the long run, the absence of barriers to entry mean that more firms enter the
contestable maret, attracted by the prospect of earning economic profit. >> reduces the
market price until AR = P = Ac, thereby reverting all firms to a position of normal profit.
The firm could be in a loss-making position in the short run (AC > P). Losses will cause firms
to exit the industry, thereby reducing the market supply and raising the market price until AR
= P = AC. This means the industry will revert to a position of normal profit in the long run.

LR:

The existence of free entry to and exit from the industry means firms in monopolistic
competition will earn zero economic profit in the long run. They still remain in the industry
because if firms are achieving normal profit (AR=P=AC) then they are making the same
amount of profit as they could in their next best alternative.
- The demand curve (D=AR) and marginal revenue curve (MR) are now more price
elastic owing to the presence of more firms in the market (due to a greater
substitution effect). This is also because these firms have less market power due
to the availability of many substitutes.

Monopolistic competition and allocative efficiency

- Not allocative efficiency (MC = AR) in short run and long run >> effectively gaining
consumer surplus thereby making consumers worse off.
- The monopolistically competitive firm does not operate at the lowest point on its AC
curve because there are limited opportunities to exploit economies of scale. This
means they struggle to get the demand needed to achieve these cost savings. >>
consumers are deprived (剥夺) of enjoying a larger volume of output at a lower
average price.
- Can also occur owing to the vast degree of choice that consumers have. Competition
can be wasteful, such as advertising clutter and junk mail. Receiving too much
marketing information from competing firms in the same industry can cause
information overload or misinformation >> market failures
- Price maker >> (P>MC) >> suggests that the firm could operate at a larger scale, up
to the point where P=MC thereby maximizing efficiency gains. Nevertheless, the
monopolistically competitive firm faces far more rivalry than in oligopoly or monopoly
markets so is less inefficient. Also, because there are many firms in monopolistic
competition, consumers could benefit from more product variety. Eg.many shopping
malls have a large range of restaurants operating in a ‘food hall’ area of the shopping
place. The vendors sell a variety of different products, creating more choice for
consumers.
 - Some firms might differentiate themselves by focusing on the quality of service (the
level of customer service), giving hairdressers… retailers a competitive advantage
over their rivals. Similarly, providing good after-sales care (售后) can also create
competitive advantages for monopolistically competitive firms, such as guarantees,
technical support and delivery services.

Advantages of large firms having significant market power

1. Economies of scale refer to cost-saving benefits from lower average costs of
production brought about by an increase in volume of production. >> Long run
concept, because to increase the scale of production a firm must be able to
increase all of its factors of production (in short turn there must be at least one
variable cost).
- When a firm grows in size, it will be able to enjoy cost savings that smaller
firms may not be able to achieve. Some of these cost savings are due to the
firm itself growing in size (internal economies of scale) and some are due to
the industry growing in size (external economies of scale).
- LRAX is ‘U’ shaped owing to economies and diseconomies of scale. >> the
lowest point on the LRAC curve represents maximum efficiency, known as the
minimum efficient scale of production.

Internal economies of scale are lower average costs brought about by an increase in the
firm itself. Factors that give rise to internal economies of scale include:

1. Specialization (managerial economies of scale)

Specialized labour are highly productive in the output of goods and services >> more
efficiency to coordinate factors of production
Carry out division of labour >> increases productivity
-> thus helping to reduce average costs of production.

2.Efficiency (technical economies of scale)

Specialized machinery, equipment and tools can be used to their full potential to raise output
(eg.car manufacturing/production of ball bearings), again helping to reduce the average
costs of production.

3.Marketing (marketing economies of scale)

- Large firms enjoy discounts in buying raw materials in bulk
 - Effective advertising and branding help to boost sales, so firms are able to produce
on a larger scale. eg. Nike and McDonald’s are able to market their brands to a
global audience, thus reducing their marketing costs per unit of sales.

4.Purchasing (purchasing economies of scale)

Large plants/factories can function efficiently only if large volumes of output are generated,
such as mass-produced cars, soft drinks, canned products, cigarettes, bottled
water/smarphones. By contrast, highly differentiated/unique output, such as wedding
dresses, have higher costs of production.

5.Financial economies
- Easy access to bank credit as better known/adequate collateral >> lower interest rate
>> a large firms

6.Research and Development

- Afford to spend large sums on R&D >> new production techniques >> raise
productivity/efficiency >> lower AC

External economies of scale are the cost-saving benefits from lower average
costs/production brought about by an increase in the size of the industry in which the firm
operates. >> typically enjoyed by all firms in the industry

1.Lower recruitment costs

If the industry that the firm is operating in is large, it is likely to have a large pool of qualified
employees.
eg. Singapore is a global financial hub, and many experienced and qualified finance
professionals live and work there, making Singapore a cost-effective and time-efficient place
for firms to recruit staff.
eg. Silicon Valley, is the global centre that hosts major high-technology, innovation and social
media companies. >> helps to attract highly skilled and suitable workers to the area, helping
firms in the San Francisco Bay area to reduce their recruitment and search costs.

2.Ancillary services
Refers to the services provided by other firms that support an industry eg.legal, financial,
courier (快递) and shipping services. If the industry that a firm operates in is large, then it is
likely that these ancillary services will already exist and be located relatively close to that
firm. The competition between these firms helps to keep their prices lower and results in
lower average costs for all firms in the area.

Diseconomies of scale are increasing average costs of production caused by an increase

in the scale of production.
- Occur when a firm is too large to manage efficiently so its unit costs begin to increase

Internal economies of scale

- Managerial diseconomies: Caused by problems of coordination, control and
communication within a firm as it grows in size (managerial diseconomies) >>
efficiency decrease >> AC increase
 - Eg.as firms get larger, managers find it more difficult to coordinate, control and
communicate with a larger workforce >> resulting in higher unit costs
- Marketing diseconomies: output expands >> market become saturated >> much
more difficult and costly to increase sales >> extra expenses to open new markets or
to promote sales >> bids up wages and prices of resources >> AC increase
- Financial diseconomies: need more loans >> As the firm might borrow large debt,
banks are not willing to lend (as risk increase)/ interest rate increase for extra loans
>> Ac increase

External economies of scale

- Eg.traffic congestion
- Causing an increase in the average costs of production for all firms in the industry.
- Higher rental costs due to the high demand for firms locating in a certain area can
also be seen in larger and growing markets
- Labour shortages in a particular area can lead to increased labour costs, especially if
the industry is growing rapidly

Internal economies of scale >> movement fown the LRAC curve

External economies of scale >> downwards shift of the whole LRAC curve

Abnormal profits
- Help to finance investments in research and development (R&S) and, hence,
innovation
- As a monopolist controls the market supply >> huge economies of scale >> sell
larger quantities and at lower average prices
- While a perfectly competitive firm might be allocatively efficient, it is unlikely to be
able to achieve the minimum efficient scale as its demand will not be sufficient to
exploit economies of scale. >> profit maximizing price in monopoly may be lower
than in long run perfect competition.
- More likely to have financial ability to finance R&D from its economic profits. R&D
helps to create new innovations (new commercially viable plans, products and
processes), thus improving the production capacity and international
competitiveness of the economy.
- Perfectly competitive firms are unlikely to achieve the economic profits needed in the
long run to be able to invest in the R&D needed to create innovative products.

Risks in markets dominated by one or a few very large firms

1.Risks in terms of output
- A lack of competition means that profit maximizing monopolists are likely to supply
less output than the social optimum (allocative inefficiency). >> welfare loss for
society due to the under-provision and under-consumption of the product. >> market
failure
- eg.OPEC (world’s largest cartel) deliberately limits the supply of petroleum in order to
have control in the market
2.Risks in terms of price
 - Able to use price discrimination >> charge different customers different prices for
essentially the same product owing to differences in their PED for the good/service.
>> enables a dominant firm to extract consumer surplus, leaving these consumers
worse off
- Anti-competitive practices >> firms that enjoy a monopoly (not a natural monopoly)
will often purposefully act in ways that will maintain the monopoly, including the
manipulation of market prices such as anti-competitive pricing strategies to prevent
potential entrants from joining the market
3.Risks in terms of consumer choice
- Lack of competition >> lack of incentive for a firm to innovate and to provide choice
for consumers. While a firm may wish to release new products to induce its
customers to buy more, this is more likely to occur in highly competitive markets.
- Eg. smartphone industry, where society would have much less choice of
smartphones had there been only one supplier in the market.
- Barriers to entry deliberately set up by the dominant firms, such as marketing
campaigns to build brand loyalty, also limit the market offering consumers a wider
choice.

-> consumer choice is not only limited in highly imperfectly competitive markets, but
imperfect knowledge can also lead to consumers making irrational decisions and cause
disincentives for firms to be innovative (due to the absence of competition)

Adv. Disadv.

Monopoly Cost differences - may Against public interest:

achieve EOS >> with lower
MC >> it can change lower 1. Produces at the output
price at higher output level level where there is neither
(abnormal profit & long productive efficiency nor
term) allocative efficiency in the
LR and SR >> existence of
welfare loss

2. Charge a higher price for

a lower output level

3. Exercise anti-competitive
behaviour to keep their
monopoly power

Have higher levels of Lack of competition

investments for R&D - may -> less incentive to keep
earn abnormal profit >> can cost low
fund R&D >> In LR, -> Diseconomies of scale
consumers may enjoy >> higher costs arise (due to
products of better quality poor management, poorly
and have more choices motivated workforce, lack of
innovation, use of new
technologies)
 Perfect competition May not achieve both
efficiencies in the SR, yet at
least it can achieve in the
LR

Government intervention in response to abuse of significant market power

1. Legislation and regulation
- Used to control firms with significant market power
- Clear guidelines set by governments to regulate the operations of firms with
monopoly power eg. European Competition Law prohibits anti-competitive acts and
the abuse of monopoly power.
- Regulators are able to use significant powers to prevent, warn or penalize firms that
abuse their power and treat customers unfairly.
Examples include:
- The prevention of mergers - If a gov’t believes that a merger between 2 very large
firms in an industry can lead to socially undesirable market dominance, they can
block (prevent) the merger from taking place. Eg.the Competition and Markets
Authority in the UK blocked the merger of 2 large supermarkets, Asda and Tesco, in
2019
- Promoting competition - a gov’t may also look for ways to promote competition in
an oligopolistic market. Strategies can centre around the removal of barriers to entry
(overly bureaucratic and legal barriers). Gov’t can also give tax breaks or free advice
for firms wishing to join an industry to make it more contestable.
- Forced pricing strategies - force a monopoly to sell at a predetermined price such
as its marginal cost (P=AR=MC) or at its average cost (P=AR=AC) >> allocative
efficiency
- Sale of existing assets - When a firm become too large and market becomes
uncompetitive >> gov’t insist the monopolist sells part of the firm or demerges
-> whether the gov’t decides to break up a firm with significant market power depends on the
perception/evidence of whether they are acting in the interest of the public (society as a
whole).

2. Government ownership
- Ensure the business is not run primarily for profit, but to provide an important service
to the general public. >> Nationalization - purchase of privately owned
assets/industries by the government. Usually occurs when the gov’t takes control of
an industry previously in the private sector in order to run it in the best interest of the
public.
- Prevent the potential exploitation of firms with significant monopoly power >> gov’t
will purchase the firm/industry at a predetermined market rate >> costly >> incur an
opportunity cost in purchasing the private monopoly & invest resources in running the
industry
3. Fines
- Financial penalties issued by governments for law infringements. >> potentially large
increase in the AC of the firm >> easier for new entrants to join the market and
compete with the monopolist because
- Damage the brand reputation of the firm >> lead to improved competition in the
market
- eg.In 2019, Google was fined $1.66bn by the European Commission for antitrust
laws relating to advertising. >> firms can be coupled with lengthy jail terms for
executives at firms caught breaking competition laws

Market failure
:arises when the free market forces, using price machanism, fail to allocate scarce resources
efficiently, meaning either too much/not enough of a good/service is produced
-> suboptimal resource allocation (allocative inefficiency)

Merit goods
:Consumption of this good is very beneficial to society
- And is underconsumed/underproduced
- Could be provided by 2 market but
- consumers may not >> be able to afford
>> feel the need to buy
- Consumption -> positive externalities
- May be limited in supply -> may be a high opportunity cost
- Rival in use - consumption reduces availability for others (need to compete)
- Excludable - limited on it to those are consuming
1.To encourage consumption so that positive externalities of merit goods can be
achieved
2.To overcome the information failures linked to merit goods
3.On grounds of equity - gov’t believe that consumption should NOT be based solely
on the grounds of ability to pay for a good or service

Public goods
:One person’s use does not diminish the use by others
-> no need to compete
-> implies MC of an extra user = ZERO
-> can be concurrently consumed
Eg.national defence, street lights
-> Non-rivalous - a person’s consumption of a public good does not limit the benefits
available to other people.
-> Non-excludable - Firms cannot exclude people from the benefits of consumption, even if
they do not pay. This means that non-payers can enjoy the benefits of consumption at no
direct financial cost to them.

Free-Rider Problem
Non-excludability >> profit-maximizing firms in the private sector do not have any incentive
to provide public goods >> under-provided, if at all, in a free market >> can be consumed at
zero marginal cost >> no incentives for the private sector to provide public goods >> market
demand for a public good does not actually exist >> the supply of a public good will be
significantly below the social optimum level level - if exist >> market failure
- Free-riders take advantage of the public goods/services provided by the gov’t without
directly contributing to such provision

Problem:
- underproduction/overconsumption of a public good/service >> highly inefficient >>
lead to the tragedy of the commons, resulting in their destruction or even extinction
eg.public beaches being destroyed by the growing # of tourists
- Free-riders do not consider the external costs of their activities eg.litter and plastic
wastes left in public parks and on public beaches, possibly causing damage to the
natural environment and ecosystems

Gov’t provision -> Public good

- Help to prevent the under-provision and under-consumption of public goods, thereby
improving social welfare
- Funding of public goods comes from gov’t in 2 ways: directly provide these / pay a
third-party contractor to do so

Advantages Disadvantages

Public goods would be available The cost to finance such expenditure, which
ultimately is passed on to taxpayer

Enables large-scale operations, so the gov’t Opportunity cost

benefits from economies of scale and
efficiency gains

Potential gov’t failure from intervening in

markets because gov’t do not necessarily
know what is best for individuals and the
societies

Contracting out
Approach to gov’t intervention in response to public goods by paying a specialized
third-party firm with the expertise to provide a public good, such as refuse collection
services.

Eg.public firework displays, highway maintenance services

Privatization of public goods is possible:

- Can be produced by private firms
- Not necessarily by the gov’t
- Not really an example of market failure if..
-> firms can find some price arrangements to reduce pricing costs
-> Efficiency can still be attained
Forcing consumers to pay for public good:
- First degree price discrimination
 - Lump sum fee payment

Demerit good
:goods which society considers harmful/undesirable and over-consumed/over-produced
- Consumption -> negative externalities

Common pool resources

- Non-excludable - not possible to prevent those who are unwilling or unable to pay
from benefiting once the resource is provided >> Free-Riders
- Rivalrous - the usage of a resource reduces the amount that is available for others
to use
- Tragedy of the commons >> degradation, depletion or destruction of a common
access resource caused by the problems of overuse and over-consumption.
- Commercial fishing -> firms face the temptation to catch as many fish as possible
(even overfish), because if they do not, rival firms will. >> leads to fish stocks being
depleted beyond their sustainable level, even though no single firm may have
intended to do so. >> over-grazing/over-harvesting of a particular common pool
resource. >> absence of a price mechanism means the market fails to allocate
scarce resources in an efficient manner.
- Unsustainable production and negative externalities of production and consumption
(ie.damaging impact to societies and economies from deforestation, overfishing,
congestion, pollution, soil erosion, destruction of natural habitats and climate change)

Tragedy of common access resources

-> Sustainability (future generations) >> refers to maintaining the ability of the environment
and the economy to continue to produce and satisfy needs and wants into the future;
sustainability depends crucially on preservation of the environment over time

eg.When factors/homes/cars use fossil fuels

-> emit pollutants into the atmosphere or into oceans, rivers, and lakes
-> ie.they ‘overuse’ a portion of these natural resources without paying for them but ‘leave’
something bad behind

eg.In the finishing industry, when fish are over caught

-> an excessive amount of the global stock of fish is used up
-> disrupts the ecosystem

eg.In the lumber industry, forests are cleared for agricultural products or for the sale of
timber
-> loss of biodiversity
-> threats to wildlife
-> threat to the ozone layer

Gov’t intervention

Adv. Disadv.
Indirect tax - Increases P >> decrease the - Demand for these products
Qd tend to be price inelastic >>
- Creates tax revenue for the little impact on the level of
gov’t >> used to raise public consumption/production
funds to deal with the external - Economists assumes that gov’t
costs of negative externalities have full information about the
or to fund other interventionist amount of negative externality,
measures which is not possible in real life
Eg : amount of tax rate ≠
- providing subsidies for firms to external cost created
adopt green technologies Over-tax (gov’t failure):
- to fund/subsidize alternative - Encourage smuggling and
policies unofficial market activities,
- for advertisement creating a parallel market for
- Fund de-addiction companies demerit goods >> cost for
policing (gov’t loses tax
revenue) & low quality of
products >> greater market
failure
- Tax is regressive >> greater
impact on low-income earners
than high-income earners
Under-tax:
- Not fully internalising the
externality and failing to solve
market failure
Macro:
- Promote more income
inequality in the society
(undesirable)

Carbon taxes - Impose additional costs to - Establishing the correct tax rate
Imposes the users of carbon fuels >> users >> effectiveness
tax on carbon pay for the environmental and Eg. Tax rate too low >> firms continue
emissions climate change caused by their to pollute
economic activities Tax rate too high >> escalated
- An effective carbon tax can costs negatively affect profits,
make it economically unemployment and consumers.
rewarding for firms to switch to - Effectiveness >> Depends on
alternative (non-carbon) fuels, the extent to which firms are
green technologies and energy able to on higher costs to their
efficient production. customers
- Simple and impartial >> highly Eg. If price inelastic demand,
effective customers less sensitive to price
change, firms charge higher price,
consumers bear a higher tax burden
- Recessive tax >> account for a
larger proportion of the income
of poorer households
- Higher income households are
in a better financial position to
switch to using more
energy-efficient technologies
Legislation - Non-market based approach - Costly (administration cost
(laws to tackle Command: ie.enforcement and monitoring
imperfect - Bans of the policy)
information - Limits Setting the right regulation:
and on the use - Caps Too strict
of scarce - Compulsory On producers:
resources) & - Innovative regulations - Increase cost significantly for
Regulation Control: firms / reduce profits so much
(monitoring - Strong enforcement & that firms may leave the
and controlling punishments country and operate elsewhere
the activity of - Incentive to change behaviour where regulations are not so
firms) in the LR strict
- Allocative efficiency & welfare - Reduce production >>
MPB -> MSB gain Unemployment
because - Shut down
smokers On consumers:
derive less - Underground (illegal) markets
pleasure from to develop where the demerit
smoking due good/service can be
to smoking purchased, often at a very high
bans price >> more policing
necessary for the gov’t & less
tax revenue
- Unless the penalties are
extremely high and consistency
enforced, people may choose
to break the rules and
regulations eg.under-age
smoking, drinking and gambling
Too lack:
- Fail to solve market failure

- Forcement and lack of liberty

Education - - Behaviour and consumption - Not effective >> do not

awareness patterns of individuals and necessarily work in changing
creation firms change >> there is a rise people’s social behaviours
in the consumption of merit - Take a long time to educate
Influencing goods and a fall in the people and for the advertised
consumers’ production of demerit goods message to be accepted and
behaviour Eg. people learn about the dangers of acted upon.
smoking/gambling, so fewer people - Opportunity cost of gov’t
smoke or go to casinos expenditure on education and
awareness creation. >> Money
- Successful advertising may could have spent on something
lead to a cultural change in more beneficial to society
Healthier
behaviour >> healthier diets, - Arguments regarding taxation
people >>
increase use of electric cars, and regulation being more
fewer
recycling, waste reduction and effective than spending time
absences from
the use of renewable energies and resources to education
work and
people to reduce their
school, with
consumption of demerit goods
external
benefits to
society and
the economy
as a whole

Deadweight
loss >> costs
for funding
education and
awareness
creation, does
not translate to
consumer/prod
ucer surplus +
administrative
costs
associated
with the
provision of
education

Tradable - Gov’t revenue increases from - Anti-competitive (against

Permits 0Q1AQe to 0P2BQe smaller firms) and they can
(cap&traded - Tradable permit schemes cause job losses (due to higher
schemes) - mean that the largest polluters costs of production)
gov’t-regulated have to purchase more permits - In a more globalized world,
emissions >> increases their cost of multinational companies can
trading production >> less competitive shift production to other
scheme that and less profitable countries to avoid the
limit pollution - The more environmentally constraints of pollution permits
in an industry friendly producers can gain and CATS
to a more extra revenue from selling their - Higher prices of tradable
socially surplus permits >> more permits have proved ineffective
efficient level. competitive and more in reducing carbon dioxide
Efficient firms profitable emissions to levels necessary
can sell any - Create an incentive for firms to to stop global warming and
excess permits develop greener or clearer climate change, especially as
that they do technologies in the LR >> fall the demand for pollution
not need to in the demand for and supply permits is highly price inelastic
use. of pollution permits. (gov’t revenue from the sale of
Aims to - Over time, the gov’t may permits also increases from
regulate choose to reduce the # of P1Q1 to P2Q2 due to the
economic pollution permits >> shifting relatively price inelastic
activity to supply of carbon emissions demand for pollution permits.
prevent from S1 -> S2 >> raises the - Cap is often deemed too high -
dangerous market price of pollution China’s national cap and trade
climate permits from P1 -> P2, programme eg.sets the limit up
change. creating a greater incentive for to 5 billion tons of carbon
firms to be more efficient and emission >> does little to
invest in clean technologies combat the underlying problem
of pollution and climate change

With economic
growth and
higher for
goods/services
, the demand
for pollution
permits can
also increase
but the cap on
pollution
creates higher
prices for
tradable
permit.
-
No change in
the Qs as the
gov’t has fixed
the # of
pollution
permits for the
industry.

International - The Kyoto Protocal >> - Require full commitment >>

agreement recognizes that individual high-income countries and
countries have different large multinational companies
Covering resources and abilities to deal have been known to
areas of with global warming and deliberately exploit low-income
environmental climate change >> countries despite national and
governance high-income countries are international environmental
eg.freshwater more obligated to do their part laws and agreements
resources, in reducing global emissions of - The failure (unwillingness) of
hazardous greenhouse gases, especially high-income countries
substances, as they are historically
global marine responsible for contributing to
environments most of the greenhouse gases
in the atmosphere today.

Collective
self-governan
ce
- refers to
voluntary
communal
actions to
combat the
problems of
negative
externalities
and the
problems
associated
with the
exploitation of
common pool
resources
Subsidies - Increase in consumer surplus - Deadweight loss >> cost of
and producer surplus funding the subsidy does not
- -> the subsidy provides an equate to additional producer or
incentive for more people to consumer surplus/administritive
consume the good >> Qm -> costs associated with the
Qopt >> reducing congestion provision of subsidies, the
on roads subsidy creates market
- Subsidizing consumers to inefficiencies
switch to less damaging or - It is difficult to set a precise
polluting activities subsidy that ensures an optimal
- Providing funding for clean allocation of resources
technologies to create (eg.merit goods)
incentives for firms to adopt - The social return on the
green technologies production and consumption of
- Subsidies to provide free merit goods is difficult, if not
drinking water in shopping subjective, to measure
malls and other public places - If the PED for the good or
to discourage the overuse of service is inelastic, the lower
single-use plastic bottles price (due to the subsidy) has
little impact on the Qd
- Opportunity cost to the
provision of subsidies >> could
have been used for other gov’t
projects that may reap greater
social gains

Gov’t - Merit goods and public goods - Economic inefficiency >>

provision become accessible to encourage consumption
everyone, regardless of their beyond the socially optimum
income or social status >> level because people do not
helps to improve the economic have to pay for these >> likely
well-being of society as a to overuse the services
whole - Opportunity cost >> money
could have spent on something
else eg.paying off gov’t debt /
lowering tax rate
- Issues of inequality >> In the
case of a shortage of supply
due to excess demand for the
good/service provided by the
gov’t, it can be difficult to
decide who should be able to
take adv. of the free/subsidized
product

Price floor - Price inelastic demand

The fall in Qd will fall proportionately
less than the rise in P, so we might not
see enough fall in Qd to solve market
externalities (not reaching social
optimum level of output)

However, if demand is really price

inelastic, producers will possibly see a
 rise in their sales revenue. They may
actually gain from it instead of
suffering.

If minimum price set too high:

- Regressive
Cast a larger effect on the low-income
consumers, increase in income
inequality (macro-objective)
- Black Markets
Find alternative supply in the black
market >> low quality of goods >> they
could even find worsen and cheaper
demerit goods (eg.alcoholic drinks) >>
potentially making the market failure
worse / Smuggling from other countries
such as England (in the case of
Scotland)

If set too low:

Quantity in the market may not reduce
to the socially optimum level >> fail to
internalise the externality

Firms:
Unintended consequences to gov’t
failure:
- They might leave the country /
Shut down

Price ceiling - Shortage (inefficiency in the

> promoting market) : people who are able
equity, to find goods at Pmax have no
encourage problem, but for people who are
consumption willing and able to buy at Pmax
of goods but are not geting the resource
because of shortage >> pure
government failure
- Black market >> consumers
are likely to be exploited by
sellers in the black market.
(price? Quality?)
- Price being lower than
equilibrium price may also
affect the quality of the good
- Enforcement : monitoring
whether producers are not
privately charging a price
beyond Pmax (eg.Berlin)
- Pmax setting at the right
level?
- Cost : If they want to solve
excess demand, they might
subsidize or direct provision to
 solve their own gov’t failure

Strengths and limitations of gov’t policies

- Challenges involved in measurement of externalities
- Degree of effectiveness
- Assumptions made in economic are not always applicable in real life
Eg.the global decrease in the # of smokers is partly due to several
interrelated factors -> laws banning smoking in public areas
-> health initiatives established by the gov’t
-> major retailers opting to stop selling cigarettes (as part of their
own corporate social responsibility)
-> anti-smoking advertisements in the mass media
-> pressure group activities from organizations such as Action on
Smoking and Health, publicizing the risks associated with tobacco smoking and
campaigning for greater restriction on cigarette and tobacco sales
-> growing education and awareness creation about the dangers
and financial costs of smoking
- Limited by time lags (eg.education & awareness creation) and the costs of
enforcement (eg.fining people who litter) or cost of gov’t provision (eg.public
healthcare services)
- Consequences for stakeholders
- large multinational companies can exploit their market power by relocating
to low-income countries where legal limits on pollution are not imposed or controlled and
monitored same extent
- Gov’t legislation and regulations such as environmental standards tend to
favour large multinational companies that have the financial resources to comply, whereas
smaller firms that face higher cost of compliance may struggle to survive. Eg.larger firms
with greener and cleaner technologies are more likely to be able to operate within their
pollution permits and sell excess rights to smaller and less-efficient rival firms.
- Indirect taxes are regressive, so have a larger impact on low-income
earners and large firms with strong market share can afford to continue burdening
other stakeholders (third parties). Their low income and PED mean gov’t
interventionist policies have minimal impact on their spending behaviour.

Importance of international cooperation (common access resource)

To deal with the limitations of gov’t policies
- Eg.policy responses to the threat to sustainability are limited by the global existence
of the lack ownership of common pool resources eg.fishing in international water
- Also vital owing to the escalating global demand scarce resources eg.non-renewable
fossil fuels, due to higher levels of economic activity and globalization

Global nature of sustainability issues:

- Governments are placing equal emphasis on the planet and people, not just profits
- eg.Sustainble Development Goals (SDG) of the United Nation’s Development
Programme (UNDP)
 - The SDGs address global challenges to sustainability, which are largely caused by
market failures and negative externalities, including issues related to poverty,
healthcare, education, infrastructure, inequalities, climate change and environmental
degradation, and human rights.

Practice questions
1.Evaluate the use of carbon taxes to reduce threats to sustainability [15]

Negative externalities of production is the negative spillover effect caused by the production
of goods or services cast on third parties, thus considered harmful to the society. It is
over-allocated and over-produced, causing market inefficiencies and welfare loss in the
market. Carbon emissions in this case demonstrates the concept of negative externalities of
production. Since the release of carbon dioxide harms the environment and causes climate
change, further affecting the whole society.

Sustainability is the concept referring to maintaining the ability of the environment and the
economy to continue to produce and satisfy needs and wants into the future; sustainability
depends crucially on preservation of the environment over time.
Carbon tax is a type of indirect tax imposed by the government on carbon emission
produced from industrial productions by increase the cost of production, thus encouraging
firms to seek for a more sustainable and eco-friendly production method. An example of
carbon tax in real life would be UK’s carbon tax set by the UK Emissions Trading Scheme
(ETS) authority.

[Diagram for negative externalities of production]

Real life example

UK setting a 52.56 euro carbon tax

Evaluation

For:1.An effective carbon tax can make it economically rewarding for firms to switch to
alternative (non-carbon) fuels, green technologies and energy efficient production.
Against: Effectiveness >> Depends on the extent to which firms are able to transport higher
costs to their customers
Eg. If price inelastic demand, customers less sensitive to price change, firms charge higher
price, consumers bear a higher tax burden
Recessive tax >> account for a larger proportion of the income of poorer households

- Higher income households are in a better financial position to switch to using more
energy-efficient technologies

For:generates tax revenue

“using 33 per cent of revenues for energy efficiency can ensure fuel-poor households are not
adversely affected by carbon taxation;” -> increase investment in developing sustainable

2.Simple and impartial >> highly effective

- Establishing the correct tax rate >> effectiveness

Eg. Tax rate too low >> firms continue to pollute
Tax rate too high >> escalated costs negatively affect profits, unemployment and
consumers.

2.Evaluate the effectiveness of price floors in achieving a reduction in the consumption of

demerit goods [15]

Negative externalities of consumption refers to the negative spillover effect to third parties in
the society due to the over-consumption of demerit goods (goods that are consider harmful
to the society), hence causing welfare loss and allocative inefficiency.

Price floor is a type of government intervention that prevent the market price of goods and
services from being too low by setting a minimum price above the equilibrium price. It is
used mostly to either force firms to increase their market price to decrease the consumption
of demerit goods or to make sure the …

Real-life example:
Scotland setting a 0.50 euro per unit of alcohol (which is 10ml of ethanol per unit)
Evaluation
1. For: “if the external cost of an additional drink is at least moderately higher for heavy
compared with lighter drinkers, then a price floor leads to larger welfare gains than a simple
Pigouvian-style tax on ethanol.” - For the case of indirect tax, it is hard for government to set
a tax rate that would completely delete the negative externalities since smokers consumption
are at different levels. There is evidence to suggest that this is true for alcohol, with the
consumption of heavier drinkers being considerably more costly than that of lighter drinkers.
When this is the case, a single tax rate must trade off price rises that are too low for the most
socially costly consumers and too high for others
Against:Due to price inelastic demand, it may actually incentivise producers to produce more
since they may actually gain more profit from the supply of alcohol. -> Doesn’t produce any
tax revenue (gov’t)

For: Data has shown price floor being effective (5% rise in average price, leading to 11%
reduction of average quantity demanded)
Against:

price floor can be a useful policy instrument, particularly when those whose consumption is
the mostly socially costly tend to buy particularly cheap variants and are price sensitive.

3.Evaluate the effectiveness of government regulations in achieving a reduction in the

consumption of demerit goods. [15]

Regulation (monitoring and controlling the activity of firms)

Real-life example
In Hong Kong, indoor areas are restricted to smoke.

Underground (illegal) markets to develop where the demerit good/service can be purchased,
often at a very high price
- Unless the penalties are extremely high and consistency enforced, people may
choose to break the rules and regulations eg.under-age smoking, drinking and
gambling

4.Evaluate the view that the most effective way in which the government can discourage
the consumption of demerits goods is through government regulations [15]
跟上题一样， 但mention some other policy eg.cigarette tax, negative advertising
(anti-smoking campaigns)

5.Evaluate the view that regulations are the most effective government response to the
market failure of negative externalities [15]
Discuss both consumption and production side policies
- Focus on one side, and mention the other side at the end
Con:
- Political pressure
- High cost of monitoring (greater than the reduction in the deadweight loss -> not
worthwhile)
Consumption:cigarettes
Production:Carbon emission

Pros:
- More accountable
Other forms of regulations such as photo on cigarettes pack ->>>> less effective as there is
time lapse (takes time for the regulation to work and to solve the negative externality)

6.Evaluate the view that the market failure caused by the consumption of demerit goods is
best dealt with through the use of taxation. [15] / To what extent might the problem of
negative externalities of consumption be resolved by the use of indirect taxation? [15]
Real-life example:
HK cigarette tax

Pros:
- Increases P >> decrease the Qd
- Creates tax revenue for the gov’t >> used to raise public funds to deal with the
external costs of negative externalities or to fund other interventionist measures
eg.providing subsidies for firms to adopt green technologies/to fund gov’t provision of
merit and public goods/services

Cons:
- Demand for these products tend to be price inelastic >> little impact on the level of
consumption/production
- Tax is regressive >> greater impact on low-income earners than high-income earners
- Encourage smuggling and unofficial market activities, creating a parallel market for
demerit goods
- Amount of tax rate ≠ external cost created

Evaluate three policies that governments might implement to reduce negative externalities
associated with the environment. [15]
Problem: Carbon emissions
3 Policies: Carbon tax, Tradable permit, International agreement (Kyoto Protocal)

7.To what extent is advertising the most effective way of increasing the consumption of merit
goods? [15]

8.Evaluate the policies a government might use to increase the consumption of university
education?

9.Using real-world examples, evaluate different approaches to managing common access

resources. [15]
Conservating natural parks (government legislation & regulations)

10.Discuss the view that the best way to reduce the threat to sustainablity, arising from the
buring of fossil fuels, is for the government to provide subsidies to firms that produce energy
through renewable sources. [15]
- Increase in consumer surplus and producer surplus
- -> the subsidy provides an incentive for more people to consume the good >> Qm ->
Qopt >> reducing congestion on roads
- Subsidizing consumers to switch to less damaging or polluting activities
- Providing funding for clean technologies to create incentives for firms to adopt green
technologies
- Subsidies to provide free drinking water in shopping malls and other public places to
discourage the overuse of single-use plastic bottles

Cons:Deadweight loss >> cost of funding the subsidy does not equate to additional producer
or consumer surplus/administritive costs associated with the provision of subsidies, the
subsidy creates market inefficiencies
 - It is difficult to set a precise subsidy that ensures an optimal allocation of resources
(eg.merit goods)
- The social return on the production and consumption of merit goods is difficult, if not
subjective, to measure
- If the PED for the good or service is inelastic, the lower price (due to the subsidy) has
little impact on the Qd
- Opportunity cost to the provision of subsidies >> could have been used for other
gov’t projects that may reap greater social gains

Other policy: “Windfall profits made by fossil fuel companies should be taxed to pay for
climate damage, according to the UN Secretary General.”

11.Discuss the view that the overuse of common access resources is best addressed by
gov’t [15]

12.Discuss the consequences of the direct provision of public goods by the gov’t [15]
Real-life example:

Public goods would be available The cost to finance such expenditure, which
ultimately is passed on to taxpayer

Enables large-scale operations, so the gov’t Opportunity cost

benefits from economies of scale and
efficiency gains

Potential gov’t failure from intervening in

markets because gov’t do not necessarily
know what is best for individuals and the
societies

13.Discuss whether there should always be direct provision of public goods by the
government [15]
- Economic inefficiency >> encourage consumption beyond the socially optimum level
because people do not have to pay for these >> likely to overuse the services
- Opportunity cost >> money could have spent on something else eg.paying off gov’t
debt / lowering tax rate
- Mention about Contracting out
- Approach to gov’t intervention in response to public goods by paying a specialized
third-party firm with the expertise to provide a public good, such as refuse collection
services. Eg.public firework displays, highway maintenance services

Market Power (HL)

Discuss the view that barriers to entry in a monopoly will always lead to abnormal
profits in the long run. (HL)
[define]
- Market failure
- Monopoly
[diagram]
[Analysis]
- Effectiveness of barriers

- Natural monopoly (if low barriers of entry such as low initial start-up cost)
Eg.for MTR, high start-up cost, EOS, partly owned by the government, franchise)

Monopoly tend to have a high barriers to entry because Branding - a monopoly, especially
one that has operated for a long period of time, has such as large amount of brand
awareness that if a new firm was to enter the industry, it would be very challenging and
expensive for it to advertise enough to compete with the existing brand. Well established
market leaders also enjoy customer and brand loyalty.
- Legal barriers (legal reasons why firms can not enter the market) - there can
be licenses or health and safety requirements. In some cases, the
government grants the right for only one firm to operate in the market, as in
the case of natural monopolists/legal monopolies. Monopolists can also
create artificial barriers to entry by protecting their intellectual property
rights through the use of copyrights, trademarks and patents.eg.gov’t
franchise
- Anti-competitive practices - some monopolies may take measures or
engage in practices that prevent other firms from entering their market.
Eg.the use of limiting price strategy means a monopolist deliberately sets the
price of their good or service below the price at which it would be possible for
a new entrant to sell it. -> reduces the contestability (竞争性）of the
monopoly’s market.
- Domination of resources - where all the resources that are required are
currently being used by the monopolist. Eg.gold or diamond mining in some
countries; all areas that are rich in gold and diamonds have already been
mined or are under the ownership of a dominant firm already, such as De
Beers - the world’s largest diamond exploration company.
- Economies of scale - cost-saving benefits of lower average costs of
production brought about by an increase in the volume of production. There
may not be enough demand in the market for a new firm to achieve the
necessary economies of scale to compete. -> any potential entrants will have
higher costs and not be able to compete with the more efficient monopoly. ->
prevent a firm from joining the market in the first place. The monopolist can
also create barriers to entry by investing in the latest innovations and
technologies. By exploiting (剥削) technical economies of scale, the higher
set-up costs can deter firms from trying to enter the market.
-

1. Discuss how governments restrict monopoly power. (HL)

- AC pricing and MC pricing
-
2. Examine the role of barriers to entry in making monopoly a less desirable
market structure than perfect competition. (HL)
Positive externalities
The positive spillover effect

A type of indirect tax imposed by gov’t on carbon emission produced from industrial
productions by increasing the cost of production thus encouraging firms to seek for a more
sustainable & eco-friendly production method. 52.56

Sustainablity refers to maintaining the ability of the environment and the economy to
continue to produce and satisfy needs and wants into the future; depends crucially on
preservation of the environment over time.

Oligopoly (concentration ratio)

Assumptions of law of demand and supply
Total product, marginal product, average product
Total revenue, marginal revenue, average revenue
Asymmetric information

Oligopoly
Characteristics:
- A few large firms dominating the market
- Sell identical goods (eg.oil) or differentiated goods (eg.fast food)
- Price setters
- High barriers of entry & exit
- Interdependence between firms —— firms will follow the action of the other firms
(eg.cameras on iphone, samsung phones)

Concentration ratio: Market share held by the dominant firms

3-firm concentration ratio -> market share of the 3 largest firms
4-firm concentration ratio -> market share of the 4 largest firms

2 conflicting incentives of ologopolisic firms (because of interdependence):

1.Collusion
- Cartel/Formal Collusion -> firms will sign a formal agreement to sell at a higher price
and restrict output -> increase in joint-profit between firms eg.OPEC
- Price leadership/Informal collusion -> Where the market leader (eg.Adidas, Nike)
increase their price -> smaller players (eg.Converse, New Balance) will follow and
increase the price (but at a smaller percentage)

Collusive firms will behave like a monopoly by selling at a higher price & restrict output =>
consumers are worse off

Diagram same as monopoly (abnormal profit)

Why is it hard to maintain a cartel:

- If theres a lot of firms
- Government regulation
- Firms might cheat
Game Theory
：It is a 2 player matrix showing different strategies that firms can adopt

Non-collusion (wont join together)

: Instead of competing on price, firms will compete on non-price competition
- Loyalty programme eg.Starbucks gold card
- Advertising, sponsorship eg.World Cup
- Service, product features eg.Genius bar, iphone cameras