Oht ch04-06

OHT 4.
CHAPTER 4. Analysis of the firms supply decision

The derivation of the firms supply curve. Conditions of supply. Elasticity of supply. Supply chains and value added. Transaction costs and the resource-based theory of supply. Forms of integration of firms. Producer surplus.
In particular, our focus is on two of the most important questions facing managers: How much should be produced and supplied? How should the supply chain be organised?
J. Nellis and D. Parker, Principles of Business Economics. Pearson Education Limited 2002.
OHT 4.2A
Learning outcomes This chapter will help you to: Understand the nature of the firms supply decision and the derivation of the firms supply curve. Appreciate how price and non-price factors impact upon supply decisions. Measure the responsiveness of supply to changes in the price of the good or service in question the elasticity of supply. Recognise the importance of supply chains and value chains in organising the supply of goods and services. Comprehend the significance of transaction costs in decisions by a firm as to whether to buy in (or outsource) inputs into the production process or to employ the inputs in-house.
OHT 4.2B
Learning outcomes Distinguish between transaction costs and resourcebased theory approaches to analysing the organisation of supply. Understand the various forms of corporate structure in terms of vertical, horizontal and conglomerate integration within the context of supply decisions. Identify the existence of producer surplus.
Deriving the firms supply curve
OHT 4.3
Figure 4.1 Deriving the supply curve for a firm in a competitive environment
OHT 4.4 In summary.. In the short run,a profit-maximising firms supply curve in a (perfectly)competitive environment is mapped out by the firms marginal cost curve (MC)lying above its average variable cost curve (AVC). The long-run supply curve in a (perfectly)competitive environment is the firms marginal cost curve lying above its average total cost curve (ATC).
OHT 4.5
Conditions of supply Changes in costs of production.
Prices of other products.

Changes in profit expectations. Climate.
OHT 4.6
Figure 4.2 Shifting the firms supply curve

Elasticity of supply
Elasticity of supply
OHT 4.7
E2 = Percentage change in quantity supplied Percentage change in price Relatively elastic supply i.e.a small percentage change in price brings about a relatively large percentage change in quantity supplied. Relatively inelastic supply i.e.a relatively large percentage change in price results in a relatively small supply response. Perfectly inelastic supply i.e.the quantity supplied is insensitive to any change in price. Perfectly elastic supply i.e.the quantity supplied is so sensitive to a change in price that even a small reduction in price will lead to nothing being supplied by the firm.
OHT 4.8
Figure 4.3 Examples of supply elastics

Supply and value chains
OHT 4.9
Figure 4.4 Supply chain and value added

OHT 4.10
Figure 4.5 The Porter value chain

Source: Adapted and reprinted with the permission of The Free Press, a Division of Simon & Schuster from Competitive Advantage: Creating and Sustaining Superior Performance by Michael E. Porter. Copyright 1985 by Michael E. Porter.
OHT 4.11
Transaction costs and resource-based theory

Transaction costs in markets are the costs of negotiating, monitoring and enforcing contracts. Resource-based theory is concerned with the resources assets,skills and knowledgeowned or controlled by the firm and hence its ability or competence to supply goods and services very competitively.
OHT 4.12
Vertical, horizontal and conglomerate integration
Hierarchical forms of organising production are associated with high levels of integration. Integration can take three main forms, namely: Vertical integration. Horizontal integration. Conglomerate integration.
Producer surplus
OHT 4.13
Producer surplus is the additional revenue that accrues to a firm when units of output are sold at a price which is in excess of the price at which the firm would have been prepared to supply, I.e. in excess of the marginal cost of production. Figure 4.6 Producer surplus
OHT 4.14A
Key learning points For a firm in a perfectly competitive industry, the supply curve shows the amount that it is willing to supply at all possible market prices. A firms short-run supply curve is mapped out by the marginal cost curve lying above its average variable cost curve. A firms long-run supply curve is traced out by its marginal cost curve lying above its average total cost curve. A supply curve can only be derived from the marginal cost curve for firms operating in very (strictly, perfectly competitive environments the concept of a supply curve is particularly inappropriate when dealing with monopoly situations because a monopoly is a price-maker, not a price-taker, and can thus select the price output combination on the demand curve so as to maximise profits.
Learning outcomes The elasticity of supply is defined as: E2 = Percentage change in quantity supplied Percentage change in price
OHT 4.14B
The numerical value of E, will always be zero or positive,with a figure of zero indicating that supply does not respond at all to price changes; a figure of more than 1 indicating a relatively elastic response;and a figure of less than 1 a relatively inelastic response. The supply chain shows the different stages in the production and supply of outputs, e.g. in the case of a manufacturing process,the provision of materials and components,the physical production of the product,its eventual distribution and sale, and after sales service.
OHT 4.14C
Learning outcomes The value chain identities where value is created (or lost) at each stage of the supply (production and distribution) process. The boundary of the firm can be explained by transaction cost theory and the resource-based theory of the firm. Transaction costs are the costs of negotiating, monitoring and enforcing market contracts for the inputs of goods and services. Resource-based theory is concerned with the assets,skills and knowledge (i.e.core competencies and distinctive capabilities) which are (a) specific to the firm, (b) difficult to imitate and (c)are able to give the firm a distinct competitive advantage in the market place.
Learning outcomes
OHT 4.14D
Vertical integration is the bringing together under one ownership and control of different stages in the production of a given good or service. Horizontal integration occurs when two or more firms,at the same stage of production, integrate usually leading to more market concentration and hence less competition in the product market. Conglomerate integration occurs when a firm enters different markets or industrial sectors. Producer surplus is the additional revenue that accrues to a firm when units of output are sold at a price which is in excess of the price at which the firm would have been willing to supply,i.e. in excess of the marginal cost of production.
OHT 5.1
CHAPTER 5. Demand, supply and price determination

The price mechanism and equilibrium price. Changes in demand,supply and equilibrium price. Price and the allocation of resources. The effects of taxes and subsidies. Cobweb theory.
OHT 5.2A
Learning outcomes
This chapter will help you to:
Understand how equilibrium prices are determined in a market economy through the interaction of demand and supply forces. Appreciate the conditions which will lead to the establishment of an equilibrium price and why a disequilibrium may arise in reality. Grasp how changes in demand and supply conditions will result in the establishment of a new equilibrium price and quantity. Recognise the importance of relative elasticities of demand and supply in the establishment of a market equilibrium.
Learning outcomes
OHT 5.2B
Appreciate the functions of the price mechanism in terms of resource allocation and how a free market economy can result in an allocation that might not be entirely satisfactory. Understand the effects of the imposition of taxes and subsidies by governments on price and quantity equilibria. Grasp the meaning of the incidence of a tax in terms of the impact on buyers and suppliers. Appreciate the principles which underlie the cobweb theory of price determination and the conditions which are likely to give rise to stable and unstable cobweb dynamics. Understand the relevance of cobweb theory in the context of certain markets, such as agricultural production, and why primary commodity prices tend to fluctuate.
The price mechanism and equilibrium price

Equilibrium price is the price at which the quantity demanded by consumers and the quantity that firms are willing to supply of a good or service are the same.
OHT 5.3
Figure 5.1 Equilibrium of demand and supply

Changes in demand, supply and equilibrium price
OHT 5.4
Figure 5.2 Effect of a shift in the demand curve
Figure 5.3 Effect of a shift in the supply curve

OHT 5.5
Price and the allocation of resources The functions of the price mechanism in a free market economy are, fundamentally, to:
Ration out scarce goods and services, so that price brings demand and supply into equilibrium.
Indicate changes in the wants of consumers and induce suppliers to alter the quantities produced in response to changes in demand. Indicate changes in supply conditions, e.g. a rise in the costs of production will induce suppliers to decrease supply, while consumers will react to the resulting higher price by reducing demand for the good or services.
OHT 5.6
Price, allocation of resources and social welfare
Market imperfections. Incomplete or inaccurate information. Time lags. Unequal distribution of income. Externalities. Government objectives.
The effects of taxes and subsidies
OHT 5.7
Figure 5.4 Tax and the price mechanism

OHT 5.8
Figure 5.5 Incidence of tax on the supplier

The effects of taxes and subsidies Subsidies

OHT 5.9
Figure 5.6 Subsidies and the price mechanism

OHT 5.10
Figure 5.7 Benefit of subsidy for producer

Cobweb theory
OHT 5.11
The cobweb theory explains the path followed in moving towards an equilibrium price and quantity in the long run where there are time tags in the adjustment of either supply or demand to changes in price.
OHT 5.12
Figure 5.8 A stable cobweb

Figure 05_09
OHT 5.13
Figure 5.9 An unstable cobweb

OHT 5.14A
Key learning points

The price mechanism describes the way in which the prices charged for goods and services determine how scarce resources are allocated in a free market economy. Equilibrium price is the price at which the quantity demanded by consumers and the quantity that firms are willing to supply are the same. Changes in the conditions of demand and supply will lead to changes in the equilibrium values of price and quantity. The functions of the price mechanism in a free market economy are to: ration out scarce resources; indicate changes in consumerswants and induce suppliers to alter production levels; indicate changes in supply conditions.
Key learning points
OHT 5.14B
The price mechanism can result in an allocation of resources that may not be regarded as satisfactory arising from: Market imperfections; Incomplete or inaccurate information; Time lags with respect to demand and supply responses; Unequal distribution of income; Externalities; Government objectives. The incidence of a tax refers to the burden of taxation and in the case of a specific tax on a good or service this generally depends on the price elasticities of demand and supply. When demand is price inelastic, the imposition of a tax ensures a large price increase and consumers bear most of the tax.
Key learning points
OHT 5.14C
In contrast,when demand is price elastic the tax causes a smaller price increase and producers bear more of the tax. When supply is price inelastic, the tax burden falls more heavily on suppliers because they are less able to nullify the impact of the tax by cutting output. When supply is price elastic, the tax burden falls less heavily on suppliers because they can reduce output as the price they receive (net of tax) declines. As in the case of a tax,the effects of a subsidy will depend on the relative values of the price elasticities of demand and supply.
Key learning points
OHT 5.14D
Cobweb theory is designed to explain the path followed in moving towards an equilibrium price and output where there are time lags in the adjustment of either supply or demand to changes in prices. A stable cobweb is one which tends towards a stable equilibrium price and quantity; an unstable cobweb describes a situation which ripples away from the equilibrium. Cobweb theory was first developed in the context of certain agricultural markets and helps, in particular, to explain why primary commodity prices tend to fluctuate.
CHAPTER 6. Analysis of perfectly competitive markets
OHT 6.1
Figure 6.1 Market structures in the competitive spectrum

Learning outcomes
This chapter will help you to:
OHT 6.2
Appreciate the significance and usefulness of the perfect competition model when analysing real-world markets. Understand the difference between price and output outcomes in the short run and long run in perfectly competitive markets. Recognise the role of supernormal profit as an incentive for new firms to enter competitive markets, leading to a reduction in market price, and therefore the dynamics of competitive markets. Distinguish between allocative and productive efficiency and how these interact to ensure economic efficiency in perfectly competitive markets. Understand the meaning of Pareto optimality and why pareto optimal outcomes occur in perfectly competitive markets.
OHT 6.3
Conditions for perfect competition

Homogeneous (identical) products i.e.the presence of perfect substitutes. No firm with a cost advantage i.e.all firms have identical cost curves. A very large number of suppliers thus no single producer by varying its output can perceptibly affect the total market output and hence the market price. Free entry into and exit from the industry ensuring that competition is sustained over time. No transport and distribution costs to distort competition . Suppliers and consumers who are fully informed about profits, prices and the characteristics of products in the market hence ignorance or incomplete information does not distort competition.
OHT 6.4
Production in the short run and long run

The short run is the time period in which at least one factor input into the production process is fixed in supply - usually this will be capital or land, although in some cases this can apply to certain types of labour (e.g.highly skilled workers). The long run is the time period in which all factors of production become variable in supply. In the long run,progress can be made towards operating at the optimal scale of production.
Short-run equilibrium
OHT 6.5
Figure 6.2 Perfect competition: short-run equilibrium (profits)

Short-run equilibrium
OHT 6.6
To summarise, in the short-run equilibrium under conditions of perfect competition:
The firm is a price-taker, not a price-maker. Marginal revenue equals average revenue and equals price; i.e. MR =AR =P . Profits are maximised where short-run marginal cost equates to marginal revenue (and average revenue). Supernormal profits can be earned given by the extent to which price (and thus average revenue) exceeds short-run average total costs at the profit-maximising output.
OHT 6.7
Figure 6.3 Perfect competition: short-run equilibrium (losses)

Long-run equilibrium
OHT 6.8
Figure 6.4 Perfect competition: long-run equilibrium (profits)

OHT 6.9
Long-run equilibrium
The firm is still a price-taker . Marginal revenue still equals average revenue and price; i.e. MR =AR =P . But profits are now maximised where long-run marginal costs are equal to marginal revenue (and average revenue). Supernormal profits (or losses) earned in the short run disappear due to market entry (or exit) so that firms in perfect competition earn only normal profits in the long run (AR =ATC).
Productive and allocative efficiency in perfectly competitive markets
OHT 6.10
Productive efficiency occurs when a firm minimises the costs of producing any level given existing technology. Technical efficiency - this occurs when inputs of the factors of production are combined in the firm in the best possible way to produce the maximum physical output. Price efficiency - this occurs when inputs into production are optimally employed, given their prices, so as to minimise production costs.
OHT 6.11
Figure 6.5 Productive efficiency in perfect competition

OHT 6.12
Allocative efficiency
Allocative efficiency denotes the optimal allocation of scarce resources so as to produce the combination of outputs which best accords with consumers demands. In other words,no other allocation of resources would produce a higher level of economic welfare, given the existing consumer demands.
Pareto optimality
OHT 6.13
A pareto optimum is said to exist when resources cannot be reallocated so as to make one person better off without making someone else worse off. There are three main conditions that must hold in order for a pareto optimum to be achieved. 1 2 3 Goods must be optimally distributed between consumers so that no reallocation increases economic welfare. Inputs are allocated in such a way that no reallocation would increase the physical output. Optimal amounts of each output are produced so that no change in output would lead to higher economic welfare. In perfectly competitive markets,these three conditions are met in the long run.
OHT 6.14
To summarise,under perfect competition:

In the short run,until the entry or exit of sufficient firms occurs,supernormal profit or losses can exist. In the long run,once the process of market adjustment is complete,only a normal profit is earned. In the long run a Pareto optimal outcome is achieved.
Perfect competition drives profit down to a normal level and provides consumers with low-priced products and services. Also, firms in perfectly competitive markets operate at optimal scale in the long run. Economists favour the perfectly competitive model because it achieves economically efficient and, therefore, welfare maximising results.
OHT 6.15A
Key learning points

A perfectly competitive market is one in which there is an extremely high degree of competition with a very large number of firms selling identical products or services, with identical cost conditions,with free entry into and exit from the industry and where ignorance does not distort competition (information is complete for all producers and consumers). Each firm in a perfectly competitive market is a price-taker it faces a perfectly elastic demand curve. Short-run equilibrium in a perfectly competitive market occurs when profits are maximised (or losses are minimised)and this is where the short-run marginal cost equates to price (and average revenue as well as marginal revenue:i.e.P (=AR)=MR=MC). Long-run equilibrium in a perfectly competitive market is attained where production occurs so that firms can earn a normal profit :i.e. P (=AR)=MR =MC =ATC. Also this will be at the output at which the long-run average cost curve is at its minimum.
OHT 6.15B
Key learning points

Perfectly competitive markets are therefore associated with both allocative and productive efficiency. Allocative efficiency denotes the optimal allocation of scarce resources so as to produce the combination of outputs which best accords with consumers demands. This will be where price equals marginal cost: P =MC. Productive efficiency occurs when a firm minimises the cost of producing any level of output,using existing technology. Productive efficiency is the product of technical efficiency (resulting from combining inputs to achieve the maximum physical output)and price efficiency (achieved by minimisation of production costs given input prices). Perfect competition is associated with pareto optimal outcomes and is a theoretical benchmark against which the economic welfare effects of real-world markets can be judged.

Oht ch04-06

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OHT 4.

CHAPTER 4. Analysis of the firms supply decision

Deriving the firms supply curve

Conditions of supply Changes in costs of production.

Prices of other products.

Figure 4.2 Shifting the firms supply curve

Figure 4.3 Examples of supply elastics

Supply and value chains

Figure 4.4 Supply chain and value added

Figure 4.5 The Porter value chain

Transaction costs and resource-based theory

Vertical, horizontal and conglomerate integration

CHAPTER 5. Demand, supply and price determination

The price mechanism and equilibrium price

Figure 5.1 Equilibrium of demand and supply

Changes in demand, supply and equilibrium price

Figure 5.2 Effect of a shift in the demand curve

Figure 5.3 Effect of a shift in the supply curve

Price, allocation of resources and social welfare

The effects of taxes and subsidies

Figure 5.4 Tax and the price mechanism

The effects of taxes and subsidies

Figure 5.5 Incidence of tax on the supplier

The effects of taxes and subsidies Subsidies

Figure 5.6 Subsidies and the price mechanism

The effects of taxes and subsidies

Figure 5.7 Benefit of subsidy for producer

Figure 5.8 A stable cobweb

Figure 5.9 An unstable cobweb

Key learning points

Key learning points

Key learning points

Key learning points

CHAPTER 6. Analysis of perfectly competitive markets

Figure 6.1 Market structures in the competitive spectrum

Conditions for perfect competition

Production in the short run and long run

Figure 6.2 Perfect competition: short-run equilibrium (profits)

To summarise, in the short-run equilibrium under conditions of perfect competition:

Figure 6.3 Perfect competition: short-run equilibrium (losses)

Figure 6.4 Perfect competition: long-run equilibrium (profits)

Productive and allocative efficiency in perfectly competitive markets

Figure 6.5 Productive efficiency in perfect competition

To summarise,under perfect competition:

Key learning points

Key learning points

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