Economics I. Part 1: Introduction. 1. Ten principles of economics. FUSL ECGE 1 er bac 1 e Quadrimestre 2012 Samuel Desguin. W.

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1 Economics I W. Vergote In class, chapters are seen in this order: 1, 2, 3, 4, 5, 6, 7, 8, 21, 13, 14, 10, 11, 15, 16, and 17. Chapter 9, 12, 17, 18, 19 and 20 are not to be studied. Part 1: Introduction 1. Ten principles of economics Thinking like an economist Interdependence and the Gains from trade The market forces of supply and demand Elasticity and its application Supply, demand and government policies Consumers, producers and the efficiency of markets Application: the cost of taxation Application: International trade Externalities Public goods and common resources The design of the tax system The cost of production Firms in competitive markets Monopoly Monopolistic competition Oligopoly The Markets for the Factors of production Earning and discrimination Income inequality and poverty The theory of consumer choice Frontiers of microeconomics Ten principles of economics HOW PEOPLE MAKE DECISIONS 1

2 People face trade-offs Making decisions requires trading off one goal against another. There is no such thing as a free lunch A trade-off is a situation that involves losing one quality or aspect of something in return for gaining another quality or aspect. It often implies a decision to be made with full comprehension of both the upside and downside of a particular choice; the term is also used in an evolutionary context, in which case the selection process acts as the "decision-maker". The cost of something is what you give up to get it As people face tradeoffs, making decisions requires comparing the cost and benefits of alternative courses of action, even if the cost of an action is rarely obvious. The opportunity cost is whatever must be given up to obtain some item the value of the benefits foregone (sacrificed). Rational people think at the margin Instead of choosing one or another solution, compromises can be made. People often use marginal changes (small incremental adjustment to a plan or an action). A rational decision maker takes an action if and only if the marginal benefit of the action exceeds the marginal cost. People respond to intensives As people make decisions by comparing costs and benefits, their behaviour may change when the cost or benefits change. HOW PEOPLE INTERACT Trade can make everyone better off Trade allows countries or firms to specialize in what they do best and to enjoy a greater variety of goods and services. Markets are usually a good way to organize economic activity We live in a market economy, which means that our economy allocates resources through the decentralized decisions of many firms and household as they interact in markets for goods and services. Prices and self-interest guide their decisions. Governments can sometimes improve market outcomes First, the government has to protect people from crime. However, above all, government has promoted efficiency and equity. Market failure (situation where scarce resource are not allocated to their most efficient use) can be caused by Externality: the uncompensated impact of one person s action on the well-being of a bystander. Market power: the ability of a single economic agent (or small group of agents) to have a substantial influence on market prices. 2

3 And yet, the government can prevent this from happening. HOW THE ECONOMY AS A WHOLE WORKS A county s standard of living depends on its ability to produce goods and services The standard of living (the amount of goods and services that can be purchased by the population in the country, usually measured by the inflation-adjusted (real) income per capita figure (GDP)) reflects the average income. This average income is due to the productivity (the quantity of goods and services produced from each hour of a worker s time). Prices rise when the government prints too much money This is called inflation, i.e. the increase in the overall level of prices in the economy. Society faces a short-run trade-off between inflation and unemployment This is illustrated by a curve named the Phillips Curve, which shows that, over a period of a year or two, policies push inflation and unemployment in opposite directions. 2. Thinking like an economist Think in terms of alternatives Evaluate the cost of individual and social choices Examine and understand how certain events and issues are related How do they work? They build theories by studying cases in different countries, which is not easy because we don t have many examples in history. They think analytically and objectively (like all scientists) Economists make assumption (=hypotheses) because they can simplify the complex world. They do so by creating models. The most basic are : Circular flow The production possibilities frontier (PPF) the more you produce of a product, the more you give up the other. What you don t produce is the opportunity cost. 2 kind of analysis are made by the economists - Positive statement : that attempts to describe the world as it is - Normative statement : that attempts to prescribe how the world should be When economists make normative statements, they are acting as policy advisors than scientists. They can offer conflicting advice because they have different values. 3. Interdependence and the Gains from trade How to evaluate the advantage of a choice? 3

4 Absolute advantage: we are comparing the productivity of only one person/firm with another. The one that requires a smaller quantity of input has an absolute advantage in that good. In other words, this is the comparison among producers of a good according to their productivity. Comparative advantage: rather than comparing inputs, we re going to compare the opportunity cost of producers. The producer who gives up less of other goods is said to have a comparative advantage in it. I other words, this is the comparison among producers of a good according to their opportunity cost. It is impossible to have comparative advantage in two bounded products: if one is relatively high, the other has to be relatively low (because opportunity cost of one good is the inverse of the opportunity cost of the other). The gains from trade are based on comparative advantage Difference in opportunity cost and comparative advantage create the gains from trade. If each person specializes, total production rises. This is the reason why countries import and export goods. Indeed, trade make everyone better off, as it allows people to specialize in those activities in which they have a comparative advantage. Part 2: Supply and demand I: how markets work 4. The market forces of supply and demand There are different kinds of markets: Competitive market: there are many buyers and many sellers and products are all the same, so that each has a negligible impact on the market price. Consequence: buyers and sellers are price takers. This kind of market is studies with the model of supply and demand. Oligopoly: few sellers that don t compete aggressively. Monopolistically: many sellers but each offers slightly different products, so they can choose their own price. Monopoly: One seller and he control the price. This involves such concepts as: Supply: how many people are willing to sell at a certain price. Law of supply: other things equal, the quantity supplied of a good rises when the price of the good rises. Shifts in the supply curve can be caused by : - Input prices (i.e. the cost of production) - Technology (i.e. the cost of production decreases) - Expectations (if we have reasons to fear a fall of sells) - Number of sellers - Natural causes (if we have to face a natural disaster, it s more difficult to produce) 4

5 FUSL ECGE 1 er bac 1 e Quadrimestre 2012 Samuel Desguin Demand: haw many people are willing (and able) to buy at a certain price. Law of demand: other thing equal, the quantity demanded of a good falls when the price of thegood rises. Shifts in demand curve can be caused by : - Consumer income - Price of related goods - Substitute (ex butter and margarine) - Complements (ex gasoline and cars) - Tastes (changes with adverts,...) - Expectations (if we know the price will go up, we ll buy more now) - Number of buyers. How do we analyse a shift? - Which curve is moving? - In which direction is it moving? - What s the new equilibrium point? Demand and supply meet at a market. The behaviour of actors of the market drives it to a price, at equilibrium. Equilibrium refers to a situation in which the price has reached the level where quantity supplied equals quantity demanded. As a result, everybody purchases and sells at a price that satisfies him. If the price is too high, there is a surplus If the price is too low, there is a shortage 5. Elasticity and its application The elasticity (measure of the responsiveness of quantity demanded or quantity supplied to one of its determinant) can be very different from a good to another. Particularly, the price elasticity (how much the quantity of a good responds to a change in the price of that good, computed as the change in quantity demanded/percentage change in price) is used in economy. It depends on: Availability of close substitutes (elastic) Necessities (inelastic) >< luxuries (elastic) Broad market (elastic) >< Narrow market (inelastic) Long time horizon (elastic, because people got more time to change their habits) >< Short How to compute the Price Elasticity? Price elasticity of demand = % change in quantity demanded/ % change in price 5

6 Total expenditure: amount paid by buyers, computed as the price of the good times the quantity purchased (=P*Q) Total revenue: amount received by sellers of a good, computed as the price of the good times the quantity sold (=P*Q) In a system without taxes, TE = TR With an inelastic demand price increases, TR increases With an elastic demand prices increases, TR decreases This leads to other measures than price elasticity of demand: income elasticity of demand (= % change in quantity demanded / % in income) cross-price elasticity of demand (= % change in quantity demanded of good 1 / % change in the price of good 2) The elasticity of supply, on the other hand, measures the quantity supplied of a good responds to a change in the price of a good (= % change in quantity supplied / % change in price). The tool of supply and demand can be applied in many different kinds of markets. 6. Supply, demand and government policies The Government has 4 major tools to influence the market: Subsidy: payment to buyers and sellers to supplement income or lower costs and which thus encourages consumption or provides an advantage to the recipient. Taxes: almost the reverse of subsidy. Price ceiling: legal maximum on the price at which it can be sold. A binding price ceiling leads to a shortage, especially with an elastic price. Price floor: legal minimum on the price at which it can be sold. A binding price floor leads to a surplus, especially with an elastic price. As we saw, a free market reaches an equilibrium price. However, everyone may not be happy with the outcome of this process, and this is why government intervenes. Unfortunately, these tools can lead to a loss of balance in the market. The tax incidence is the manner in which the burden of the tax is shared among participants of the market. The tax incidence is the same whether the tax is put on the producer or the buyer. With an elastic supply, tax falls more heavily on consumers. With an elastic demand, tax falls heavily on producers. As a conclusion, markets obey to two kinds of laws: supply and demand on the one hand, and the laws enacted by governments. These two laws are interacting. See summary p

7 Part 3: Supply and demand II: Markets and welfare 7. Consumers, producers and the efficiency of markets The welfare economics is the study of how the allocation of resources affects economic well being, i.e. the happiness or satisfaction with life as reported by individuals. Concretely, it depends on the amount of benefits for buyers and sellers. Nb. The benefits of one market are described by a graphic with supply and demand, but the impacts on the other markets around the world aren t taken in account. Who participate to a market? All those (buyers and sellers) who are situated to the right of the equilibrium point do. How is the benefits computed? For the buyers, it is called the consumer surplus, the difference between the willingness to pay (the maximum amount that a buyer will pay for a good) and the actual price of the good. It works exactly the same way with producers. For the sellers, it is called the producer surplus, the willingness to sell something at a certain price, but getting more than that for it. An example of consumer surplus: I m willing to sell a signed album of lady Gaga. There are 4 buyers: John (20$), Kelly (80$), Stephen (150$) and Susan (200$). Here, Susan will get it and she will pay 150.1$. Her consumer surplus is 50$. If I got 2 albums, the price will be 80.1$ (because at this price, there are only 2 buyers left). And the consumer surplus will be 70$ for Stephen and 120$ for Susan. In a graph, the consumer surplus is the area under the demand curve and above the horizontal line of the price, at the left of the equilibrium point, and the producer surplus is the area under the horizontal line of the price and above the surplus, at the left of the equilibrium point. Everybody who buys something will do it because he values higher than the price (and viceversa for the buyer). CS = value to buyers (-) amount paid to sellers PS = amount received from buyers (-) cost to sellers TS = value to buyers (-) cost to sellers CS + PS = total surplus (this implies that consumers and sellers are treated equally). If we try to increase the total surplus, we are trying to maximize the size of the cake (efficiency), without wondering how to divide it (equity). 7

8 FUSL ECGE 1 er bac 1 e Quadrimestre 2012 Samuel Desguin 8. Application: the cost of taxation Taxes are one of the tools used by governments to intervene in markets (to lower the consumption of pollutant goods, as an example) and raise revenue for public projects (to pay policeman). Concretely, a tax can be defined as a wedge between the price buyers pay and the price sellers receive. A tax always implies a shift in a demand or supply curve (whether it is levied on sellers or buyers), but the result is the same: the tax is burdened by the two of them. As a result: Quantity sold falls The quantity lost is called the deadweight loss. It represents the potential gains from trade among buyers and sellers that don t get realised due to the tax. The more supply and demand are elastic, the more the deadweight loss is important. Government get a tax revenue This quantity is measured by the Quantity times the size of the tax. With a tax too important, DWL can get very large, even more than the tax revenue, and make the tax revenuee lower. The quantity earned for the government can be measured by the Laffer curve, which has the shape of a reversed quadratic function. The benefit received by buyers and sellers falls For the buyer, this benefit is measured by the consumer surplus. This is the difference between the price that the consumer would have paid for a good and the price he actually has to pay. It works exactly the same way for producer. The total surplus loses the sum of the tax revenue and the deadweight loss. The tax is burdened by consumer and producer 8

9 FUSL ECGE 1 er bac 1 e Quadrimestre 2012 Samuel Desguin To see how much each part burdens the tax, we have to study tax incidence. This is quite easy to calculate: the tax makes the demand or the supply shift to the left and a new quantity equilibrium is reached, between Initial price tax and initial price + tax. The exact position of the new equilibrium depends on the elasticity of demand and supply. As an example : The burden of the tax falls more heavily on the side of the market that is less elastic. / 9. Application: International trade Part 4: The sector economics in the public 10. Externalities When the market works as it should, the market leads self-interested actors to maximize the total benefit, the invisible hand rules the market. Unfortunately, market failures can still happen. An externality refers to the uncompensated impact of one person s actions on the well-being of by a bystander. In other words, the responsible actor doesn t bear the full cost of the outcome. The government s role is to take account of these external effects and to try to protect the interest of bystanders. Externalities cause markets to be inefficient and thus fail to maximize total surplus. 9

10 FUSL ECGE 1 er bac 1 e Quadrimestre 2012 Samuel Desguin Negative externality The external cost is the sum of the negative externalities, such as pollution. As a solution, internalizing an externality involves altering incentives so that people take account of the external effects of their actions. With that taken in account, a new equilibrium is reached, which is more representative of reality. The new supply curve is social cost (private cost + external cost). The triangle between optimum, equilibrium and [Qmarket(inter)social cost] is called the welfare lost. To summarize, negative externalities lead markets to produce a larger quantity than it is socially desirable. Positive externality There can also be positive externalities, like education or bee hives when they are next to orchards. Here, the new supply curve is called social value (private value + social benefit) ). However, the same triangle is called the welfare lost. 10

11 To summarize, positive externalities lead markets to produce a smaller quantity than is socially desirable. Correcting externalities As we said, government intervenes to achieve an optimal outcome. One way to have the decision maker taking in account the social cost is to put taxes on the product. Such a tax is called internalizing an externality, which means altering incentive so that people take account of the external effects of their actions. On the other hand, government can subsidize goods that have positive externalities. Sometimes, however, externalities are solved with private solutions: Moral Codes and social sanctions Charitable organizations Integrating different types businesses Contracting between parties As an example, a way to solve positive externalities like orchards [verger] next to and bee hives, they can sign a contract or to merge. Firms willing to merge always have to ask the government before merging, because otherwise it could lead to monopolies. Some people think private market is effective enough to deal with externalities. As a result, the Coase theorem suggests that private parties can solve the problem of externalities on their own, if they can bargain (negotiate) over the allocations of resources, without costs. In other words, we ll compare the total social cost and the total social benefit. The bystanders and the actors will bargain until they find an agreement in which everyone is better off and the outcome is efficient. Unfortunately, even when a mutually beneficial agreement is possible, private actors often fail to resolve the problems caused by externalities. The cause of this failure may be the transaction costs, which are the costs incurred (subir) by the parties in the process of agreeing and following through a bargain. The hire of a translator, as an example, is a transaction cost. So, usually, corrective taxes are the most efficient response to a negative externality. Taxes enacted to correct those externalities are called Pigovian taxes. The advantage of such a tax is that is also improves government s welfare, as there is no deadweight loss in a social point of view. Two ways for government to decrease pollution can lead to the same result: - A correcting tax 11

12 - Charged pollution permits 11. Public goods and common resources As public goods and common resources are goods people do not pay for when they choose to enjoy their benefit, they represent a special challenge for economic analysis. Indeed, usually, the price users have to pay is the signal that guides their decision, and we can observe the market forces. Different kinds of goods Excludability is the property of a good that a person can t use without paying for it. 12

13 Rivalry is the property of a good that the use of one person diminished other people s use. Excludable Non-excludable Rival Private goods Ice cream, clothes,... Common resources Congested roads, fishes Non-rival Natural monopolies Cable TV, toll roads Public goods Uncongested non-toll roads In this chapter, we ll examine non-excludable goods, i.e. free of charge and available to everyone. Public goods Free rider problem: a free rider is a person who receives the benefit of a non-rival good but avoids paying for it (as an example, people watching firework without paying for it, foreigners using roads without paying taxes to the government). This is why private market wouldn t make efficient benefits on such goods. The government, however, can potentially remedy the problem by providing the public good and levying global taxes to pay it. Before providing the public good, the government will make a cost-benefit analysis. This is a study that compares the cost and the benefit to society of providing a public good. Common resources Common resources, unlike public goods, are rival goods. This raises another problem: Tragedy of the commons: fact that common goods tend to be used more than desirable, from the standpoint of the whole society (as an example, clean air, water, roads, wild life...). As these tragedies may usually be foreseen, government may act against those in various ways (here, the example of congested roads): - Paying for the service (ex to have to pay to enter the centre of a congested city) - Give more substitutes (public transport) - Take away the common (to privatize, because this way, the owner will protect the good) all men have greater regard for what is their own than what they posses in common with others (Aristotle). - To put general taxes (to tax gasoline) / 12. The design of the tax system Part 5: Firm behaviour and the organization of industry 13

14 13. The cost of production First assumption: the goal of all the firms is to maximize profits (even if this is never written in their credo) because they are bound by investors, who want those to make profit. Profit ( ) = TR TC TR = Total revenue, amount received for the sales. Easy to compute, it s the price * the quantity TC = Total cost, market value of the inputs. What is paid by the firm is called the explicit costs (input costs that requires an outlay of money by the firm) and the opportunity cost of this is called the implicit cost (input costs that do not require an outlay of money by the firm). Economists vs. Accountants: The firm makes economic profit only when total revenue > explicit and implicit costs. Examples of implicit costs: If I m computer-skilled, the opportunity cost of working in a bakery is the 100$/hour I would earn working as programmer. If I invest in material instead of depositing it in saving, the opportunity cost of material is the interest I would have received from the bank. Some functions used to show the production of a firm. The production function (or marginal product) is the increase in output that arises from an additional unit in input, computed as the relationship between the quantity of inputs and the quantity of outputs. This function always slopes upward, but less and less quickly as the inputs are more important. The total cost is the sum of the fixed costs (that are not determined by the quantity of output produced) and the variable costs (that are dependent on the quantity of output produced). This function always slopes upward, more and more quickly as the inputs are important. 14

15 The marginal cost (MC) is the increase in total cost that arises from an extra unit of production. This is an upward sloping function. MC = TC / Q The average total cost (ATC) is the total cost divided by the quantity of output. This function always has a U- shape, and always crosses the curve MC at its lowest point (when slope = 0). ATC = TC/Q. The average variable cost (AVC) is the variable cost divided by the quantity of output. This function has a U- shape, and is always lower than ATC. The long run In the long run, a firm can adapt its ways to produce in order to reduce to reduce total cost. As a result, long-run average total cost can decline thanks to the economies of scale (properties whereby long-run average total cost rises as the quantity of output increases). Indeed, in the longrun, coordination problems tend to diminish. 14. Firms in competitive markets First, let s have a look at the different possibilities : In a perfect competitive market, consumers and firms are price takers because consumers have the choice between many firms offering the same product (homogenous goods). Besides, there is a great amount of information available to buyers and sellers (price comparison, reviews...). Plus: - Firms can freely enter or exit the market (even if it costs time and money). - If the firm is present in the market, it can choose whether to produce or not to produce (to shut down temporarily, like some restaurant in the evening or Walibi during the winter). - If it produces, the question is how much. 15

16 FUSL ECGE 1 er bac 1 e Quadrimestre 2012 Samuel Desguin In competitive markets, average revenue (TR/amount of output) = Marginal revenue from the sale of an additional output) = price. revenue ( in total A firm always want to maximize the profit: [ ] = P*Q TC (Q). Here, the only variable is Q, as the P is fixed by the market. As long as the selling of one more unit is more valuable than the cost of its production, then the firm will increase its production. Profit max is when MR = MC, independently of whether the market is perfectly competitive or not. In a perfectly competitive market: MR = Price (in a situation without deadweight loss). Sometimes, the curve of price can go lower than the intersection between MC and ATC. Let s analyse this graph: - If P > ATC, the firm will produce anyway, and make profit. - If ATC > P > AVC, the firm will produce in the short run, because it s variable cost will be covered, but it will close in the long run. 16

17 - If P < AVC, the firm will close anyway. The market s supply curve is the firm s MC curve in the short run, beginning at the price where it crosses AVC. In the long run, the supply curve is the part of the MC that lies above the ATC. Sunk costs are costs that have already been committed and cannot be recovered. As an example: I bought a ticket for the theatre and arriving there, I notice that I lost it. I ll buy another one, since I still value more a night at the theatre than the price of the ticket. For a firm, those costs enter in account when they decide if they are entering the market, but not when they have to decide to exit or not. In the long run, profit = 0 With a maximizing-profit quantity (or minimizing-loss quantity, in that event) profit (or loss) is the area between price and ATC (the point of the ATC that is on the same vertical line that the intersection between Price and MR). As we know, more the supply is important, more the price will decrease. Yet, as there is still profit to make, more firms will enter the market, and offer more supply. Thus, in the long run, the number of firms in the market will reach an equilibrium at which the price equals the minimum of ATC. As a final consequence, the market supply in the long-run is a horizontal line. Then, the reason why firms stay in the market with 0 profit revenue is that the firm s revenue compensates the owners for the time and money they expend to keep the business going. So, when we talk about 0 profit situation, we refer to normal profit (minimum amount required to keep factors of production in their current use), which includes the opportunity cost. As a result, 0 profit situation economic profit is 0 but accounting profit is positive (see the different way accountants and economists measure costs, chapter 13). However, the long-run supply curve may slope upward, for two reasons: If the resources are limited, the marginal price increases. If the costs of production are different between the firms. In this situations, some firms can make profit, even in the long run. 15. Monopoly Definition of a monopoly A monopoly is a situation where a firm is the sole seller of a product without close substitutes. All the firms that applied a copyright on a product are said to have a monopoly on this product. - Competitive market firm = price taker. - Monopoly market firm = price maker. (Nb.: the consumer is a price taker in any case). This diminishes the market outcome, but the Competition Commission in Europe keeps an eye on all the monopolistic firms, in order to improve it. 17

18 In monopolistic situations, the MC is different from the Price. Microsoft office student version is an example: Price = 119 but marginal cost = <5. A monopoly happens when: - A key resource is owned by a single firm. It is rarely a cause of monopoly. - The government gives a single firm the exclusive right to produce some good or service. Government may grant a monopoly if it is viewed to be in the public interest (it may also encourage some desirable behavior, or improve public health). The patents and the copyright are the tools used by governments to do so. - A natural monopoly appears when a single firm can supply a good or service to an entire market at a smaller cost than could two or more firms. This appears when economy of scale diminishes the average total cost (as an example, the market of water. It would be very expensive to have a parallel network of tubes). Monopolies making production and pricing decisions A) DRAWING THE DEMAND AND MARGINAL REVENUE CURVES FOR A MONOPOLY Since a monopoly firm is the sole producer, when it reduces its price, two effects happen: - Output effect: quantity sold increases. The monopolistic firm faces the market demand curve, which is a downward sloping curve (remind: a competitive firm s demand curve is completely elastic the curve is horizontal). - Price effect: price decreases. The amount of money earned on each unit sold diminishes. Because of the fact that in order to sell one unit more, we have to decrease de price of all the goods, the Marginal Revenue slopes quicker downward than the Average Revenue (which is the demand curve). In other words: - In a monopoly ( ) < 0 - In a competitive market ( ) = 0 18

19 - Marginal revenue = - Price P = A BQ Price > MR = 2 B) CHOOSING THE PRICE THAT MAXIMIZES PROFIT A monopoly maximizes profit by producing the quantity at which marginal revenue equals marginal cost. In the graph below, this occurs at point A (Demand curve = average revenue). So, the price set by the firm in order to maximize profit is the point B. So, in any case, max is when MR = MC. But, as we can observe, 19

20 - In competitive markets, prices equals the intersection point P = MC = MR - In monopolized market, price is over this intersection point P > MC = MR C) COMPUTING PROFIT Whether we are in a perfect competition or a monopoly, = TR TC = (P ATC)*Q. As we can see, the Monopoly profit = (Monopoly Price ATC)*(Quantity sold). The loss in society s welfare caused by monopolies This graph gives rise to the fact that monopoly market diminishes quantity and increases price. The amount of the welfare loss for society is computed this way: Because the price chosen by the firm is on the right of the equilibrium (intersection between supply ( marginal cost) and demand), the price charged is above marginal cost, and not all the consumers 20

21 who value the good at more than it cost will buy it. Thus, the quantity produced and sold by a monopoly is below the socially efficient level. Deadweight loss = ( ) Nb.: The Efficient quantity is the quantity that would have been chosen in a competitive market (intersection between MC and Demand). The deadweight loss caused by a monopoly is similar to the deadweight loss caused by a tax. The difference between the two cases is that the government gets the revenue from a tax, whereas a private firm gets the monopoly profit. Government deal with problem of monopoly in one of these four ways: - Making monopolized industries more competitive. - Regulating the behavior of monopolies. To prevent this deadweight loss, the European Union increase competition with antitrust laws: o Article 101: agreements between firms are prohibited o Article 102: firms with a predominant position cannot abuse of their position. - Turning some private monopolies into public enterprises. - Doing nothing at all. Price discrimination - Purpose: their purpose is to get rid of the deadweight loss, and this way, to make a monopolistic situation good for the general welfare. - Way: selling the same good at different prices to different customers, even though the costs for producing for the two customers are the same. - Effects : o It can increase the monopolist s profits. o It can reduce deadweight loss. 21

22 In the end Monopoly is a matter of degree. It is true that many firms have some monopoly power. It is also true that their monopoly power is usually limited. In these cases, we will not go far wrong assuming that firms operate in competitive markets, even if that is not precisely the case. 16. Monopolistic competition A monopolistic competition is a market structure in which many firms sell products that are similar but not identical. As in usual, firms can enter or exit the market freely. Thus, as we saw, number of firms in the market adjusts until economic profit is driven to 0. Examples: computer games, restaurants, books... This market structure lies between the two extremes that are perfect competition and monopoly. Competition with differentiated products SHORT RUN Like in a monopoly market, the firm faces a downward sloping demand curve, and a MR that lies below the demand. As a consequence, a monopolistic competition market follows the same rules that monopolist s for profit maximizing: 22

23 LONG RUN The difference between monopolistic competition and monopoly is that firms enter the market freely. So, if firms are making profit, other firms will have incentive to enter the market, until demand diminishes and is driven to 0: Compare monopolistic competition with other markets MONOPOLISTIC COMPETITION AND PERFECTLY COMPETITIVE MARKET - As in a competitive market, price equals ATC (because firms enter and exit the market freely, thus profit is driven to zero). - Profit maximization MR = MC 23

24 MONOPOLY AND MONOPOLISTIC COMPETITION - For a competitive firm, price equals marginal cost and for a monopolistically competitive firm, price exceeds marginal cost. - Profit maximization MR = MC - The price is higher in a monopolistically competitive firm (= markup) - As there is a markup, there is a deadweight loss. As a result, the quantity produced is not the more efficient for society. - Downward-sloping demand curve MR < P In the end It is true that there is a deadweight loss with a monopolistic competition, but government usually doesn t intervene - Because it is interesting to have some slightly different goods - It would be expensive to intervene The theory of monopolistic competition describes the main part of markets in economy. To summarize 24

25 17. Oligopoly The fourth type of market is characterized by: - Few firms, so every firm has a large impact on the market - Same or similar product The key feature of oligopoly is the tension existing between cooperation and self-interest. To simplify the concept of oligopoly, we ll make models with duolopolies. The follows basically the same rules as oligopolies, but are easier to explain. Cooperation or competition The few firms in the market may choose to cooperate: - Collusion: make an agreement about quantities to produce or prices to charge. It is illegal, punished by the law. - Cartel : act in unison In a perfect cooperation, firms reach equilibrium where the sum of wealth created for firms is maximized, which means less production and higher price (less than monopoly but more than perfect competition). 25

26 However, due to competition laws, or impossibility to make a compromise, or to self-interested treason (One of the firms, following self-interest, decides to sell more at a lower price, and screw the cooperation. Each firm will produce more than what was arranged, because whatever the other firm does, it is in its self-interest to do so) cooperation doesn t happen and the market becomes a competitive market. The last reason of the failure of cooperation is the Nash equilibrium, which is the situation where each firm chooses their best strategy to maximize profit given the strategy chosen by others. In other words, they are following self-interested incentives. Which amount of production? The study of how people behave in strategic situations is called the game theory. - Choosing individually: in order to maximize profit, the firms produce greater quantity of output than the monopoly and less than competition. So, P>MC. - Dominant strategy: to choose the best strategy regardless of other s strategy. - Cooperation: Firms that care about future profits will cooperate in repeated games rather than cheating in a single game to achieve a one-time gain. In the point of view of society, oligopoly is not desirable. This is why law prevent firms from doing so. Part 6: The economics of labour market / 18. The Markets for the Factors of production / 19. Earning and discrimination 26

27 FUSL ECGE 1 er bac 1 e Quadrimestre 2012 Samuel Desguin / 20. Income inequality and poverty Part 7: Topics for Further Study 21. The theory of consumer choice Two key concepts are to be understood in this chapter: - The budget constraint (BC) is the limit on the consumption bundles that a consumer can afford. In a graph, it shows the trade-off the consumer faces between two goods. - The consumer s preferences are shown by the indifference curve (IC). This is a curve showing consumption bundles that give the consumer the same level of satisfaction. Properties of this curve : o Higher indifference curves are preferred to lower ones o Indifference curves are sloping downward o Indifference curves do not cross o Indifference curves are bowed inward o The marginal rate of substitution (MRS) shows the slope of the curve. o Less bowed easy to substitute (at the extreme: perfect substitutes, like coins) o Very bowed hard to substitute (at the extreme: perfects complements, like shoes) When we combine the IC and the BC and when the IC is tangent to the BC, the intersection between the two is called the Optimum point. This optimum point can move, when: There is an increase in income. It will shift the BC curve to the right and lead to an increase of both goods, unless one of the goods is an inferior good (ex: public transportation, carapills...) There is a change in the price of one good. It will lead to a change in the slope of BC. The curve will rotate around the other good (Q2). 27

28 FUSL ECGE 1 er bac 1 e Quadrimestre 2012 Samuel Desguin A change in the price of one good will lead to two effects: Income effect, is the change in consumption that results when a price change moves the consumer to a higher or lower indifference curve Substitution effect is the change in consumption that results when a price change moves the consumer along an indifference curve to a point with a different marginal rate of substitution. Demand curves can sometimess slope upward, with goods called Giffen goods. Those goods are always inferior goods, but special ones: their income effect dominates their substitution effect. These goods are very rare. 28

29 FUSL ECGE 1 er bac 1 e Quadrimestre 2012 Samuel Desguin Another example: an increase in the wages can have different consequenceses in the choice of a worker between leisure time and work time: some can choose to work more, and some might choose to work less and spend more hours of leisure. When we put together all these optimum points along the same graph, depending on the price of the good, we obtain the demand curve. As a conclusion: optimal consumption choice (Demand) >< Optimal production choice (Supply) / 22. Frontiers of microeconomics Glossary Microeconomics focusess on the individual parts of the economy. How households and firms make decisions and how they interact in specific markets. Macroeconomics looks at the economy as a whole. It studies economy-wide phenomena, including inflation, unemployment, and economic growth. Positive statements are statements that attempt to describe the world as it is descriptive analysis. Normative statements are statements about how the world should be prescriptive analysis. 29