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2.3 Theory of the firm

	Abnormal profits	Losses	Allocative efficiency	Productive efficiency
Perfect competition
Short run
Long run
Monopoly
Short run
Long run
Monopolistic competition
Short run
Long run
Oligopoly
Short run
Long run

PES

Price elasticity of supply is a measure of the responsiveness of supply to changes in price.
If PES is equal to zero, PES is perfectly inelastic. In the very short-run, it is impossible for firms to increase supply straight away, no matter what the price level is, until new factors of production are employed. Thus, it is possible that PES is zero.

 

Value of PES	Elasticity	Interpretation
Between 0 and 1	Inelastic	A change in the price leads to a less than proportionate change in supply
Greater that 1 (less than infinity)	Elastic	A change in the price leads to a greater than proportionate change in supply
1	Unit elastic	A change in the price leads to a proportionate change in supply

Determinants of PES

How much costs rise as output increases – PES will be lower thus inelastic if costs rise significantly as producers attempt to increase output.
Time period considered – perfectly inelastic in the short run before new factors of production are employed.

                               

YED

Income elasticity of demand is a measure of the responsiveness of demand for a product to changes in consumer income. 

Like the CED, the sign is important. It tells whether the good is inferior or normal. Recap: the demand for normal goods rises as income rises and the demand for inferior goods falls as income rises. 

Value of YED	Good	Income Elasticity	Interpretation
Positive	Normal		Demand increases with income
Between 0 and 1	Necessity if low	Inelastic	Change in demand is less than income change.
Greater than one	Superior if high	Elastic	Change in demand is more than income change.
Negative	Inferior		Demand decreases as income increases

Significance of income elasticity for sectoral change (primary, secondary, tertiary) as economic growth occurs:
An underdeveloped country experiences larger output from the primary sector. As economic growth occurs, incomes rise and since the YED for agricultural goods is low and more income-inelastic, the economy notices a higher demand for goods from secondary sectors. As the economy grows and income increases further, the demand for tertiary products increases as its YED is higher and thus more income-elastic. The result is that over time, the share of agricultural output as a share of total output in an economy shrinks, while the share of manufactured output grows.

CED

 It is a measure of the responsiveness of demand for one good to a change in price of another good.

 The sign of the value follows: 

Applications of XED

By single business: Coca-cola and Sprite are both produced by the same company. Since they are substitutes, a fall in the price of Sprite will decrease demand for Coca-cola. Should the firm let this happen? First it must have information about the PED for Sprite, so that it can determine whether a price cut will lower or raise total revenue. Then, it must measure the CED to find the degree of substitutability between them. The more positive is it, the greater the decrease in demand for Coca-cola will be.
By rival businesses: A large CED would mean that if Coca-cola increases its price, it would lose a lot of consumers to Pepsi.
Merges: Competitors may decide to merge if they produce close substututes. This is illegal as it reduces competition. Governments should measure CED to ensure merging does not occur with competitor firms.
Complementary goods: A very negative CED means that lowering the price of one good can result in a significant increase in demand and sales for the other. Advantages can be taken from complementarities.

2.2 PED

It is a measure of how much the quantity demanded of a product changes when there is a change in the price of the product. It is the absolute value of the percentage change in quantity demanded, over the percentage change in price.

Possible range of values

Value of PED	Demand	Interpretation
Between 0 and 1	Inelastic	Quantity demanded is relatively unresponsive to price
Greater than 1	Elastic	Quantity demanded is relatively responsive to price
1	Unit elastic	Change in price causes an equal change in demand
0	Perfectly inelastic	Quantity demanded is completely unresponsive to price
Infinity	Perfectly elastic	Quantity demanded is completely responsive to price

Varying elasticity along a straight-line D curve

On any straight line demand curve, there is an elastic portion at high prices, and an inelastic portion at low prices. The midpoint of a curve is unit elastic demand. This arises simply from arithmatics.

However, in practice, if the price of an expencive good increases, then the real income will decrease even further, leading to a relative elastic demand. In the case of a cheaper good, the demand is already at a large quantity. Due to the law of diminishing marginal utility, purchasing one more unit of the good is not in question. Therefore, demand is inelastic at low prices.

Talking about graphs, it is important to note that PED is only comparable if the two curves intersect. If they are parralel, the curve which has the highest point of unit elasticity (PED=1), has the highest PED.

Total Revenue (TR=PxQ)
An increase in price of a good which has ineastic demand will increase TR.


Determinants of PED
Number and closeness of substitues - demand will be inelastic if consumers have no choice but to buy that one good.
Necessity of the product - food has inelastic demand, however, the more specified the product is, the less inelastic is the demand.
Time period considered - in the short-run, demand is likely to be inelastic.

Applications of PED

Total Revenue (TR=PxQ)

An increase in price of a good which has ineastic demand will increase TR, while it will decrease if demand is elastic. If the demand is unit elastic, a change in price does nto cause any change in total revenue. This links with the firm's decision to change price. It is impossible to predict the effect on profit as total costs may increase faster than total revenue.

Indirect taxes

May be imposed on goods with inelastic demand in order to increase tax revenues.

2.1 Markets

Markets include any kind of arrangement where buyers and sellers of a particular good, service or resource are linked together to carry out an exchange.

Local market: a bakery sells bread to members of the community.

National market: A local takeaway restaurant has consumers nationwide.

International market: The world oil market includes producers and consumers from different countries.

	Number of firms	Market power	Product	Barriers to entry	Examples
Perfect competition	Many small firms	none	homologous	none	agriculture
Monopoly	One large	Very significant	One, no substitutes	high	energy suppliers
Monopolistic competition	Many, relatively small firms	some	Differentiated	Very low	restaurants
Oligopoly	Few large	significant	either	high	Cars, steel

Importance of price as a signal and as an incentive in terms of resource allocation:

As signals, prices communicate information to decision-makers. As incentives, prices motivate decision-makers to respond to the information.

Demand

Demand is the willingness and ability to consume at a given time, at a given price.
The law of demand states that as price increases, demand decreases, ceteris paribus.

Determinants of demand

Number of buyers

Tastes

Income – demand increases for normal goods and decreases for inferior goods.

Prices of substitutes (if they satisfy a similar need)

Prices of complementary goods (if they tend to be used together)

Expectations of future income

Expectations of future prices

Distinction between a movement along and a shift of the demand curve

Any change in price produces a change in demand (movement). Any change in a determinant produces a change in demand (shift).

Higher level:

Exceptions to the law of demand (the upward-sloping demand curve)

Ostentatious (Veblen) goods

These are goods which display wealth pretentiously. A person derives from utility from the desire to impress other people than from the consumption itself. High prices are associated with increased social status.

Giffen goods

Staple goods which the poor buy less of when prices decrease as the increase in real income may be used to buy better quality and more expensive substitutes. On the other hand as prices rise, they have less real income to consume a better substitute, so will buy more of the staple good.

Bandwagon effect

If prices rise and there are expectations that they will rise even further, demand will increase. For example, in stock markets as the price of shares rises there is a shift of the demand curve to the right.

Supply

Supply is the willingness and ability to supply at a given time, at a given price.

The law of supply states that as the price of a good increases, its supply will increase, ceteris paribus.

Determinants of supply

Number of firms

Costs of factors of production

Technology lowers cost of production

Prices of goods the firm could produce

Expectation of future prices

Taxes as a cost of production

Subsidies reduce costs

Supply shocks, such as natural disasters.

Distinction between a movement along and a shift of the supply curve

Any change in price produces a change in quantity supplied (movement). Any change in the determinants produces a change in supply (shift).

Interaction of demand and supply

Equilibrium market clearing price and quantity occurs where the quantity that consumers are able and willing to buy are the same as the quantity suppliers are able and willing to produce.

Consumer surplus is the higher price consumers are willing to pay for a good minus the price actually paid.

Producer surplus is price received by firms minus the lowest price that they are willing to accept in order to produce the good.

Price controls

Maximum price:

Causes

To protect consumers and unusally imposed on merit goods, such as low-cost food for the poor during food shortages, rented accomodations for low income earners. 

Consequences

Shortages – price is below equilibrium, so there is excess demand and shortage of supply.

Decrease in quantity supplied – since there is a shortage.

Underallocation and allocative inefficiency of resources – too few resources are being allocated to produce the good.

Non-price rationing – favutitism

Illegal markets for a lower price

Minimum price:

Causes 

To raise income of producers of goods that experience large flunctuations or foreign competition, such as agriculture.
To protect workers by setting a minimum wage.

Consequences

Surpluses
Decrease in quantity demandedand purchased
Firm inefficiency - no incentive to reduce cost of production because of the protection of the min. price
Overallocation of resources - a larger than optimum quantity is produced
Illegal sales at prices below the floor

Price support/buffer stock schemes

Govt intervenes to stabilize prices, such as in the commodities market. A price band is set, with max. and min. prices.

An increase in supply may cause prices to fall below the set band. To prevent prices from sinking, the government buys the surplus and stores it. This shifts the demand curve to the right, so that the equilibrium is at the bottom price.
On the other hand, a decrease in supply may send prices off the roof, to an equilibrium above the price band. This causes a shortage from the supply at the top price, to the quantity demanded at top price. To intervene, the govt. sells the stored good.
Problems arise as storage costs are high. Improvements in technology suggest that surpluses are likely. It is also difficult to provide the correct price bands.

Commodity agreements

Different countries operate a buffer stock scheme together. 

Make sure you can draw diagrams explaining each case.