TOPIC 1 : DEMAND AND SUPPLY X and Y are positively related if X Y. X and Y are negatively(inversely) related if X Y. Substitutes/complements.

s. Substitutes goods are goods that can be used in place of another good. If good X and Y are substitutes. E.g. butter and margarine are substitutes goods. Complements : are goods that are used in conjunction with each other. E.g. CD player and CD. (A) DEMAND Quantity demanded of X is the amount of a commodity that households wish to purchase. It is a desired quantity, not actual quantity purchased. Determinants of Quantity Demanded : The demand function : + x D = f (Px, Py, I ) where Px = Price of the good X. Py = Price of another good Y. I = Income of household. Px : A fall in Px will lead to an increase in quantity demanded. PY : An increase in PY will lead to an increase in the demand for X if X and Y are substitutes. I : An increase in income will lead to an increase in the demand for X if X is a normal good, but a fall if X is an inferior good.

Demand curve or Demand schedule. The Law of demand shows the negative relationship between price and quantity demanded: Quantity demanded increases when the price of a commodity fall, and vice versa. Hence, the demand schedule is downward-sloping. A fall in prices will lead to an increase in quantity demanded which is represented by a movement along the demand curve. P P0
a

Px X P1 b D (PY , I ) X0 X1 Quantity, X

Market Demand curve The market demand curve is the horizontal sum of the individual demand curve of all households in the market. Household A Household B Market : A + B
P $2 $1 A B DA 1 2 x 2 3 P 2 $1 A

P 2 B DB x 3 5 X $1 A B DA + DB

Shifts in Demand curve. I will Dx or Py will Dx if X and Y are substitutes. An increase in demand shifts the entire demand curve to the right, and vice versa. This means that, at each price level, more X is now being demanded.
P

$1

D0 3 4

D1 X

(B) Supply Quantity Supplied is the amount of a commodity that firms are able and willing to sell. It is a desired sale, not actual sale. Determinants of Quantity supplied: The supply function + + - x S = f (Px, Tech, W, r ). Px = Price of commodity Tech = state of technology W = wages. r = interest rates Px : An increase in Px will lead to an increase in quantity supplied. Technology: An improvement in technology means that more output could be produced with the same inputs. Hence, supply will increase. W and r : An increase in W or r will lead to an increase in the cost of production, causing firms to produce and supply less.

Supply curve or Supply schedule The Law of supply postulates that the quantity supplied will increase as prices rise, and vice versa. Therefore, the supply curve has a positive slope. A rise in prices will lead to an increase in quantity supplied, which is represented by a movement along the supply curve. P S ( W, r ) P1 P0
A B

Px X

X0

X1

Quantity, X

Market Supply curve The market supply curve is the horizontal sum of the supply curve of all firms in the market.
Firm A P $2 $1
A

Firm B SA P $2
A

Market : A + B SB B P $2
A

SA + SB
B

$1

$1

Shifts of the supply curve An increase in supply shifts the supply curve to the right, and vice versa. This means that, at each price level, more quantity will be supplied. P
So P0

S1

X0
S S D D

X1

Quantity, X

(C) The determination of prices Price is determined by the interaction of demand and supply forces. Equilibrium price and quantity occur at the point where demand = supply. This occurs at the intersection of the demand curve and the supply curve. P0, X0 = Equilibrium price and equilibrium quantity. Above equilibrium price, we have excess supply: P will fall. Below equilibrium price, we have excess demand: P will rise.
P Excess P1 P0 P2 Excess Demand 10 Xo 15 D(buyers,consumers) X Supply A S(producers, sellers, firms)

(D) Effect of shifts on equilibrium price and quantity E.g. I for a normal good. P P1 P0 a

So

I D Hence, P and X. D1 ( PY , I1 ) Do ( PY , Io)

Xo

X1

E.g. If X and Y are complements, then an PY Px So P0 P1 b

D0 (PY , I ) D1, (PY , I ) X1 Xo X

Y X PY D D . Hence, P and X. 1

E.g. wages(w) of workers producing X. w costs of production S S . P S1 (w1, ro) So (wo, ro) P1 P0 b

Hence, P and X

Do(Py, I) X1 X0 X

(E) (Demand) Elasticity Elasticity measures the responsiveness(sensitivity) of demand to changes in prices, income, prices of substitutes or complements, etc. Price elasticity of demand measures the responsiveness (sensitivity) of quantity demanded with respect to a percent change in price. P = Price elasticity of demand = percentage change in demand for X percentage change in Price P = % X = - 2 P by 1% X by 2%. %P Note that the sign is always negative for a negative slope demand curve. The demand for a good is more price elastic(sensitive) when there more substitutes in the market. I = Income elasticity of demand = percentage change in demand for X percentage change in Income I = %X = 3 I X. %I Hence, when the income elasticity is positive, good X is a normal good. Py = Cross price elasticity of demand = percentage change in demand for X percentage change in the price of another good Y = % X = +3 PY X. % PY Hence, when the cross price elasticity is positive, good X and Y are substitutes.

Price Elasticity of Demand Elastic :P> 1. For every 1% change in P, X changes by more than 1% (responsive or sensitive or elastic). Hence TR = P * X and vice versa. |P| = % X = 2 %P Inelastic :P < 1. For every 1% change in P, X changes by less than 1% (not responsive or inelastic). Hence TR = P * X and vice versa. |P| = % X = 0.2 %P Unit Elasticity means P = 1. For every 1% change in P, X change by the same 1% (unit elastic).
If demand is elastic p > 1 P At P0, quantity demanded=Xo At P1, quantity demanded=X1 P0 P1
A

B D 0 X0

B D X1 X

Elastic demand

Inelastic demand

D D X X

Perfectly elastic demand: |= P

Perfectly inelastic demand:|=0 P D

Supply elasticity : Price elasticity of supply measures the responsiveness(sensitivity) of quantity supply with respect to a one percent change in price.
Perfectly or completely elastic supply P P S SF Perfectly or completely inelastic supply

Topic 2 (A)The Production Possibility Frontier (PPF) It shows the maximum combination of goods that can be produced given the amount of resources and the state of technology in the economy. Consider an economy producing two goods, X and Y with labour as the only means of production. Assume that labours are equally suitable in the production of X and Y. One unit of labour can produce either 2 units of Y or 1 unit of X. There are 100 units of labour. 100L , 1L 2Y 1X The PPF or the labour constraint can be expressed as Y = 200 2X.
Good Y 200 L A C

dY = 2Y dX 1X

150 B

2Y 1X 25
D

2 26

100

Good X

Opportunity cost The 'cost' which society pays for its choices is called the opportunity cost. The opportunity cost of a unit of X is 2 units of Y per unit of X The opportunity cost of producing 25 units of X is 2 units of Y per X. Efficiency Every point on the PPF is a productive-efficient point because it is not possible to increase the output of one good without reducing the output of another good. Hence, goods produced on the PPF have opportunity costs. Bundle A is an efficient allocation as producing more X requires giving up some Y. Bundle B is an inefficient allocation as there is no opportunity cost associated with the production of an extra unit of any good. Bundle C is an unattainable combinations (illustrates scarcity).

(B) The shape of the PPF with two constraints. Let us now suppose that labour is not the only means of production. We need capital (say machines), as well as labour, to produce both X and Y. One unit of capital produces either 1 unit of Y or 2 units of X. Assume a total of 100 machine hours is available. One unit of labour produces either 1 unit of X or 2 units of Y, and there are 100 labour hours available. The L-constraint : Y = 200 2X. The K-constraint : Y = 100 X. As both labour and machines are needed for the production process of both X and Y, both constraints have to be satisfied simultaneously. This means that a pair of X and Y will be feasible only if both constraints are satisfied.
Y 200 150 100 A E

Use both K and L to produce X & Y L

100L , 1L

2Y 1X

100K , 1K

1Y 2X

K 2 25 70 100

200 X

At point A, the combination of 150Y and 25X satisfies the labour constraint because there are enough units of labour to produce it. But it does not satisfy the capital constraint. So if we insist on producing 25 units of X, we will have to reduce our production of Y in order to make it feasible. This means that we will have to reduce Y until we reach the binding limit imposed by the capital constraint. This is given by point E

(D) Specialization and trade.

Countries will be able to have more of everything once they specialize and trade. Countries 1 can produce, and consume, either 6 units of C or 2 units of F, or any convex combination of these two extremes. Countries 2 can produce, and consume, either 6 units of C or 6 units of F, or any convex combination of these two extremes.
Clothes(C) 6 Sell C Country 1 dC = 3C 3 A dF 1F 3 B 6 Clothes(C) Sell F Country 2

3 1 2 Food(F) 3

OC1 = 3 units of C OC2 = 1 unit of C 1unit of F 1unit of F Country 2 has a comparative advantage in the production of F. Produce F and sell F. Country 1 has a comparative advantage in the production of C. Produce C and sell C.

If the international price of X is 2 units of Y per unit of X, then each country can specialise in the production of one good, and trade with each other. Both countries can become better off. Feasible sets after specialization and trade, with an agreed price of 2C per F. (2C / 1F)
Clothes(C) 6 Sell C Country 1 Clothes(C) 6 Sell F Country 2

3 1 1.5 2

2 Food(F) 3 4.5

Both countries now have consumption opportunities which they did not have before. They could now consume outside their initial PPF. Evidently, both households are better off (assuming that having more of all goods is indeed equivalent to being better off) after specialising and trading.

Tutorial 2 1) An economy produces two goods, X and Y. It uses two means of production, labour and capital. A unit of labour can produce either 1 unit of X or 4 units of Y (or any linear combination of the two). A unit of capital can produce either 4 units of X or 1 unit of Y (or any linear combination of the two). There are 100 units of each means of production. a) Draw the production possibility frontier of the economy when the two goods can only be produced by a mixture of both factors. b) What will be the opportunity cost of X if the economy produces 50 units of X? c) Given that the production technology is linear, will the opportunity cost of X remain unchanged when we produce 90 units of it ? 100L , 1L 1X 4Y 100K , 1K 4X 1Y

a)

Y 400 L-constraint

Labour constraint: Y = 400 4 X or X = 100 Y Capital constraint Y = 100 X Y = 100 (100 Y) X = 80. Y = 80

100 80

K-constraint

4
50 80 90 100

400

The PPF is given by the heavy line as both capital and labour are required for the production of each unit of X and Y. b) When the economy produces 50 units of X, we are to the left of point A above. The binding constraint is that of capital. Hence, the opportunity cost is unit of Y per X. c) When we produce 90 units of X, we are to the right of point A above. Hence, the opportunity cost of X is 4 units of Y per X.

2) To produce one unit of commodity X requires half a unit of labour( no capital is needed). Each unit of X needs storage space during the production process which is limited up to 180 units of X. Commodity Y, on the other hand, requires a quarter of a unit of labour and half a unit of capital for the production of one unit. There are 100 units of labour and100 units of capital. a) Draw the production possibility frontier. b) What will be the opportunity cost of Y when we produce 30 units of it. c) What will be the opportunity cost of X when we produce 80 units of it. d) Had we produce 120 units of X efficiently and the international price of X was 1Y per X, what would now be produced in this economy? 1X L, 1S 2X 4Y
S L

180X, 100K, 1K

1Y

100L, 1L
a) Y 400

L K 2Y 1S

180X

L : Y = 400 2X K : Y = 200 At point A, 400 2X = 200 X = 100 and Y = 200

K

200 90 40 30

B 2
80 100 120 180 200

L: Y = 400 2X or X = 200 Y S: X = 180 At point B, 200 Y = 180 Y = 40 and X = 180

X

b) When 30 units of Y are produced, 180 units of X can be produced. The opportunity cost of producing 30 units of Y is 0 unit of X. c) When 80 units of X are produced, 200 units of Y can be produced. The opportunity cost of producing 80 units of X is 0 unit of Y. d) At 120 units of X, the opportunity cost of a unit of X is 2 units of Y per X. Since the international price of X was 1Y per X, it means foreigners can produce X at a lower opportunity cost. It also means this economy has a comparative advantage in producing Y and hence, it is likely to specialise and produce at point A. It will then sell Y to buy X and hence, can become better off by consuming beyond their original PPF.

TOPIC 3 Indifference Preference Theory

A) Budget Line : The Budget Line shows the maximum combinations of good X and Y that a consumer can buy with his income. Budget line equation: PX X + PY Y = I Slope of budget line, dY/dX = (Io/PY0 ) / (Io/PX0 ) = PX0 / PY0 units of Y per unit of X. It gives the market rate of exchange. Suppose Io = $1,000, PX = $50, PY = $10 Y Peter Io =100 0 PY 75
A 5 1
0 0

Pt A: 5 PX0 + 75 PY0 = Io

PX0 0 PY 5 6 Io =20 0 PX X
0 0

Every point on the same BL has the same PX , PY , and Io

Shifts of the Budget Line 0 If Px falls, the budget line will rotate right along pivot (Io/PY ). 0 If Py falls, the budget line will rotate upward along pivot(Io/PX ). If Income increases, the budget line shifts parallel outward as more of X and Y can now be bought, and vice versa.
Y Io 0 PY Px Y Io 1 PY B A
0 PX 0 PY 1

PY

Io 0 PY PX 0 PY Io 0 PX

B A

Io 1 PX

Io 0 PX

Y I1 0 PY Io 0 PY A

I H B
0

The further the budget line from the origin, the higher the income. PX 0 PY
0

PX 0 PY

Io 0 PX

I1 0 PX

B Utility Theory Utility is the satisfaction a consumer gets from consuming a good. Total Utility is the total satisfaction from the total consumption of a good. It rises as more of X and Y are consumed. Marginal Utility is the additional satisfaction one derived from consuming 1 more unit of a good. It diminishes as consumers consume more and more of a good. Thus, although total utility rises, marginal utility declines as a consumer consumes more and more of a good.

C) Indifference Curve(IC) or Utility Curve(U)

An utility curve shows the combinations of goods X and Y that give the household equal utility or satisfaction. Therefore every point on an utility curve has the same utility.
Y

Y0 Y1

A =10 X0 B =10 Uo =10 units of utility X1 X

Deriving the slope of the indifference curve. If we give up some units of good Y, the total loss in utility = dY MUY. If we increase the consumption of good X, the total gain in utility = dX MUX. Along the same utilty curve, the loss of utility from Y = gain in utility from X for utility to remain the same. Hence, dY MUY = dX MUx dY = MUx dX MUY the slope of the utility curve = MUx MUY An Indifference map is a set of indifference curves or utility curves (U). Properties of the Indifference maps: 1) Every point on the same utility curve has the same level of satisfaction or utility. ( see point A and B) 2) Utility curves that are further away from the origin have higher utility. 3) Utility curves cannot intersect each other. (parallel) Y
C A B

U2 = 50 utils U1 = 20 utils Uo = 10 utils X

3

D) The equilibrium of a household Utility maximisation:

Consumer is maximising utility at point A where the budget line is tangent to the utility curve. At the point of tangency, the slope of the budget line (Px/PY) equals the slope of the utility curve (MUx/MUY), i.e. Px/PY = (MUx/MUY). Utility is not maximised at point B as one can consume at A with Io to get a higher Uo. It is only at A where utility cannot be further increased. Y Io PY
0

Y0

A is the utility-maximising bundle.

Uo
PX 0 PY
0

X0 Y Io PY
0

Io 0 PX

Y0

A is the utility-maximising bundle.

Uo
B

U1 X

X0

Io PX0

F) Demand Curve Income increases Normal goods: buy more. E.g. Houses. Inferior goods: buy less. E.g. black and white TV.
Y BI BN BN A

U1 Uo

BI 3 5 8 I2 0 PX Io 0 PX I1 0 PX X

The Substitution Effect (SE) and the Income Effect (IE) Px falls. 1) Substitution effect (SE) When consumers will have more incentive to buy more X because it is now relatively cheaper, i.e. PxX and vice versa. It is a movement along the same utility curve. For all goods, the SE is such that a PxX. 2) Income effect (IE) When Px falls, consumers will feel wealthier because their real income( I / PX ) increases. It is a movement to another utility curve. PX real income( I / PX ). For normal goods, the IE is such that real income X. For inferior goods, the IE is such that an real income X. 3) The Total Effect PxTE = SE + IE. For inferior goods, SE > IE: (SE dominates)

(G) Hicksian versus Slutsky definition of real income. Hicksian : Based on Hicksians definition of real income, real income is measured by utility. The higher the utility, the higher the real income. Hence, every point on the same utility curve has the same real income. The real income at point C is higher than that at point A.
Y

C A

U1 B Uo X

Slutsky : the original bundle of goods, bundle A(Xo,Yo) is used as the reference point for real income.
Example Px Y Io PY0
N

A U1 U0

Io 1 PX

Io 0 PX

Px : The individuals real income becomes lower based on both Hicksians and Slutskys definition of real income.

SE and IE

If Px, show the SE and IE for X which is a normal good. 1) The consumer initially consumes bundle A to maximise utility, Uo. 2) Px will cause the budget line to rotate out as more X can now be purchased. He will now choose bundle B and beomes richer because his utility(U1) or real income based on Hicks definition of real income is higher. 3) To find the SE, shifts the new budget line parallel until it is tangent to the original indifference curve, Uo at point C on the dotted budget line. At point C, his his utility(Uo) or real income remains the same as before(point A). Hence, the IE had been successfully removed.
Example Px Y Io PY0 A C B
N

TE = SE + IE

Uo SE X0 Example Px Y Io PY0
N

U1

IE X1 Io X2 0 PX Io X 1 PX

C A U1 U0 Notice that when X is a normal good, the SE and IE always move in the same direction.

IE

SE

X2

X1 Io X0 1 PX

Io 0 PX

X
7

Normal and inferior goods Income When the price of X has fallen from PX0 to PX1, the substitution effect suggests that the individual will move from point A to point C. This is always true, regardless of whether the good is inferior or normal.
Y Io PY0 X inferior X normal

B A

B C

U1 Uo

IE

I N

SE IE
I

X0 X2 X1 X2N

Io 0 PX

Io 1 PX

The move from the dotted line at C to the new budget line requires a parallel shift, which is equivalent to an increase in nominal income. This, therefore, is the income effect. There are now two main possibilities: 1. If X is a normal good, consumption increases with income. Hence, the individual will choose point BN which must be on the right of point C. 2. If X is an inferior good, consumption decreases with income. Hence, the individual will choose point BI which must be on the left of point C

Complements and gross substitutes When the consumption of Y increases as the price of X falls, we say X and Y are complements. Examples of such goods are cars and fuel. As the price of fuel falls, there will be greater use of private cars and greater consumption of fuel. In a case where the consumption of Y falls as the price of X falls, we say that X and Y are gross substitutes. Again, a fall in the price of X will lead to more consumption of X. A typical example can be the use of private cars and public transport. When the price of public transport drops, people will tend to use car less and travel more on public transport.
Y Io 0 PY Example Px

Y0

C S

Complements

Gross substitutes

U0

X0

Io 0 PX

Io 1 PX

Example Px B
S

Y0

Gross substitutes
U0

Complements

Io 1 PX

Io 0 PX

What is rationality? The economic concept of rationality involves two assumptions: Assumption 1 People know their desires and know the consequences of each choice of means. Assumption 2 People will behave in a consistent manner. By this we mean that if people have two feasible options available and choose one over the other, they should not, at a later date, choose the other option if both are still feasible. Option A or B: Choose A. Later if A and B are still feasible : if choose A: rational.

10

Tutorial 2 1) In a world of two goods, will the fact that one of the goods is normal have any implication regarding whether the two goods are gross substitutes or complements? X is normal. Are X and Y substitutes? Y Io 0 PY X normal

Yo

BN

Complements

S BN

U0

Gross substitutes

X0 X1

Io 0 PX

Io 1 PX

2) In a world of two goods, when the demand elasticity of good X is greater than unity, X and Y must be gross substitutes and X is more likely to be a normal good. True or false? Explain. Y Io 0 PY X normal

Yo

Complements c

U0 SE X0 X1 Io 0 PX

Gross substitutes

Io 1 PX

Px demand is elastic Total spending on X will rise. As nominal income is unchanged, total spending on Y must fall. As the price of Y remains unchanged, the quantity demanded of Y must fall. Y Hence, X and Y must be gross substitutes. From the diagram, they lie on the right of C. Therefore, X is a normal good.

11

3) In a world of two goods, if the price of x decreases at the same time that the price of y increases in such a way that the real income under Slutskys definition remains unchanged, individuals will be worse off. True or false, explain.

Px and PY such that Slutsky real income remains unchanged. Indiv worse off?
Y Io 0 PY Io 1 PY A B

The individual becomes better off

U1 U0

Io 0 PX

Io 1 PX

12

4) You observe a consumer in two different market situations: (i) (ii) earning $100 and spending it on 5 units of x at the price of $10 each and 10 units of y at the price of $5 each; earning $175 and buying 3 units of x at the price of $15 and 13 units of y at the price of $10. Is the consumer rational ?

Io = 100, Px0 = 10, Py0 = 5. Choose A(5X,10Y) I1 = 175, Px1 = 15, Py1 = 10. Choose B(3X,13Y). Is he rational?
Y

1) He choose A when B is feasible.

20 17.5
13 B

2) He chose B when A is still feasible.

10

10

11.67 I1 = 175 1 Px 15

We begin at point A where the following budget line applies: Px0 Xo + Py0 Yo = Io. 10 5 + 5 10 = 100 Now, we have a new budget line and a new choice B: 1 1 Px X1 + Py Y1 = I1 15 3 + 10 13 = 175 Is A(5X, 10Y) is on the new budget line?

13

5) A good is a normal good whenever the substitution and income effects work in the same direction. True or false? Explain. Y
0 PX X 0 PY

X normal X inferior

Px

A
1 PX X 0 PY

Uo

BN IE SE X2 X0 X1 X

When an individual receives income in kind of units of X, the SE and IE can move in the opposite direction even if the good is a normal good.

14

6) "It is better to give the poor a subsidy for food rather than an income supplement which they are likely to spend on other goods and alcohol." Suppose individuals consume only two goods, X, which is food and Y, which is other goods (including alcohol), and that they have an income of I. a) Show the effects on consumption of paying income supplement of S; b) Show the effects on consumption of paying a subsidy of s per unit of X consumed; c) Compare the effects of the two schemes assuming that government spending on each individual is the same in both cases (this means that if under the subsidy scheme the individual chooses Xs then sXs = S); 6(a,b) Y Io + S 0 PY Io 0 PY Yo A Y Income supplement(S) Per-unit subsidy(s)

B U1 U0 PX 0 PY
0 0

Io 0 PY A B U1 U0 X2 Io 0 PX Io 0 PX - s

Xo c) Y Io + S 0 PY Io 0 PY Y2
A

PX 0 PY Io Io + S 0 0 PX PX

C
B

U2 U0 U1

X2 Io 0 Io +0S PX PX

Io PX - s
0

0 0 0 0 P.U. BL : (Px - s )X2 + PY Y2 = I0 or Px X2 + PY Y2 = I0 + sX2 0 0 Lump BL : Px X2 + PY Y2 = I0 + S

15

7.

A beauty parlour Drop Dead Gorgeous (DDG) wishes to create an exclusive and discerning clientele for its beauty treatments. To get the type of clients it hopes for, the parlour sets the price per treatment above the market rate. To get the exclusive attentions of its clients, it only accepts people who normally take more than a certain number of treatments per period (say B). These first B visits are part of a joining fee(F) package. a) Describe the budget constraint facing consumers. What are the conditions for the proposal to attract some customers? b) Will all consumers join DDG? c) Could joining the clientele of DDG mean a reduction in ones visits to the beauty parlour? If so, would this mean that beauty treatment is an inferior good? Y Io 0 PY Io - F 0 PY B
A Uo
0 Px Px 0 0 PY PY B + Io - F 1 PX

Io 0 PX

To capture some customers, the new budget line must be at least tangent to the original Uo. b) Will all consumers join DDG? Y Io 0 PY Io - F 0 PY
A A

A B B + Io - F 1 PX Io 0 PX

X
16

c) Could joining DDG mean fewer visits. Would this mean that X is an inferior good? Y Io 0 PY Io - F 0 PY
B C A

Inferior good Normal good

U1 Uo

X1 X2 X0

Io 0 PX

Ending up with fewer visits does not necessarily mean that X is an inferior good.

17

Ting Mun Kwong

TOPIC 4 : Production and the Behaviour of the Firm.

(A) Output (X) The Production function: X = f(L, K) relates output(X) to two factors of production, labour (L) and capital (K). Inputs (L,K) Technology Output(X) 1) Product definition Total Product (TP) = total output = X . Average Product of labour (APL) or average output = X / L = output per worker. Marginal Product of labour (MPL) = dX/dL is the extra product(output) produced by one extra labour. Marginal Cost (MC) = dC/dX is the extra cost of producing one extra output. 2) Cost definitions Total Cost = Fixed Costs + Variable Costs. C = FC + VC FC does not vary with output (cost of building a factory). VC increases with output, eg. wages, utility bills. C = FC + VC X X X AC = AFC + AVC Average cost AC = Average FC + Average VC Average cost (AC) varies inversely with average product (AP). AC = C / X = $100 / 10TVs = $10 / 1TV Marginal cost (MC) varies inversely with marginal product (MP). When AP per worker is rising, AC falls as each new worker adds the same amount to cost, but a greater amount to output, thereby lowering the average cost per unit of output. Whenever marginal product is rising, the cost of an extra unit (the marginal cost) will be decreasing. Hence, when AP AC and when MP MC and vice versa.

(B) The SHORT RUN Short run : At least one input (factor of production) is fixed, eg capital, which implies diminishing returns to factor of production. Initially, MP rises due to specialisation. Eventually, MP falls due to diminishing returns to a factor of production because one inputs is fixed. 1) Initially, the increase in MP leads to a corresponding fall in MC. 2) Up to a certain level of output, diminishing returns sets in, causing MP to fall and MC to rise. The Law of Diminishing Returns states that if increasing quantities of a variable factor (e.g. labour) are applied to a given quantity of fixed factor (e.g. capital), the MP of the variable factor(L) will eventually decrease. This will lead to a corresponding increase in MC. The fixed factor limits the amount of additional output that can be realised by adding more of the variable factor(L). Therefore the law of diminishing returns (that MP will eventually fall) implies eventually increasing MC. To sum up: MP MC and vice versa. Therefore, all short-run cost (SRC) curves are the mirror (opposite) image of the short-run product curves due to diminishing returns to factor of production(L).

(C) The LONG RUN Returns to Scale Long run : All inputs or factors of productions are variable. This implies returns to scale. Again all long-run cost curves are the mirror (opposite) image of the product curves due to returns to scale. Scale refers to the size of operation. Returns to a Factor(SR) Versus Returns to Scale(LR) a) Returns to factor (marginal product) refer to the marginal product of one factor while keeping the other factor inputs constant(K). SR b) Returns to scale refer to situation when all input levels increase by the same proportion. Increasing returns to scale (IRS) or economies of scale could originate from managerial and labour specialisation or more efficient use of capital. Here output increases at a faster rate than inputs(costs).AC = C / X Decreasing returns to scale (DRS) or Diseconomies of scale could be due to management problems or access to skilled labour as the business becomes bigger and more complex. Here output increases at a slower rate than inputs(costs).AC = C / X Constant returns to scale (CRS): output increases at same rate as inputs. AC is Constant.

D) Short-run cost curve

All short-run cost (SRC) curves are the mirror (opposite) image of the short-run product curves due to diminishing returns to factor. The Marginal Product (MP) of Capital or Labour defines the increase in output for one-unit increase of a particular input, keeping the other one constant. We typically assume that the marginal product is increasing for low levels of an input, but decreasing for high levels. This is referred to as increasing and diminishing returns to a factor, respectively. This assumption yields a graph which depicts the level of output attainable for every level of one input (labour), keeping the level of the other input (capital) constant.

X MP TP

XA MP

L1 C MC A MC

L SRC C Tangent ray M AC is minimum at pt M or XM

ACA $

ACB XA

ACC XM XC X SRAC

ACA ACC ACM

A M

XA

XM

XC

X
4

SRC C C MCM

M MC = AC where AC is minimum. MCM

ACA $

ACB XA

ACC XM XC SRMC CM X SRAC

ACA ACC ACM

A AM XA

C M MC = AC where AC is minimum. XM XC X

E) Long-run Cost curve(LRC)

The general form of the cost function in the two inputs model is C (K, L) = wL + rK. Assume the production function initially exhibits IRS follows by DRS.

IRS: output increases faster than inputs. DRS: output increases slower than inputs. X TP

XA

V(K,L) C LRC C Tangent ray DRS M AC is minimum at pt M or XM

A IRS

ACA 0 $

ACB XA

ACC XM

XC

LRAC A M

ACA ACC ACM

XA

XM

XC

LRC C

MCM

A IRS

M MC = AC where AC is minimum. MCM

ACA 0 $

ACB XA

ACC XM

XC

LRMC CM LRAC A AM XA

ACA ACC ACM

C M MC = AC where AC is minimum. XM XC X

F) Long Run Average Cost (LRAC ) and Short run average cost (SRAC) The LRAC shows the lowest cost of producing any output when all inputs are variable. Input prices (W 0 and r0) and technology are assumed to be fixed. $ LRAC(W 0, r0)

IRS:AC

DRS: AC

XM AC

X LRAC SRAC

SRAC (Ko) SRAC(K2) SRAC(K3) SRAC SRAC SRAC (K1) SRAC

X0

X1

X2

XM

The LRAC shows the lowest average cost to produce each level of output in the long run.

G) Isoquants and Isocosts A) Isoquant (equal quantity) shows the combination of two inputs, labour (L) and capital (K) that will produce the same quantity of output (X). Thus, all points on an isoquant curve have the same output. Isoquant analysis helps us to understand how the firm determines the least cost method of production.
K

K0 3K K1

A 10X L0 B 10X Xo = 10 L1 L

1L

The slope of the isoquant is defined as dK/dL when X is unchanged. If we reduce K by dK, output will fall by dK MPK. In the same way, if we increase L by dL, output will rise by dL MPL. Along the isoquant, the fall in output as a result of a fall in K has to equal to the rise in output as a result of a rise in L. Hence, dK MPk = dL MPL or dK/dL = MPL / MPk Therefore, slope of isoquant = MPL / MPk Properties a) Every point on the same isoquant has the same level of output (X). b) Isoquants that are further away from the origin represents higher output (X). c) Isoquants cannot intersect each other. (parallel)
K

X2 = 70 X1 = 30 Xo = 10 L
9

H) Isocost (equal cost) shows the combinations of two inputs (L,K) that can be hired with budgets, Co and for given prices of labour (Wo) and capital (ro). Cost (Co) is constant along an isocost. Slope of isocost = w / r Y Slope = (Co / ro) / (Co / Wo) = Wo / ro
K C0 r0 PK Xo w0 Isocost r0 C0 / w0 PL Firm
Io/PY
0

Peter

Uo
0

Io/PX

Shifts of Isocost. Wo causes the isocost to rotate out along pivot Co/ro ,and vice versa. ro causes the isocost to rotate out along pivot Co/Wo ,and vice versa. Co shifts the isocost out parallel to the right, and vice versa, as more L and K can now be purchased.
K C0 r0 W K C0 r1
C0

r0 w0 r0 Co w0 K C C1/ r0 C0/ r0 A w0 r0 B w0 r0 C0 / w0 C1 / w0 L
10

w1 r0 Co w1 L Co w0 L

C) Combining Isocost and Isoquant. The cost-minimising output is found at the point of tangency between the isocost and the isoquant. K
Co

r0 Tangent pt A is the output-maximising pt A

Xo

Co Wo

The tangent point (A) represents the maximum output that can be produced for a given cost (Co). Expansion path: K LR expansion path
Co

r0 K1 SR:K0 A BL

S
Xo X1 C1 CS w0 w0

SR expansion path( K is fixed)

L0

L1 C0 w0

Short-run expansion path Along the short-run expansion path, the level of capital is fixed and the only way to increase output is through increases in labour inputs. Long-run expansion path The long-run expansion path depicts the firm's growth of output when all inputs are increased by the same proportion, along the ray through the origin.
11

Tutorial 4 1) The minimum average cost is always at the point where it equals marginal cost. True or false? Explain. 2) Suppose that a long run cost function displays increasing returns to scale and then decreasing returns to scale. What does this imply for the shape of the long run average and marginal cost curves. 3) An increase in wages means that the new optimal choice of input mix will contain much less expensive labour which will be substituted by the cheaper capital. Therefore, the same level of output could be produced at exactly the same level of cost as before the change. Also the optimal input mix falls. True or false? Explain. 4) Explain why short run average cost is never less than long run average cost. 5) If long run marginal cost equals short run marginal cost at the point where neither of them equals their average costs, the short run optimal input mix will not be the same as the long run optimal mix for that level of output. True or false? Explain. 6) The short-run marginal cost will always equal the long-run marginal cost at the point of minimum short-run average cost when there are increasing returns to scale. True or false? Explain. 7) a) Under which conditions will the long-run average cost and marginal cost be the same? b) Will the short-run average cost be the same as the long-run average cost? c) Will the short-run marginal cost be the same as the short-run average cost? 8) The short-run marginal cost will always equal the long-run marginal cost at the point of minimum short-run average cost when there are constant returns to scale. True or
false? Explain.

12

Tutorial 4

1) True, refer to lecture. Derive. 2) Same as pg 6. IRS, then DRS imply that LRAC and LRMC are U-shape. Derive. 3) W : the same X can be produced with the same costs. T/F. False, as at pt B, the cost is the same(Co), but less output is produced. Capital to labour ratio or input mix, K/L
K Co

r0 K1 K0 B A X0 K L L1 C0 / w1 L0 X1 C0 / w0 L

13

4) Why SRAC LRAC ? To produce Xo, SR & LR : pt A. SRC = LRC = Co SRAC = LRAC. K

LR expansion path
Co ro

K1 K0 A

BL

BS Xo

SR expansion path X1

K L

L0 L1

C0 W0

CL CS w0 w0

SRC(Ko)

LRC

CS CL C0

B L B

X0 $

X1

XM

X LRAC

SRAC(Ko) SRMC(Ko) A LRMC

SRAC=LRAC

SRMC=LRMC

X0

X1

XM

14

5. False. If SRMC = LRMC pt A or Xo : SR K/L = LR K/L 6. False. 7. a) Under which conditions will the long-run average cost and marginal cost be the same? Under Constant returns to scale. b) Will the short-run average cost be the same as the long-run average cost? No. SRC

LRC At pt B or X1 : SRC = LRC SRAC = LRAC

B A
LRACA

LRMCB

Xo

X1
SRMC SRAC SRMC SRAC

With CRS: At min SRAC :

LRAC = LRMC

Xo

X1

8. The short-run marginal cost will always equal the long-run marginal cost at the point of minimum short-run average cost when there are constant returns to scale. True or
false? Explain. True

15

TOPIC 5 Perfect Competition(PC) PERFECT COMPETITION (PC) A) Characteristics 1) Many agents (buyers and sellers) - both are price takers. 2) Homogenous products. 3) Free entry and exist - low barrier to entry/exit. LR profit = 0. 4) Perfect information - both buyers/sellers know the market price. 5) Free mobility of factors of production - low barrier to entry/exit of factors of production. There are two immediate conclusions: a) All agents are price takers. As there are a large number of agents, none of the agents can, on their own, change the market price. b) There will be a single price in the market due to perfect information. B) Demand curve and Revenue curve As the firm is a price-taker, its demand curve is perfectly elastic. In a perfectly competitive market, the firm's demand curve is horizontal as price is fixed, whereas the industry's demand curve is the usual downward sloping demand curve. Single firm Market or Industry $ P So 6 A 5= P0 D=P=MR 5= P0 Do 1 2 x0 x X0 X

C) Rules for profit-max in a perfectly competitive(PC) market. Rule (1) Short run : Produce only if P AVC as part of the revenue (P - AVC) X can be used to cover fixed cost. Long run : Produce only if P AC in the long run. AC = AFC + AVC TC = TFC + TVC 14 = 10 + 4. If P = $7, the firm should still produce. Rule (2) To maximise profit(), PC firm will produce up to the output where MR = MC or as P = MR Produce until P=MC to maximise $ MC P
MR MC A

MR = P=D

1 2 3

Economic profit() = TR TC = PX - AC(X) = (P AC) X When P > AC, firms are making economic profit. When P < AC, firms are making economic losses. When P = AC, economic profit = 0. Normal profit.

D) Supply curve of a PC Firm = MC. Firms short-run supply curve $ MC=S AVC P1 S P0
S

Firms long-run supply curve $ MC = S AC

P*

P*

X0 X1

1) The supply curve in the short run is the part of MC above AVC. The reason is that in the short run if P < AVC, firms will shut down., 2) The supply curve in the long run is the part of MC above AC. The reason is that in the long run, if P < AC, firms will shut down. E) Short-Run Supply curve of a perfectly competitive industry. The industry supply curve is the horizontal sum of the supply curve of each firm in the industry. Firm A P $2 $1 A

MCA=SA B

P $2 $1

Firm B MCB=SB B A

P $2 $1

Market : A + B SA + SB or MCA + MCB B A 3 5 X

F) Long-Run Equilibrium for a perfectly competitive firm. 1) In the long-run, all PC firms will only earn zero economic profit. Otherwise profit/losses will lead to entry/exit of firms which will cause a corresponding shift in the supply schedule until economic profit or losses = 0. Industry $ Firm P MC(wo, ro)
AC(wo, ro)

So(wo, ro) P0

A x0 x

P0

A Do X0 X

Effect of taxation. Per-unit tax(t) on firms: $ MC0 + t MC0 AC0+t AC0

Lump sum Tax(T) $ MC0 ACo + T /X AC0

x0 AC = ACo + t t MC = MCo + t Effect of subsidy. Per-unit subsidy(s) $

t

x0 C =C+T T AC = AC + T x
T

x1

Lump sum Subsidy(S)

MC0 MC0 - s AC0 AC0-s

MC0

AC0 ACo S x

x0 AC = ACo - s S MC = MCo - s Per unit: Both MC and AC shift parallel:

S

x0 x1 S AC = AC - S x Lump change in costs

Consumer Surplus(CS) and Producer Surplus(PS) Consumer Surplus (CS) is the net benefit to consumers of being able to buy units of a good more cheaply than the amount they will willing to pay. Producer Surplus (PS) is the net benefit a producer gets by obtaining a higher price for any unit than the additional cost incurred in producing that unit. P S0 9 8 5 = P0
3 2 A

Do (willingness to pay) XPC =3 X Output XPC. S0

01 2 P 9 8 5 = P0
3 2

CS PS

Do 01 2 XPC =3 X

Allocative efficiency Allocative efficiency occurs when it is impossible to change the allocation of resources in such a way as to make someone better off without making someone else worse off. This condition is satisfied in a perfect competitive market where the demand curve intersects the supply curve. P

S0 = MC

5 = P0

1 2

3 4

Do ( willingness to pay) 0 Xm XPC =2 3 X

By producing more X from Xm to XPC , CS + PS can be further increased by area 1 + area 2. At XPC , CS + PS are maximised. It is clear, we can increase neither consumer nor producer surpluses without reducing the other. In that sense, the perfectly competitive solution is allocative efficient.

Tutorial 5 Perfect Competition 1. An increase in demand for a good in a perfectly competitive industry will in the long run bring about an increase in the number of firms in the industry although each firm will produce as much as before the change. True or false? Explain. 2. "In the long-run, a lump sum tax will be completely transferred onto consumers. Therefore, one can safely say that in competition, with free entry and exit, consumers always carry the full burden of taxation. Discuss. 3. "If a lump-sum subsidy is granted to every firm in a competitive industry, the output of each of the original firms will fall in the long-run". Discuss (a) when only the original firms qualify for the subsidy; (b) when all firms qualify.

Tutorial 5 1. D # of firms; x unchanged. T/F . Firm Industry $ MC P S0 AC P1 P0

A B

P1 P0
A

D1 Do

x0 x1 Firm $ P1
AC B A

x MC AC P P1 P0

X0 X1 Industry S0
B A

D1 Do

x0 x1 Firm $ P1
AC B A=C

X0 X1 Industry

MC AC

P P1 P2, P0
A B

S0
2

S1

1 Do x0 x1 x2 x X0 X1 X2

D1 X

Short Run : An increase in demand shifts the demand curve to the right causing market price and industry output to increase to P1 and X1 respectively. At P1, firms will produce x1 where P1 = MC to maximise profit. Each firm now makes economic profit. Firms output and industry output increase; P. Long Run : Economic profit will attract new firms to enter the industry. As more outputs are produced and supplied, the market supply schedule will shift to the right and price will fall until there is no more economic profit. The market is now at equilibrium. Firms output(x) unchanged; Industry output(X); price unchanged; more firms in the industry.

10

2.

AC1 P0

Lump-sum Tax(T) MC0 AC0 + T x AC0

P S0

Losses

P0

x0

Xo

$ MC0 AC0 + T x AC0

SLR S0
B A

Losses

B A

T x1

P1 P0

x0 x1

X1 Xo

SR: AC shifts up. As cost of production goes up, firms make economic losses. LR: Losses will cause some firms to close down and market supply falls and shifts to the left until economic losses is zero at point B(P=min AC). Hence, X, P, x. Consumers bear the full burden of the tax. Allocative efficient as P = MC.

11

3. When only existing firms qualify for the lump sum subsidy, S $ P MC0 S0 AC0 AC0 - S x A A P0
P0 AC1 D

x0

Xo

SR: AC shifts down. Economic profit. LR : When all firms qualify for the lump sum subsidy, S

$ MC0 AC0 AC0 - S x

S0 SLR
A B

P0 P1

A B

P0 P1

x1 x0

SR: AC shifts down. Firms make economic profit. Hence, X, P, x.

Xo X1

LR: Profit: new firms will enter and market supply will shift to pt B(P = min AC)

12

Topic 6 MONOPOLY (MP) A) Characteristics of a monopoly 1) One single producer (seller). 2) Very strong barriers to entry: may be due to economies of scale or patents. 3) Perfect information and mobility. 4) Homogeneous good. Firm's demand curve is the market demand curve (sole producer) and is downwardsloping. B) The Demand function and Marginal Revenue function. Revenue, R = P X Marginal Revenue (MR) is defined as dR/dX. MR = dR = P dX + X dP dX MR = dR = P dX MR = P 1 + dX dX + dP X dX dP X dX P As = dX P , hence 1 = dP X dP X dX P MR = P 1 + 1 MR = P 1 1 || MR is a function of the current price and the demand elasticity.

C) Linear demand and demand elasticity. A monopolist will never produce along the inelastic part of the demand schedule. P = a bX. Example: Assume a linear demand function: 2 Revenue R = PX = aX bX . Hence dR / dX = MR = a 2bX P a demand elastic : || > 1 Unit elastic : || = 1 demand inelastic : || < 1 b D 20 40 X

MR 2b 0

MR

D) Profit maximization for the monopolist. 1. How much to produce to maximise profit? Set MR = MC To maximise profits, the monopolist will produce up to the output where MR = MC. 2. Whether to produce?Produce as long as: P AC. The final market configuration of the monopolist is shown below. P

PM AC MC =MR

MC

AC

A MR XM 5 D 10 X

1) Produce the output where MR = MC to maximise profit. Project a vertical line from the equilibrium output to the demand curve and read the price on the vertical axis. (D) Monopolistic Power Monopolistic power, P / MC refers to the producers ability to keep price above marginal cost: the greater is the gap, the greater is the firms power to exploit the market. When P = MC, P / MC = 1 ( no monopolistic power) Monopolist produces where MR=MC P 11 P MC = 11 1 The greater the price elasticity of demand,, the smaller the degree of monopolistic power. For the case where = as in perfect competition, the firm has no power. P / MC = 1 3 If , P MC = MC

(E) The inefficiency of the monopolist The demand schedule represents individuals' willingness to pay. Under perfect competition, the triangle A-C-Pc depicts what we called the consumer surplus in the sense that this is part of what the consumer was willing to pay, but ended up paying less ( the market price Pc). Similarly, the marginal cost schedule represents the seller's willingness to sell. The difference between the prices he gets for each unit and the price for which he, or she, was willing to sell is called producer surplus (triangle Pc -C-F). We interpret both surpluses to be the benefits generated by the market. P A PM PC MC = S(PC)
B

PS M

CS

Deadweight loss

MR

D X

1 2 XM XPC

If we now compare the two equilibria, M( under monopoly) and PC ( under perfect competition), we can clearly see the way in which the monopolistic market structure is inefficient.
In the case of the monopolist, we see that by moving from point M or output XM (which is the monopolist allocation) to XPC , both consumer and producer surpluses can be increased. Hence, the monopolist solution is inefficient in the sense that we can have more of one thing (benefits of either consumers or producers) without giving up another (benefits to the other group). The loss of consumer surplus and producer surplus associated with a monopolist is given by

the shaded triangle B-C-M. This is called the deadweight loss, which is a net loss to society. Hence, a monopolist is inefficient as it leads to deadweight loss.

Tutorial 6 Monopoly 1. Monopolist always produces in the inelastic portion of its demand schedule. T/F Revenue, R = P X MR = dR = P dX + X dP dX MR = dR = P dX MR = P 1 + dX dX + dP X dX dP X dX P As = dX P , hence 1 dP X MR = P 1 + 1 MR = P 1 1 False, a monopolist will never produce in the inelastic portion of its demand schedule as MR is negative. = dP X dX P

2. Can one say that the greater is the price elasticity of demand, the less power will the monopolist enjoy. monopolistic power . T/F Monopolist produces where MR=MC P 11 P MC = 11 1 If , P MC = MC

3. Analyse the effects of a lump-sum tax on a monopolist. Will such a tax help in rectifying the monopolist's inefficiencies? P MC0 P1 P0 0 AC A MR Xo XPC X1 X
M

AC1= AC0 + T X AC0

The lump-sum tax would constitute a fixed increase in costs and would therefore affect AC, but not MC. AC shifts up by T/X which means that the new AC would be asymptotic to the original one as the quantity produced increases. As marginal costs remain unchanged, the monopolist would not change its profit maximising output where MR=MC at point A. However, profits is now lower as AC is higher. Hence, X and P unchanged, profit . As the tax does not affect the equilibrium condition in the monopolist market and in this respect, it does not alter the inefficiency created by the monopolist. The lump-sum tax would not change the deadweight loss which would still be triangle M-C-A. However, if members of society have different weightage in the social welfare function, it is possible to re-distribute the tax to the more needy group. In other words, the policy can fuel a social improvement. Hence, some of the inefficiency may be compensated through an appropriate use of the tax revenue. 4. An increase in the fixed cost will have no effect on the equilibrium price and output of a monopolist. True or false, explain. An increase in the fixed cost by $F would constitute a fixed increase in costs and would therefore affect AC, but not MC. AC shifts up by F/X which means that the new AC would be asymptotic to the original one as the quantity produced increases.

5. Analyse the effects of a unit subsidy on a monopolist. Will such a subsidy provide any improvement? 1999 ZB 4b. P P0 P1 MC0 MC0-s AC0 AC0-s

D MR

X0X1 XPC

The subsidy will shift AC and MC parallel down, resulting in a higher level of output. This means that the subsidy is effective in bringing the output closer to the allocative efficient output. X, P, profit . 6. An effective imposition of a maximum price will necessarily cause a monopoly to reduce its output. T/F, explain. P MC0 AC0 P0 Pmax A MR0 X0 X1 8 X, P = Pmax. X B D1

7. A famous gallery which houses a large exhibition of rare impressionistic paintings faces demand from tourists as well as locals. The tourists demand schedule begins at a higher price and its price elasticity of demand is more inelastic than that of the locals. a) Draw the demand and the marginal revenue curves facing the monopolist. b) Determine the output and price if the firm cannot price-discriminate. P Tourists P Locals P Monopolist D1 P* P1 P* D2 MR1 5 D1 x MR2 x 5 MRT X P* D1 +2

b) Cannot price discriminate. P

P2 P1 d a z T X0 XL X1 T b H Constant MC DT MRT X

Will produce X1 and sell to both tourists and locals at P1

Topic 7 MONOPOLISTIC COMPETITION Monopolistic competition is the market structure where there are many sellers producing differentiated product. Sellers are price-makers. Therefore, it faces a downward sloping demand curve which means it can change the price at which it sells its own output. A) Characteristics: same as perfect competition except product is differentiated. 1) Differentiated product. 2) Freedom of entry and exit. 3) Large number of firms. 4) Perfect information and mobility. Firms demand curve is downward sloping. Product differentiation can take the form of non-price competition such as advertising and providing better services. There are, apart from advertising, many methods which firms can adopt to create differentiation. The following list contain a few examples: Packaging Product Design Types of services Location

B) The Monopolistic Competitive model : Short-run equilibrium Firms set output such that MR = MC to maximise profits. Equilibrium output is given by XSR and the price charged is PSR. This is the situation in which each firm earns economic profits. Long-run equilibrium In the long run, economic profit will attract new firms to the industry. With more substitutes and greater competition, the demand for each firm will fall and become more elastic until it is tangent to the average cost curve. Firm will produce at the tangent point. P

PSR

MC

AC

AC

DS MR

XSR

PSR PLR AC B

MC

AC

MR
XLR

DLR

DS X

XSR

Long-run equilibrium = 0 P MC AC =PLR

AC

DLR XLR X

Tutorial 7 Monopolistic Competition 1) How will a lump-sum tax on firms in monopolistic competition affect their long-run output? It is good of the government to tax the industry in such way as it forces the long-run equilibrium to be nearer to the point of minimum average cost. Hence, with proper calculation of the lump-sum tax, the government can restore allocative efficiency in the economy and reduce the monopolistic power of the firm. Comment on this statement.
P AC1
Losses

MC0 B A

AC1

P1 P0

AC0

D1 MR0 D0

XLR X1 XAE Xpc

SR: Lump-sum tax AC and leads to economic losses. LR: Losses cause some firms to close down. With lesser competition, the demand for each firms output will rise and become less elastic. Hence, the demand schedule will shift up and become steeper until it is tangent to AC. Hence, X closer to the point of minimum average cost. The industry becomes less inefficient. X or unchanged. P Firms produce where MR=MC to maximise profits. P 11 P MC = 11 1 2) An increase in fixed cost will have no effect on the equilibrium price and output of a firm in monopolistic competition. It will also not affect its inefficiency. True or false, explain. in fixed costs by $F: New cost = Cost + F : AC converged up. = MC

3) An increase in annual license fees will have no effect on the long-run equilibrium of firms in monopolistic competition. True or false, explain. in annual license fee by $L: New cost = Cost + L : AC converged up.

Topic 8 Factors Market (A) The demand for factors The demand for factors of production comes from the firm, the producing agent. It can be derived as a result of the desire of the firm to maximize profits. Remember that the profit function is: = R(X) - C(X) = Px X - wL - rK where L stands for labour and K for capital goods. Price of labour is wages (w) and the price of capital is the interest rate (r). The aim of the firm is to maximize profits. We must now inquire what that would mean for the choice of inputs. (B) The Demand for Labour (MRPL ) Marginal product of labour, MPL is the extra product produced by one extra labour. Marginal Revenue Product of Labour, MRPL = MPL . MR. It is the money value of the marginal product. Assume there is only 1 variable input labour (L) with unit cost w. The question is how much labour should the firm demand if its objective is to maximise profit. The competitive firms objective is to choose labour to maximise profit, i.e. Max ()= PX(L) wL
L

where p is the price per unit of output.

d dL

= P dX dL

-w =0

MPL P = w MPL is the extra product produced by one extra labour. Therefore, to maximise , firm would hire labour up to the point where MPL P = w, where the money value of the marginal product (or the Marginal Revenue Product of Labour) equals the nominal wages. The diagrams is shown below: Labour Demand Curve W W0 SL = W 0 PX Real Labour Demand Curve SL

0 = W 0 0 PX DL MRPL = P X MPL

MPL L0 L

1 2

L0

Optimality in consumption- leisure space. The individual will want to choose the most preferred combination of consumption and leisure. Given the shape of indifference curves and the fact that utility is increasing with an increase in both leisure and consumption, such an optimal point is captured in the following diagram. Formally, this problem takes the form of: Maximising U(X, Le) s.t. Px X = w ( - Le) and its solution is exactly point A. X Wo Px
0

Xo

A U0

Wo 0 Px Le
0

Le

Deriving the Supply of labour Upward-sloping part of Ls (pt A to pt B) An increase in wage from Wo to W 1. At the lower end of wage levels, income is very low. Labours will more likely to respond to the increase in the wage level by working more. From A to B, when w work or Ls(labour supply). w SE Ls IE Ls Backward-bending part of Ls (pt B to pt C) An increase in wage from W 1 to W 2 . At the other end, when your hourly wage is enormous, you are unlikely to be impressed by a proposed increase in your hourly wage. You are more likely to work less and have more fun. You are more likely to think to yourself, If I am paid more, I'd better spend more time at the golf course so that other people can see that I am a high flyer. From B to C, when w work or Ls(labour supply). w SE Ls IE Ls X W2 0 PX 0 = W 0 PX 2 = W 2 0 PX 1 = W 1 0 PX SL C

IE>SE

W1 0 PX W0 0 PX

SE>IE U2 U1 U0
A

Xo
B

0 = W 0 0 PX

Le Le Le 10 13 16

Le Leisure
A

Ls 8

Ls

Ls

Ls = - Le B B Ls = Le

Ls Labour Supply

Market equilibrium Consider the aggregate demand for labour based on the marginal product of labour and the supply of labour which is based on the simple horizontal summation of individuals' supply curves: Pt A is the equilibrium point. e A

DL SL L

Tutorial 8 1) Derive the supply curve of labour and explain why it may be backward bending? See lecture notes. 2) Is leisure a normal good or inferior good? X W1 0 PX le inf le normal

B B
U I

UP

BACK

W0 0 PX

B C

U N

B A

B N

Xo Le 11

SE
C

U0 Le 16
0

=24

Le

On the upward part, w Ls Le. Leisure can be a normal or an inferior good. On the backward part, w Ls Le. Leisure must be a normal good. 3) When labour supply is upward-sloping, leisure cannot be inferior. True or false, explain. False.

4) The backward bending part of labour supply can only be a result of leisure being a normal good. True or false, explain. True.

5) The backward bending supply curve of labour means that leisure is an inferior good. True or false, explain. False.

6) Consider an individual who treats leisure as an inferior good. Would he work more hours when nominal wages increase? X W 1 0 PX Inferior

BI W 0 0 PX C U1

U0 1 0
A

Le Le Le A 7 9 Ls

Le

7) Suppose that a labourer has chosen to work Lo hours at the going real wage of 0 and 0= w/p. He is now offered the following: i) an increase in their real wage to 1 per hour, ii) an increase of B pounds per hour (which is greater than the increase in the first option, B > 1 - 0 ) but only for overtime (the hours above Lo); a) What will happen to the labour supplied by this individual under each of these proposals assuming that his choice is in the upward region of his labour supply ? b) Will your answer be different if he is at the backward bending region of his labour supply ? c) Is it possible that the labourer might be indifferent between the two schemes?

7(a,b) Option 1: W 0 to W 1 per hour. (W 1 > W 0) 0 Option 2: Same W 0 for the first normal Ls hours, but pay overtime pay of W 2 per hour thereafter. W 2 > W 1 X W 1L
0 PX

Option 1 B
UP

Option 2 W1 0 PX

BACK

W 0L PX
0

W 0L B
B

B W2 0 PX

PX

A W1 0 PX Le0 Ls
0

W0 0 PX

U0 L Le
1

A W0 0 PX

U1 U0 L Le

Le Le0 Ls Here, Ls always

Upward part of Ls: Ls Backward part of Ls: Ls.

7(c) It is possible for him to be indifferent to the two schemes. X W1 L PX

0

B2 W0 L
0 PX

B1 U1
0

Le

Le