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Economics

Chapter 1 Lecture 1

Economy. . .
. . . The word economy comes from a Greek word for one who manages a household.

Founder of economics
Adam smith is the founder economics (From 16 June 1723 died 17 July 1790 ). He wrote a very first book of economics named Wealth of Nations Wealth of Nations: the first modern work of economics. It earned him an enormous reputation and would become one of the most influential works on economics ever published. Smith is widely cited as the father of modern economics and capitalism.

Economics
Economics is the study of scarcity and efficiency. Economics is the study of how society manages its scarce resources. Economics is the study of how societies use scarce resources to produce commodities and distribute them among different people.

Economics
Definition of economics "the science which studies human behavior as a relationship between ends and scarce means which have alternative uses." by Lionel Robbins

Microeconomics and Macroeconomics


Microeconomics

focuses on the individual parts of the economy.


How households and firms make decisions and how they interact in specific markets

Macroeconomics

looks at the economy as a whole.


How the markets, as a whole, interact at the national level.

Microeconomics and Macroeconomics


Microeconomics focuses on how decisions are made by individuals and firms and the consequences of those decisions.
Ex.:

How much it would cost for a university or college to offer a new course the cost of the instructors salary, the classroom facilities, the class materials, and so on.

Having determined the cost, the school can then decide whether or not to offer the course by weighing the costs and benefits.

Microeconomics and Macroeconomics


Macroeconomics examines the aggregate behavior of the economy (i.e. how the actions of all the individuals and firms in the economy interact to produce a particular level of economic performance as a whole). Overall level of prices in the economy (how high or how low they are relative to prices last year) rather than the price of a particular good or service.
Ex.:

Scarcity . . .
. . . means that society has limited resources and therefore cannot produce all the goods and services people wish to have.
Scarcity is the situation in which there is not enough of something to satisfy all the desires for that thing.

Efficiency
Economic efficiency describes how well a system generates desired output with a given set of inputs and available technology. Efficiency is improved if more output is generated without changing inputs, or in other words, the amount of "waste" is reduced.

Absence of waste.

Needs and Wants

A need is something that is necessary for organisms to live a healthy life.


The idea of want can be examined from many perspectives. In secular societies want might be considered similar to the emotion desire, which can be studied scientifically through the disciplines of psychology or sociology.

Resources
The basic resources that are available to a society are factors of production:
Natural resources Human resources Capital resources Time resources

Natural resources
It includes good fertile land , rivers , mountains, water fall, sunshine and things that are inside the curst of the earth.

Human resources

All those able bodies, people who are able to work and contribute to production. it is most important factor to contributes to production and in the growth of economy. Worker must acquire education, skill and knowledge.

Capital resources
It includes machine, plants, tools, roads, bridges and highways. it is also important factor to contributes to production and in the growth of economy.

Time resources
It is also very important resource, because utilization of limited time to produce goods and services to fulfill the needs and wants of economic requirements.

Economic Problems

Human wants are unlimited, but resources are not.


Three basic questions must be answered in order to understand an economic system:
What to produced? How to produced? For whom to produced?

Economic Problems
What to produced? What goods and services should be produce. those goods and services are needed by the economy. How to produced?

Which resources are utilize (Land, labour, capital & organization) to produced goods and services these are required for economy

Economic Problems
For Whom to Produce? Is production done for army or for producers or for households. Goods( Guns and butter) and services education) are required for military or society.

Economics

Chapter 1 Lecture 2

Inputs and Outputs


Resources or factors of production are the inputs into the process of production; goods and services of value to households are the outputs of the process of production or the result of any process which you working for. Inputs: it can primary such as land and labour and it can be secondary such as capital and managerial skill (entrepreneurial skills).

Capital formation and creation process


Capital formation means creation of new capital assets. Process Saving: that part of an individual income which is not spent on consumption. Banks: are financial institutes which accept deposit and lend it out to entrepreneurs for production purpose as a loan. They work for profit it is deference b/w interest paid to depositor and receive form debtor

Capital formation and creation process


Money: is liquid assets. Money is lubricant it helps in production. it is medium of exchange. Investment is the process of using resources to produce new capital. Capital is the accumulation of previous investment.

Opportunity cost & Trade off


Opportunity cost is that which we give up or forgo, when we make a decision or a choice. Opportunity cost means the next best alternative sacrifice. Resources are scarce so we give up or forgo one and take other goods or services. Trade off means choosing more of one thing and given up other thing.

Capital Goods and Consumer Goods

Capital goods are goods used to produce other goods and services. Consumer goods are goods produced for present consumption.

Market and its Kinds


A market in economics means settlement of transaction b/w buyers and sellers. Market is the institution/place through which buyers and sellers interact and engage in exchange. Market target allocation of scarce resources in an appropriate and economical manner. Kinds

Market for goods Market for services

Economic Systems
Economic systems are the basic arrangements made by societies to solve the economic problem. They include:

Command economies
Laissez-faire economies Mixed systems Islamic system

Command economy
In a command economy or Socialism, a central government either directly or indirectly sets output targets, incomes, and prices. All decisions of what, how and for whom to produce are taken by state.

Laissez-faire economy or Capitalism


In a laissez-faire economy or capitalism individuals and firms pursue their own self-interests without any central direction or regulation. All decisions of what, how and for whom to produce are taken by them self.

Mixed Systems, Markets, and Governments


Where both government and private sector are contribute in market. Since markets are not perfect, governments intervene and often play a major role in the economy. Some of the goals of government are to: Minimize market inefficiencies Provide public goods Redistribute income

The Production Possibility Frontier


With the given resources (land, labour, capital and organization) & technology of a country the maximum amount of output it can produce is known as production possibility frontier (ppf) The production possibility frontier (ppf) is a graph that shows all of the combinations of goods and services that can be produced if all of societys resources are used efficiently.

Production Possibility Frontier

Possibilities A B C D E F

Butter (Million) 0 10 20 30 40 50

Guns (In thousand) 150 140 120 90 50 0

Production Possibility Frontier

The production possibility frontier curve has a negative slope, which indicates a trade-off between producing one good or another. Points inside of the curve are inefficient

At point H, resources are either unemployed, or are used inefficiently.

Production Possibility Frontier


A move along the curve illustrates the concept of opportunity cost and trade off. From point D, an increase the production of capital goods requires a decrease in the amount of consumer goods

Production Possibility Frontier

Outward shifts of the curve represent economic growth. An outward shift means that it is possible to increase the production of one good without decreasing the production of the other

Division of labour
Division of labour: means the splitting up of the process of production into sub processes. The complete task of product making is not perform by an individual but by the group of workers taken up a certain parts of production. it is also known as specialization. Concept of division of labour is given by Adam Smith, he explain with the example of pin making factory

Demand & Supply

Chapter 3 Lecture 3

Consumer Demand
Demand in economics means that desire which is backed by ability to buy and willingness to buy.

Ability + willingness = demand

Law of Demand
Other things remains the same a fall in price is accompanied by an increase in quantity demanded and conversely a rise in price is followed by fall in quantity demanded.

Schedule of Demand
Schedule of demand shows a series of price of goods and services and quantity demanded at those price.
Possibilities A B C Price 5 4 3 Quantity demanded 9 10 12

D
E

2
1

15
20

Demand Curve
DD is demand curve and it is downwards sloping showing inverse relationship between price and quantity demanded.

Determinants of Demand
Consumer income Size of population Prices of related goods Tastes Expectations

Determinants of Demand Consumer income


Consumer income is major factor that influence demand, if increase in income that will increase the demand and vise versa. Increase in income better off Decrease in income worse off

Determinants of Demand Size of population


The size of market is affect demand. the demand of goods & services in big market( china) is very large and the demand of goods & services in small market (Pakistan) is low.

Determinants of Demand
Substitutes & Complements

When a fall in the price of one good (Coffee) reduces the demand for another good (tea), the two goods are called substitutes. When a fall in the price of one good (milk) increases the demand for another good (tea), the two goods are called complements.

Determinants of Demand Taste


Taste is also important factor that influence demand reflection of many factor both physical and psychological that increase/decrease demand.

Determinants of Demand Special influences


Climatically change Religious occasion Cultural occasion Other events

Change in Quantity Demanded


Change in Quantity Demanded
Movement

along the demand curve. Caused by a change in the price of the product.

Shift in Demand
Change in Demand
A

shift in the demand curve, either to the left or right. Caused by a change in a determinant other than the price.

Simple Linear Regression


Simple linear regression analysis analyzes the linear relationship that exists between two variables.

y a bx
where: y = Value of the dependent variable x = Value of the independent variable a = Populations y-intercept b = Slope of the population regression line

Simple Linear Regression

The coefficients of the line are

n xy x y n x ( x)
2 2

or

y b x a n

a y bx

Correlation

The correlation coefficient is a quantitative measure of the strength of the linear relationship between two variables. The correlation ranges from + 1.0 to - 1.0. A correlation of 1.0 indicates a perfect linear relationship, whereas a correlation of 0 indicates no linear relationship.

An algebraic formula for correlation coefficient

[n( x ) ( x) ][ n( y ) ( y ) ]
2 2 2 2

n xy x y

Demand forecasting
Y = a + bX or Qdx = F(Px,Y, Pc,Ps,T,N,..)

a = - bX or (a) = (Y - b(X)) / N
b = nYX (Y) ( X)/ nX2- (X)2 Where b = The slope of the regression line a = The intercept point of the regression line and the y axis. n = Number of values or elements X = Price Y = Quantity Demanded

Demand forecasting
Y(Q) 8 9 X(P) 5 4 YX 40 36 X2 25 16 Y 12.2 3 66 (X)(Y) nYX nX2 990 855 275

11
15 18 61

3
2 1 15

33
30 18 157

9
4 1 55

X
YX X2 b

15
225 55 -2.70

(X)2

225

21.3

Forecasted Demand
6

A
B C D E

1
2 3 4 5

18.6
15.9
Price

5 4 3 2 1 0 0 5 10 QDx 15 20

13.2 10.5 7.8

Problem
The manager of a seafood restaurant was asked to establish a pricing policy on lobster dinners. Experimenting with prices produced the following data:
Obtain the regression line and interpret its Forecasted demand. Determine the correlation coefficient and interpret it
Sold (y) 200 Price (x) 6.00

190
188

6.50
6.75

180
170 162 160

7.00
7.25 7.50 8.00

155
156 148 140 133

8.25
8.50 8.75 9.00 9.25

Demand & Supply

Chapter 3 Lecture 4

Supply and Stock


Supply in economics means the amount of commodity offered for sale in the market at certain period of time and at certain price. Stock means the amount of commodity which is ready for sale but not offered for sale in the market and kept back in warehouse. Durable good have distinction b/w supply and stock. Non Durable good (perishable)have no distinction b/w supply and stock.

Law of Supply
Other things remains the same a fall in price is accompanied by an decrease in quantity Supplied and conversely a rise in price is fallowed by increase in quantity Supplied.

Schedule of Supply
Schedule of supply shows a series of price of goods and services and quantity supplied at those price.
Possibilities A B C Price 5 4 3 Quantity Supply 18 16 12

D
E

2
1

7
0

Supply Curve
SS is Supply curve and it is upwards sloping showing same/positive relationship between price and quantity supplied.

Determinants of Supply
Price

of Inputs Availability of Inputs Technology Government policies Expectations

Determinants of Supply Price and Availability of Inputs


Price of Inputs if the price are lowered then supply will increase and vise versa (e.g. oil) Availability of Inputs if inputs are easily available in market subsequently supply will increase and vise versa.

Determinants of Supply Technology


Technology is very essential factor for influencing supply if latest technology is use for production supply will increase and vise versa

Determinants of Supply Government policies


If government imposes the taxes on inputs that will lead to decline in supply and if government reduces the taxes on inputs afterward supply will increase.

Determinants of Supply Special influences


Climatically change Religious occasion Cultural occasion Other events

Change in Quantity Supplied


Change in Quantity Supplied
Movement

along the supply curve. Caused by a change in the price of the product

Shift in Supply
Change in Supply
A shift

in the Supply curve, either to the left or right. Caused by a change in a determinant other than the price.

Equilibrium
Equilibrium in economics we understand a state of balance or on interaction between two opposite forces working in the opposite direction settle at one point that is equilibrium price. The term price equilibrium is market price.

Schedule of Equilibrium
Possibilities A B C D Price 5 4 3 2 Quantity demanded 9 10 12 15 Quantity supplied 18 16 12 7 State of the market Surplus 9mn Surplus 6mn Equilibrium Scarcity 8mn

20

Scarcity 20mn

Equilibrium
The equilibrium price come at the intersection of demand and supply curve at point C. The equilibrium price and quantity comes where the units supply equal to amount demand

Shift in Equilibrium due to shift in demand and supply

Elasticity and Its Application

Chapter 4 Lecture 5

Elasticity . . .
is a measure of how much buyers and sellers respond to changes in market conditions allows us to analyze supply and demand with greater accuracy.

Price Elasticity of Demand


Price

elasticity of demand is the percentage change in quantity demanded given a percent change in the price. is a measure of how much the quantity demanded of a good responds to a change in the price of that good. of quantity demand due to change in price is known as elasticity of demand.

It

Responsiveness

Computing the Price Elasticity of Demand


The price elasticity of demand is computed as the percentage change in the quantity demanded divided by the percentage change in price. Price Elasticity = Of Demand
Percentage Change in Qd Percentage Change in Price

EP (%Q)/(%P)

Elasticity, Percentage Change and Slope


Because the price elasticity of demand measures how much quantity demanded responds to the price, it is closely related to the slope of the demand curve.
But instead of looking at unit change, elasticity looks at percentage change. What do we mean by percentage change?

Brief Assessment on Percentages


If there are 50 tomatoes in a store and you picked 16 of them, what percentage of the total did you pick? Paul used to weigh 200 lbs last year, but now he only weighs 175 lbs. How many lbs did he lose? What is the percent change of the loss? What is the average of 300 and 330? What is the midpoint?

Computing the Price Elasticity of Demand


Price elasticity of demand Percentage change in quatity demanded Percentage change in price

Q/Q P Q EP P/P Q P
Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 cones then your elasticity of demand would be calculated as:

Types of Elasticity

Price elasticity Income elasticity

Cross elasticity

Types of Elasticity Price elasticity

Price Elasticity = Of Demand

Percentage Change in QD Percentage Change in Price

Income Elasticity of Demand


Income

elasticity of demand measures how much the quantity demanded of a good responds to a change in consumers income. It is computed as the percentage change in the quantity demanded divided by the percentage change in income.

Types of Elasticity Income elasticity

Income Elasticity = Of Demand

Percentage Change in QD Percentage Change in Income

Q/Q I Q EI I/I Q I

Cross Price Elasticity of Demand


Elasticity measure that looks at the impact a change in the price of one good has on the demand of another good. % change in demand Q1/% change in price of Q2. Positive-Substitutes Negative-Complements.

Types of Elasticity Cross elasticity

Price Elasticity = Of Demand


Coffee)

Percentage Change in QD (Tea) Percentage Change in Price

Qb/Qb Pm Qb EQbPm Pm/Pm Qb Pm

Ranges of Elasticity
Inelastic Demand
Percentage

change in price is greater than percentage change in quantity demand. Price elasticity of demand is less than one.

Elastic Demand
Percentage

change in quantity demand is greater than percentage change in price. Price elasticity of demand is greater than one.

Perfectly Inelastic Demand


- Elasticity equals 0
Price

Demand

$5 1. An increase in price... 4

Quantity 100 2. ...leaves the quantity demanded unchanged.

Perfectly Elastic Demand


- Elasticity equals infinity
Price 1. At any price above $4, quantity demanded is zero. $4 2. At exactly $4, consumers will buy any quantity. 3. At a price below $4, quantity demanded is infinite. Quantity

Demand

Inelastic Demand
- Elasticity is less than 1
Price

1. A 25% $5 increase in price... 4 Demand

Quantity 90 100 2. ...leads to a 10% decrease in quantity.

Unit Elastic Demand


- Elasticity equals 1
Price

1. A 25% $5 increase in price... 4 Demand

Quantity 75 100 2. ...leads to a 25% decrease in quantity.

Elastic Demand
- Elasticity is greater than 1
Price

1. A 25% $5 increase in price... 4 Demand

Quantity 50 100 2. ...leads to a 50% decrease in quantity.

Determinants of Price Elasticity of Demand

Necessities versus Luxuries


Availability of Close Substitutes Definition of the Market Time Horizon

Determinants of Price Elasticity of Demand

Demand tends to be more inelastic


If the good is a necessity. If the time period is shorter. The smaller the number of close substitutes. The more broadly defined the market.

Determinants of Price Elasticity of Demand Demand tends to be more elastic :


if

the good is a luxury. the longer the time period. the larger the number of close substitutes. the more narrowly defined the market.

Method Measuring Elasticity Total Revenue


Total

revenue is the amount paid by buyers and received by sellers of a good. Computed as the price of the good times the quantity sold.

TR = P x Q

Elasticity and Total Revenue


Price

$4

P x Q = $400
P

(total revenue)

Demand

100

Quantity

The Total Revenue Test for Elasticity


Increase in Decrease in Total Revenue Total Revenue Increase in Price Decrease in Price INELASTIC DEMAND ELASTIC DEMAND ELASTIC DEMAND INELASTIC DEMAND

Method Measuring Elasticity the


Average Formula
The Average (midpoint formula) is preferable when calculating the price elasticity of demand because it gives the same answer regardless of the direction of the change.

(Q2 Q1 )/[(Q2 Q1 )/2] Price Elasticity of Demand = (P2 P1 )/[(P2 P1 )/2]

Method Measuring Elasticity the Average Formula


(Q 2 Q1 )/[(Q 2 Q1 )/2] Price Elasticity of Demand = (P2 P1 )/[(P2 P1 )/2]
Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 cones the your elasticity of demand, using the midpoint formula, would be calculated as:

Method Measuring Elasticity of Straight line


The lower portion of a downward sloping demand curve is less elastic than the upper portion.

Importance of Price Elasticity of Demand


Profit maximization requires that business set a price that will maximize the firms profit Elasticity tells the firm how much control it has over using price to raise profit If e > 1, then the % Change in QD > % Change is Price and demand is said to be elastic

An increase in price will reduce total revenue A decrease in price will increase total revenue

Importance of Price Elasticity of Demand

If e < 1, then the % change in QD < % change in price, and demand is said to be inelastic
An increase in price will increase total revenue A decrease in price will decrease total revenue

If e = 1, then the % change in QD = %


change in Price, and demand is said to be unit elastic
An increase in price will have no impact on total revenue A decrease in price will have no impact on total revenue

Computing the Price Elasticity of Supply


The price elasticity of supply is computed as the percentage change in the quantity Supplied divided by the percentage change in price. Price Elasticity = Of Supply
Percentage Change in QS Percentage Change in Price

Supply Elasticity

Utility

Chapter 5 Lecture 6

Utility
The value a consumer places on a unit of a good or service depends on the pleasure or satisfaction he or she expects to derive form having or consuming it at the point of making a consumption (consumer) choice. In economics the satisfaction or pleasure consumers derive from the consumption of consumer goods is called utility. Consumers, however, cannot have every thing they wish to have. Consumers choices are constrained by their incomes.
[

Within the limits of their incomes, consumers make their consumption choices by evaluating and comparing consumer goods with regard to their utilities.

Total Utility versus Marginal Utility


Marginal utility is the utility a consumer derives from the last unit of a consumer good she or he consumes (during a given consumption period), ceteris paribus. Total utility is the total utility a consumer derives from the consumption of all of the units of a good or a combination of goods over a given consumption period, ceteris paribus. Total utility = Sum of marginal utilities

The Law of Diminishing Marginal Utility


The law of diminishing marginal utility state that: as the amount of a good consumed increase, the marginal utility of that good tends to diminish. We can illustrate this law numerically. We can take an example of cup of ice cream give to our consumer without any interval or break then we will see that marginal utility will be diminish. If he consume more and more of a good its marginal utility tends to decline. While its total utility keeps an increasing but at slower and slower rate.

The Law of Diminishing Marginal Utility

Over a given consumption period, the more of a good a consumer has, or has consumed, the less marginal utility an additional unit contributes to his or her overall satisfaction (total utility). Alternatively, we could say: over a given consumption period, as more and more of a good is consumed by a consumer, beyond a certain point, the marginal utility of additional units begins to fall.

The Law of Diminishing Marginal Utility


Schedule
Cup of Ice cream 0 1st 2nd 3rd 4th 5th 6th Total utility 0 4 7 9 10 10 8 Marginal utility 0 4 3 2 1 0 -2

The Law of Diminishing Marginal Utility


Graph of Total & Marginal utility

Law of Equi-Marginal Utility Assumptions


Our consumer is rational person. His aim is to maximize his satisfaction. Money is limited & price are given and he has to accept the prices. Marginal utility of money is constant. Our consumer is facing the law of diminishing marginal utility in each direction of purchase. He will arrange his purchases in order of its importance

Law of Equi-Marginal Utility

The fundamental condition of maximum satisfaction or utility is the equi-marginal principles, it state that a consumer having a fixed income and facing given market prices of goods will achieve maximum satisfaction or utility when the marginal utility of the last dollar spend on each good is exactly the same as the marginal utility of the last dollar spent on the any other good.

LAW OF EQUIMARGINAL UTILITY


Marginal utility of money Unit of consumptio n 1 2 Good A Good B

Income= 10 Prices of both good A & B = 1units Marginal utility of money is =14 utils

1st =14 2nd =14

24 units 22

20 18

3rd =14
4th=14 5th=14

3
4 5

20
18 16

16
14

6th =14

14

Law of Equi-Marginal Utility


marginal utility of the last dollar spend MUa MUb =--------- = ---------$Pa $Pb

Indifference Analysis

Cardinal vs. Ordinal Utility


Cardinal utility : Satisfaction provided by any good or bundle of goods can be assigned a numerical value by a utility function.

Ordinal utility : People are able to rank each possible bundle in order of preference. People are not required to make quantitative statements about how much they like various bundles.

indifference curve properties


An indifference curve should not slope up. Better bundles are to the northeast. Indifference curves are downward sloping and bowed inward. Indifference curves become less vertical as we move down them and to the right.

Indifference curves cannot cross/intersect.


If indifference curves crossed, it would violate the prefermore-to-less principle.

Assumptions
Our consumer is rational person. His aim is to maximize his satisfaction. Money is limited & price are given. He makes purchase in combination of 2 basket of good A & B simultaneously. He is indifferent to select a combination of the 2 goods he makes different combination & all the goods giving him equal level of satisfaction.

Indifference Curve

Indifference curve that is a tool of which shows different combinations of two goods given to consumer same level of satisfaction or a curve that shows combinations of two goods among which an individual is indifferent. The slope of the indifference curve is the ratio of marginal utilities of the two goods.

Indifference Curve

The absolute value of the slope of an indifference curve is called the marginal rate of substitution.

Schedule of IC or Indifferent plans


Schedule of IC shows a series of combinations of 2 goods.
Combination A B C Food 1 2 3 Clothing 6 3 2

D E

4 5

1. 1

Graphing the Indifference Curve


Clothing (units per week)

6 5 4

Indifference curves slope downward to the right. If it sloped upward it would violate the assumption that more of any commodity is preferred to less.

B
3

2 1 1 2 3

Point A,B,C,D are given our consumer same level of satisfaction and hence he is indifferent & all combinations are equally preferred.

D IC
4 5 Food (units per week)

Diminishing Marginal Rate of Substitution

Law of diminishing marginal rate of substitution the scarcer a good, the greater its relative substitution value; its marginal utility rises relative to marginal utility of the good that has become plentiful. The rate at which one good must be added when the other is taken away in order to keep the individual indifferent between the two combinations.

Schedule of IC and Marginal rate of substitutions


Schedule of IC shows a series of combinations of 2 goods and marginal rate substitutions.
Combination A B Food 1 2 +1 Clothing 6 33 1:3 M.R.S

C D
E

3+1 4+1
5

21 1.1/2 - 0.1/2
1

1:1 1:1/2

Diminishing Marginal Rate of Substitution


Clothing (units per week)

A
6 5 4

-3

MRS = 3

Indifference curves are convex because as more of one good is consumed, a consumer would prefer to give up fewer units of a second good to get additional units of the first one. MRS is measured by the slope of the indifference curve:

1
3

B
MRS = 1

-1
2

1
-1/2

C
MRS = 1/2

1
1 2 3 4 5

MRS C
Food (units per week)

A Group of Indifference Curves

Consumers will have a whole group of indifference curves, each representing a different level of satisfaction. If he/she prefers more to less, Consumer is better off with the indifference curve that is extreme to the right.

Indifference Map
Clothing (units per week) An indifference map is a set of indifference curves that describes a persons preferences for all combinations of two commodities. IC3 show higher level of satisfaction to her then IC1 and IC2.

IC3
IC2 IC1
Food (units per week)

Consumers Choice
Consumer buy clothing and foods. She/he wants to maximize her/his utility given a budget constraint.

What is a Budget Constraint?

A budget constraint shows the consumers purchase opportunities as every combination of two goods that can be bought at given prices using a given amount of income.

Budget Constraint

Clothing cost $1 and Food cost $1.5 each. Sophie has $6 income to spend. She can buy 6 cloth units or 4 food units or some combination of each.

Graphing the Budget Constraint

Budget Constraint

The slope of the budget constraint is the ratio of the prices of the two goods.

The slope changes when the prices or income change.

Budget Constraint with Income effect


Clothing (units per week) 80

Pc = $1

Pf = $2

I = $80

A B

Budget Line 2F + C = $80 Pc = $1 Pf = $2 I = $40

60

C
40

D
20

E
0 10 20 30 40

Food (units per week)

Budget Constraint with Price effect


Clothing (units per week) 80

Pc = $1

Pf = $2

I = $80

A B

Budget Line 2F + C = $80 Pc = $1 Pf = $4 I = $80

60

C
40

D
20

E
0 10 20 30 40

Food (units per week)

Indifference Curves Equilibrium

Sophie will maximize her satisfaction by consuming on the highest indifference curve as possible, given her budget constraint. The best combination is the point where the indifference curve and the budget line are tangent and that point shows equilibrium of consumer.

Indifference Curves Equilibrium

The best combination is the point where the slope of the budget line/price ratio equals the slope of the indifference curve/MRS of two goods.

Indifference Curves Equilibrium

At point B U3 the budget line and the indifference curve are tangent and no higher level of satisfaction can be attained.

Indifference Curves Equilibrium

Pf MUf EQUILIBRIUM Pc MUc

Changes in Income
An increase in income will cause the budget constraint out in a parallel fashion Since px/py does not change, the MRS will stay constant as the worker moves to higher levels of satisfaction

Indifference Curves Equilibrium with income effect

Increase in Income
If x decreases as income rises, x is an inferior good
Quantity of y
C B

As income rises, the individual chooses to consume less x and more y Note that the indifference curves do not have to be oddly shaped. The assumption of a diminishing MRS is obeyed.
U1

U3 U2

Quantity of x

Changes in a Goods Price


A change in the price of a good alters the slope of the budget constraint
it also changes the MRS at the consumers utility-maximizing choices

When the price changes, two effects come into play


substitution effect income effect

Changes in a Goods Price


Even if the individual remained on the same indifference curve when the price changes, his optimal choice will change because the MRS must equal the new price ratio
the substitution effect

The price change alters the individuals real income and therefore he must move to a new indifference curve
the income effect

Indifference Curves Equilibrium with Price effect

Changes in a Goods Price


Quantity of y To isolate the substitution effect, we hold real income constant but allow the relative price of good x to change The substitution effect is the movement from point A to point C A C The individual substitutes good x for good y because it is now relatively cheaper Quantity of x Substitution effect

U1

Production

Chapter 6 Lecture 10

Production Function
1. Production - short run
Productive efficiency The Law of diminishing marginal returns

2. Production - long run


isoquants & isocosts least cost method of production

Production
By production in economics we understands the creations of utility. Utility can be created in three ways.
Form utility: can be created by changing the shape of the matter & performing an act of production (e.g. log of wood). 2. Place utility: the worker creates utility by changing the place of that matter (e.g. Coal miner).
1.

Production
3. Time utility: can be created by taking the product over long period of time (e.g. crops is harvested, preservation of grains).

Productivity

Productivity is a measure of the efficiency of production. Productivity is a ratio of what is produced to what is required to produce it. Usually this ratio is in the form of an average, expressing the total output divided by the total input. Productivity is a measure of output from a production process, per unit of input.

Productive capacity
Productive capacity: in economy is determent by the size & quality of labor force. By Quality & quantity capital stock(FOPs) By nation technical knowledge The ability to use the knowledge The nature of public & private institutions

Production Function
Production Function: means the relationship b/w amount of input required to the amount of output that can be obtained is called Production Function. To explain it further we can say that for given state of engineers & scientific/ technological knowledge of production function significance the maximum amount of that can be produce with quality of inputs.

Production Function
e.g. the task of ditch digging is perform in USA where large & expensive tractor is driven by person along with supervisor the ditch which is 50ft length & 5ft in depth can be dough in 2 hours. Where as the same task is performed in China where 50 worker with one hand pickle complete the task in one whole day. In USA the task is capital intensive & where as in China the task is labour intensive.

Total, Average and Marginal Product


Total product means the total amount of output produce in physical term like bushel of wheat/ dozens of boat. Average product means total product divided by number of product. Marginal Product means input is the extra output produce by one addition units of input while other input are constant.

Total, Average and Marginal Product


Units of Input (labour) 1 2 3 4 5 Total product 2000 3000 3500 3800 3900 1000 500 300 100 Marginal product Average product 2000 1500 1166.67 950 780

Total & Marginal Product

Law of Diminishing Marginal Returns


This is basic law of production according this law we get less & less of extra output. When we will add additional dozen of input while other inputs held/remain constant. In other word the marginal product of each units of input will declines as the amount of that input increase, holding other all inputs remain constant.

Law of Diminishing Marginal Returns

The L of D.M.R express a very basic relationship as more & more labour is add to fixed area of land, machine & other input the labour has less & less of other factor to work with. Marginal product falls because the land get crowded, the machine is over work so the marginal product of labour declines

Law of Increasing Marginal Returns


Law of Increasing Marginal Returns operate in case of manufacturing industry because machine are control by man, he may use better technology to over come the problem. The entrepreneur is rational person & he voids all of the law of diminishing Marginal returns.

Law of Marginal Returns


Units of Input (labour) 1 2 3 4 5 6 Total product 100 200 400 700 1000 1200 100 200 300 300 200 I.M.R I.M.R C.M.R C.M.R D.M.R Marginal product Returns

7 8

1350 1450

150 100

D.M.R

Law of Marginal Returns


C.M.R

300

Marginal Returns

250
D.M.R

200 150 100 0 1

I.M.R

No. of input labour

Return To Scale

The laws of Returns to Scale study the behavior of production when all the productive factors or inputs are increased or decreased simultaneously in the same ratio. We analyze here the effect of doubling, trebling and so on of all the inputs of productive resources on the output of the product.

Return To Scale

It has also three distinct stages


Increasing Returns to Scale (10% increase in input leads to 20% increase in output)
Constant Returns to Scale (10% increase in input leads to 10% increase in output) Diminishing Returns to Scale (10% increase in input leads to 9% increase in output)

Fixed and Variable Costs


Fixed

costs are those costs that do not vary with the quantity of output produced. Variable costs are those costs that do change as the firm alters the quantity of output produced.
Short

Run vs. Long Run Costs

Family of Total Costs


Total

Fixed Costs (TFC) Total Variable Costs (TVC) Total Costs (TC)

TC = TFC + TVC

Family of Total Costs


Quantity Total Cost Fixed Cost Variable Cost

0 1 2 3 4 5 6 7 8 9 10

$ 3.00 3.30 3.80 4.50 5.40 6.50 7.80 9.30 11.00 12.90 15.00

$3.00 3.00 3.00 3.00 3.00 3.00 3.00 3.00 3.00 3.00 3.00

$ 0.00 0.30 0.80 1.50 2.40 3.50 4.80 6.30 8.00 9.90 12.00

Total-Cost Curve...
$16.00 $14.00 $12.00

Total-cost curve

Total Cost

$10.00 $8.00 $6.00 $4.00 $2.00 $0.00

10

12

Quantity of Output (glasses of lemonade per hour)

Relation Between Production Function and Total Cost. Dimininishi ng Returns

Average Costs
Average

costs can be determined by dividing the firms costs by the quantity of output produced. The average cost is the cost of each typical unit of product.

Family of Average Costs


Average

Fixed Costs (AFC) Average Variable Costs (AVC) Average Total Costs (ATC)

ATC = AFC + AVC

Family of Average Costs


Quantity AFC AVC AC

0 1 2 3 4 5 6 7 8 9 10

$3.00 1.50 1.00 0.75 0.60 0.50 0.43 0.38 0.33 0.30

$0.30 0.40 0.50 0.60 0.70 0.80 0.90 1.00 1.10 1.20

$3.30 1.90 1.50 1.35 1.30 1.30 1.33 1.38 1.43 1.50

Marginal Cost
Marginal

cost (MC) measures the amount total cost rises when the firm increases production by one unit. Marginal cost helps answer the following question:
How

much does it cost to produce an additional unit of output?

Marginal Cost
(Change in total cost) MC = (Change in quantity) = TC

Average-Cost and Marginal-Cost Curves...


$3.50 $3.00 $2.50

MC
Costs
$2.00 $1.50 $1.00 $0.50

AC AVC

AFC
0 2 4 6 8 10 12

$0.00

Quantity of Output (glasses of lemonade per hour)

Three Important Properties of Cost Curves


Marginal

cost eventually rises with the quantity of output.


Law of Diminishing Marginal Returns

The

average-total-cost curve is U-shaped. The marginal-cost curve crosses the average cost curve at the minimum of average cost.

Costs in the Long Run


For many firms, the division of total

costs between fixed and variable costs depends on the time horizon being considered.
In

the short run some costs are fixed. In the long run fixed costs become variable costs.

Average Total Cost in the Short and Long Runs...


Average Total Cost ATC in short run with small factory ATC in short run with medium factory ATC in short run with large factory

ATC in long run 0


Quantity of Cars per Day

Economies and Diseconomies of Scale


Average Total Cost

ATC in long run

Economies of scale 0

Constant Returns to scale

Diseconomies of scale
Quantity of Cars per Day

Isoquants

An isoquant
is a contour line which joins together the different combinations of two factors of production that are just physically able to produce a given quantity of a good.

Construction, slope and maps

An isoquant
45 40 35

Units of capital (K)

30 25 20 15 10 5 0 0 5 10 15 20 25

Units Units of K of L 40 5 20 12 10 20 6 30 4 50

30

35
fig

40

45

50

Units of labour (L)

Diminishing marginal rate of factor substitution


14 12

g
K = 2

MRS = 2

Units of capital (K)

MRS = K / L

10 8 6 4 2 0 0 2
L = 1

isoquant
4 6 8 10 12 14
fig

16

18

20

22

Units of labour (L)

An isoquant map
30

Units of capital (K)

20

10

I5 I2
20
fig

I3

I4

0 0 10 Units of labour (L)

I1

Isocosts
Actual output also depends on costs isocosts

join combinations of K & L - same cost assuming constant factor prices

Construction, slope & map

An isocost
30

25

Assumptions PK = 20 000 W = 10 000 TC = 300 000

Units of capital (K)

20

15

10

TC = 300 000
0 0 5 10 15 20 25
fig

30

35

40

Units of labour (L)

Finding the least-cost method of production


35

Assumptions
30 25

PK = 20 000 W = 10 000 TC = 200 000

Units of capital (K)

20 15

TC = 300 000
TC = 400 000
10 5 0 0 10 20 30
fig

TC = 500 000

40

50

Units of labour (L)

Finding the least-cost method of production


35 30

Units of capital (K)

25 20 15 10 5 0 0 10 20 30
fig

TPP1

40

50

Units of labour (L)

Least cost method of production

Tangency between iso-quant and isocost Where:


Slope of iso-quant = slope of iso-cost

Successive points of tangency - scale expansion path

Firms in Competitive Markets


Chapter 14

The Meaning of Competition


A perfectly competitive market

has the following characteristics:


There

are many buyers and sellers in the market. The goods offered by the various sellers are largely the same. Firms can freely enter or exit the market.

The Meaning of Competition


As a result of its characteristics, the

perfectly competitive market has the following outcomes:


The

actions of any single buyer or seller in the market have a negligible impact on the market price. Each buyer and seller takes the market price as given.
Thus,

each buyer and seller is a price taker.

Example of Competitive Markets


Eggs vs. Nike Sneakers. Pay attention to the difference between the two market structures. Which brand names do you recognize?

QuickTime and a Video decompressor are needed to see this picture.

Revenue of a Competitive Firm


Total revenue for a firm is the selling price times the quantity sold.

TR = (P X Q)

Revenue of a Competitive Firm


Marginal revenue is the change in total revenue from an additional unit sold.

MR =TR/ Q

Revenue of a Competitive Firm

For competitive firms, marginal revenue equals the price of the good.

Total, Average, and Marginal Revenue for a Competitive Firm


Quantity (Q) 1 2 3 4 5 6 7 8 Price (P) $6.00 $6.00 $6.00 $6.00 $6.00 $6.00 $6.00 $6.00 Total Revenue Average Revenue Marginal Revenue (TR=PxQ) (AR=TR/Q) (MR=T R / Q ) $6.00 $6.00 $12.00 $6.00 $6.00 $18.00 $6.00 $6.00 $24.00 $6.00 $6.00 $30.00 $6.00 $6.00 $36.00 $6.00 $6.00 $42.00 $6.00 $6.00 $48.00 $6.00 $6.00

Profit Maximization for the Competitive Firm


The

goal of a competitive firm is to maximize profit. This means that the firm will want to produce the quantity that maximizes the difference between total revenue and total cost.

Profit Maximization: A Numerical Example


Price (P) $6.00 $6.00 $6.00 $6.00 $6.00 $6.00 $6.00 $6.00 Quantity (Q) 0 1 2 3 4 5 6 7 8 Total Revenue (TR=PxQ) $0.00 $6.00 $12.00 $18.00 $24.00 $30.00 $36.00 $42.00 $48.00 Total Cost (TC) $3.00 $5.00 $8.00 $12.00 $17.00 $23.00 $30.00 $38.00 $47.00 Profit (TR-TC) -$3.00 $1.00 $4.00 $6.00 $7.00 $7.00 $6.00 $4.00 $1.00 Marginal Revenue Marginal Cost (MR=T R / Q ) MC= T C / Q $6.00 $6.00 $6.00 $6.00 $6.00 $6.00 $6.00 $6.00 $2.00 $3.00 $4.00 $5.00 $6.00 $7.00 $8.00 $9.00

Harcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.

Profit Maximization for the Competitive Firm...


Costs and Revenue

The firm maximizes profit by producing the quantity at which marginal cost equals marginal revenue.

MC

MC2

ATC
P=MR1 AVC

P = AR = MR

MC1

Q1

QMAX

Q2

Quantity

Profit Maximization for the Competitive Firm


Profit maximization occurs at the quantity where marginal revenue equals marginal cost.

Profit Maximization for the Competitive Firm

When MR > MC increase Q When MR < MC decrease Q


When MR = MC Profit is maximized. The firm produces up to the point where MR=MC

The Interaction of Firms and Markets in Competition


Price And Costs Firm
MC A S2 P=MR0 b ATC =$7 d c AVC ATC P=MR1 B

Market Price
S1

a $10

D0 q4 q3 q2 q1 10 units

qF

Q1

Q2

QM

Copyright 2001 by Harcourt, Inc. All rights reserved

The Marginal-Cost Curve and the Firms Supply Decision...


Costs and Revenue This section of the firms MC curve is also the firms supply curve (long-run).

MC

P2 P1

ATC
AVC

Q1

Q2

Quantity

The Firms Short-Run Decision to Shut Down


A shutdown

refers to a short-run decision not to produce anything during a specific period of time because of current market conditions. Exit refers to a long-run decision to leave the market.

The Firms Short-Run Decision to Shut Down


The firm considers its sunk costs when deciding to exit, but ignores them when deciding whether to shut down.
Sunk

costs are costs that have already been committed and cannot be recovered.

The Firms Short-Run Decision to Shut Down


The

firm shuts down if the revenue it gets from producing is less than the variable cost of production.

Shut down if TR < VC Shut down if TR/Q < VC/Q Shut down if P < AVC

The Firms Short-Run Decision to Shut Down...


Costs

Firms short-run supply curve.


MC

If P > ATC, keep producing at a profit.


ATC

If P > AVC, keep producing in the short run.

AVC

If P < AVC, shut down. 0 Quantity

The Firms Short-Run Decision to Shut Down


The portion of the marginal-cost curve that lies above average variable cost is the competitive firms short-run supply curve.

The Firms Long-Run Decision to Exit or Enter a Market


In

the long-run, the firm exits if the revenue it would get from producing is less than its total cost.

Exit if TR < TC Exit if TR/Q < TC/Q Exit if P < ATC

The Firms Long-Run Decision to Exit or Enter a Market


A firm

will enter the industry if such an action would be profitable.

Enter if TR > TC Enter if TR/Q > TC/Q Enter if P > ATC

The Competitive Firms LongRun Supply Curve...


Costs MC = Long-run S Firm enters if P > ATC

ATC
AVC Firm exits if P < ATC

Quantity

Monopoly
Chapter 15

Copyright 2001 by Harcourt, Inc. All rights reserved. Requests for permission to make copies of any part of the work should be mailed to: Permissions Department, Harcourt College Publishers, 6277 Sea Harbor Drive, Orlando, Florida 32887-6777.

Monopoly
While a competitive firm is a price taker, a monopoly firm is a price maker.

Monopoly
A firm

is considered a monopoly if . . . it is the sole seller of its product. its product does not have close substitutes.

Why Monopolies Arise The fundamental cause of monopoly is barriers to entry.

Why Monopolies Arise


Barriers to entry have three sources:

Ownership of a key resource.


This tends to be rare. De Beers is an example

The government gives a single firm the exclusive right to produce some good.
Patents, Copyrights and Government Licensing.

Costs of production make a single producer more efficient than a large number of producers.
Natural Monopolies

Economies of Scale as a Cause of Monopoly...


Cost

Average total cost

Quantity of Output

Monopoly versus Competition


Monopoly Is the sole producer Has a downwardsloping demand curve Is a price maker Reduces price to increase sales
Competitive Firm Is one of many producers Has a horizontal demand curve Is a price taker Sells as much or as little at same price

Demand Curves for Competitive and Monopoly Firms...


(a) A Competitive Firms Demand Curve Price Price (b) A Monopolists Demand Curve

Demand

Demand 0 Quantity of Output

Quantity of Output

A Monopolys Revenue

Total Revenue

P x Q = TR

Average Revenue

TR/Q = AR = P

Marginal Revenue

TR/Q = MR

A Monopolys Marginal Revenue A monopolists marginal revenue is always less than the price of its good.
The

demand curve is downward sloping. When a monopoly drops the price to sell one more unit, the revenue received from previously sold units also decreases.

A Monopolys Total, Average, and Marginal Revenue


Quantity (Q) 0 1 2 3 4 5 6 7 8 Price (P) $11.00 $10.00 $9.00 $8.00 $7.00 $6.00 $5.00 $4.00 $3.00 Total Revenue (TR=PxQ) $0.00 $10.00 $18.00 $24.00 $28.00 $30.00 $30.00 $28.00 $24.00 Average Revenue (AR=TR/Q) $10.00 $9.00 $8.00 $7.00 $6.00 $5.00 $4.00 $3.00 Marginal Revenue (MR= TR / Q ) $10.00 $8.00 $6.00 $4.00 $2.00 $0.00 -$2.00 -$4.00

A Monopolys Marginal Revenue When a monopoly increases the amount it sells, it has two effects on total revenue (P x Q).
output effectmore output is sold, so Q is higher. The price effectprice falls, so P is lower.
The

Harcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.

Demand and Marginal Revenue Curves for a Monopoly...


Price $11 10 9 8 7 6 5 4 3 2 1 0 -1 -2 -3 -4

Marginal revenue 1 2 3 4 5 6 7 8

Demand (average revenue)

Quantity of Water

Harcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.

Profit-Maximization for a Monopoly...


Costs and Revenue 2. ...and then the demand curve shows the price consistent with this quantity. B 1. The intersection of the marginal-revenue curve and the marginalcost curve determines the profit-maximizing quantity... Average total cost A Demand Marginal cost Marginal revenue 0 QMAX Quantity

Monopoly price

Comparing Monopoly and Competition

For a competitive firm, price equals marginal cost.

P = MR = MC

For a monopoly firm, price exceeds marginal cost.

P > MR = MC

A Monopolys Profit Profit equals total revenue minus total costs.

Profit = TR - TC Profit = (TR/Q - TC/Q) x Q Profit = (P - ATC) x Q

Harcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.

The Monopolists Profit...


Costs and Revenue Marginal cost Monopoly E price B

Average total cost

Average total cost D

C Demand

Marginal revenue 0 QMAX Quantity

The Monopolists Profit


The monopolist will receive economic profits as long as price is greater than average total cost.

Public Policy Toward Monopolies


Government responds to the problem of monopoly in one of four ways.
Making monopolized industries more competitive. Regulating the behavior of monopolies. Turning some private monopolies into public enterprises. Doing nothing at all.

Two Important Antitrust Laws

Sherman Antitrust Act (1890)


Reduced

the market power of the large and powerful trusts of that time period. the governments powers and authorized private lawsuits.

Clayton Act (1914)


Strengthened

Marginal-Cost Pricing for a Natural Monopoly...


Price

Average total cost Regulated price

Average total cost


Loss

Marginal cost

Demand
0 Quantity

Price Discrimination
Price discrimination is the practice of selling the same good at different prices to different customers, even though the costs for producing for the two customers are the same. In order to do this, the firm must have market power.

Price Discrimination

Two important effects of price discrimination:


It

can increase the monopolists profits. It can reduce deadweight loss.

But in order to price discriminate, the firm must


Be able to separate the customers on the basis of willingness to pay. Prevent the customers from reselling the product.

Oligopoly
Chapter 16

Copyright 2001 by Harcourt, Inc. All rights reserved. Requests for permission to make copies of any part of the work should be mailed to: Permissions Department, Harcourt College Publishers, 6277 Sea Harbor Drive, Orlando, Florida 32887-6777.

Imperfect Competition
Imperfect competition includes industries in which firms have competitors but do not face so much competition that they are price takers.

Types of Imperfectly Competitive Markets


Oligopoly Only a few sellers, each offering a similar or identical product to the others.
Monopolistic Competition Many firms selling products that are similar but not identical.

The Four Types of Market Structure


Number of Firms?

Many firms
One firm Few firms Type of Products? Differentiated products
Monopolistic Competition

Identical products
Perfect Competition

Monopoly

Oligopoly

Tap water Cable TV

Tennis balls Crude oil

Novels Movies

Wheat Milk

Characteristics of an Oligopoly Market


Few

sellers offering similar or identical products Interdependent firms Best off cooperating and acting like a monopolist by producing a small quantity of output and charging a price above marginal cost There is a tension between cooperation and self-interest.

A Duopoly Example
A duopoly is an oligopoly with only two members. It is the simplest type of oligopoly.

A Duopoly Example: Demand Schedule for Water


Quantity 0 10 20 30 40 50 60 70 80 90 100 110 120 Price $120 110 100 90 80 70 60 50 40 30 20 10 0

Total Revenue $ 0 1,100 2,000 2,700 3,200 3,500 3,600 3,500 3,200 2,700 2,000 1,100 0

A Duopoly Example: Price and Quantity Supplied


The price of water in a perfectly competitive

market would be driven to where the marginal cost is zero: P = MC = $0 Q = 120 gallons The price and quantity in a monopoly market would be where total profit is maximized: P = $60 Q = 60 gallons

A Duopoly Example: Price and Quantity Supplied


The socially efficient quantity of water is

120 gallons, but a monopolist would produce only 60 gallons of water. So what outcome then could be expected from duopolists?

Competition, Monopolies, and Cartels


The duopolists may agree on a

monopoly outcome.
Collusion
The

two firms may agree on the quantity to produce and the price to charge.
two firms may join together and act in unison.

Cartel
The

However, both outcomes are illegal in the United States due to Antitrust laws.

Summary of Equilibrium for an Oligopoly


Possible
Joint

outcome if oligopoly firms pursue their own self-interests:


output is greater than the monopoly quantity but less than the competitive industry quantity. Market prices are lower than monopoly price but greater than competitive price. Total profits are less than the monopoly profit.

How the Size of an Oligopoly Affects the Market Outcome


How

increasing the number of sellers affects the price and quantity:


The

output effect: Because price is above marginal cost, selling more at the going price raises profits. The price effect: Raising production lowers the price and the profit per unit on all units sold.

How the Size of an Oligopoly Affects the Market Outcome


As

the number of sellers in an oligopoly grows larger, an oligopolistic market looks more and more like a competitive market. The price approaches marginal cost, and the quantity produced approaches the socially efficient level.

Game Theory and the Economics of Cooperation


Game

theory is the study of how people behave in strategic situations. Strategic decisions are those in which each person, in deciding what actions to take, must consider how others might respond to that action. Show its a Beautiful Mind at this point!-The bar scene

Game Theory and the Economics of Cooperation


Because

the number of firms in an oligopolistic market is small, each firm must act strategically. Each firm knows that its profit depends not only on how much it produced but also on how much the other firms produce.

The Prisoners Dilemma


The prisoners dilemma provides insight into the difficulty in maintaining cooperation.
Often people (firms) fail to cooperate with one another even when cooperation would make them better off.

The Equilibrium for an Oligopoly


A Nash equilibrium is a situation in which economic actors interacting with one another each choose their best strategy given the strategies that all the others have chosen (I.e. Dominant Strategy)