Core Economy Textbook

7.1: BREAKFAST CEREAL: CHOOSING A PRICE: How would you choose price for a product? You need to consider demand curve, as your decision will affect your profits, and consider costs. Suppose unit cost was $2. To maximise profit, you would produce how much you expect to sell. Cost = unit cost x quantity Total revenue = price x quantity Profit= total revenue – total costs Isoprofit curves can be drawn. To achieve a high profit, you want price and quantity to be as high as possible, but this is constrained by demand curve. - Horizontal line shows where profit is zero - Profit would be maximised at E, you reach highest possible isoprofit curve while remaining in the feasible set, where demand is tangent to the isoprofit curve. - The isoprofit curve is your indifference curve, and its slope at any point represents the trade-off you are willing to make between P and Q—your MRS. You would be willing to substitute a high price for a lower quantity if you obtained the same profit. - The slope of the demand curve is the trade-off you are constrained to make— your MRT, or the rate at which the demand curve allows you to ‘transform’ quantity into price. You cannot raise the price without lowering the quantity, because fewer consumers will buy a more expensive product. When quantity is low, profit is low Increase in quantity cause profit to rise until maximum point E Profit falls to zero where price equals unit cost 7.2: ECONOMIES OF SCALE AND THE COST ADVANTAGES OF LARGE-SCALE PRODUCTION: A reason why large firm are more profitable is because it produces output at lower cost per unit. This may be due to two reasons: Technological advantages: Large-scale production often uses fewer inputs per unit of output. Cost advantages: In larger firms, fixed costs such as advertising have a smaller effect on the cost per unit. And they may be able to purchase their inputs at a lower cost because they have more bargaining power. Economics of scale or increasing returns describe technological advantages of large-scale production. If we increase all inputs by a given proportion, and it: increases output more than proportionally, then the technology is said to exhibit increasing returns to scale in production or economies of scale increases output less than proportionally, then the technology exhibits decreasing returns to scale in production or diseconomies of scale increases output proportionally, then the technology exhibits constant returns to scale Economies of scale may be due to specialisation within the firm, or due to engineering reasons. There are also built in diseconomies of scale. Cost advantages: Cost per unit may fall as firm produces more output. This happens if there is a fixed cost that doesn’t depend on output. For example, cost of research and development, obtaining a patent and product design. Moreover, large firms are able to purchase their inputs on more favourable terms, because they have more bargaining power. Demand advantages: People may be more likely to buy if a firm already has lots of users. These demand side benefits are called network economies of scale. 7.3: PRODUCTION: THE COST FUNCTION FOR BEAUTIFUL CAR To decide a price manager must know the demand and production costs. For producing and selling cars firm needs premises and equipment etc. The firm’s owners (shareholders) won’t invest in the firm if they could make better use of money by investing elsewhere, what they can earn elsewhere is an opportunity cost. Top panel shows cost at different levels of output Some costs do not vary these care fixed costs, the only fixed costs are F, where Q equals 0. As quantity increases, total cost rises. And firm employs more workers Lower panel shows average cost. Average cost is lowest at B At each point on the cost function, the marginal cost (MC) is the additional cost of producing one more unit of output, which corresponds to the slope of the cost function. If cost increases by ∆C when quantity is increased by ∆Q, the marginal cost can be estimated by: Top panel shows cost function Lower panel shows average cost curve and marginal cost curve Increasing marginal cost leads to average cost to rise At Q(0) MC < AC. AC curve slopes downwards more is produced it decreases At D AC rise, when AC < MC, AC upwards When AC = MC AC is at its lowest this point AC is flat because as curve slopes point. At 7.4: DEMAND AND ISOPROFIT CURVES: BEAUTIFUL CARS: Cars are differentiated products. We expect a firm selling differentiated products to face a downward sloping demand curve. Demand curve: Each consumer has a willingness to pay (WTP) for a car, which depends on how much the customer values it. The consumer will buy a car if price is less than or equal to WTP. The isoprofit curves: Firms profit is the different between its revenue and total costs C(Q). Profit = PQ -C(Q) This gives us the economic profit. Economics profit is the additional profit above the minimum return required by shareholders. If P = AC firms’ economic profit is zero. Average cost is decreasing when Q is less than 40, and increasing otherwise. It has increasing marginal costs, as it is upward sloping line. Curves cross at B. The higher isoprofit curves show higher profits. Profit is higher on the curves closer to the top right corner. Isoprofit curves slope downwards where P>MC, and upwards where P MC it would be better to increase production as selling more gives more revenue than cost Profit is maximised where MR = MC 7.7: GAINS FROM TRADE: People volunteer in economic interactions for economic rent. The total surplus for parties is a measure of the gains from exchange. We have assumed: Firms decide how many items to produce and sets a price Consumers decide whether to buy To find the total surplus by consumers you add the surplus of each buyer. This is shown by shaded orange triangle between demand curve and line where price is P*. Producer surplus is purple shaded area between vertical line and marginal cost curve. Pareto efficiency: The allocation of cars in this market is not pareto efficient. As there are some consumers who do not purchase at firms chosen price, but would be willing to pay more than the cost to the firm. Firms profit maximising price is at E, but there are unexploited gains from trade Suppose firm chooses F instead. This allocation is pareto efficient. Consumer surplus increases Producer surplus decreases, but total surplus has increased At E there was a deadweight loss 7.8: THE ELASTICITY OF DEMAND: The price elasticity of demand is a measure of responsiveness of consumers to a price change. Elasticity is related to the slope of the demand curve. If curve is quite flat, elasticity is high. A steeper demand curve corresponds to a lower elasticity. If demand is inelastic, firm cannot increase Q without a large drop in P so MR < 0. Profit margin is affected by elasticity. 7.9: USING DEMAND ELASTICITIES IN GOVERNMENT POLICY: If government puts a tax on a good, the tax will raise the price paid, so effects of tax depend on elasticity of demand: If demand is highly elastic: A tax will cause a large reduction in sales. That may be intentional, as when governments tax tobacco to discourage smoking because it is harmful to health. If a tax causes a large fall in sales: It also reduces potential tax revenue. So, if government wishes to raise tax revenue, they should choose tax products with inelastic demand. 7.10: PRICE-SETTING, COMPETITION, AND MARKET POWER: Our analysis of firms pricing decision applies to any firm producing differentiated products. Monopolies are firms selling differentiated goods where they have a lot of power. Firms set prices way above marginal cost. This is not pareto efficient and is a case of market failure. It creates a deadweight loss. The manufacturers of specialised cars, face little competition so have less elastic demand. It can set high prices and so earns monopoly rents. A firm will be in a strong position if it has few close substitutes, we say a firm like this has market power. Competition policy: Potential consumer surplus is lost because prices are raised and fewer consumers buy, so there is a deadweight loss. A particular concern is when there are a few firms that may form a cartel (group that collude to keep prices high). Competition policy is used to prevent this. 7.11: PRODUCT SELECTION, INNOVATION, AND ADVERTISING: Firm may be able to increase demand through advertising and marketing. Ideally goods chosen to be produced would be with high demand and low elasticity. Elasticity can be kept low through having copyright and patent laws. Advertising is used to inform consumers of products and its USP. 7.12: PRICES, COSTS, AND MARKET FAILURE: Market failure occurs when market allocation of a good is pareto inefficient. Product differentiation is not the only reason for the ability for a price to be made above marginal cost. A second reason is decreasing average costs, perhaps due to economies of scale, or input prices declines as firm purchases larger quantities. In such cases, average cost of production is greater than marginal cost, and average cost slopes downwards. Price must equal at least average cost to not make a loss, so it is above marginal cost. Utilities typically have increasing returns to scale. If a single firm can supply whole market at lower average cost than two firms, the industry is said to be a natural monopoly. Policymakers may not be able to induce firms to lower their prices by promoting competition, since average costs would rise with more firms in the market. A price above marginal cost whatever the reason results in market failure. Too little is purchased, so there is a deadweight loss.