Microeconomics HL
Theory of the firm
Market Failure
Cost/Revenue Theory
Supply and Demand
Monopolistic competition
Monopoly
Perfect competition
Oligopoly
Price Floors/Ceilings
Subsidies
Indirect Taxes
Elasticity
Definition: a tax on the expenditure on goods and services paid indirectly to the government through the seller.
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
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
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
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%)
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
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.
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
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
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
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
Definition: payment by the government to firms to lower costs and price and increase supply
Why Governments Grant Subsidies?
- Support particular industries/firms
- Lower costs and prices of essential goods
- Improve allocation of resources where there are positive externalities
- Enable firms to compete with overseas firms
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
Tax Burden:
- If PED>PES producers pay more of the tax
- If PES>PED consumers pay more of the tax
Short-run
In the short-run, firms in monopolistic competition can experience abnormal profits or losses
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
Effect on Diagram:
- Supply curve shifts vertically downwards by the amount of the subsidy
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
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
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
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.
Evaluation:
- The opportunity cost of government spending on subsidy
- If the subsidy will take away efficiency
- Although consumers get to buy the products for lower prices, the subsidy is funded through tax fund which are essentially funded by the consumers
- What damage will it do to the sales of foreign firms whom are not receiving subsidies
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
Barriers to entry:
- Economies of scale
- Brand loyalty
- legal barriers such as patents and licenses
- natural monopoly
- start up costs
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
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)
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Externalities
Positive Externality of Consumption
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
Negative Externality of Consumption
Positive Externality of Production
Negative Externality of Production
Price Ceiling:
Definition: a maximum price on a good set by the government that is below the equilibrium price resulting in a shortage
These occur when the production of a good or service creates external costs that are damaging to third parties
- Occurs when there are TWO SUPPLY CURVES, but the MPC curve is greater than the MSC curve, this the output is greater than the socially optimal level of output
Why Impose Price Ceilings:
- Make necessities available to poorer consumers
Solution: tax the good to increase the cost and reduce the output of the good
Evaluating monopoly in terms of perfect competition
- able to participate in research and development
- large economies of scale
- inefficient
- low output and higher price
These occur when the production of a good or service creates external benefits that are good for third parties
- Occurs when there are TWO SUPPLY CURVES, but the MBC curve is greater than the MPC curve, and the output is lower than the socially optimum level of output
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
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
Goods that when consumed by individuals, produce negative benefits for third parties in societies
- Has TWO DEMAND CURVES, with the MPB greater than the MSB, and the output is higher than the socially optimum level of output
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
These are goods and services that, when consumed, will provide external benefits to third parties
- there are TWO DEMAND CURVES, with MSB greater than MPB, but the production is lower than the socially optimum level of output
Solution: the government can subsidize the good to decrease the price and increase output
Why impose and indirect tax?
- provide government revenue
- encourage decreased consumption of demerit goods
- improve allocation of resources where negative externalities exist
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
Solution: the government can impose an indirect tax, or promote negative advertising of that product
Solution
- subsidise the industry in which there is an externality in order to shift the MSC curve down
- use positive advertising to encourage consumption of the product
- introduce laws relating to the product, however this will be politically unpopular
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
Determinants of PED:
- Number and closeness of substitutes
- Degree of necessity
- Proportion of income spent on the good
- Time
Demand function: Qd = a - bP
- a = x-intercept
- b = slope
Supply function: Qs = c + dP
- c = x-intercept
- d = slope
Determinants of PES:
- Time
- Mobility of factors of production
- Ability to stock store
- Unused capacity of firms