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Microeconomics HL (Elasticity (PED (price elasticity of demand) =…
Microeconomics HL
Elasticity
PED (price elasticity of demand) = percentage change in the quantity demanded over the percentage change in the price of the product
YED (income elasticity) = percentage change in the quantity demanded over the percentage change of the incomes
XED (cross elasticity of demand) = the percentage change in the quantity demanded of object A, over percentage change in the price of object B
PES (price elasticity of supply) = the percentage change in the quantity supplied of a product over the percentage change in the price of the product
Determinants of PED:
- Number and closeness of substitutes
- Degree of necessity
- Proportion of income spent on the good
- Time
Determinants of PES:
- Time
- Mobility of factors of production
- Ability to stock store
- Unused capacity of firms
Theory of the firm
Monopolistic competition
Assumptions of the model:
- The industry is made up of a large number of firms
- The firms are small, relative to the size of the industry; thus the actions of one firm do not have a significant impact on its competitors
- The firms all produce slightly differentiated products
- Firms are completely free to enter or exit the industry, there are no barriers to entry or exit
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Short-run
In the short-run, firms in monopolistic competition can experience abnormal profits or losses
Long-run
All firms in monopolistic competition will earn normal profits in the long run, due to the lack of barriers to entry/exit, as firms over time will join the industry if firms are earning abnormal profit in the short-run, and firms will exit the industry if they are making loses in the short-run
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Monopoly
Assumptions:
- one or two firms that dominate the industry
- there are significant barriers to entry including economics of scale, start up costs
- no close substitutes
Natural monopoly
- when a firm has such large economies of scale that it is able to supply for the entire market
Efficiency
- the presence of deadweight loss indicates that there is allocative inefficiency
- the underallocation of resources is indicated by P>MC
- there is also productive inefficiency since the monopolist produces at a higher than minimum average cost
Evaluating monopoly in terms of perfect competition
- able to participate in research and development
- large economies of scale
- inefficient
- low output and higher price
Barriers to entry:
- Economies of scale
- Brand loyalty
- legal barriers such as patents and licenses
- natural monopoly
- start up costs
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Perfect competition
Demand and revenue curves:
- the industry has standard demand and supply curves which determine the equilibrium price at which all firms sell at
- each firm uses the industry price so they are price-takers
- the demand curve for each firm is perfectly elastic meaning that price is constant at every level of output
Profit and loss in the short-run:
- in the short-run at least one of the factors of the firm is fixed
- profit-maximizing level of output is MC=MR
- when price> ATC the firm is earning abnormal profit
- when P=minimum ATC this is the break-even price, zero economic profit also called normal profit
- Price=minimum AVC is the shut down price, where the loss is equal to the total fixed cost
Long-run:
- in the long-run the firm earns normal profit
- if a firm begins to earn abnormal profit other firms will enter the industry
Abnormal profit in the short-run:
- abnormal profit will attract new firms to enter the industry
- as they enter, the industry supply curve shifts right leading to an increase in the price for each firm
- this causes the firms to begin earning a normal profit in the long run and eventually new firms stop entering
Losses in short-run
- if firms are making losses in the short-run they are initially unable to leave because they have at least one fixed input
- when the firms enter long-run they have no fixed inputs and are free to leave
- this causes the industry supply curve to shift less and leads to an increase in the price
- this causes the firms to earn normal profits in the long run
Efficiency
Allocative
- allocative efficiency achieved at P=MC
- achieved in the long-run
Productive
- occurs when production takes place at the lowest possible cost (minimum ATC)
- Perfect competition is the only market structure where allocative and productive efficiency are achieved at the same time
Evaluating perfect competition
Benefits
- efficient market structure
- low price for consumers
- competition among firms
- market responds to consumer tastes
- market responds to changes in technology
Limitations
- unrealistic assumptions
- limited opportunity to take advantage of economies of scale
- lack of product variety
- market failure
- not enough resources for research and demand
Assumptions:
- large number of firms that are independent to each other
- all firms produce identical products
- free entry and exit into the market
- there is perfect information
- perfect resource mobility
Oligopoly
Price discrimination
First degree price discrimination: when the consumer can negotiate prices with the seller, and the product goes towards the highest bidder - and the producer gains the revenue from consumer surplus
Second degree price discrimination: when the price changes depending on the usage of the product: eg. mobile phone data plans
Third degree price discrimination: Occurs when consumers are identified in different market segments and separate price is charged in each segment to accommodate for the different price elasticities of demand
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Market Failure
Price Floors/Ceilings
Definition: a government intervention in the market involving the setting of price floors and price ceilings thus preventing the market from reaching a market-clearing equilibrium price.
Price Ceiling:
Definition: a maximum price on a good set by the government that is below the equilibrium price resulting in a shortage
Why Impose Price Ceilings:
- Make necessities available to poorer consumers
Consequences of Price Ceilings:
- Shortages (excess demand)
- Non-price rationing mechanisms
- Underground/parallel markets
- Inefficient resource misallocation
- Consumers: some loose as they miss out but some win as they purchase at a lower price
- Workers loose their jobs due to less supply
- Loss of producer revenue
- No economic gain or losses for the government but might gain political popularity
Price Floor
Definition: a minimum price set by the government that is above the market equilibrium price resulting in a surplus
Why Impose Price Floor:
- For minimum wages to protect low skilled workers or farmers
Consequences of Minimum Wage:
- Illegal workers
- Workers whom are employed benefit from higher wage but there are other workers whom are left unemployed
- Firm have higher costs of production
- Consumers may need to pay higher price to cover the increased costs of firms
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Indirect Taxes
Definition: a tax on the expenditure on goods and services paid indirectly to the government through the seller.
Specific vs. Percentage Tax
Specific: a fixed amount of tax that is imposed per unit of the good (e.g. cigarette tax)
Percentage (ad valorem tax): the tax is a percentage of the price and so the amount of the tax increases with an increase in price (e.g. GST 10%)
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Tax Burden:
- If PED>PES producers pay more of the tax
- If PES>PED consumers pay more of the tax
Evaluation:
Consumers: pay higher price and buy lower quantity
Producers: revenues decrease as they receive a lower price and lower quantity
Workers: less produced therefore less workers needed
Government: gains tax revenue which can be used to fix negative externalities
Society: resource misallocation (under-allocation)
Why impose and indirect tax?
- provide government revenue
- encourage decreased consumption of demerit goods
- improve allocation of resources where negative externalities exist
Cost/Revenue Theory
Short run (6-12 months) at least one factor of production is fixed.
Long run (12+ months) all factors of production are variable; except for technology.
Breakeven price: P = ATC (price per unit is able to cover the average cost per unit).
Shut down price: P = AVC (price per unit can only just cover average variable costs - any price below P and the firm should shut down.
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Revenue Theory
- When PED is elastic, any firm wishing to increase revenue should lower its price
- When PED is inelastic, any firm wishing to increase revenue should raise its price
- When PED is unity (PED = 1), any firm wishing to increase revenue should leave the price unchanged, since the revenue is already maximised
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Supply and Demand
Demand: the quantity consumers are willing and able to buy at a given price level
Non-price determinants of demand:
- Income; affects whether consumers buy normal or inferior goods
- The price of other goods (substitutes/complements)
- Tastes/preferences of consumers
- Other factors such as the size of population, changes in age/income distribution, seasonal/government changes
Supply: the quantity of goods that producers are willing and able to supply at a given price
Non-price determinants of supply:
- The cost of factors of production
- The price of other products, which the producer could produce instead of the existing product
- The state of technology
- Expectations
- Government intervention
Supply function: Qs = c + dP
- c = x-intercept
- d = slope
Demand function: Qd = a - bP
- a = x-intercept
- b = slope
