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ECON1101 MICROECONOMICS 1 SEMESTER 1 2008 COURSE NOTES

Last Revised: 15th August 2008 kaheiyeh.web.officelive.com

CONTENTS

Contents
Page 2: Introduction to Economic Concepts Page 7: Efficiency, Comparative Advantage & The Gains from Trade Page 9: Demand, Supply & Equilibrium Page 13: Elasticity Page 17: Applications of the Competitive Model Page 20: The Theory of the Firm: Production & Cost Page 24: Perfect Competition Page 28: Monopoly Page 31: Monopolistic Competition, Oligopoly & Business Strategy Page 37: Resource & Labour Markets; Income Distribution Page 43: Market Failure, Transaction Costs, Uncertainty, Externalities & Public Goods

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INTRODUCTION TO ECONOMIC CONCEPTS

Week 1 Introduction to Economic Concepts


What is Economics? Economics is the study of choice under conditions of scarcity. It is concerned with the most efficient use of resources to attain maximum satisfaction (wants). Fundamentally, society has unlimited wants and scarce resources to satisfy those wants. There are an unlimited amount of scarcities but all have two basic limitations: Time Spending Power These limitations force people to make choices on how to most efficiently spend time and spending power. Economics also includes the study of the consequences of these effects on society (cause and effect). For example: If an individual decides to spend less on air travel, they will spend less of there holidays away from home, meaning more time is spent at home. There are four fundamental scarce resources that we need to consider: Land Limitations in actual land area and raw materials on that land. Labour There are limits to the number of workers and the skills that they possess. Capital This is regarded as assets and that there are a limited amount of assets. Entrepreneurial Ability This is the ability to combine resources to produce a product and beat the risk that it entails. In short, economics is concerned with the production, distribution and the consumption of goods and services. MICROECONOMICS focuses on the individual parts of the whole economy. i.e. Individual households/firms. Positive economics deals with facts only and avoids judgements while Normative economics usually involves a judgement in how the economy should be. Economists usually disagree due to normative comments which carry one's judgement. For example: "Unemployment is at 5%" would be Positive while "Unemployment should be lowered" is Normative. The "Other things being equal" assumption It is assumed that everything but the one being considered is constant. This is so the economist can focus on the objective rather than on the many outside factors.

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INTRODUCTION TO ECONOMIC CONCEPTS

Economics Resources and Relative Intensity Economic resources can be split into two broader categories: Property Resources Land Raw Materials Capital Human Resources Labour Entrepreneurial Ability The relative intensity at which a resources is used is divided into: Land-Intensive commodity Something which requires use of large amounts of land (Agriculture) Labour-Intensive product Something which requires large amounts of workers and skill (Services) Capital-Intensive product Something which requires many assets (Manufacturing) Efficiency Efficiency is the relationship between inputs and outputs (Maximum efficiency is attained when there is minimal input and maximal output).

Allocative Efficiency Resources are devoted to satisfy the needs and wants of the market. Resources are effectively allocated when: Marginal Costs = Marginal Benefits. (MC=MB) If MB>MC, then economic ability should be expanded. Likewise, if MB<MC, then the economic ability should be reduced.

Productive Efficiency When goods and services are produced by using the lowest cost methods.

To achieve such efficiency, there must be full employment and full production.

Full employment All available resources should be used (Land, Labour, Capital ...) Full production Ensuring that the maximum amount of produced from the employed resources. Our resources are "underemployed" if they do not achieve full production.

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INTRODUCTION TO ECONOMIC CONCEPTS

Specialization increases efficiency and this comes in two forms: Division of Labour This results in greater productivity as work is divided into smaller specialized parts for specific skills and attributes. Geographic Specialisation Some parts of the world are more better suited to do some things. Such as the Middle-East is better for oil and China is better for manufacturing. This forms the basis for trade (This will be seen next week) The Production Possibilities Curve (PPC) [Also the Production Possibilities Frontier (PPF)] This illustrates choice and opportunity cost on a graph. It describes the limit of goods and services that can be produced efficiently. Production = The Conversion of (Land, Labour, Capital ...) into goods/services

Points on the curve show maximum efficiency. Points inside the curve can be achieved but are inefficient (There is underemployment and/or unemployment). Points outside the curve are superior but unattainable with current resources

The PPC looks at a snapshot in time, or over a short period. It looks at two products which are a capital good (A good used to make consumer goods) and consumer good (The end product to the consumer). There are some assumptions with the PPC: Full employment Full production Technology does not change Only producing two goods. Opportunity Cost Opportunity cost is what we forego when we make a choice. It includes both the implicit (foregone interest, labour earnings etc.) and explicit costs. These are non-monetary and monetary respectively. The accounting profit is net revenue - expenses and the economic profit is equal to the revenue minus opportunity costs. That is: Accounting Profit = Net Revenue - Expenses Economic Profit = Accounting Profit - Opportunity Costs The Law of Increasing Opportunity Costs This occurs because the PPC is concave and never a straight line. This entails that these resources lack perfect inter-changeability or flexibility. For the purposes of simplified explanations, the PPC can be straight.

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INTRODUCTION TO ECONOMIC CONCEPTS

Economic Growth on the PPC Economic growth can be described on the PPC as an outward shift of the curve to the right. This occurs due to: Expanding Resources Technological Advances In the end, Economics asks five fundamental questions: i. How much total output is to be produced? ii. What combination of outputs is to be produced? iii. How are these outputs to be produced? iv. Who is to receive and consume these outputs? v. How can the system be adapted to change? To answer these questions, we must first look at the type of economic systems.

Pure Capitalism (Laissez-faire) This is like a democracy; a government is there to enforce laws and private ownership. There is freedom of enterprise and choice. The Command Economy The government owns resource and property and also have heavy influence on business activities.

In reality, most economies are a mix between these two extremes.


Authoritarian Capitalism High degree of government control but privately owned property. Market Socialism Public ownership of property but markets play a significant role.

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EFFICIENCY, COMPARATIVE ADVANTAGE & THE GAINS FROM TRADE

Week 2 Efficiency, Comparative Advantage & The Gains from Trade


This week explores the economic basis of trade. We ask: Why do nations trade and what are its benefits. Economic Basis for Trade Nations trade because of differing economic resources in countries. Say, one country has better production of wheat over another. The movement of resources is partially restricted. Resources are relatively immobile between countries so hence, there are differing costs of making a product in different countries. Countries trade because each nation produces goods at a different rate of efficiency. This is the economic basis for trade. Specialization and Comparative Advantage Comparative advantage is the ability of a country to product a good at the lower opportunity cost than all others. Absolute advantage is when a country produces a good with less resources than others. In this way, there can be mutually beneficial trade between two nations with specialisation. More efficient use of resources is gained when countries specialise. As long as opportunity costs differ between two parties, trade can be beneficial to all involved. The Commodity Terms of Trade This is the rate at which one commodity can be exchanged for another in physical units. For example: 1 Car = 1 Computer There must be some analysis of this rate so that both parties can benefit from trade. Both nations will gain from trade (Gains from Trade), which results in increases in the consumption of goods and services through efficient allocation of resources in trade. The global amount of goods produced has increased and thus, consumption increases. However, trade is limited by each country's production constraints as described by the PPC (PPF). For equal opportunity costs, nations should find a point on the PPF where there Marginal Costs = Marginal Benefits (I believe this is where the gradient of the curve is -1 but is not confirmed; so don't go on it).

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EFFICIENCY, COMPARATIVE ADVANTAGE & THE GAINS FROM TRADE

Arguments for restricting trade Trade benefits all involved, however, some countries limit trade for some markets. Trade can be restricted in the following ways: Tariffs These are taxes placed on imported goods. Quotas This is a set maximum number of a good that can be imported. Exchange Controls Import Licensing Requires a corporation to acquire a license to import to a certain market. Embargoes A complete block of trade with a certain nation. Export Taxes Taxes places on exported goods. Subsidies Money granted by the government to domestic corporations Administrative Barriers There are several reasons as to why limiting trade can be good for a country: To increase domestic employment The Infant-Industry argument This is when the government tries to protect new businesses from fierce competition from more mature and efficient corporations in the market until it can become more mature itself. Prevention of the importation of "cheap" goods That is, the prevention of the importation of goods which are fake, bootstraps, pirate, illegal etc. Prevention of "dumping" Dumping is where products which are defective are thrown and sold at a very cheap price in a market. There are also some non-economical arguments such as: The country may wish to gain a degree of self-sufficiency so that it does not have to rely so much on other countries. To preserve its culture and values. It may decide not to trade with certain countries.

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DEMAND, SUPPLY & EQUILIBRIUM

Week 3 Demand, Supply & Equilibrium


First off, what is a market? A market is any institutional structure, or mechanism, that brings together buyers and sellers of particular goods and services. In economics, a market is not a physical place, rather a group of buyers and sellers with the potential to trade with each other. The market determines the price and quantity of a good or service. Supply & Demand The Supply & Demand model is designed to illustrate and explain how prices are determined in perfectly competitive markets (A market in which has many small buyers and sellers that cannot influence the price or quantity of a good or service). Although perfect competition is rare, many markets come reasonably close to it. The analysis of them gives useful insights into real markets. Demand Demand is a schedule that shows the quantities of a product that consumers are willing and able to purchase at each specific price point in a set of possible prices. This information is tabular and the demand curve is an illustration of the demand schedule. As always, all other variables are held constant. Note that the demand "curve" is still called a "curve" even if it is a straight line. Law of Demand The Law of Demand states that the demand curve is always sloped downward. That is: When price falls, demand rises When price rises, demand falls This inverse relationship is the Law of Demand. Why does this law exist? It does for 4 reasons: 1. Common sense and simple observation People normally buy a good if it is at a lower price than a higher price. 2. Diminishing marginal utility Successive units of the same product yield less satisfaction than previously. Therefore, consumers only buy the product again if there is something extra, or price is reduced. 3. Substitution effect At a lower price, we now have the incentive to substitute the cheaper good for "something better". 4. Income effect At a lower price, we can now buy more of the same product (Higher "buying power") without sacrificing anything else.

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DEMAND, SUPPLY & EQUILIBRIUM

Determinants that Shift the Demand Curve A shift in the Demand Curve is called a change in demand. The Demand Curve will shift to the right (left) if: Income/Wealth () Income is an individual's ability to spend money. Common sense tells us a person with higher income will buy more of a normal good, hence the demand for a normal good goes up. The demand for an inferior good lowers as when people have the income, they try to stay away from "cheap" alternatives. Price of Substitute () A substitute good is a good that an individual could buy instead. This means that as prices rise for that substitute good, demand will go up for this good as consumers can buy this cheaper alternative. Population () As the number of buyers in the market increase, it is obvious to note that there will be more people that demand a certain good, hence the demand curve will shift towards the right. Expected Price () If the expected price of a good is to rise in the future, people are more likely going to stockpile a lot of the good now. This causes extra demand for a good which causes a shift towards the right. Price of Complement () A complement good is a good that goes well with this good (Like butter with bread). So as the price of the complement increases, this good will experience higher demand as people want to buy both. Taste shifts towards good (bad) If there is a trend in taste that goes along with the product for the good, then more people will want to buy it, hence an increase in demand. *Note: For the opposite effect, use the opposite word for each underlined part. Shifts vs. Movements along the Demand Curve A shift in the demand curve is when a different amount of goods/services are now demanded at the same price point. A movement along the demand curve is when the price of the goods/services have changed as well as the amount demanded. Changes in Quantity Demanded A "change in demand" must never be confused with a "change in quantity demanded". A change in demand is when the entire curve shifts towards the left or right (as mentioned above), while a change in the quantity demanded indicates a movement from one point to another point (ie. A movement along the demand curve).

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DEMAND, SUPPLY & EQUILIBRIUM

Individual and Market Demand Up until now, all the above have been mentioning an individual market. The total market demand can be calculated by adding up all the price points horizontally on the demand curve and/or the demand schedule. Supply Supply is the various amounts of a product that producers are willing and able to supply at various prices during a specific period of time. Like the Demand Curve, this information can be represented on the supply schedule and the supply curve. Law of Supply The Law of Supply shows a direct relationship between price and quantity supplied. That is: As price increases, quantity supplied increases As price decreases, quantity supplied decreases Determinants that Shift the Supply Curve The Supply Curve will shift towards the right (left) if: Price of Input () As the price of a resource for the good goes down, the cost of making a good decreases, hence, suppliers can make more of the product. Price of Alternate Good () As the price of the alternate good decreases, suppliers will switch to this good as it will be more profitable for them. Expected Price () If the price is expected to decrease in the near future, suppliers will try and maximise profits from that product now, hence, more will be made. Number of Firms () As the number of firms increase, there is a larger supplier base for that certain good. Technological Advance As technologies advance, a single supplier can produce more than before with more efficient methods. Favourable Weather (Unfavourable Weather) Subsidies (Taxes) *Note: For the opposite effect, use the opposite word for each underlined part. Shifts vs. Movements along the Supply Curve A "change in supply" is when the entire supply curve shifts, while a "change in quantity supplied" indicates movement from one point to another point (ie. A movement along the supply curve). Supply and Demand: Market Equilibrium

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DEMAND, SUPPLY & EQUILIBRIUM When we put the supply and demand curves together, we form a new graph which illustrates many new things. We can discover: The equilibrium price The price at which the market sells at which Supply = Demand. The equilibrium quantity The amount at which the market supplies at which Supply = Demand. In essence, these two are the y-axis and x-axis values correspondingly at where the two curves cross each other. Excess Demand An excess demand occurs when Demand > Supply, or in other words, a shortage. This is where the current price point is below the equilibrium price. Competition in the market will eventually correct this problem where prices will rise back to the equilibrium price. Excess Supply An excess in supply occurs when Supply > Demand, or in other words, a surplus. This is where the current price point is higher than the equilibrium price. Competition in the market will eventually correct this problem where prices will fall back to the equilibrium price. Changes in Supply and Demand Changes or shifts in the curves for supply and/or demand disrupt the established equilibrium in the market. This causes changes in the equilibrium price and quantity and the market will adjust to this new value in time. When one curve shifts and we know the direction of the shift, we can determine the direction that both the equilibrium price and quantity will move in. However, if both curves shift, we can only determine the direction for either price or quantity; not both. This table shows the changes in supply and demand and it's effect on the equilibrium price and quantity. Increase in Demand Increase in Supply No Change in Supply Decrease in Supply P? Q P Q P Q? No Change in Demand P Q No Change P Q Decrease in Demand P Q? P Q P? Q

Where P = Price and Q = Quantity.

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DEMAND, SUPPLY & EQUILIBRIUM

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DEMAND, SUPPLY & EQUILIBRIUM

Week 4 Elasticity
The Price Elasticity of Demand The responsiveness of the quantity of a product demanded to a change in its price is reflected in its demand curve. The price elasticity of demand is the responsiveness of the demand to a change it its price. This may vary considerably between different price ranges for the same product (which we will note at a later point). The numerical measure of this responsiveness is called the price elasticity of demand. The Price Elasticity Formula The formula for price elasticity of demand is:

Percentage change in quantity demanded of good X

Ed = Ed =

--------------------------------------------------------------------Percentage change in the price of X Change in quantity of X --------------------------------------------Original quantity demanded of X x Original price of X ----------------------------Change in price of X

To measure the price elasticity of demand, we use common units of percentages, rather than absolute amounts so that they can be compared. Absolute amounts can be affected by the choice of product and units. Also, we take the absolute value of the coefficient as that is what we are interested in. When: Ed > 1, we call this Elastic demand where a given percentage change in price results in a larger percentage change in quantity demanded. Ed < 1, we call this Inelastic demand where a given percentage change in price results in a relatively smaller percentage change in quantity demanded. Ed = 1, we call this Unit elasticity where a given percentage change in price results in an equal percentage change in quantity demanded. There are some special cases where a good is perfectly elastic (Like a small farmer supplying to a large supermarket chain. Any change in price would result in no products sold as the large supermarket chain has many more other suppliers with lower prices.), and some cases where a good is perfectly inelastic (Such as some types of medicine which the consumer will still buy regardless of the cost because it is vital to them).

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DEMAND, SUPPLY & EQUILIBRIUM Midpoint Formula The midpoint formula is used to find the Mid-point Elasticity (or Arc Elasticity) which is the elasticity of a given demand curve between two points. It measures the average price elasticity along this small section of the curve. As a general rule, the lower Price goes, the less elastic the demand curve is. It should be noted that Ed is not always constant on the demand curve. It is given by (simplified):

Q (P1 + P2)

Ed = ------------------P (Q1 + Q2) Determinants of Price Elasticity of Demand


Substitutability The large the number of a good's substitute, the more elastic it is. Proportion of Income The larger the proportion of income that is spent on the good, the greater the elasticity of the product. Luxuries vs. Necessities Luxurious goods are generally elastic while necessities are usually inelastic. Time The longer the time period between changes of price, the more elastic demand is.

Total Consumer Expenditure (Total Revenue) The total amount that consumers spend on a product is the area that is bounded by the x-axis, y-axis, the price and the quantity. Consumers' Total Expenditure = Firm's Total Revenue. A firm will usually try to maximise this area.

Elastic Demand A change in price here will cause total revenue to change in the opposite direction (an inversely related function). That is, when Price goes up, TR goes down and vice-versa. Inelastic Demand A change in price here will cause total revenue to change in the same direction (a directly related function). That is, when Price goes up, TR goes up and vice-versa. Unit Elasticity A change in price here will not change TR.

The Price Elasticity of Supply The price elasticity of supply measures the responsiveness of producers to a change in a certain good's price. It is calculated in the same way as demand but instead, using the percentage change in quantity supplied instead of quantity demanded.

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DEMAND, SUPPLY & EQUILIBRIUM

i.e. %Qs Es = ----------%P Time Periods When analysing the elasticity of supply, it is useful to distinguish between the different time periods.

Immediate Time Period (Market Period) This is the time period that is happening now and cannot respond to a change in demand and price. The Short Run This is a period of time in which at least one factor of production is fixed. Output can be altered by changing the intensity of use and of the variable factors and supply is more elastic. The plant capacity of the industry is presumed to be fixed here. The Long Run The is a period of time in which all factors of production are variable. The elasticity of supply increases and in extreme cases even becoming perfectly elastic.

In general, the longer the time period, the more elastic supply becomes. Cross-Price Elasticity of Demand This is a measure of how sensitive consumer purchases of one product are to a change in the price of some other product. This is particularly useful for looking at substitute goods and complementary goods to a certain product. It enables us the predict how much the demand curve for the first product will shift when the price of the second product changes. This is given by the formula: Percentage change Quantity Demanded of Good A EAB = -------------------------------------------------------------------Percentage change in Price of Good B If this result is positive, then products A and B are considered substitute goods. This is because an increase in consumption of either good also increases consumption in the other good. If this result is negative, then products A and B are considered complementary goods. This is because an increase in consumption of either good will decrease consumption in the other good. If this result is zero or close to zero, then products A and B are considered independent goods. That is, a change in price of either of these products will not affect the demand for the other as they are not related (i.e. CDs and Butter).

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DEMAND, SUPPLY & EQUILIBRIUM

Income Elasticity of Demand This is a measure of the responsiveness of demand to a change in income (Y). It enables us to predict how much the demand curve will shift for a given change in income. This is given by the formula: Percentage change in Quantity Demanded of a Good Ey = -------------------------------------------------------------------------Percentage change of Income If the result is positive, then these goods are normal goods as when income increases, quantity demand also increases. If the result is negative, then these goods are inferior goods as when income increases, quantity decreases.

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APPLICATIONS OF THE COMPETITIVE MODEL

Week 5 Applications of the Competitive Model


Economic Surplus Economic Surplus is the sum of all the individual economic surpluses gained by suppliers and buyers in the participating market. The two different types of surpluses are consumer surplus and producer surplus. These are measured by the area under the curve and is divided by the equilibrium price. The consumer surplus is the top portion while the producer surplus is the bottom portion.

Consumer Surplus This is economic surplus gained by the buyers of a product. It is measured by their reservation price (marginal benefit) and the price they pay. Producer Surplus This is economic surplus gained by the suppliers of a product. It is measured by the difference between the price they receive and the reservation price (marginal cost). Note: Reservation Price is the maximum price that the market is willing to pay for a certain product (i.e. The equilibrium price)

Surplus and Efficiency When the market is using resources effectively at a competitive stage, then the sum of consumer and producer surplus will be maximized. At this point in time, resources are used in activities in which they are valued most in; thus, a competitive equilibrium is efficient. This means that the total economic surplus here is lower than at any other price/quantity combination. Wastage would occur at these other points. Both underproduction and overproduction are caused by obstacles and create a deadweight loss. A deadweight loss is a decrease in consumer and producer surplus that results from an inefficient allocation of resources. Obstacles that could cause a deadweight loss include: Price and Quantity regulations (ie. Quotas) Taxes and Subsidies Externalities These are costs borne by a third party, such as the need to account for pollution. Monopolies Price Ceilings and Shortages A price ceiling is the legislated maximum legal price that a seller may charge for a certain product or service. These always result in shortages, but the size of this shortage depends on the elasticity of supply and demand for that certain product or service. A price ceiling effectively restricts the market forces from moving the market back to its equilibrium price and quantity.

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APPLICATIONS OF THE COMPETITIVE MODEL An example of a price ceiling is rent control, where there is a legislated maximum rent for the renting of accommodation. A result of price ceilings is usually black markets for that certain product or good. Illegal arrangements are made between the supplier and buyer at a price higher than the legal price. This is because there is an excess demand for the product and the supplier knows that the market will buy the product at a higher price simply because there are none left to buy in the legal market. The Labour Market and Minimum Wage A minimum wage is inefficient because it creates an excess supply (the opposite of price ceilings). Once again, this legislated minimum prevents market forces from moving the market back to its equilibrium price and quantity. This actually creates unemployment as employers are less willing to take on workers due to the price. Taxes and Efficiency Most people have the idea that the price of an item will rise by the same amount of tax that is applied to it. However, this is not always the case. Whoever pays for the tax depends on the elasticity of the supply and demand for that certain product or good. This is called the Incidence of Tax. The more inelastic demand is for a certain good, the more likely the tax will be borne by the consumer. The opposite of this also holds true. The most common case of tax is that both the supplier and the consumer will bear some part of the tax. However, how much that each bears is determined by the elasticity of demand for that certain good. The more inelastic that demand or supply is, the smaller the decrease in quantity and also the smaller the deadweight loss. Taxes in Practice It is usual for a government to apply sales tax to an item that has a relatively low elasticity of demand (such as petrol, cigarettes and alcohol) because there will be minimal loss in quantity for a large benefit in tax revenue. However, it is unusual to apply tax to relatively high elasticity goods as tax revenue will be minimal. Any tax that is applied to the labour market usually results in the worker taking all of it due to its low elasticity. Taxing reduces the equilibrium quantity and therefore, taxing activities that people usually pursue to excess can increase total economic surplus.

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APPLICATIONS OF THE COMPETITIVE MODEL

International Trade Restrictions Economic Impact of Tariffs There are five direct effects and impacts to the economy caused by tariffs: Consumption Loss This is a measure of the benefits lost to consumers that is then lost and not recaptured. In simpler terms: This means that there will be less consumers of a certain product in the market. Production Loss This is the value of production lost to society. In simpler terms: This means that there will be less production of a certain product in the market. Deadweight Loss This is the reduction in the total level of welfare across society due to tariff protection. Effects on foreign producers The income of foreign producers will fall. Government revenue Government revenue will rise as this is essentially income for the government. However, this does not increase a country's wealth as it is merely a transfer of revenue from the consumers to the government. Some indirect effects are: The direct promotion and expansion of relatively inefficient industries. The contraction of relatively efficient industries in which a country may have a comparative advantage. Tariffs vs. Quotas A quota is much more restrictive than a tariff as it directly controls the quantity of a certain good that can be allowed into the local market. However, a tariff only serves as a deterrent for suppliers to not supply that certain good to the market. Tariffs distort the operation of price in the market but demand and supply still determine the quantity of imports. Tariffs benefit the government and quotas benefit the protected industry in terms of revenue. There are some other ways of restricting trade between countries which include: Non-tariff barriers such as licensing. Voluntary export restrictions agreed to by countries. Motivations such as the need to protect a certain industry due to culture etc. Subsidies A subsidy works exactly like a tax, except that it is the other way around. The amount that the consumer and supplier can save on a certain product or service depends on the elasticity of the product.

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THE THEORY OF THE FIRM: PRODUCTION & CO

Week 6 The Theory of the Firm: Production & Cost


Production The inputs of production are: Labour, Capital, Land, Raw Materials and other goods and services provided by other firms. The way in which all this is pieced together is the firm's technology. A firm's technology is treated as a given value and the constraint on the production is the production function itself. The production function tells us the maximum output that a certain amount of input can generate over a period of time. That is: Output = f(input) The Long Run and Short Run It is useful for us to classify a firm's decisions in the long and short run.

Long Run A time period where it is long enough for all variables of a company to be variable. Short Run A time period where one of the company's inputs cannot be varied.

Production in the Short Run When a firm makes a short run decision, there is nothing they can do about their fixed inputs, which means that they are stuck with whatever quantity they have and that they need to vary other inputs. The Law of Diminishing Returns As the first few inputs are added, the Marginal Product of Labour (MPL) increases but then it reaches a point where it starts to diminish. This is called the Law of Diminishing Returns. Such a case would be the hiring of workers. The hiring of an extra worker may not bring the exact same amount or higher amount of output than the last worker did. Simply the Law of Diminishing Returns states that: As we continue to add more of any one input (holding the other inputs constant), Its marginal product will eventually decline. Fixed, Variable and Total Costs

Total Fixed Cost (TFC) These are costs that stay the same and do not vary when input or output in varied. These are usually costs associated with the pure running of the firm. Such as: buildings, machinery etc.

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THE THEORY OF THE FIRM: PRODUCTION & COST

Total Variable Cost (TVC) These are costs that vary as the amount of output varies in the firm. These are usually the costs associated with the production of the actual good or service. Total Cost (TC) This is the sum of Fixed costs and Variable costs at each individual output level.

Average Costs These costs are the averages of those found in the above. That is, they can be found by dividing them by the output quantity of the firm.

Average Fixed Cost (AFC) Although by definition, these do not change as output changes the AFC declines as output increases. AFC = TFC/Q

Average Variable Cost (AVC) AVC = TVC/Q

Average Total Cost (ATC) This can be found in two ways, either: ATC = TC/Q or ATC = AFC + AVC.

Marginal Cost Marginal cost is the addition to the total cost of production as a result of one additional unit of product. Marginal cost is given by MC = TC/Q. The Relationship of Marginal Cost with Average Total Cost and Average Variable Cost When depicted on a graph, the Marginal Cost curve always intersects the ATC and AVC costs at their lowest points. The MC curve is generally the opposite of the MPL curve. As MPL increases, MC will decrease but as MPL decreases (due to the Law of Diminishing Returns), MC will start to increase. Generally:

At low levels of output, the MC curve lies below the AVC and ATC curves At higher levels of output, the MC curve will rise above the AVC and ATC curves As output increases; the average curves will first slope downward and then slope upward

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THE THEORY OF THE FIRM: PRODUCTION & COST

Shifts in the Cost Curves When more efficient technology is discovered, the productivity of inputs would rise and hence Marginal Cost and Average Cost curves would move downward. The opposite is also true for increasing input prices. Production Costs in the Long Run Costs behave differently in the long run when compared to the short run. This is because all factors of production are now variable and there are no fixed variables to consider. Thus, the firm's goal in the long run is to maximize revenue and minimize costs. They do this by following the least-cost rule. Least-Cost Rule This rule states that: the least-cost output occurs when the cost of any output is minimised when the marginal product per dollar's worth of each resource used is the same. For Labour and Raw Materials, this is given by: [MP of Labour / Price of Labour] = [MP of Materials / Price of Materials] The Long-Run Cost Curve The Long Run Average Total Cost (LRATC) curve shows the lowest per-unit cost at which any output can be produced after the firm has had time to make all appropriate adjustments in its plant size. The LRATC of a firm is actually comprised of segments of the short run ATC at different plant sizes. Hence, the curve usually it not smooth and has many bumps. These bumps signal when the firm should increase the size of the plant to achieve more profits for the same output with a smaller plant. Economies of Scale and Diseconomies of Scale

Economies of Scale This is the force that reduces the average cost of producing a product as the firm expands the size of its output in the long-run. This is the downward sloping part of the LRATC curve . This can be a result of: Labour specialization Managerial specialization Efficient capital By-products Research and Development

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THE THEORY OF THE FIRM: PRODUCTION & COST

Diseconomies of Scale Diseconomies of scale can occur when a firm increases its output so much that it is producing too large of an output for managers to efficiently control and coordinate the firm's operations. This is shown by the upward sloping section of the LRATC curve of the firm. Constant returns to scale is when there exists a section where the economies of scale stops and where diseconomies of scale begins. This range is where the LRATC will equal over that range. Economies of Scale can be an important factor in determining the type of market that should be used in that certain industry. Minimum efficient scale (MES) is the point at which the smallest level of output can be used to minimize LRATC. Where MES is: Small compared to market demand There should be many small firms operating in the market (Perfect Competition)

About 25% of the market demand There should be a few big firms operating in the market (Oligopoly) Almost all of market demand A large single firm operating in the market (Natural Monopoly)

This is also a reason why firms may want to merge so that they can "slide" down the LRATC and achieve a MES.

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PERFECT COMPETITION

Week 7 Perfect Competition


The Four Basic Market Models There are four basic market models that we can refer to that are relatively distinct: Perfect Competition Pure Monopoly Monopolistic Competition Oligopoly This week will focus on Perfect Competition. The Requirements of Perfect Competition For Perfect Competition, there must be: A very large number of suppliers and buyers (So much that each acts as a price taker and none are price makers.) A standardized product that is otherwise indifferentiable to products produced by other firms. Suppliers must be able to easily leave or enter the market (ie. There are no significantly large barriers to entry or exit from the market.) Is Perfect Competition Realistic? Like all models, perfect competition cannot possibly be achieved in reality, however, many markets come close to being in perfect competition which makes studying the model worthwhile. *Note: In reality, firms are likely to break at least one of the rules as mentioned above. Demand to a competitive seller Because each firm is a price taker and that each firm produces negligible, small amounts to the market they obviously cannot affect the overall quantity demanded and quantity supplied. Hence, the demand curve here is perfectly elastic for the firm (NOT the market). If they raise or lower prices from the normal market price, buyers have many other firms to go to in order to buy the good they want. Goals and Constraints of Perfectly Competitive Firms Like all firms in any market, a perfectly competitive firm faces cost constraints and technology constraints. These influence directly on the amount supplied by the firm. Revenue For a firm in a perfectly competitive market, Price is the firm's demand curve as it is perfectly elastic; it defines the price the firm must sell at.

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PERFECT COMPETITION

Short Run Profit Maximisation There are two approaches to maximizing profits in the short run for a perfectly competitive firm: Total Revenue - Total Costs Approach A firm is usually faced with these three problems: Should the firm produce? If so, how much? What will be the profit? Generally, the firm should produce if TR is greater than TC or if TC is greater than TR but only if the costs exceed the revenue by some amount that is less than the TFC. There are three cases that can occur from here: Profit-Maximization Here, TR is greater than TC and the firm will try to find an optimum output level where the difference between TR and TC is the greatest, hence the greatest profit as Profit=TR-TC.

Loss-Minimization This is where TC is greater than TR but the difference does not exceed the TFC. Here, the firm will try to minimize its losses in the short run by minimizing the difference between TR and TC. Close-Down If the firm's TC is greater than the TR and the difference exceeds the TFC such that even the firm's TVC are not covered, then the firm should close down as it will not make an profit in the foreseeable future.

Marginal Revenue - Marginal Cost Approach This approach believes that profit is maximized when MR=MC. Three features should be noted in the MR=MC approach: 1. Firms would rather produce than close-down. 2. The rule is a guide to profit maximization for all firms in all markets and is not necessarily limited to perfect competition. 3. In a perfectly competitive market, MC=P. Three cases also occur in this approach: Profit-Maximization Since MR defines the price the firm should sell at, if MR is always above the ATC and AVC curves then the firm will be maximising its profits if it sells a quantity at the point MR=MC=P.

Loss-Minimization If MR drops below the ATC curve but is still above the AVC for some part, then the firm should produce where MR=MC to minimize its losses.

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PERFECT COMPETITION

Close-Down If MR below both the ATC and AVC curves then the firm should just close-down as producing at MR=MC will still produce a loss which cannot even cover the firm's variable costs.

A firm's short run supply curve can be found from analysing the MR=MC approach. Since all cases are from tracing the MR curve to the MC curve and that the firm will not produce if the MR goes below the AVC; hence, we can deduce that the supply curve for a firm is all the points on the MR curve above the AVC curve. Firm and Industry Equilibrium Price Since the firm is a price taker, it always extrapolates the price that it should sell at from the market equilibrium price. Hence, the firm's price will always be the same as the market equilibrium, however, each individual firm's quantity supplied at that price will be different. Profit Maximization in the Long Run In a long run competitive market, profits and losses are what drive firms to enter and exit the market. Entry into the market does not necessarily have to be in the form of establishing an entire new firm; it can also be the act of simply starting a new line to cater for that market. The same also applies to exiting a market where a firm can simply switch a supply line; not necessarily going out of business altogether. As demand moves up for a certain product, firms currently in the market will experience above normal profits as they can sell more of a product to the market. However, this also entices firms to enter the market, which cause the supply curve to also shift towards the right, effectively ending any economic benefit for those firms. This results in a shift to the right of quantity supplied and possibly a change in price. The opposite is also true. If demand went down, all firms would have economic losses which will force some to exit the market. This means the supply curve will then shift left until equilibrium is reached again where there are zero economic profit for all firms. However, an increase in technology results in a rightward shift of the supply curve. This does not entice new firms into the market as demand has not risen. Ultimately, consumers will benefit from this as there are lower prices associated with the production of the good, hence the consumers can buy a good or service for a lower price. Perfect Competition and Efficiency The three point equality where MC=AC=MC shows us the perfect equilibrium where Allocative and Production efficiency is being achieved. There are cases where: P > MC (Underallocation) P=MC=MR is where a firm should produce, however, a profit-seeking firm may produce at a point which does not reach this which means there is a net loss to consumers and also less than maximum profits for the firm.

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PERFECT COMPETITION

P < MC (Overallocation) Similarly, production of a good should not go above this equilibrium as it would mean less than maximum profits for the firm due to the wastage so the products will not be sold.

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MONOPOLY

Week 8 Monopoly
What is a Monopoly and why do they exist? A monopoly is where one single firm operates and supplies a certain good or service, for which there is no close substitute, to the market; there are no competitors. There are no competitors because of the barriers to entry. If a monopoly exists, there is usually an economic reason as to why it exists instead of a perfectly competitive market. Barriers to Entry These are obstacles that prevent the entry of new firms into an industry/market. However, sometimes the society is best served by one single firm in the market. Most monopolies, however, arise from a range of legal barriers such as: Government regulated markets (such as the postal industry) Licensing Patents and Copyrights Monopolies can also arise if one firm controls all, or a vast majority of raw materials required. Natural Monopolies as a result of Economies of Scale If economies of scale persist to a point such that it only requires a single firm to serve the entire market, then this is called a natural monopoly. Unless, the government intervenes, the market will stay as a natural monopoly due to market forces. Natural monopolies are discussed next week. Price-Setting Strategies for a Monopoly There are two types of price-settings that a monopoly can take: Single-Price Monopoly This is where the firm sells at one single price to all buyers. Price Discrimination This is where the firm sells at different prices to different types of buyers. The price differences here are not justified by the cost differences. The only times where a firm can price discriminate is when: It is a monopoly; or, The market can, and is, be segmented; or, The end product cannot be resold. Thus, with price discrimination, a monopolistic firm can generate more profits as they can usually cater to a segmented market with different prices to attract all different segments of the market. The Monopoly as a Price-Setter The single firm in the monopoly is a price setter and so, sells at the price which it wants to. The demand curve for a monopoly is the same as the demand curve for the market since they are the only firm operating in the market.

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MONOPOLY A monopoly only makes one decision regarding the price and quantity of a product to be sold. Once it determines the output level, price is then automatically set for that level of output. A monopoly works in the same way as a firm in a perfectly competitive market in that they maximize output when MC=MR. The monopoly does not have a supply curve because price and output are not independent. Profit and Loss in a Monopoly A monopoly experiences a profit when P > ATC, this is because P is the price they sell at and these are above the total costs, hence, there is an area of above-normal profit for the firm which is defined by the area under the point P, above the point of ATC and the quantity supplied. Likewise, a monopoly experiences a loss when P < ATC because they are selling at a point that is below their total costs. However, remember that as long as P > AVC, the firm can still operate at a loss-minimizing case, however if P < AVC, then this is the shut-down case. Usually, a monopoly does not shut down as they are the only firm in the market that can supply the product to the market, hence, it is usually subsidised by the government so that it can stay in the market. This subsidy is usually in the form of tax-payers money. A Monopoly in the Long-Run As seen, firms in a perfectly competitive market usually cannot earn a sustained economic profit in the long run as the entry of additional firms will negate this until the firm earns normal profit again. However, a monopoly can sustain an economic profit in the long run as there are barriers to entry for new firms. A privately owned monopoly should never be running at an economic loss in the long run, as this will cause them to shut down and the market will have no supplier. However, a public monopoly can sustain an economic loss in the long run with government subsidies. Public monopolies are usually in the form of infrastructure, and thus, it is vital for the government to subsidise the firm or the entire city/nation will be left without that vital piece of infrastructure that can be detrimental to the entire nation's economy. Comparing a Monopoly to Perfect Competition When comparing a monopoly to perfect competition, consumers ultimately lose in a monopoly because the monopolistic firm is a price-setter and can set any price at which the consumer has no choice but to pay for as they are the only firm that is supplying to the market. Due to these higher prices, the consumers, as a result, normally buy less of the product which usually sets off a chain reaction in which the price continually rises as the firm needs the profit and consumers will in turn, keep lowering the amount they will buy. Economic Effects of Monopoly Monopolies are usually not productively and allocatively efficient. They do not necessarily produce where ATC is a minimum (Productive Efficiency) and they do not usually produce where P=MC (Allocative Efficiency). The supply curve for a monopoly is effectively, its marginal cost curve. That is: S=MC.

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MONOPOLY

Monopolies are usually controlled/owned by a few at top level of management and since they usually charge a higher price than they would in a perfectly competitive market, this extra is usually given to the owners at the expense of society. This contributes to the differences in income distribution in society. Monopolies may be better suited to certain markets if economies of scale can only be achieved in that certain market with one firm supplying the whole market. However, Xinefficiency may occur as monopolies do not necessarily have to use the best technology, or the firm may be fuelled by low morale as it does not need to fix this problem as there are no competitors. Managers may be risk-averse people and will always choose the more stable path for a firm which may be the most inefficient for the firm. Empirical evidence shows that as the firms in a market decrease, X-inefficiency increases. In the very long run, dynamic efficiency comes into play which is the ability of a firm to develop the most efficient production techniques over time. In perfect competition, each firm has high dynamic efficiency as each wants to make a profit. However, in a monopoly, the firm has a large amount of money to go about developing new products, but, has no incentive to do so because they do not face any competition. Because there are barriers to entry, the monopoly can afford to be inefficient. Regulating a Natural Monopoly When market forces create a natural monopoly in a market, government intervention is required to fix the price of the good sold to the consumer. By regulating the monopoly like this, some unfavourable aspects of a monopoly are removed and thus, ultimately benefits society. Price can be regulated by: Marginal Cost Pricing Rule This sets the price to D=MC and is considered the socially optimum price. Average Cost Pricing Rule This sets the price to D=ATC and is considered the fair-return price. Without any intervention, the monopoly will sell at the point on the demand curve above the point where MR=MC. However, this point is usually where there is high cost and low quantity. However, as both of the options mean bringing the price to equal ATC or below ATC (MC is below ATC), then the monopoly will be operating on a loss and governments will be required to subsidise them at the cost of taxpayers. This means that the firm is ultimately costing everyone in society; not just those who buy the good or service from them.

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MONOPOLISTIC COMPETITION, OLIGOPOLY & BUSINESS STRATEGY

Week 9 - Monopolistic Competition, Oligopoly & Business Strategy


Characteristics of Monopolistic Competition

Large Numbers of Firms (About 100) Monopolistic competition refers to a market where there are a relatively large number of suppliers that are offering almost identical products with minor differences. However, this relatively large number of firms is not as large as the many thousands required for perfect competition. As a result of these characteristics of monopolistic competition, the following also result: Small market share for each firm as there are many firms in the market. No collusion is possible between firms due to the amount of firms. Independent actions occur as the firm does not take into account the reactions of the many other small firms.

Product Differentiation Each firm in monopolistic competition has a slightly different product to the other firms. These can be differentiated by: Product Quality Services/Conditions (Such as warranties, credit policies, speed of delivery etc.) Location (Usually of a service, or where a good can be bought) Promotion and Packaging (Branding of products and advertising) Implication (Some people may specifically like one firm's products and will pay more for it) Easy Entry Since there are many firms in the market already, it can be safe to assume that economies of scale can be achieved at a low level of quantity and that capital requirements to establish a presence in the market are minimal. However, we must note that these are minor barriers and that there may be other additional minor legal barriers which are not present in perfect competition.

Price and Output Determination in Monopolistic Competition A firm's demand curve in a monopolistic competitive market is close to perfectly elastic, but however, it is not perfectly elastic as it is in perfect competition. This occurs because there are slight differences in the products that each firm sells and the differences may justify the increment or decrement in the price of the product (i.e. the cross-price elasticity of demand here is less than perfect). Another factor is that there are not as many firms in a monopolistic market as a perfect market. The Short Run As usual, the firm will try to maximize its profits, or minimize its losses by producing where MR=MC. In the short run, the firm is faced with either an above normal profit or a loss.

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MONOPOLISTIC COMPETITION, OLIGOPOLY & BUSINESS STRATEGY

The Long Run The profits or losses experienced by a firm in monopolistic competition will be the same as that of one in perfect competition. If they are experiencing above normal profits, then this will encourage new firms to enter the market. Likewise, if they are experiencing economic loss, firms will exit the market. Both of these will cause the firms in the market, in the long-run, to achieve zero economic profits. The tangency solution results in the long run equilibrium for firms in this market. The point where MR=MC is also usually the point where the demand curve is tangent to the average costs curve. This means the firm will make zero economic profits in the long run. There are some complications with this as usually, firms may experience the following: A level of product differentiation that cannot be attained by other firms. This causes some slight monopoly to occur. Entry is not completely restricted and with product differentiation occurring, most firms will likely have to do more to enter the market. Economic Efficiency of Monopolistic Competition In Monopolistically competitive markets, both productive and allocative efficiency is achieved. Excess capacity occurs and this is where firms will produce at a higher unit cost than where ATC is at a minimum; the equilibrium point. This usually happens because there is an excess amount of firms in the market and all these firms are underutilised, and these extra costs caused by underutilisation are ultimately borne by the consumer. However, product differentiation means that consumers have a much wider range of products to choose from than just the single homogenous product that is offering in perfectly competitive markets and the single product that is offered in a monopoly. Non-Price Competition Because many firms in this market will not be satisfied with normal profit, many will engage in non-price competition to capture more of the market. Non-price competition includes things that enhance a product without altering its price such as advertising, sales promotion and product differentiation. In monopolistic competition, each firm has sells a slightly different product and thus, a firm must continually develop more high quality sales promotion, advertising and product differentiation to gain extra customers. This is because other firms can just as easily copy the product the firm currently has and to sell that. By continually developing quality, the firm can possibly sustain a long run above normal profit providing that the non-price competition generates enough demand for the product to outweigh the costs of it. Product Differentiation Product differentiation means that a consumer will be offered a wide range of types for any given single product (be it a difference in brand, quality etc.). This ultimately benefits consumers as they will have a much wider range of products to choose from, each with their own unique differences. However, as the amount of types of a single product increase, a

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MONOPOLISTIC COMPETITION, OLIGOPOLY & BUSINESS STRATEGY consumer will become increasingly confused as it will take additional time and effort to assess these differences and choose a product. This usually leads to a conclusion by the consumer that price is attributed to quality. While this may be true to some extent, it can damage the demand of a firm selling a high quality product at a low price. Product Development The result of product development is product differentiation. This helps drive innovation and general improvement of the product over time. Product development can help a firm by providing a temporary increase in market share for the firm until other firms can imitate that product. However, product development may result in superficial changes to a product that in no way, increases its usefulness (such as new packaging). Advertising Advertising is said to benefit consumers by giving them information regarding the unique properties of a product and helping them to make a choice about which product to use. It can also promote competition within the market as other firms will be fully exposed to the advertising of that firm and will immediately try to counteract. Advertising is also the backbone of many media who use it as their primary source of revenue. However, advertising can be seen as persuasion of consumers into buying a product without truthfully stating all the facts. Competitive advertising is usually misleading and tries to insult the user's intelligence in order to make them buy the product to improve it. Advertising can also be seen as an inefficient use of resources as it diverts labour and property resources away from areas that otherwise need those resources. Advertising can also promote monopoly growth by stabilising market power and can also bias media portrayals of events if it is to report on a firm that is a major advertiser with them. Oligopoly An oligopoly is a market where a few firms dominate the market for a certain good or service. They may produce a homogenous product or a differentiated product; there is no standard here. These firms usually, together, have a high concentration ratio. A concentration ratio is the percentage of the total industry sales that are accounted for by the largest firms in each industry. The causes of an oligopoly arise from entry barriers. These usually arise from the millions and even billions and dollars of investment into machinery, equipment and such to even start the firm. Then there are also the huge costs involved with advertising to gain a foothold in the market. However, the ownership of patents and strategic control of raw materials can also be entry barriers to enter an oligopoly. If a new firm does successfully enter the market, it is usually subject to a merger with an existing company. This benefits both firms as they will have a larger combined size, market share and market power. Firm Behaviour in an Oligopoly: Game Theory Game Theory is shown as a payoff matrix that shows the effects on both firms due to the actions of each individual firm.

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MONOPOLISTIC COMPETITION, OLIGOPOLY & BUSINESS STRATEGY

The following is shown by Game Theory: Mutual interdependence of firms Firms in an oligopoly are interdependent on each other and one firm's actions can affect another firm. Collusive Tendencies Because of the benefits that usually arise when firms choose the "worse" outcome individually for them, there is the tendency to collude with the other firms so that they also choose this outcome. By choosing these, both firms can ultimately benefit in the end with higher profits. However, these cartels are illegal in Australia. Incentive to Cheat Following collusion, any one of the two firms can change its strategy and hence, benefit itself at the expense of the other firm. However, most firms try not to do this for the fear of retribution by the other firm The Nash Equilibrium is defined as the cell which results due to each firm's individual thinking. That is, they will choose the option that is better for them. The results of these two decisions is what is called the Nash Equilibrium. The Dominant Strategy is the cell where the outcome will be the best for both firms. This usually will not result without any sort of collusion between the two firms as Nash Equilibrium is usually not the same cell as the dominant strategy. Price-Output Behaviour There are four distinct models for the oligopoly because of the interdependence of firms and also the diversity of an oligopoly. Oligopolies come in many types such as one with a few large firms, and another with a few large firms and a small competitive fringe. The Kinked Demand Curve The kinked demand curve results from an oligopoly with few large firms, no collusion between any of them and a differentiated product. There are several possibilities here:

Price Matching When a firm in the oligopoly changes price, all the other firms will follow suit and change their good/service to this price as well. The firm that first initiates the price change will gain a small increase in sales at the expense of the other firms until they match their prices. In this case, the Demand and MR curves for the firms will be more elastic. Not Price Matching Another possibility is that all the other firms will ignore the price change set by the firm. If the firm decreases its price, then it will gain a steady increase in sales due to the other firms charging a higher price. If the firm increases its price, then it will have a steady decrease in sales. Sales here do not drop to zero for both cases because each firm can sell a differentiated product. Some consumers will still have a preference for the firm's product, even if it is slightly higher priced. In this case, the Demand and MR curves for the firms will be more inelastic.

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MONOPOLISTIC COMPETITION, OLIGOPOLY & BUSINESS STRATEGY

Mixed Strategy This strategy is when some firms price match and some don't. This results in a kinked demand curve that is defined by the lower portions of the demand curves of both the above cases. It also comprises the" non-price match" MR curve until the point P where the "price match" MR starts.

The kinked demand curve usually results and it shows us that the firms in the oligopoly are reluctant to change price. This is because it may initiate a price war between the firms which can result in the failure of all firms in the oligopoly which is detrimental to all involved. Thus, some firms can live with the fact that a firm has changed its price but some will still try to counteract this. Collusion and Cartels As seen in game theory, most firms would be better off with collusion and cartels. First, we assume that situation is like the one seen in the kinked demand curve, but in this case, with homogenous products. The firms will charge price where MR=MC. If the firm decides to move its price and the other firms do not, this could be disastrous as they all sell a homogenous product; meaning consumers can easily go to a competitor for the good/service. If the firm then retaliates, all the firms in the market move down their demand curves and can drive some firms to a point where they must minimise losses. Here, the firms will be motivated to collude so that this does not occur. Formal collusion takes the form of a cartel where all firms sign a written agreement about price and production of a certain good/service. However, cartels are illegal in Australia and most collusion takes place informally in the form of gentlemen's agreements, which are verbal agreements that usually take place in informal places. This is to reduce the chances of being caught. Their elusive characteristic means firms that undertake gentlemen's agreements are more difficult to detect and prosecute. Collusion, however, is hard to establish and maintain even if it was legal. Each firm's product demand curve and costs are different, especially if they were selling a differentiated product. Even firms with homogenous products will usually have differing efficiencies and market share. Thus, is it likely that even these firms will have some difficulty to keep to a set price and output level. Also, the higher the number of firms, the more harder it is to keep collusion running and cheating will be rampant. Price Leadership: Tacit Collusion Price Leadership is where one dominant firm in the industry initiates price changes and other firms follow suit. This is a type of collusion but does not involve agreements, meetings or any communication at all. Firms may follow this dominant firm because they are the most efficient, largest or oldest in the industry. The following tactics will mostly be used: Changing prices infrequently, as there is a risk that firms following the dominant firm will not follow the change in price, thus resulting in potential losses.

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MONOPOLISTIC COMPETITION, OLIGOPOLY & BUSINESS STRATEGY

The dominant firm will usually announce the changes in price before they are actually implemented so that there will be a general consensus to change price among the industry. The dominant firm will not necessarily choose the most efficient price to operate at. It may do this to discourage new firms from entering the market.

Cost-Plus Pricing This is a simple strategy where firms simply charge a price with is the cost of the product/service plus an extra amount. It may use this formula because costs for a certain product/service may be hard to calculate; and is especially problematic if the firm sells many products. Non-Price Competition in an Oligopoly Generally, oligopolies do not like price competition and thus, must rely on non-price competition to generate profits through capture of market share. Advertising between oligopoly firms can also be measured with game theory. Typically, firms in an oligopoly with have more than sufficient economic power to engage in strong non-price competition. Oligopoly and Economic Efficiency Oligopolies usually are inefficient because the minimum ATC (productive inefficiency) is not necessarily chosen and price also does not necessarily need to be set at a point where it is equal to MC (allocative inefficiency). However, oligopolies can have dynamic efficiency where they may result in long-term technological improvement in quality and efficiency of production of a certain product.

Competitive View There is strong incentive for a firm to develop this efficiency as they do not like to engage in price wars, it is necessary to lower costs through this efficiency. Schumpeter-Galbraith View This view shows that firms will have the money to engage in this improvement and that the barriers to entry will ensure that an oligopoly will properly benefit from this new technology.

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RESOURCE & LABOUR MARKETS; INCOME DISTRIBUTION

Week 10 Resource & Labour Markets; Income Distribution


Resource Markets in Perspective A resource market, such as a labour one differs a lot from the other markets that we have studied so far. In a labour market, the sellers of labour care about the conditions in a workplace and wages. Also, the price at which labour is sold is actually the wage rate for that seller. Resources are: A major determinant of money income. For example, if a certain employee works more productively, there is more money income for the firm whereas if an employee does not work as productively, money income is not as much. Rationed through resource allocation. Just as how end-products are distributed out to consumers, resources must be distributed out to firms and resource prices determine this. A cost. Firms will try to minimise their costs and resources are ultimately a cost to the firm. Not without ethical issues. Inequality in pay, gender etc. This raises the normative issue around the distribution of income. However, the nature of the market for each resource is different. It depends on: The type of resource being traded The type of market The policies and practices enforced by the government The types of unions and firms involved Marginal Product Theory In previous markets, the way to maximise profits would have most likely been when MR=MC. This same analysis can be applied to resource inputs only. To maximise profits, the firm should try to attain the position where MRP = MRC. That is; that the amount of revenue that a resource can attain equals the amount the resource costs. This explains the supply curve but it does not explain the demand curve for a resource. Demand for a Resource The demand for a resource depends on the size of the market. Are there a large amount of buyers or a small amount? Resource Demand under Perfect Competition in the Product Market If a firm is in a large market and it produces the good that is sold in that market, then resource demand is the derived demand. This means that the demand for a resource will depend on: The productivity of a resource in producing the good,

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RESOURCE & LABOUR MARKETS; INCOME DISTRIBUTION

The market value of the good it is to produce.

An example: If a resource is highly productive but it produces a good that no one wants, then there will be no demand for that type of resource. The price of a resource is always constant for each unit and the only way the demand curve slopes down if because of diminishing marginal productivity. The MRP schedule, in this case, is the firm's demand curve for a resource. In this case, MRP can be found through this equation: MRP = MP x P. Resource Demand under Imperfect Competition in the Product Market Labour demand here is much more complex than one of perfect competition. Imperfect competition implies: monopolies, oligopolies and monopolistic competition. In these markets, the product demand curve is downward sloping and thus, the firm must lower its price to increase sales. MRP is calculated here as MRP = MP x MR. In comparison to perfect competition, the MRP is less elastic and imperfectly competitive firms are much less responsive to wage cuts (in terms of the number of employees hired). Market Demand for a Resource The previous two cases analyse a firm's demand for a resource. This analyses the total market demand for a resource. This can be done by adding up each individual firm's demand curves together. However, the curve for each firm in perfect competition is derived from the assumption that product price is constant. If the resource price decreases , all the firms in the market may hire more of the resource, thus altering the demand curve. If product price falls, the true market demand curve will end up being less elastic than the derived curve. Changes in Resource Demand Demand for a resource will change when there is a: Change in Product Price Change in Productivity The productivity change in other inputs can affect that of a resource. Technological advance can also greater productivity of resources. Increases or decreases in labour quality also mean that more or less of a resource needs to be hired. Prices of other resources Just like for a product, there are also complimentary and substitutes for a resource. These follow the same rules as for complimentary and substitute goods in a product market. Elasticity of Resource Demand The determinants of the elasticity of a resource's demand are: Rate of Marginal Product Decline

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RESOURCE & LABOUR MARKETS; INCOME DISTRIBUTION The higher the rate of MP decline, the more inelastic the demand for the resource becomes. Ease of Substitutability The more easily a resource can be substituted, the greater the elasticity of demand. Elasticity of Product Demand The elasticity of product demand for the good that the resource produces has an effect on the elasticity of the resource itself. In general, these two have the same elasticity. Resource Cost-Total Cost Ratio The larger the cost of the resource in relation to total production costs, the more greater the elastic it is.

Imperfect Competition in Resource Market In imperfect competition, a firm's decision to hire more inputs of a resource means the price of the resource will increase. Also, if the firm is large (or a monopsony: a market with only one buyer of a resource), it will have to increase the price it offers for a resource to attract more. However, this higher price must be paid for all unit of input employed. Labour Markets Labour is a resource, and in a competitive labour market, workers act as the many individual suppliers or labour and the many firms are the buyers of this labour (demand). Both here are price-takers as the market has many buyers and sellers. Each firm will only hire up to the point where P=MRP if it wishes to be efficient. The demand curve for any labour market is always downward sloping due to increasing costs associated with a rise in wage rate. As this increases the firm's costs, demand starts to decrease. This can cause firms to look into capital (machinery) to replace workers as labour. Likewise, as the wage rate increases as more are hired, the supply curve in any labour market slopes upwards. Workers are attracted by high wage rates into the market and thus, supply grows (substitution effect). However, as workers gain higher wages, their demand for leisure also increases as they have more wages to spend on leisure (income effect); this starts to drive the supply curve downward. Wage Determination Perfectly Competitive Labour Market Wages in a competitive labour market are determined in much the same way as a normal competitive product market. The quantity and wage rate at which labour is sold/bought is where the supply and demand curves cost. For the firm, they must buy labour at the set wage rate or they will not get any labour at all. Monopsony This is much like a monopoly except that this time, there is only one buyer instead of only one seller. Here, the firm acts as the price-setter for the wage rate at which workers are employed.

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RESOURCE & LABOUR MARKETS; INCOME DISTRIBUTION

Instead of taking the supply curve from the individual firm in a perfectly competitive model, the firm takes the supply curve (which is upward sloping) from the total market; because it is the only buyer in the whole market. MRC here always exceeds the wage rate because when hiring an extra worker at a higher wage rate, the firm in a monopsony must increase the wages of all the workers already hired to the same level. Thus, costs will always be higher than the actual wage rate t hire the new worker. The equilibrium in a monopsony for the firm is where MRP=MRC, which is the usual for all labour market models. However, previously, this has been where S=D, but in a monopsony, this is not the case. The firm will hire at a point that will be at a lower wage rate and lower quantity than if it were in a competitive market. Trade Unions To correct imperfections in the supply of labour, usually in a monopsony, trade unions act on behalf of the workers to negotiate higher wages and working conditions. Most trade unions aim to increase the demand for labour itself. It is seen that a higher demand will induce a higher wage and a higher quantity hired. This is usually achieved by: Increasing demand for the product/service is produces Increasing productivity of labour Trade unions may also aim to shift the supply curve to the left for the same wage outcome (exclusive unionism), but a lower amount hired. This is done through licensing (i.e. they need a medical license to work as a physician). Most economists see licensing as a device to maintain high wages and not quality of labour. When a strong trade union forms in a monopsony, it creates a bilateral monopoly. This is where there is a single seller of labour and a single buyer of labour. Economic theory/concepts cannot explain the outcome of this. However, this is considered more socially desirable than a monopsony by itself. Minimum-Wages Minimum-wages are usually used as an anti-poverty device by ensuring that everyone gets a fair enough income to live on. There is argument for and against this: Against Potentially drives firms out of business because of higher costs Increases unemployment as a result Lower wage rates are better than none For Increases in productivity Can induce higher employment in a monopsony market Empirical-evidence has suggested those in employment will escape poverty and those without employment will be driven deeper into poverty.

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RESOURCE & LABOUR MARKETS; INCOME DISTRIBUTION

Wage Differentials Wages are different because every worker has: Different skills Different education Different abilities Different training Even if two workers have exactly the same characteristics, they will not necessarily receive the same wage. Differences in working conditions are usually compensated (i.e. you get more money working as a builder than a teller at a bank because it is more hazardous). The labour market is also relatively immobile in the form of: Geographical Workers are usually reluctant to move to a new location for a job. This reluctance usually grows with age. Institutional Some workers may be qualified in a certain area, but not in another. Sociological Although there is equality enforced in the market, women and some racial groups are still forced to accept lower wage rates. Income, Economic Rent and Opportunity Cost Economic Rent is the income that the owner receives for some part in production above the amount that would be required to induce the owner to provide it for use (the opportunity cost). Qualitatively: Economic rent is the area under the wage rate and above the supply curve. Opportunity cost is the area under the supply curve and the area left of the quantity demanded. Income Inequality Income inequality arises usually as a result of the different wages paid to different workers based on their ability, skill, training, education etc. and also on risk and property ownership. The Lorenz Curve The degree of income inequality can be shown graphically by the Lorenz Curve. If there was income equality, the graph would be a perfect straight line as illustrated by the Perfect equality line. The Gini Coefficient The Gini coefficient is defined as the area between the perfect equality line and the lorenz curve. If zero, there is perfect equality and if the ratio is one, there is perfect inequality. However, there can be some problems in measuring actual income due to taxes, transfers and time.

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RESOURCE & LABOUR MARKETS; INCOME DISTRIBUTION

Equality vs. Efficiency

For Equality There will be greater consumer satisfaction as marginal utility declines with higher incomes. Those with lower incomes spend their money on items with high marginal utility whereas those with high incomes spend it on those with low marginal utility which brings less consumer satisfaction. Inequality is said to impair on productivity and efficiency and also foster non-economic inequalities (such as voting rights etc.) For Efficiency Income inequality is essential to provide an incentive to gain an education and work. If everyone has the same income, there is no incentive to work.

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MARKET FAILURE, TRANSACTION COSTS, UNCERTAINTY, EXTERNALITIES & PUBLIC GOODS

Week 11 - Market Failure, Transaction Costs, Uncertainty, Externalities & Public Goods
Market Failure & Its Sources Two major cases of market failure in a competitive price system are recognised by economists. These are when: The market produces the wrong amount of goods and services. There is a failure to allocate any resources at all to the production of certain goods and services whose output is economically justified. Spillovers (Externalities) These occur as a result of the first case. It is perfectly normal in a competitive market. It is when costs or benefits associated with the production or consumption of a good or service that flow on to parties external to the market transaction. These are divided into spillover costs and spillover benefits. Spillover costs (Negative Externalities) can be things such as pollution associated with the production or operation of a certain good or service. The party external to the market transaction here is the community which ultimately bears the cost of having pollution in their society without being properly compensated for. These are usually very common as there sometimes are no ways that a product or service cannot fully eliminate spillover costs. Some examples include, pollution, aircraft noise and logging. Here, the firm produces at Q1 because of the external cost but the social optimum is lower at Q2. Marginal Private Cost (MC) + Marginal Social Cost (MSC) = Externalities in Production Spillover benefits (Positive Externality) can come in the form of immunisation programs. This benefits the consumer itself by immunizing themselves against the disease but it also benefits society overall because the disease can be eradicated with prevention of the disease. Education is also another form of spillover benefit. These are usually a lot less common than spillover costs are. Some examples include the planting of trees to reduce carbon in the air. Here, the firm produces at Q1 because of the external benefit but the social optimum is higher at Q2. Marginal Private Benefit (MB) + Marginal Social Benefit (MSC) = Externalities in Consumption Efficiency and Its Effect on Spillovers Economic efficiency is achieved when any extra benefits gained makes more negative benefits. However, economic efficiency does not necessarily mean that it is fair to everyone. This is why governments must intervene on spillovers as producers are usually only interested in economic efficiency.

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MARKET FAILURE, TRANSACTION COSTS, UNCERTAINTY, EXTERNALITIES & PUBLIC GOODS

Public Goods and Services A good or resource can be defined as follows: Excludable: It is possible to stop others from gaining the benefits of a product. Non-excludable: The opposite of excludable or it is too costly to do so. Rival: If the use of the product decreases the quantity available to others. Non-Rival: No effect on quantity available. A pure private good is one that is excludable and rival whereas a pure public good is one that is non-excludable and non-rival. The exclusion principle rarely applies to a public good and thus, this is called a pure public good. The free-rider problem usually results and this is when individuals can benefit from a public good without having to pay any money at all and many will have to turn to the government to fix this spillover cost or benefit. Mixed goods are those that reside in between a pure private and a pure public good. These come in the form of excludable but non-rival and non-excludable but rival. Tragedy of Commons results when rival but non-excludable goods are overused and detriment all. Many types of government intervention are required to prevent this from happening and to deal with market failure. These usually come with controversy, because some will disagree and some will agree with the government's role in bringing in economic efficiency (usually at the mercy of labour). Traffic jams are an example of a tragedy of commons. Solutions to Market Failure Correcting Spillover Costs To solve spillovers, a simple method is to apply legislation, such as those against pollution. These laws will limit the amount of pollution a firm can produce as a by-product, or will make the firm pay for the pollution it causes. Legislation can cause the supply curve to shift towards the left as a result. Specific taxes can also be implemented that approximates the amount of spillover cost per unit of output. This way, the government tries to place the costs back onto the offending firm. However, individual bargaining can also be used without government intervention. A tax on the producers that is the same as the cost of the negative externality per unit will effectively move the supply curve to the left by the amount of tax per unit and will bring it back to the market equilibrium. Tradeable permits can also be used where a firm can only produce so much amount of negative spillover as their permits allow. Firms can sell these and buy these in an organised market if they need more or do not need as much. The Coase Theorem suggests that intervention is not required if: Legal ownership is clearly defined and can be transferred easily. Numbers of people involved are small Costs of bargaining are negligible An efficient solution will be produced with bargaining between the parties involved in the spillovers. However, this is rarely applied to the real world as spillover issues usually involve

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MARKET FAILURE, TRANSACTION COSTS, UNCERTAINTY, EXTERNALITIES & PUBLIC GOODS large amounts of people. Here, the free-rider problem will effectively destroy any agreement reached. Correcting Spillover Benefits Government intervention here in the form of subsidies to both the buyer and the producer can correct spillover benefits. This works by reducing the costs of buying the good to the consumer and also reducing the costs of production to the producer. In this way, both the consumer and the producer do not feel as if they have been cheated out of buying a product and it benefits others who do not pay for it. Cost-Benefit Analysis However, there is a problem with measurement of spillover costs or benefits because of measurement problems. How will we best measure the amount of pollution produced from cars? A factory? This can present a problem as to how governments can help correct spillover costs as this type of legislation can be difficult to enforce due to difficulties in measuring. Such as a certain tax could be very hard to enforce if it is hard to measure the amount of pollution that is produced by it. Measurement of pollution produced itself could be a very costly problem. Transaction Costs The Principal-Agent Problem The agent is defined as the person who is employed by the principal for the purpose of working for them. The principal and the agent usually have different interests and it is this conflict of interest that results in the Principal-Agent problem. To solve this issue, a contract is signed where both parties agree on some incentives for the agent so that their interests are aligned with those of the principal's. The Sharecropper Model The sharecropper model clearly defines this principal-agent problem. In this model, the agent is the worker who tends to the land while the principal is the one who is running the farm. The outcome of the agent's pay can be dependant on the amount he harvests or just a set amount. The risk-adverse agents will be fine with a lower base salary but no commission as they do not like the risk involved with a variable salary and will make that trade off for a lower fixed salary. The risk-loving agents will want a much higher base salary if they are to be influenced to be switched to a fixed salary. This is because they can earn more in a salary plus commission wage rate than with a fixed salary, thus, they will need a much larger fixed salary to convince them to move over. However, from the principal's point of view, it is much better to have a salary plus commission model for the farm as the workers will, no-doubt, work much harder to harvest as much as possible because they will get more money from harvesting more. The agent, under a fixed salary scheme, will have no incentive to do work unless there is monitoring in place that will deter them from not doing their job.

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MARKET FAILURE, TRANSACTION COSTS, UNCERTAINTY, EXTERNALITIES & PUBLIC GOODS Contracts These can be fixed with complete contracts between principals and agents so that each can benefit from an aligned interest. Contracts can be classified into 3 different types: Spot Contracts: These contracts are usually informal and short term. Relational Contracts: These are longer term and usually try to set out the framework for a relationship between the agent and the principal. Implicit Contracts: These are usually unwritten and mutually accepted between two parties. These are usually based on the fact that both parties have common interests. Risk and Uncertainty This looks at the economic analysis of risk undertaken by a firm. The risk itself is quantifiable in economics with a method known as probability distribution. The expected value of a venture is measured with its weighted average of all possible outcomes. For example: You host an outdoor party. If it does not rain you profit $30,000; If it does rain you lose $5,000. The Bureau says there is an 0.8 chance of rain that day. The expected value would be = (30000)(0.2) + (-5000)(0.8) = $2000 A risk-loving person would put more than $2000 onto this project. A risk-neutral would put exactly $2000 and a risk-adverse would put less than $2000 onto the project. Asymmetric Information The rise of uncertainty and risk usually is because of asymmetric information between the two parties involved in a market transaction. This is where one party in the transaction knows more than the other about the goods or services involved in the transaction (This is known as adverse selection). Thus, the party with more information will usually try to exploit this against the one that does not know as much. An example is this is with high quality cars and low quality cars. If the sales person knows which car is good quality and which is not, and the buyer does not, then the buyer will go for the cheaper car. This results in a market where only poor quality items will be sold. However, signals are used to fix this information asymmetry. Signals are things that come bundled with the good or service that can inform consumers of the actual specifications of a product. An example is a warranty. This usually gives the consumer confidence that the product will not be faulty for that time period that the warranty applies and that if it does indeed become faulty, a replacement will be available for them free of charge. Contracting Costs If a firm contracts part of its operations to another firm, there is always uncertainty and risk associated with the principal and agent. There is asymmetric information and possibilities of adverse selection and moral hazard (where the supplier in the contract has no control). To gain control, the supplier may introduce waiting-periods, excess etc. but this incurs monitoring and controlling costs to the supplier.

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MARKET FAILURE, TRANSACTION COSTS, UNCERTAINTY, EXTERNALITIES & PUBLIC GOODS This can create problems if a firm has signed contracts with suppliers to supply raw material or goods/services to the firm. The firm here is usually at the mercy of the supplier and the supplier can halt the entire firm if it stops supplying the contracted good/service. Contract or Internalize This provides incentives for a firm to integrate vertically (whereby it buys or expands out to cover its whole production process from raw material to finished product). The benefits of vertical integration are: 1. Lowering transaction costs (No need to write contracts/invoices etc. to suppliers as it is all done internally. However, management costs may go up due to the increasing size of the firm) 2. Ensuring steady supply (More reliable supply as you control it. Many firms are usually at the mercy of their suppliers because suppliers can potentially stop the entire firms operations.) 3. Being able to avoid government intervention 4. Extending market power 5. Eliminating market power of other suppliers Basically, the question the firm has to ask here is, "Do we want to make or buy our supplies?" (Contracting Out vs. Vertical Integration). Both have their costs and benefits. If contracting costs out, the firm can benefit from a more competitive supply market, lower administration costs (due to a smaller firm), and flexibility in changing to a different good/service. However, this comes with higher market transaction costs and uncertainty/risk in supply.

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