Economic Condition Analysis

Lecture No.: 1

Topics: Understanding Demand, Supply and Production issues

The Demand Curve:

The graphical representation of the demand schedule is the demand curve.

Law of downward – sloping demand: When the price of a commodity is raised buyers
tend to buy less of the commodity ceteris paribus. Quantity demanded tends to fall as
price rises for two reasons: Substitution effect and income effect.

The Supply Curve:

The graphical representation of supply schedule is the supply curve.

Forces behind the supply curve: The major elements underlying the supply curve are:
Cost of production i.e.prices of inputs and technological advances, prices of related
goods, government policy an special influences.

***Equilibrium with supply and demand curves

Price Elasticity of Demand:

The price elasticity of demand sometimes simply called price elasticity measures how
much the quantity demanded of a good changes when its price changes. The precise
definition of price elasticity is the percentage change in quantity demanded divided by
the percentage change in price.

Price elasticity of demand ep= percentage change in quantity changes / percentage change in price
Perfectly Elastic Demand ep = 0

Unit elasticity ep = 1
Inelastic demand ep = Infinity

Price Elasticity of Supply:

Price elasticity of supply is the percentage change in quantity supplied divided by

percentage change in price.
Application to major economic issues:

1. Impact on long run relative decline in farming:

2. Crop restrictions
3. Demand for necessary goods
4. Use of consumer products
5. Tax issues
6. Relative product price
7. Employment and unemployment
8. Energy price control
Production and Marginal Products:

Production function: The production function specifies the maximum output that can
be produced with a given quantity of inputs. It is defined for a given state of
engineering and technical knowledge.

Total, Average and Marginal product:

Marginal product: The marginal product of an input is the extra output produced by
1 additional unit of that input while other inputs are held constant.

The Law of diminishing return: The law of diminishing returns holds that, we will
get less and less extra output when we add additional doses of an output while
holding other inputs fixed.

Returns to scale:

Constant return to scale: CRS denote a case where a change in all inputs leads to a
proportional change in output.

Increasing returns to scale (also called economies of scale): IRS arise when an
increase in all inputs leads to a more than proportional increase in the level of output.

Decreasing returns to scale: DRS occur when a balanced increase of all inputs leads
to a less than processes, scaling up eventually reach a point beyond which
inefficiencies set in. These might arise because the costs of management or control
become large.

Productivity: Productivity is a concept measuring ratio of total output to a weighted

average of inputs. Two important variants are labor productivity, which calculates the
amount of output per unit of labor and total factor productivity, which measures
output per unit of total inputs (typically of capital and labor).

Empirical estimates of the aggregate production function:

i. Total factor productivity has been increasing throughout the twentieth century
because of technological progress and higher levels of worker education and
skill.
ii. The capital stock has been growing faster than the number of worker – hours.
As a result labor has a growing quantity of capital goods to work with; hence
labor productivity and wages have tended to rise even faster than the 1 ½
percent per year during the twentieth century.
iii. The rate of return on capital (the rate of profit) might have been expected to
encounter diminishing rate of returns because of each capital unit now has less
labor to cooperate with.
iv. Over the twentieth century, labor productivity grew at an average rate of
slightly more than 2 percent per year.
 LECTURE NO: 2

ECONOMIC ANALYSIS OF COSTS

Fixed costs:

FC sometimes called as “overhead” or “sunk cost”. They consists of rent for factory or
office space, contractual payment for equipments, interest payments on debts, salaries of
tenured faculty and so forth. These must be paid even if the firm produces no output, and
they do not change if output changes.

Variable costs:

Variable costs are costs which vary as output changes. Examples include materials
required to produce output, production workers to staff the assembly lines, power to
operate factories.

Cost concept: TC=FC+VC

Marginal cost:

MC denotes the extra or additional cost of producing 1 extra or additional cost of

producing 1 extra unit of output.

Average cost:

Average cost is the total cost divided by the total number of units produced.

Average cost = Total cost / Quantity

Some important rules

• When marginal cost is below average cost, it is pulling average cost down
• When MC is above AC, it is pulling AC up.
• When MC just equals AC, AC neither rising not falling and is at its maximum.
Hence, at the bottom of a U- shaped AC, MC=AC=minimum AC.

This is a critical relationship. It means that a firm searching for the lowest average cost of
production should look for the level of output at which marginal costs equal average cost.
Because the last unit produced costs less than the average cost of all the previous units
produced. If the last unit costs less than the previous ones, the new AC (i.e.AC including
the last unit) must be less than the old AC, so AC must be falling. By contrast, if MC is
above AC, the last unit costs more than average cost (AC including the last unit) must be
higher than the old AC. Finally, when MC just equal to AC, the last unit costs exactly the
same as the average cost of all previous units. Hence, the new AC; the one including the
last unit, is equal to the old AC; AC curve is flat when AC equals MC.
Quantity Fixed Variable Total cost Marginal Average cost Average Average
cost cost (TC) cost (AC) Fixed variable
(FC) (VC) (MC) cost cost
(AFC) (AVC)
0 55 0 55 Infinity Undefined
1 55 30 85 30 Infinity
25 85 55 30
2 55 55 110
20
3 55 75 130 30 55 27 ½ 27 ½
4 55 105 160 40* 43 ½ 18 1/3 25
5 55 155 210 50 40 13 5/4 26 ¼
6 55 225 280 - 42 11 -
7 55 - 370 90 46 2/3 9 1/6 37 ½
8 55 - 480 110 52 6/7 7 6/7 45
60 6 7/8 53 1/8

Cost

8
TC
7

4
Variable and Fixed
2 cost

1
FC

1 2 3 4 5 6 7 8 9 10
Quantity
Average & Marginal cost

AC
MC

80
AVC
70

60

50

40

30

20
AFC
10

1 2 3 4 5 6 7 8 9 10

Quantity
 Lecture No.:3

ANALYSIS OF PERFECTLY COMPETITIVE MARKET

Significant feature of PCM:

1. Under perfect competition, there are many small firms, each producing an
identical product and each too small to effect the market place.
2. The perfect competitor faces a completely horizontal curve.
3. The extra revenue gained from each extra unit sold is therefore the market price.
4. In perfect competition there is easy entry and easy exit.

Demand curve of PCM

p p

D S

d d

q
q
Industry output Firm output

Competitive Supply where marginal cost equals price:

Rule for a firm under perfect competition is that, the firm will maximize profits when it
produces at that level where marginal cost equals price:

Marginal cost = Price or MC = P

Quantity Total cost Marginal Average Price Total Profit
cost cost revenue
0 55000 - - - - -
1000 85000 27 85 40 40000 - 45000
2000 110000 22 55 40 80000 -30000
3000 130000 21 43.33 40 120000 -10000
3999 159960.01 38.98 40 40 159960 -0.01
39.99 40 40 160000 0
40
4000 160000 40.01
4001 160040.01 40.02 40 40 160040 -0.01
5000 210000 60 42 40 200000 -10000
 AC
MC
Price,
AC,
MC d’

d’’

quantity

At the profit maximizing output the firm has zero profits, with total revenues equal total
costs (these are economic profits and include all opportunity costs, including the owner’s
labor and capital). Point B is the zero profit point, the production level at which the firm
makes zero economic profits; at the zero profit point, price equals average cost, so
revenues just cover costs.

Total cost and the shut down condition:

In general, a firm wants to shut down in the short run when it can no longer cover its
variable costs.

Suppose, the firm were faced with a market price of Tk.35.00 shown by the horizontal d’’
d’’ line. At that price MC equals price at point C, a point at which the price is actually less
than the average cost of production.

Reason for producing even though a firm incurring loss: A firm can cover its contractual
commitments even when it produces nothing. In the short run, the firm must pay fixed
costs such a interest to the bank, directors salary and others. The balance of the firm’s
costs are variable costs, such as costs for raw material, production workers, and fuel
which would have zero cost at zero production. It will be advantageous to continue
operations, with P at least as high MC, as long as revenue covers variable costs.
Basically, low market price at which revenues just equal variable costs (or, equivalently,
at which loses exactly equal fixed costs) is called the shutdown point.

Shutdown rule: The shutdown point comes where revenues just cover variable costs or
where losses are equal to fixed costs. When the price falls below average variable costs,
the firm will maximize profit (minimize its loss) by shutting down.
 AC
MC
AVC
M

M’

Shutdown point

Shortcomings of perfectly competitive market:

1. Market failure

a. Imperfect competition: When a firm has market power in a particular market (say
it has a monopoly because of a patented drug or a local electricity franchise, the
firm can raise the price of its product above its marginal cost. Consumers buy less
of such goods than they would under competition, and consumer satisfaction is
reduced. This kind of reduction of consumer satisfaction is typicalof the
inefficiencies created by imperfect competition.

b. Externalities: Externalities arise when some of the side effects of production or

consumption are not included in the in market prices.

c. Imperfect information: In perfect competition it is assumed that, buyer and seller

have complete information regarding the market and the product. But in real
world the information are not always available to everyone.
 IMPERFECT COMPETITION:

Imperfect competition: Imperfect competition prevails in an industry whenever individual

sellers have some measure of control over the price of their output.

If a firm can appreciably affect the market price of its output the firm is classified as an
“imperfect competitor”.

Imperfect competition prevails in an industry whenever individual sellers have some

measure of control over the price of their output.

Imperfect competition does not imply that a firm has absolute control over the price of a
product.

An imperfect competitor has some but not complete discretion over its price.

For a perfect competitor, demand is perfectly elastic; for an imperfect competition,

demand has a finite elasticity.

p Firms demand under Firms demand under

perfect competition P d‘ imperfect competition
d

d d

d‘

q
Firm quantity q Firm quantity

VARIETIES OF IMPERFECT COMPETITION:

The varieties of imperfect competition can be categorized as follows:

a. Monopoly

b. Oligopoly

c. Monopolistic competition
 TYPES OF MARKET STRUCTURE

Structure Number of Part of Firm’s degree Methods of

producers and economy where of control over marketing
degree of prevalent price
product
differentiation
Perfect Many Financial None Market
competition producers, market and exchange or
identical agricultural auction
products products
Monopolistic Many Retail trade Some Advertising and
competition producers, (pizza, beer, quality rivalry,
many real or personal administered
perceived computer) prices
difference in
product
Oligopoly Few producers, Steel, Some Advertising and
little or no chemicals quality rivalry,
difference in administered
product prices
Monopoly Single Franchise, Considerable Advertising
producer, monopolies
product without (Electricity,
close water)
substitutes Microsoft
windows,
patented drugs

Sources of Market Imperfections:

Most cases of imperfect competition can be traced to two principal causes:

1. Industries tend to have fewer sellers when there are significant economies of large
scale production and decreasing costs.

• Costs and market imperfections

2. Barrier to entry.

• Legal restrictions
• High cost entry
• Advertising and product differtiation
 (a) Perfect competition (b) Oligopoly (c) Monopoly

D
MC AC MC AC D D
AC

MC

P AC

MC

Q Q Q

1234 10000 12000 100 200 300 100 200 300

 LECTURE NO.:4

UNCERTAINTY AND GAME THEORY

Speculation:

Speculation involves buying and selling in order to make profits from fluctuations in
prices. The economic function of speculator is to move gods from periods of abundance
to periods of scarcity.

Arbitrage: The simplest case is one in which speculative activity reduces or eliminates
regional price differences by buying and selling the same commodity. This activity is
called arbitrage, which is the purchase of a good or asset in one market from immediate
resale in another market in order to profit from a price discrepancy. As a result of
arbitrage, the price difference between markets will generally be less than the cost of
moving the good from one market to the other.

Hedging: One important function of speculative markets is to allow people to shed risks
through hedging. Hedging consists of reducing the risk involved in owning an asset or
commodity by making a counteracting sale of that asset. Hedging allows businesses to
insulate themselves from the risk of price changes.

The economic impact of Speculations:

1. Market efficiency
2. Possibility of even marginal utility.

Risk and uncertainty: Risk is the probability to default. A person is risk averse when
the displeasure from losing a given amount of income is greater than the pleasure from
gaining the same amount.

Insurance and Risk Spreading:

Market handles risk by risk spreading. This process takes risks that would be large for
one person and spreads them around so that they are they are but small risk for a large
number of people. The major for of risk spreading is insurance, which is a kind of
gambling a reverse.

Capital markets and risk sharing:

Another form of risk sharing takes place in the capital markets because the financial
ownership of physical capital can be spread among many owners through the vehicle of
corporate ownership.
Market failure in information:

While insurance is a useful device for reducing risks, sometimes insurance is not
available. The reason is that, efficient insurance can thrive only under limited conditions.

The conditions for efficient insurance are:

1. There must be large number of insurable events.

2. The events must be statistically independent.
3. There must be sufficient experience regarding such events so that insurance
companies can reliably estimate the losses.
4. The insurance must be relatively free from moral hazard. Moral hazard is at work
when insurance increases risky behavior and thereby changes the probability of
loss.
5. Sometimes private insurance is unavailable because of adverse selection. Adverse
selection arises when the people with the highest risk are also the most likely to
buy the insurance.

Social insurance:

When market failures are so severe that the private market cannot provide adequate
coverage, there are may be a role for social insurance, which is mandatory insurance
provided by the government. Example: Unemployment insurance.

GAME THEORY

Game theory analyzes the way that two or more players choose strategies that jointly
affect each other. This theory was developed by John Von Neumann (1903-1957) a
Hungarian-born mathematical genius. Game theory has been used by economists to study
the interaction of oligopolists, union management disputes; countries trade policies,
international environmental agreements, reputations, and a host of other situation.

Price setting:

Firm A matching
P1

Firm B undercutting

P2
BASIC CONCEPTS of Game Theory:

nEwbooks price

Normal price Price war

Normal price A $10 B $-100

Amaging $ 10 $-10
price

Price war C -$ 10 D $-50

$100 $-50

Alternative strategies:

In alternative strategy two firms have the highest joint profits in outcome. Each firm
earns $10 when both follow a normal – price strategy. At the other extreme is the price
war, where each cuts its price and runs a big loss.

In between are two interesting strategies where only one firm engages in the price war. In
outcome C for example nEwbooks follows a normal price strategy while Amaging
engages in a price war. Amazing takes most of the market but losses a great deal of
money because it is selling below cost; nEwbooks is actually better off selling at a normal
price rather than responding.

Dominant Stategy

In considering possible strategies, the simplest case is that, of a dominant strategy. This
situation arises when one player has a single best strategy no matter what strategy the
other player follows. If nEwbooks conducts business as usual with a normal price,
Amazing will get $10 of profit if it plays the normal price and will lose $100 if it declares
economic war. Amazing will lose $ 10 if it follows the normal price but will lose even
more if it also engages in economic warfare. This also holds for nEwbooks. Therefore, no
matter what strategy the other firm follows, each firm’s best strategy is to have the
normal price. Charging the normal price is a dominant strategy for both firms in this
particular price – war game. When both players have a dominant strategy, we say that,
the outcome is a dominant equilibrium.
Nash equilibrium: (The rivalry game)

nEwbooks price

High price Normal Price

High price A $200 B $150

Oxy steel $ 100 -$20

price

Normal price C -$ 30 D $10

$150 $10

The firm can stay at their normal price equilibrium, which found in the price war game.
Or, they can raise their price in the hopes of earning monopoly profits. Our two firms
have the highest joint profits in cell A; here they earn a total of $300 when each follows a
high price strategy. Situation A would surely come about if the firms could collude and
set the monopoly price. At the other extreme is the competitive style strategy of the
normal price, where each rival has profits of $10.

In between are two interesting strategies where one firm choose a normal price and one a
high price strategy. In cell C, for example, nEwbooks follows a high price strategy but
Amazing undercuts. Amazing takes most fo the market and has the highest profit of any
situation, while nEwbooks actually losses money. In cell B, Amazing gambles on high
pirce, but nEwbooks normal price means a loss for Amazing.

In this game Amazing has a dominant strategy; it will profit more by choosing a normal
price no mater what nEwbooks does. On the other hand, nEwbooks does not have a
dominant strategy, because nEwbooks would want to play normal if Amazing plays
normal and would want to play high if Amazing plays high.

Now it is safe for nEwbooks for choosing normal price where he could assume high
payoff in relation to the action of Amazing. This is the basic of game theory: you should
set your strategy on the assumption that your opponent will act in his or her best interest.

The Nash Equilibrium is also sometimes called the non cooperative equilibrium, because
each party chooses that strategy which is best for itself – without collusion or cooperation
and without regard for the welfare of society or any other party.
Some Important Examples of Game Theory

1. To collude or not to collude:

2. Prisoners Dilemma:

Keins

Confess No confess
A 5 years B 10 years
Smith
5 years 3 months
C 3 months D 1 years

5 years 1 years

3. The pollution game

U.S. Steel

Normal price Price war

Normal price A $100 B $120

Oxy Steel $ 100 $30

Price war C -$30 D $100

$120 $100

The pollution game is an example of a situation in which the invisible – hand mechanism
of efficient perfect competition breaks down. This is a situation in which the non-
cooperative or Nash equilibrium is inefficient.

When the Nash equilibria become dangerously inefficient, governments may step in. By
setting efficient regulations or emissions charges, or perhaps by establishing efficient
property rights, government can induce firms to move outcome. A, the “low pollute, low
pollute” world. In that, equilibrium the firms make the same profit as in the high
pollution world, and the earth is a healthier place to live in.

4. Deadly arms races:

In deadly arms race the cooperative agreement could lead to pay off both parties.
 LECTURE NO:5

Comparative Advantage and Protectionism

International Trade and Domestic Trade:

There are three important differences between domestic and international trade:

1. Expanded trading opportunities

2. Sovereign nation
3. Exchange rates

Reasons for International Trade:

1. Diversity in natural resources:

2. Difference in tastes:
3. Difference in costs:

Comparative Advantage among Nations:

The principle of comparative advantage holds that each country will benefit if it
specializes in the production and export of those gods that it can produce at relatively low
cost. Conversely, each country will benefit if it import those goods which it produces at
relatively high cost.

Richardo’s Analysis of comparative advantage:

Assumptions:

1. Two nations
2. Two commodity
3. All production cost in terms of labor hour.

Necessary labor for production (labor – hour)

In America In Europe
Product
1 unit of food 1 3
1 unit of clothing 2 4

In America, it takes 1 hour of labor to produce a unit of food, while a unit of clothing
requires 2 hours of labor. In Europe the cost is 3 hours of labor for food and 4 hours of
labor for clothing. We see that, America has absolute advantage in both goods, for it can
produce them with greater absolute efficiency than can Europe.
However America has comparative advantage in food, while Europe has comparative
advantage in clothing, because food is relatively inexpensive in America whle clothing is
relatively less expensive in Europe.

From these facts, Richardo proved that both regions will benefit if they specialize in their
areas of comparative advantage – that is if America specializes in the production of fod
while Europe specializes in the production of clothing. In this situation America will
export food to pay European clothing, while Europe will export clothing to pay for
American food.

Before trade: When all international trade is illegal or because of a prohibitive tariff, the
real wage of the American worker for an hour’s work as 1 unit of food or ½ unit of
clothing. The European worker earns only 1/3 unit of food or ¼ unit of clothing per hour
of work. Clearly, if perfect competition prevails in each isolated region, the prices of food
and clothing will be different in the two places because of the difference in production
costs. In America, clothing will be 3 times as expensive as food because it takes twice as
much labor to produce a unit of clothing as it does to produce a unit of food. In Europe,
clothing will be only 4/3 as expensive food.

After trade: Now suppose that, all tariffs are repealed and free trade is allowed. For
simplicity, further assume that, there are no transportation costs. Then clothing is
relatively more expensive in America (with a price ratio of 2 as compared to 4/3), and
food is relatively more expensive in Europe (with a price ratio of ¾ as compared to ½).
Given these relative price, and with no tariffs or transportation costs, food will soon be
shipped from America to Europe and clothing from Europe to America.

As European clothing penetrates the American market, American clothiers will find
prices falling and profits shrinking and they will begin to shut down their factories. By
contrast European farmers will find that the prices of foodstuffs begin to fall when
American products hit the European markets; they will suffer losses, some will go
bankrupt, and resources will be withdrawn from farming.

After all the adjustment to international trade have taken place, the prices of clothing and
food must be equalized in Europe and America.
 PROTECTIONISM

Supply and Demand Analysis of Trade and Tariffs:

Domestic supply

8 Domestic
production
Price of
clothing in
America
Import World supply
4

Domestic Demand

100 400

Quantity of clothing in America

• Effect of free trade and Open Trade.

Trade Barriers:

• Tariff: A Tariff is tax levied on the imports.

= Prohibitive tariff: A tariff which is so high that it chokes off all imports.
= Non-Prohibitive tariff: A tariff which injure but not kill the imports

• Quota: A quota is a limit on the quantity of imports.

Difference between Tariff and Quotas:

There is no essential difference between tariffs and quotas, some subtle differences do
exist. A tariff gives revenue to the government, perhaps allowing other taxes to be
reduced and thereby offsetting some of the harm done to consumers in the importing
country. A quota on the other hand, puts the profit from the resulting price difference into
the pocket of the importers or exporters lucky enough to get a permit or license.
Economists therefore termed Tariff less evil than Quotas.
The Economic Costs of Tariff:

M H J
World price plus
tariff
6

E F
L A C
World Price
4

100 150 250 300

Diagrammatic Analysis:

1. Area B is the tariff revenue collected by the government. It is equal to the amount
of the tariff times the units of imports and totals Tk.200.
2. The tariff raises the price in domestic markets from Tk.4 to Tk.6 and producers
increase their output to 150. Hence total profit rise to Tk.250 shown by area
LEHM and equal to Tk.200 on old output and Tk.50 for additional 50 units.\
3. Finally a tariff imposes heavy cost on consumers. The total consumption surplus
loss is given by area LMJF and is equal to Tk.550.
4. The overall social impact is, then a gain to producers of Tk.250 a gain to the
government of Tk.200 and a loss to consumers Tk.550. The net social cost is
Tk.100.
5. Area A is the net loss that comes because domestic production is more costly than
foreign production. When the domestic price rises, businesses are thereby induced
to increase the use of relatively costly domestic capacity. They produce output up
to the point where the marginal cost is Tk.6 per unit instead of Tk.4 per unit under
free trade.
6. In addition, there is a net loss to the country from the higher price, shown by area
C, This is the loss in consumer surplus cannot be offset by business profits or
tariff revenue. This area represents the economic cost incurred when consumers
shift their purchases from low cost imports to high cost domestic goods. This is
equal to Tk.50.