Markets and Firms

Economic concepts

Consumption
Define: act of using goods and services to fulfill wants

Production
Define: transformation of inputs into outputs by firms to earn profits
✅ inputs include: i) labour ii) land and raw materials iii) capital

Problem of scarcity
Define: excess of what humans wants over what can be produced to fulfill those wants

Macroeconomics objectives
✏high and stable economic growth
✏low unemployment
✏ low rates of inflation
✏avoidance of payments of deficit
✏stable financial system
✏ avoidance of excessive rate of fluctuations
✏avoidance of excessively financial distressed sectors of economy

Circular Flow of income
(relationship bet firms and owners of factors of production)


Opportunity cost: cost of the activity measured in terms of it best alternative foregone

Demand and Supply

R bet Demand and Price

  • law of demand
  • income effect
  • substitution effect
  • quantity demanded

Other Determinants of demand

  • consumer tastes
  • number and price of substitute goods
  • number and price of complementary goods
  • consumer incomes
  • distribution of income
  • expectations of future price changes

RS bet Supply and Price

  • Short T: increase price increase supply
    but beyond a certain output, cost also increases
  • Long T: if price remains high, production set up by firms and total market supply increases

Other determinants of supply

  • cost of production/ distribution
  • profitability of alt prdts
  • profitability of goods in joint supply
  • nature, random shocks and other unpredictable events
  • aims of producer
  • number of suppliers

4 main causes for change in prices:
i) changes in inputs
ii) changes in technology
iii) organisational changes within firm
iv) changes in gov. policies

Price controls

  • Maximum price ( price ceiling)
    ✅ will result in DEM>>>SUP
    Food , daily essentials

-Minimum Price
✅will result in DEM<<< SUP
Wages, agricultural commodities, alcohol etc

Elasticity and Uncertainty

Price elasticity
= % change in quantity demanded/ % change in price
🏁elastic
🏁 inelastic
🏁unit elastic


Determinants of PED

  • availability of sub goods
  • proportion of income
  • time period

Income elasticity of demand (IED)
= % change in quantity demanded/
% change in income


high for normal good and low for inferior goods


Cross-price elasticity of demand (CEPD)
= % change in quantity demanded of Good X/
% change in price of Good Y


  • complementary goods ( both negative)
  • substitute good ( positive)


Price Elasticity of Supply
= % change in quantity supplied/
% change in price


Determinants

  • time period - longer time, higher PES
  • costs i.e lower cost will increase PES


Elasticity and TAX


INDIRECT TAX


results: increase tax, increase price to consumer, decrease quantity demand and sold.

  • company receives less than original price after tax(Pp)
  • tax is co paid by consumer and business

Tax revenue = (Pc-Pp)* Q


How is tax revenue split bet P and C ?
✅depends on price elasticity of demand and supply


  • more elastic demand , smaller price increase( lesser consumer burden) ,greater fall in quantity sold


  • more elastic supply, higher PES because of lower marginal inputs, greater price increase( higher consumer burden) greater fall in quantity sold



SUBSIDY

  • paid to supply to reduce cost
  • downward shift in supply curve
  • price will fall by less than subsidy so that both P & C will benefit
    ✅ elasticity:
  • more elastic demand, smaller decrease in price, greater rise in quantity sold ( higher cost of subsidy)
  • more elastic supply, greater decrease in price, greater rise in quantity sold

Time Dimension of market adjustment
⚠ change in D or S will result in

  • Small SR Quantity change
  • Large SR price change
    followed by:
  • Large LR Quantity change
  • Small LR Price change

Price Expectations and speculations

  • stabilizing speculation
  • destabilizing speculation

Risk and Uncertainty

  • Risk: probabilities are known
  • Uncertain: probabilities are unknown

Consumer demand
and uncertainty

Marginal Utility Theory


Utility, in monetary terms, max price a person would be prepared to pay for 1 more unit of good


  • Marginal Utility: additional satisfaction of


    consuming 1 extra unit of good within a given period of time


  • Diminishing Marginal Utility: additional utility gained from consuming successive units of a good will decrease.


  • Marginal Consumer Surplus(MCS): excess utility gained over and above the price paid for an additional unit of good i.e MCS= MU- P


  • Total Consumer Surplus : TU - TE i.e excess of what the person would pay over what they actually paid



RATIONAL CONSUMER BEHAVIOR: attempts to maximise the total consumer surplus. consume up to a point MU=P

MU and demand curve of good

  • principles of diminishing MU implies individual's demand curve
    slope downwards
  • market demand curve = horizontal sum of all individual demand curve, hence slope downwards.
    CONS:
  • interdependence of changes in consumption of diff goods
  • dependence of consumption of income

Demand under conditions of risk & uncertainty

  • imperfect info
  • attitudes towards risk and uncertainty
    *E[X] = xP(X=x)
    ✏risk -neutral
    ✏risk loving
    ✏risk averse
    in conditions of uncertainty, individual are generally more cautious

Diminishing MU(income) and attitudes to Risk

  • refers to individual gains less additional utility from each extra pound of income

Insurance

  • spread its risks through offering multiple of independent risks
  • Law of large numbers => larger numbers, more predictable outcome
  • diversification of companies-> reinsurance / diversification

Problem with unwary insurance companies

  • asymmetric information
    ✅ unobservable characteristics -> adverse selection ( to screen, background check, higher premiums paid etc)
    ✅ unobservable actions -> moral hazards ( monitor behaviours or penalties set i.e NCD, refusing claim etc.)

Expected utility theorem ( U = utility function)

  • E(Uw) = Sum [(U(w)* p(w)]
    Benefits of the insured
  • people are risk averse, hence feeling of certainty gives them extra utility
    - Max premium = E(U(a-X)]= U(a-P)

  • Max premium = E[U(b+Q-X)] = U(b)


  • feasibility of insurance contract

Production and Cost

measuring cost of inputs

✏Factors not owned by company - explicit
✏Factors owned by firm- implicit costs
✏historic cost of factor- $$ paid for it
✏ replacement cost of factor- cost to replace
✏ sunk cost - cost cannot be recouped


✏bygone principle: only variable costs should be considered

Production in SR

cost in the SR

  • factor productivity= higher productivity means lower production cost
  • factor prices= higher prices imply higher production cost

Total cost = TFC +TVC
Marginal cost = dTC / dQ
AFC= TFC/Q
AVC= TVC/Q
AC = (TFC+TVC)/Q= AFC+ AVC


MC< AC , AC must be falling
MC> AC , AC must be rising
MC=AC, AC is at min.

Production in the LR


  • scale of production

✅ change all factor inputs by same percentage i.e increasing, decreasing, constant
( Economies of scale - LRAC fall as scale of production increased)

  • causes:
    ✅specialization & division of labour
    ✅ indivisibilities -> container principle, greater efficiency of large machines, multistage production
    ✅ organisational - rationalisation
    ✅ spreading of overhead costs
    ✅ financial economies
    ✅ economies of scope

location of production:


production techniques to use

technical/ productivity efficiency - cost-minimising combination of factors for a given output level -
🌲: MPP/P = MPPi/Pi=MPPii/Pii


Diseconomies of scale
❌poor industrial relations
❌ managerial problems of co-ordination
❌ poor motivation of workforce
❌problems in area holding up prodn

transport costs: distance from market/ raw materials
industrial clusters: interconnected companies in same location
i) improve productivity
ii) encourage innovation
iii) encourage formation of new businesses to meet needs of cluster- VC & skilled labour available to reduce cost and lower risks of new business set up

ULTIMATE DECISION

VSR= all fixed
SR = at least 1 fixed
LR = all factors are variable but fixed quality
VLR= all factors are variable with adjustable quality, hence productivity changes.

✅short run = period of time where at least 1 input factor is fixed
Long run = all factors are varied


✅ Law of diminishing (marginal) returns
as more variable factors are combined with fixed factors, increase in total output will eventually decrease ( applies in SR as fixed factors become overloaded.


✅ TPP = f( K, L) i.e amount of output produced over time
k = capital , L = labour


✅APP= TPP/ Q
✅ MPP= dTPP/dQ [ 1 extra cost of unit /extra cost of variable factor]

Cost in LR

LRAC

  • decrease up til a certain level due to economies of scale
  • increase beyond a certain level due to diseconomies of scale

MES( minimum efficient scale) = level of output beyond which there is no further economies of scale


  • assumptions:
    i) technology and factor quality are given
    ii) firms chooses cost minimising combination of factors
    iii) discounts are given on bulk purchases

RS bet LR and SR AC
-

Revenue and Profit

Revenue

Total revenue= Price * Quantity
Average revenue= TR/Q = P

  • AR curve = P = firm's demand curve

MR= dTR/dQ


Price taker: D =AR=MR P usually is at industry equilibrium
TR for such companies is a straight line curve ( Y=X)
Price maker: can influence the price charged for its good or service

Short run shut-down point AVC= D=AR
Long run shut-down point AR = LRAC

Profit maximisation

Total profit = TR-TC
SR Profit




AC / MC
SR Profit