Section 7-The Price System & The

Micro economy
Chapter 30-Utility
• Utility: is the satisfaction gained from consumption of a product.

• Total utility: is the satisfaction gained from the consumption of all units of a product

over a particular period of time.

• Marginal utility: is the satisfaction gained from one more unit of a product consumed

over a particular period of time.

o Note: Consumers purchase products when P≤MU

• Law of diminishing marginal utility: states that as the quantity consumed of a product

by an individual increases, marginal utility decreases.

o Diminishing marginal utility assumes that consumers are always rational. However, in

some cases like buy 1 get 1 free or when payment can be deferred using credit card,

the consumers may not be rational.

• Equi-marginal principle: Consumers maximize their utility where their marginal valuation

for each product consumed is the same.

Chapter 31-Indifference Curves & Budget Lines

• Budget line - the combinations of 2 products obtainable with income and price

• Marginal rate of substitution: is the quantity of one product an individual is prepared

to give up in order to obtain an additional unit of another leaving the individual at same

utility. It is diminishing.
• Indifference curve: this shows the different combinations of two goods that give a

consumer equal satisfaction. Refer to Equi-marginal principle as well

• Indifference curve

o Higher curves present at higher consumption.

o All curves are downward sloping

o Indifference curves cannot cross

o Indifference curves are convex to the origin

\n

• Substitution/Income effect: is the change in quantity demanded of a product due to

change in relative price/real income.

The budget line will shift when there is:

o A change in the prices of one or both products with nominal income (budget) remaining

the same.

o A change in the level of nominal income with the relative prices of the two products

remaining the same.

 The substitution effect is shown

on the indifference curve (IC) I1. The point moves on the curve from E1 To E2 or vice

versa. This causes the budget line to change from B1 to the dotted budget line. The

income effect causes point to move from E2 to E3 causing a shift in IC from I1 to I2. The

table below shows how price change affects different types of goods.

• Price effect = Substitution effect + Income effect.

• Giffen/Veblen good: are goods whose price and demand are directly related as they

are necessary/luxurious.

PRICE
EFFECTS
Good Demand
Price change Price effect (on demand)
type change
Fall Normal Both effects ↑ Rise
Sub. effect ↑ > In. effect
Fall Inferior Rise
↓
Sub. effect ↑ > In. effect
Fall G/V Fall
↓
Rise Normal Both effects ↓ Fall
Sub. effect ↓ > In. effect
Rise Inferior Fall
↑
 PRICE
EFFECTS
Sub. effect ↓ > In. effect
Rise G/V Rise
↑

Costs
• Production function- this shows the maximum possible output from the given set of

factor inputs.

• Marginal product - the in the change output arising from the use of one or more units of

a FOP

• The minimum efficient scale (MES) is the balance point at which a company can

produce goods at a competitive price.The MES is the point on a company's long-run

average cost curve where economies of scale have been exhausted, and constant

returns have begun.

• Diminishing returns - where the output from an additional unit of input leads to a fall in

the marginal product.

• Fixed costs - those costs that are independent of output in the short run so that is a

straight line and doesn’t change with output.

• Variable costs - those that vary directly with output; all costs are variable in the long run

so the graph is curved and changes with output

• Total cost= total fixed cost + total variable cost. It starts at the fixed cost line and follow

the variable cost line since it the combination of both

• Average fixed cost= total fixed cost / output

• Average variable cost= total variable cost / output

• Average total cost= total cost / output

• Marginal cost= change in cost/change in quantity

• Isoquant: is a curve that shows a particular level of output over a combination of inputs.

It is similar to the indifference curve. Output refers to the total physical product.

The points x, y and z on the graph below shows the same output.

Costs in the short run

Costs in the long run

 LRAC envelope curve

In the LRAC envelope curve

when the curve is sloping down there are increasing economies of scale. The lowest

point on the curve has constant economies and as the curve starts rising there are

decreasing economies of scale present.

Least cost combination:

• (MPP factor A) / (P factor A) = (MPP factor B) / (P factor B)

Profit
 There are 3 types of profit:

• Normal profit- a cost of production that is just sufficient for the firm to keep running in

the same industry

• Subnormal profit- any profit less than the normal profit. If the problem persists then the

firm will leave the industry and go into one that will make a profit. This is where p<ac

• Supernormal profit- is any profit in excess of normal profit. It only exists in the short term

and only for monopolies TR>TC

Revenue
• Total revenue (TR) = price x quantity

• Average revenue (AR)= total revenue / output

Revenue:

• Total revenue (TR) = price x quantity

• Average revenue (AR)= total revenue / output

When TR is maximum, MR is 0

Economies and diseconomies of scale

• Increasing returns to scale- where output increases at a proportionately faster rate than

the increase in factor outputs.

• Decreasing returns to scale- Where factor input increase at a proportionally faster rate

than the increase in output

• Economies of scale - the benefits gained from falling long-run average costs as the

scale of output increases

• External economies of scale: cost saving accruals to all firms in an industry as the scale

increases
• Diseconomies of Scale - where long-run average cost increase as the scale of output

increases

Economies of scale
Internal External
Technical Transport
Financial Concentration
Managerial Knowledge
Marketing Ancillary industries
Purchasing Specialised labour
Risk-bearing Reputation
Increased dimensions
Economies of scope

Diseconomies of scale
Internal External
Lack of communication Competition for inputs
Demotivation Congestion
Alienation Pollution
Slack management (X-inefficiency)
Non-flexibility
Labour disputes & turnover

Types of market structure and their objectives

• Market Structure - the way in which market is organised in terms of the number of firms

and barriers to the entry of new firms

• MNC- A multinational corporation (MNC) is one that has business operations in two or

more countries.
• Industry- group of productive enterprises or organisations that produce or supply goods,

services, or sources of income.

• Barriers to entry- any restriction that prevents new firms from entering an industry.

• Perfect competition an ideal market structure that has many buyers and sellers,

identical or homogeneous products and no barriers to entry

• Monopoly - a pure monopoly is Just 1 firm in an industry with very high barriers of entry.

• Monopolistic competition a market structure where there are many firms, differentiated

product and few barriers to entry

• Oligopoly- a market structure with few firms and high barriers to entry.

• Imperfect competition - any market structure except for perfect competition.

• Types of objectives:

o Different objectives of firm

o Profit maximisation- gain a lot of profits

o Sales revenue maximisation- maximise turnover

o Sales maximisation - maximize volume of sales

o Satisficing - reasonable level of profit

o Loss minimizing

o Ethical objectives
 Perfect Competition
Perfect competition occurs when all companies sell identical products, market share

does not influence price, companies are able to enter or exit without barrier, buyers

have perfect or full information, and companies cannot determine prices.

Characteristics:

• large no. of buyers and sellers have perfect knowledge

• No individual firm has an influence on the market price

• products are homogenous on identical

• Freedom of entry or exit

• All consumers have complete info about the product, prices, means of production
 The graph above is called the

perfect competition model. In the industry in the short run a new firm enters

Monopolistic competition
Characteristics:

• large no of buyers and sellers

• Few barriers to entry and exit

• Consumers have a wide choice of differentiated products

• Firms have some influence on the market price

Barriers to entry and pricing strategy

Barriers to entry:

• Impossible to enter because industry is state owned- natural monopoly

• High fixed or setup costs

• If a firm is shutting down some costs cannot be recovered- barriers to exit

• Ads and brand name with a high degree of customer loyalty is difficult to overcome

• Economies of scale- lower for large firms

• Production process patented by legal company

• Some firms may already have monopoly access to raw materials

• Pace of innovation is quick

• Firms can hide existence of abnormal profit by limit pricing

• Market conditions

Pricing strategy:

Limit pricing- where firms will deliberately lower the prices and abandon a policy

maximization to stop new firms from entering a market.

Predatory pricing: is adopted by monopoly/oligopoly to force competitions out of

market thereby exploit monopoly power by setting prices well below average cost.

Price leadership- a situation in a market whereby a particular firm has the power to

change prices, the result of which is that competitors follow this lead.
 Price discrimination- Price

discrimination is when identical or largely similar goods or services are sold at different

prices by the same provider in different markets.

 Diagram A shows the

existence of consumer surplus. This shows that the consumers are willing to pay more

than what is charged by the firm. However, in diagram B, there is no existence of

consumer surplus, this means that the firm leaves no room for the consumers to be able

to pay extra rather they charge the highest price the consumers are willing to pay. The

two diagrams show how the same firm charges different prices in 2 different industries

to increase profit. The firm may do this because of different elasticities in 2 markets or

the income of the majority of people in different markets.

Oligopoly
Characteristics:

• Market is dominated by a few firms

• Decisions are independent

• High barriers to entry

• Products may be differentiated

• Uncertainty and risks associated with price competition may lead to price rigidity

Cartel- a formal agreement between oligopoly firms to limit competition by limiting

output or fixing prices. They decide prices in the industry & long term survival of a cartel

depends upon the high barriers to entry

Threats to a cartel
• possibility of a price war - 1 firm breaks rank to gain higher market share

• if some members have higher costs - less profits

• no dominant firm that has the power to control others

• legal obstacles do not act in the best interest of consumers.

Non-price competition

• physical characteristics

• location

• service level

• advertising

Collusion- a non-competitive, secret and sometimes illegal agreement between rivals

which attempts to discreet the market’s equilibrium.

Kinked demand curve- a means of analysing the behaviour of firm in oligopoly where

there is no collusion.

The logic of the kinked demand

curve is based on
• A few firms dominate the industry

• Firms wish to maximise profits

Impact of price rise

• If a firm increases the price, then it becomes more expensive than rivals and therefore,

consumers will switch to its rivals.

• Therefore for a price rise, there is likely to be a significant fall in demand. Demand is,

therefore, price elastic.

• In this case, of increasing price firms will lose revenue because the percentage fall in

demand is greater than the percentage rise in price.

Impact of price cut

• If a firm cut its price, it is likely to lead to a different effect. In the short term, if a firm cuts

price it would cause a big increase in demand and therefore would lead to a rise in

revenue. The firm would gain market share.

• However, other firms will not want to see this fall in market share and so they will

respond by also cutting price to follow the first firm. The net effect is that if all firms cut

price – the individual firm will only see a small increase in demand.

• Because there is a ‘price war’ demand for a firm is price inelastic – there is a smaller

percentage rise in demand.

• If demand is inelastic and price falls, then revenue will fall.

Monopoly
Characteristics of a monopoly

• A single seller

• No close substitutes
• High barriers to entry

• Monopolist is the price maker

Positives of monopoly

• a monopolist cannot at always make abnormal profit

• competitive market has uncertainty of profits - monopolist can invest this and provide

better quality and job security

• investment may take the forms of process innovation.

• profit would be used to finance product innovation.

• If benefits of economies of scale would be passed on to consumers then they would

have gained from it

X inefficiency - where the typical costs In a competitive market above those experienced

in a more competitive market. This happens when the firm lacks the incentives to lower

the costs.

Natural monopoly- A natural monopoly is a type of monopoly that exists typically due to

the high start-up costs or powerful economies of scale of conducting a business in a

specific industry which can result in significant barriers to entry for potential competitors.
 This can also be made by government for example utilities because private firms may

exploit the customers.

Note: Only the monopoly can make abnormal profit in the short run. A monopoly is the

only firm in the market which means there is one buyer and several sellers who sell to

the monopoly firm. Due to this the monopoly can ask the firms to reduce the prices

therefore increasing profits since the average cost has reduced. The monopoly firm can

also charge quite high prices to the consumers since the consumers have no choice but

to buy from the monopoly firm. This increases revenue and therefore profits as well.

Comparing monopoly with perfect competition

• price in monopoly is higher than it is in perfect competition

• monopoly output is lower

• the monopolist is making short term abnormal profits

• the firm in perfect competition is productively efficient, producing the optimum output. It

is also allocatively efficient, producing where price = MC

• The monopoly firm captures consumer surplus and turn it into abnormal profit

• The monopoly firm is productively inefficient, producing less than the optimum output in

the search for extra profit. The price change is well above marginal cost and so is not

allocatively efficient.

• If a perfectly competitive industry was turned into a monopoly, there would be a welfare

loss of area x in addition to greater allocative inefficiency.

Perfect competition comparison with a profit maximizing monopoly

 Contestable market
Any market structure where there is a threat that potential entrants are free and able to

enter this market

Features of contestable market

• free entry

• Number and size of firms are irrelevant

• only normal profit can be earned in the long run

• threat of potential entrants into the market is overriding

• all firms are subject to the same regulations and gov. control.

• mechanisms must be in place to prevent the use of unfair pricing designed by

established firms to stop new firms from entering.

• cross subsidisation is eliminated

Relationship between different costs and revenues
Profit maximising

Relationship between AR, MR and TR

AC and MC relationship

AC can fall, when MC is rising when MC is less than AC. AC cannot rise, when MC is

falling.
 Why do small firms exists?
Why so many small firms exist in a world where the power lies with the monopolies

• economic activities where size of market is small to support large firms

• business may involve specialist skills possessed by few people

• where the product is a service- offer customers personal attention

• small firms may be the big firms of tomorrow

• There are particular obstacles to the growth of small firms.

• the entrepreneur may not always have expansion as the objective of firm

• recession and rising unemployment can trigger an increase in start-ups

• small businesses may receive financial help.

• small businesses are more efficient and competitive

Why and how firms grow

motives behind firms growth

• have reduction in ATC over time through benefits of EOS

• achieve higher profits, → boost sales → profits

• diversity product range economies of scale

• capture resources of another business.

 Economies of scope - reduction in ATC made possible by a firm increasing the different

goods it produces

Internal growth - firm decides to retain profits and invest it in the business for it to grow

External growth- firm expands by joining others through takeover or mergers

• Diversification- where the firm grows through the production or sale of a wide range of

different products

• Vertical integration- where a firm grows by producing backward or forwards in its supply

chain.

o Vertical forward integration is for producing forward in the supply chain

o Vertical backward integration is for producing backward in the supply chain

• Conglomerate integration- producing in an unrelated industry

• Horizontal integration: where a firm merges or acquires another in the same line of

business.

Game theory
Prisoner’s dilemma- The prisoner's dilemma is a standard example of a game analyzed

in game theory that shows why two completely rational individuals might not cooperate,

even if it appears that it is in their best interests to do so.

The prisoner’s dilemma presents a situation where two parties, separated and unable to

communicate, must each choose between co-operating with the other or not. The

highest reward for each party occurs when both parties choose to co-operate.

Principal agent problem- a principal hires an agent to own the business but there is a

case of info. failure since the principal is unable to ensure that the appointed agent is

taking the necessary decisions to run the firm in the best interests of shareholders. For

ex. agent is following objective of satisficing whereas the principal believes he or she is

implementing policy of profit maximization.