Test (2)

Chapter 3: Application of Elastic and Price theory

Chapter 4: Theory of Consumer Behavior
Chapter 5: Theory of firm- production and cost
Chapter 6: Market Structure
Chapter 7: Market Failure

Chapter 3: Application of Elastic and Price Theory

1) Elasticity – measure of the responsiveness of one variable to another. The greater the
elasticity, the greater the responsiveness
2) Demand Elasticity – Measure of the responsiveness of quantity of demand to another
variable.
- Three types: Price Elasticity, Income Elasticity, Cross Elasticity
- Quantity of demand response to change in price of income.
3) Price Elasticity of Demand – Responsiveness of quantity demand to change in price of
goods.
- Percentage change in quantity demanded divided by the percentage change in price.
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑
-
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒
- Midpoint Formula :
𝑄1−𝑄0 𝑃1−𝑃0
÷ (𝑃1+𝑃0)/2
(𝑄1+𝑄0)/2
- Sign of price elasticity: Law of Demand: Price increase, Demand decrease; price
elasticity of demand always negative. ( No – sign in value)
- Degree of Elasticity
- Ed ˃ 1 : elastic
- 0 ˂ Ed˂ 1 : Inelastic
- Ed = 1 : Unit elastic/ unitary elasticity
- Ed = 0 : infinite inelastic/ perfectly inelastic
- Ed = ∞ : perfectly elastic
 - If demand is inelastic, Change in quantity will be smaller than change in price
- when price increases, total revenue increase as quantity fall less than increase in price.
- when price decreases, total revenue decrease as quantity rise less than fall in price.
- Firm price strategy : demand elastic, should decrease price to increase revenue; demand
inelastic, should increase price of increase revenue
- Determinant of Price Elasticity of Demand
- Availability of substitute
- Width of market definition
- Necessities VS Luxuries
- Percentage of one budget spent on good
- Time
4) Income Elasticity of Demand
- Income Elasticity of Demand measure of the responsiveness of quantity demand to
charges in the consumer income.
- Percentage change in quantity demanded divided by the percentage changes in income
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑
- 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑖𝑛𝑐𝑜𝑚𝑒
- Midpoint formula
𝑄1−𝑄0 𝑌1−𝑌0
- ÷ (𝑌1+𝑌0)/2
(𝑄1+𝑄0)/2
- Ey˃1 : income elastic
- 0 ˂ Ey ˂ 1 : income inelastic
- Ey = 1 : income unit elastic/ unitary elasticity
- Classfication of goods
- if positive, normal good; increase in consumer income, increase the quantity demand
- if negative, inferior good; increase in consumer income, decrease quantity demand
5) Cross Elasticity of demand
- Responsiveness of quantity demanded of one good changes with changes in price of
other groods.
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑜𝑓 𝑔𝑜𝑜𝑑
- 𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑎𝑛𝑜𝑡ℎ𝑒𝑟 𝑔𝑜𝑜𝑑
- Midpoint formula:
𝑄1−𝑄0 𝑃1−𝑃0
- ÷ (𝑃1+𝑃0)/2
(𝑄1+𝑄0)/2
 - Information provided: quantity response to a change in price of another good.
- Classification of goods
-If positive, substitution good; Ec˃0

- If negative, complementary good, Ec˂0

6) Price Elasticity of Supply
- Responsiveness of quantity supplied with the change of price
- Value: positive to show the relationship is positive
𝑃𝑒𝑟𝑐𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑜𝑓 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑠𝑢𝑝𝑝𝑙𝑖𝑒𝑑
- 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒
𝑄1−𝑄0 𝑃1−𝑃0
- Midpoint formula : ÷
(𝑄1+𝑄0)/2 (𝑃1+𝑃0)/2
- Elasticities
- Above 1, supply elastic
- Less than 1, supply inelastic
- Exactly 1, supply unitary elastic
- Exactly 0, supply perfectly inelastic
- Infinity, supply perfectly elastic
- Determinants of Price Elasticity of Supply
- Time
- Possibility of Substitution
- Cost of Increasing Production/ Marginal Cost
- Type of Goods
- Mobility of Factors of Production
- Price Regulation
- Government may intervene market for certain
purposes
- Above Market Price: Price Floor
Price set higher than Market Price to help producers.
*Rise from Pe to Pn when government implements
price floor (minimum)
* Lead to excess supply
* Government will buy excess supply to maintain price
* To stabalize income of producer and prevent
minimum wage from decreasing
- Below Market Price: Price Ceiling
Price set lower than Market Price to help consumers.
*Price decrease from Pe to Pm when government
implement price ceiling ( maximum)
* Lead to excess demand/ shortage
* Government limit amount of goods people can buy
individually (system of rationing)
* may have to import overseas or increase local
production
Form of price ceiling
- Rent Control : limits that landlords can charge, lead
to shortage of houses in market
- However, may lead to emergence of black market
- Underground Market
When there is shortage of goods, customers willing to
pay higher price
- Pm goes up to Pu and dealer earn the green area
- Taxes and Subsidies
-Taxes: to raise revenue for public projects
- discourages market activity, when implemented,
quantity demanded decreases, buyer and seller share
burden.
- Tax incidence: sharing the burden amongst
participants of market.
*Tax results to market equillibrium, even if customer
pay more, seller still get less.
 - Tax implied on seller
- supply curve shift left
- higher equillibrium price, lower
quantity
- reduce size of market
- Tax levied between seller and buyer
- Buyer
*Pay higher price
- Seller
* Receive lower price

- Subsidies
- Amount of money ppaid by the government to customers or producers on unit of output
- Opposite effect from tax
- Purpose
* Lower price of essential goods
* Guarantee Supply of products
* Enable local producers to compete
with overseas
- Implied
-Impact on supply
-Supply curve shift right
- Lower equillibrium price, higher
quantity
-Increase size of market
- Levied with buyer and seller
-buyer
*pay lower price
-seller
*receive higher price

Chapter 4: Theory of Consumer Behaviour

- Cardinal Utility theory
- Study of consumer behaviour by measuring how much (the Number) one market basket
is preffered to another
- Assuming satisfaction is measurable
- Background of Demand
* Consumers purchase goods and services to get th satisfaction (utility)
- Total Utility : total amount of satisfaction a person gets from consuming all the
commidity in a period of time
- Marginal Utility
- Additional satisfaction received when a person consumes an extra unit within a given
time period
- Changes in utility when consuming an extra unit
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑡𝑜𝑡𝑎𝑙 𝑈𝑡𝑖𝑙𝑖𝑡𝑦
- 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦
- Diminishing Marginal Utility : States that as a good is consumed, additional units will
provide less satisfaction compared to the previous

- Law of diminishing Marginal Utility

- States that marginal utility decreases as consumption increases
- Demand price fluctuates depending on marginal utility, price also declines as
consumption increases, price and demand are inversely related, which is law of demand.
- Marginal utility decreases as quantity consumed increases, and willingness to pay
depends on marginal utility.
- Marginal Utility : Money as the unit of utility
- Amount consumer prepares to pay for goods.
- Consumer surplus: Excess of what a person has prepared to pay for a good, over what
the person actually pays.
* Maximum: should purchase more additional units as long as they get additional
consumer surplus.
- Optimal consumption: Combinations of goods to purchase : Law of equi-marginal
principle
-Consumer maximizing his total utility will allocate his income to purchase a
combination of goods in such ways that his marginal utility of the last dollar spent on
each commodity will be equal.
𝑀𝑈𝐴 𝑀𝑈𝐵
- =
𝑃𝐴 𝑃𝐵
- Ordinal Utility
-Study of consumer behavior by creating a ranking of market baskets in order of most to
least preferred.
- Assuming that utility is not measurable but comparable.
- Indifference curve theory
* shows all combination of goods that will give an equal amount of satisfaction to
customer
* All combinations of goods on the indifference curve will yield the same amount of
utility.
- Marginal rate of substitution
*The amount of one good that a consumer is willing to give up to purchase another
amount of another good.
𝑌
*𝑋
* Shape of the indifference curve is a hyperbola, because of diminishing rate of
substitution
- Diminishing rate of substitution states that when a person gives up an amount of a good
for another good, the less that the consumer is willing to give up that good for the other
good.
 - Indifference map
* A graph that shows a whole set of indifference curve
* The further the curve from the origin, the higher level satisfaction a person feels.

- Budget line
- Graph showing all the possible combinations of two goods purchased based on given
prices and given budgets

- Shift in budget line

- Change in Income
 -Change in Price
- Optimal Consumption Point
- when consumer utility is maximized where indifference curve intersects with the budget
line

- Income consumption curve: a line showing a person’s optimum level of consumption of two
goods changes as income changes
*Assuming that both prices are constant
 - Price consumption curve : line which shows the optimum combination of purchase when
price of one good changes
*Assuming income and the other price remains constant

- Limitation of indifference analysis

- Difficulty in deriving indifferent curve
- Consumers may not behave rationally
- Influence from advertisement
- Certain goods are purchased only now and again or one at a time

Chapter 5: Theory of Firm- production & costs

- Production: transformation of resources and factors of productions into goods and
services
- Types of inputs :
1. Fixed Input
2. Variable Input
- Fixed input: an input whose quantity cannot be changed with the quantity produced in the
short run.
*Considered as Fixed Cost, and does not change with output change
- Variable input: an input whose quantity can be changed as output changes in the short
run.
*Considered as Variable Cost, changes as output changes.
- Short run: a period in which at least some output is fixed.
- Long run: a period which all inputs can be varied ( none of the inputs in firm are fixed
inputs)
- Production in Short run
-Total physical product (TPP): total quantity of output produced by a firm with given
inputs
- Average physical product (APP): the quantity of total output produced per unit of a
variable input, holding all other inputs as fixed.
*APP = Total physical product/Total variable input
- Marginal physical product (MPP): the quantity of total output produced with change of
a variable input, holding all other inputs as fixed.
* MPP = Change in output/Change in variable input
* as more variable input are added to fixed inputs, the variable inputs would yield less
additions to output.
-Law of diminishing return (product): As larger amount of a variable inputs are combined
with fixed inputs, the MPP of the variable input will eventually decline.
- Relationship between total, average and marginal product function.
-TPP, APP and MPP are initially increasing until maximum and then decreasing.
- Marginal Product > Average Product, Average product increasing
- Marginal Product = Average Product, Average product at maximum
- Marginal Product < Average Product, Average product is decreasing.
- when TPP is at maximum, APP = 0

- Determining Optimal Production

- Least Cost Combination: Combining the various factors of production which will result
to least cost and maximum output.
- States that will use two factors of production in such ways that extra product (MPP)
from the last dollar spent is equal.
-Assumptions:
* Two factors of production
* Company aiming to maximize profits
* Price of factors are constant
* Factors are homogeneous
 𝑀𝑃𝐿 𝑀𝑃𝑐
- =
𝑃𝐿 𝑃𝑐

◦ 𝑀𝑃𝐿 is marginal productivity of labour

◦ 𝑃𝐿 is price of labour
◦ 𝑀𝑃𝑐 is marginal productivity of capital
◦ 𝑃𝑐 is price of capital
𝑀𝑃𝐿 𝑀𝑃
- If 𝑃 > 𝑃 𝐶 , use more labor to yield greater extra product (MPP)
𝐿 𝐶
*diminishing return of labor set in, Thus 𝑀𝑃𝐿 will fall.
* as less capital is used, 𝑀𝑃𝑘 will rise.
𝑀𝑃𝐿 𝑀𝑃𝐶
* = , then company would stop substitution
𝑃𝐿 𝑃𝐶

◦ Isoquant/ Iso-cost Analysis: firms choice of optimum production can be shown.

- Construct isoquant and isocost line
- Isoquant: A line showing all the alternative combinations of the factors that can produce
a given a level of output
- Isocost: A line showing all the combinations that cost the same to employ

◦ Isoquant curve: slope of curve shows marginal rate of factor substitution

-Marginal rate of factor substitution: rate of a factor that can be substituted with another
as others levels of output remain constant
𝐾
- MRS = 𝐿
- The shape of isoquant curve is “hyperbola” because of diminishing marginal rate of
factor substitution.
-Diminishing marginal rate of substitution
*State that the more a factor (labour) are being used relative to another factor (capital),
would lead the MPP of that factor (MPL) to fall relative to the MPP of another factor
(MPC).
◦ Isoquant Map
- A graph showing a whole set of isoquant
curve.
- The further away a particular curve is
from the origin, the higher the level of
output it represent.
◦ Isocost Curve
- A line showing all the combinations of
two factors that cost the same to employ
- Least cost combination of factors
(producer equilibrium) is achieved when
total cost is minimize where isoquant
curve intercept with the isocost curve.
*From figure 5: Point A and Point C result
a higher isocost. Least cost combination
achieved at Point B where isoquant just
touches the lowest possible isocost.
◦ Production Surplus
- Is the difference between
what producers are willing and able to
supply a good for and the price they
actually receive.
- Maximization: Seller should go on
selling additional units as long as they
gain additional producer surplus. In other
word, as long as the price they received
higher than price they willing to sell.

◦ Firm’s cost
- Total cost (TC)
◦ Is the sum of fixed costs and variable cost
◦ TC = TFC + TVC
◦ Total fixed cost curve
◦ Exhibit cost fixed at certain amount (e.g RM 100) regardless of any output level
◦ Total variable cost (TVC)
◦ Exhibit cost vary at any output level
◦ The shape of the TVC curve reflects increasing marginal returns at small
quantities of output and decreasing marginal returns at large quantities
◦ Average fixed cost (AFC)
◦ Total fixed cost divided by quantity of output
◦ Exhibit average total fixed cost per-unit output produce
◦ AFC = TFC/Q
◦ Average variable cost (AVC)
◦ Total variable cost divided by quantity of output
◦ Exhibit average total variable cost per-unit output produce
◦ AVC = TVC/Q
◦ Average total cost (ATC)
◦ Total cost divided by quantity of output
◦ Exhibit average total cost per-unit output produce
◦ ATC = TC/Q
◦ Marginal cost (MC)
◦ Is the change in total costs (TC), that results from a change in output (Q)
◦ MC = TC/ Q
◦ Average total cost curve

◦ Exhibit total cost per-unit of output produced

◦ Also exhibit increasing marginal return at the beginning and decreasing marginal return
later

◦ Marginal cost curve

◦ Exhibit additional total cost with one additional output produced

◦ U shape is attributable to increasing, then decreasing marginal returns (law of

diminishing marginal returns

◦ Long run cost of production

◦ In long run, every input are variable input.
◦ Hence, firm can change the usage of fixed input in the production of goods and services.
◦ For that, long-run average cost curve is derived by multiple short-run average cost curve.
◦ Long Run Average Total Cost Curve shows the lowest unit cost at which the firm can
produce any given level of output. Put another way, the LRATC curve touches each
short-run ATC curve at its lowest point (at only one point) at a given level of output.

◦ Economies and Diseconomies of Scale

◦ Economies of Scale exist when inputs are increased by some percentage and output
increases by a greater percentage, causing unit costs to fall
* to take advantage of buying in bulk
◦ Constant Returns to Scale exist when inputs are increased by some percentage and
output increases by an equal percentage, causing unit costs to remain constant
◦ Diseconomies of Scale exist when inputs are increased by some percentage and output
increases by a smaller percentage, causing unit costs to rise
*lack of something that causes problems
◦ Minimum Efficient Scale is the output level at which average total costs are minimized
(Point A)
◦ Internal economies of scale: Refer to the efficiency of production within a firm
- Technical economies
- Purchasing economies
- Administrative savings
- Financial savings
◦ Internal diseconomies of scale: Refer to the inefficiency of production within a firm
- Poor communication
- Co-ordination problems
- Technical diseconomies
- Specialisation diseconomies
◦ External economies of scale: include the benefits of positive externality enjoyed by
firms as a result of the development of an industry or the whole economy
◦ External diseconomies of scale: are costs which are outside the control of a single firm
and result of the growth of a specific industry. (result of the negative externality)
 ◦ Firm’s Revenue
- Total revenue (TR) : A firm’s total earnings from a specified level of sales within a
specified period:
- TR = P x Q
- Average revenue (AR)
◦ Total revenue per unit of output.
◦ When all output is sold at the same price, average revenue will be same as price.
- AR = TR/Q
- Marginal revenue (MR)
◦ The extra revenue gained by selling one more unit per period of time
- MR = TR/Q
- The profit maximizing rule:
◦ Profit is at maximum when marginal revenue equals to marginal cost.
-MR = MC
-This is because:
◦ When MR > MC, additional revenue is greater than additional cost per unit of
additional quantity. Hence, firm’s should increase its production.
◦ When MC > MR, additional cost is greater than additional revenue per unit of
additional quantity. Hence, firm’s should decrease its production.

◦ Production Surplus: Is the difference between what producers are willing and able to
supply a good for and the price they actually receive.
-Maximization: Seller should go on selling additional units as long as they gain
additional producer surplus.
*In other word, as long as the price they received higher than price they willing to sell.

Chapter 6: Market Structure

◦ Market structure: A set of market characteristics such as number of firms, ease of
firm entry, and substitutability of goods.
◦ It is the particular environment of firm that would influence the firm’s pricing and output
decisions.
◦ Four (4) distinct market structure:
◦ Perfect competition ( Pure competition): A large number of firms, standardized
product, and easy entry (or exit) by new or existing firms.
- A theory of market structure based on 4 assumptions:
◦ Large number of buyers and seller
 There are many sellers (supply) and many buyers (demand).
 None of which is large in relation to total sales or purchases. – each buyer
and seller acts independently of others and has no influence on price.
◦ Homogenous product
  Each firm produces and sells a homogeneous product.
 Product from firm A’s and firm B’s are identical and cannot be
distinguish.

◦ Perfect information
 Buyers and sellers have all relevant information about prices, product
quality, sources of supply, and so forth. – they know everything that
relates to buying, producing and selling of product.

◦ No barrier of entry and exit

 Firms have easy entry and exit. – there are no barriers to entry and exit.

◦ Zero transaction cost

 Buyers and sellers do not incur costs in making an exchange of goods in a
perfectly competitive market.
◦ Rational buyers
 Buyers capable of making rational purchases based on information given.

◦ Perfect factor mobility

 In the long run factor of production are perfectly mobile, allowing free
long term adjustments to changing market conditions.
◦ Monopoly: One firm that is the sole seller of a product or services with no close
substitutes, entry is blocked for other firms.
◦ Monopolistic competition: Close to pure competition, except the product is
differentiated among sellers rather than standardized and there are fewer firms.
◦ Oligopoly: An industry in which only a few firm exist, so each is affected by the price-
output decisions of its rivals.
◦ Market Power: Is the ability of a firm to profitably raise the market price of a good or
service over marginal cost.
-Firms in perfect competition market have no market power. this is because of its
characteristic. As result, all firms in perfect competition market are price taker.
◦ Price Taker: Is a seller that does not have the ability to control the price of the product it
sells;it takes the price determined in the market.
- A firms is restrained from being anything but a price taker if :
*It finds itself one among many firms where its supply is small relative to the total
market supply.
* It sells a homogeneous product in an environment.
*Where buyers and sellers have all relevant information.
◦ Market demand curve and firm demand curve in perfect competition
 - When the equilibrium price has been established, a single perfectly competitive firm
faces a horizontal demand curve at the equilibrium price. In other word, demand
curve for firms in perfect competition is perfect elastic.
- Perfect elastic – change in price will result an infinite change in quantity.

◦ Marginal Revenue in Perfect Competition

- The firm’s marginal revenue (MR) is the change in total revenue that results from
selling one additional unit of output:
-MR = TR / Q
-For a Perfectly Competitive Firm: Marginal Revenue = Average Revenue (TR/Q) =
Equilibrium Price = Demand.
-The reason why MR=AR=DD=P in perfectly competition market is because all firms
sell at market equilibrium price.
◦ Theory and Real World Markets
- Perfect competition assumptions closely met in some industries:
◦ Wheat Market
◦ Stock Market
◦ Other markets approximate perfectly competitive behavior, because they have
negligible control over price.
- There is no pure perfect competition market in the economy.
- This is because:
◦ Perfect information
 Consumers and producers has no perfect knowledge on price, utility,
quality and production methods of products.
◦ Zero transaction cost
 There are always cost incurs in making exchange of goods in market as
there are limitation such as geographical, time and etc.
◦ Rational buyers
 Most of the time, buyers are irrational. They are influence by emotion
rather than rational mind.
◦ Perfect capital mobility
  Factors of production aren’t perfectly mobile. There is a cost incur in
mobilizing factors of production such as training, abolishment.
◦ Profit Maximzation
- Profit Maximization Rule:
◦ Produce the quantity of output at which:
- MR= MC
- The firm will continue to increase its quantity of output as long as marginal revenue is
greater than marginal cost.
- The firm will stop increasing its quantity of output when marginal revenue and marginal
cost are equal.
- For the perfectly competition firm, the profit-maximization rule is:
P = MR = MC = DD/P = MC
◦ Quantity of output that perfectly competitive firm will
produce: The firm’s demand curve is horizontal at the
equilibrium price. Its demand curve is its marginal revenue
curve. The firm produces that quantity of output at which
MR=MC or P=MC
- Resource allocative efficiency and production efficiency:
- Resource Allocative Efficiency
◦ A firm that produces the quantity of output at which:
Price = Marginal Cost
◦ Resources are allocated in the most efficient what to
produce the mix of product and services that is most wanted by society
(consumers).
◦ In other word, it’s achieved when market equilibrium occur where consumer and
producer surplus is maximize.
- Productive Efficiency A firm that produces its output at the lowest possible per
unit cost (minimum amount of resources will be used to produce any particular
output).
◦ P= minimum ATC (unit cost)
◦ To charge a price that is just consistent with the cost.
◦ A perfectly competition firm is resource allocative efficient (P = MR = MC) –
uses the limited amounts of resources available to society in a way that maximizes
the satisfaction of consumers.
◦ Productive efficiency alone doesn’t ensure the efficient allocation of resources.
Least – costs production must be used to provide society with the “right-good” –
the goods that consumers want most.
◦
- Profit maximization and Loss maximization for perfect competitive firm:
1) Case 1 – P > ATC > AVC
2) Case 2 – P < AVC < ATC
3) Case 3 – ATC > P > AVC
- How to Read Diagram?
- Determine the point at which MR=MC.
- Determine Pe and Qe.
- Calculate TR and TC to identify profit and loss.
- Make decision : a) Shut Down
b) Continue Operation
- A firm produces in the short run as long as price is above average variable cost (P>AVC).
( Case 1 & 3)
- A firm shuts down in the short run if price is less than average variable cost (P<AVC).
Example: In Case 2, if the firm produces in the short run, it will take a loss of RM450. If
it shuts down, its loss will be less. (Fixed costs = RM400)
- A firm produces in the short run as long as total revenue is greater than total variable
costs (TR > TVC). (Case 1 & 3)
- A firm shuts down in the short run if total revenue is less than total variable costs (TR <
TVC). If the firm shuts down, it only has to pay off fixed costs. If the firm continues to
produce, it will lose not only its fixed costs, but part of its variable costs as well. (Case 2)

- What should company do in short run?

A firm produces in the short run

- price > average variable cost (P > AVC)
- total revenue > total variable costs (TR >
TVC)
A firm shuts down in the short run
- price < average variable cost (P < AVC)
- total revenue < total variable costs (TR <
TVC)
- The perfectly competition firm produces
(supplies output) in the short-run if P > AVC (P=MR=MC).
- It shut down if P<AVC.
- Short-Run (Firm) Supply Curve:
- the portion of the firm’s marginal
cost curve that lies above the
average variable cost curve.
- Only a price above average
variable cost will induce the firm to
supply output.
- Why are the curves upwards sloping?
- Because the market supply is the horizontal “addition” of firms’ supply curves which
are upward sloping.
- Each firm’s supply curve is that portion of its marginal cost curve which lies above the
average variable cost curve.
- Marginal cost curves have an upward sloping portion because of the law of diminishing
marginal returns.
- Perfect Competition in the Long Run
 3 Conditions Characterize of Long-Run Equilibrium
1. Economic profit is zero (normal profit): Price (P) is equal to short-run average total cost
(SRATC).
◦ If P > SRATC : positive economic profits attract new firms to enter the industry.
◦ If P < SRATC : positive economic losses some firms will exit the industry.
◦ If P = SRATC : zero economic profit (normal profit) no incentive to enter or
exit the industry (LR equilibrium exists).
2. Firms are producing the quantity of output at which Price (P) is equal to Marginal Cost
(MC).
3. No firm has an incentive to change its plant size to produce its current output; that is,
SRATC=LRATC at the quantity of output at which P=MC.
 Long-run perfect competition equilibrium exists when:
◦ There is no incentive for firms to enter or exit the industry- normal profit to be
earned in the LR.
◦ There is no incentive for firms to produce more or less output:
P =MC
◦ There is no incentive for firms to change plant size:
min SRATC = min LRATC
◦ LR competitive equilibrium exists when:
P=MC= min SRATC = min LRATC
- Perfect Competition and Production Efficiency
- Productive Efficiency is the situation that exists when a firm produces its output at the
lowest possible per unit cost (lowest ATC).
- The perfectly competitive firm is productively efficient in Long-Run Equilibrium.
- When firms enter an industry for profits:
- New firms bring down the prices for consumers; the market can affect price and profits.
- The potential benefits that existing firms can enjoy if they can successfully limit entry
into the industry.
- But in perfectly competition, firms are freely enter of exit the market.
- Thus, new firms enter the market will bring down the price (shifting the market supply
curve to right).
- As result, existing firms are suffering losses.
- Because of economic losses, some firms will leave the industry.
- Market Supply shifts leftward.
- Equilibrium price rises.
- Firms will continue to leave, causing price to rise, until economic profits are zero.

- Monopoly
- Characteristic of monopoly:
◦ There is one seller
 Firm in monopoly is a sole seller in the market
◦ Produce and sell unique product
 The single seller sells a product for which there is no close substitute
◦ There are extremely high barriers to entry
- 3 types of barriers to entry:
- Legal barriers: Public Franchise, Patents, Government Licenses
- Economies of scale: Natural monopoly : the condition where economies of
scale are so pronounced in an industry that only one firm can survive
- Exclusive ownership of a necessary resources
◦ Market power: Firm in monopoly has market power. Hence, they are able to set
the price more than marginal cost (P>MC).
◦ Example: Public Utilities (Electricity, Water and Gas)
◦ Government Monopoly: monopolies that are legally protected from competition
in form of public franchises, patents
- Example: TNB, Syabas
◦ Market Monopoly: monopolies that are not legally protected from competition.
( through EOS or exclusive ownership of a resources
- Example: DeBeers
- Monopolist Demand and Marginal Revenue:
*In the theory of monopoly, a monopoly firm is the industry and the industry is the
monopoly firm
*Since the monopolist is the sole supplier in its market, the monopoly firm faces the
(downward-sloping) market demand curve
 *The monopoly has the market power to control the price
*Unlike the perfectly competitive firm, the monopolist can raise its price and still sell its
product (though not as much)
*If the monopolist wants to sell additional output, it must lower price in order to do so. If
the monopolist wants to charge a higher price, it will do so at the expense of a reduction
in quantity sold
- A single monopoly firm faces a inelastic demand curve
- Because, he is the sole producer and no close
substitution for its product
- inelastic – change in quantity is smaller than a
change in price

◦ The firm’s marginal revenue (MR) is the change

in total revenue that results from selling one
additional unit of output
- MR = TR / Q
- For a Monopoly Firm: Marginal Revenue is
different than demand curve as the firm have
market power
- The monopolist’s demand curve lies above its
marginal revenue curve
- Profit Maximization:
◦ Profit Maximization Rule:
◦ Produce the quantity of output at which
- MR= MC
◦ To maximize profit – monopolist charge the highest price per unit at which this quantity
of output can be sold
- P > MC
◦ Monopolist is not resources allocative efficient because it charge price more than
marginal cost
- P> MC
- If a firm maximizes revenue, does It automatically maximize profit too? The price that
maximizes total revenue is not necessarily the price that maximizes profit. Maximizing
profit is not consistent with maximizing revenue when variable cost exist. Maximizing
revenues is the same as maximizing profits only when a firm has no variable costs
- Example:
◦ Suppose TR = RM100, TFC = RM40 and TVC = RM20
◦ Because TC = TFC + TVC = RM(40 + 20) = RM60
◦ The firm’s profit = TR – TC = RM(100-60) = RM40
◦ Suppose the firm can sell one more unit of a good: TR and TVC rises to RM105 and
RM30 respectively
◦ TC = TFC + TVC TC = RM70
◦ The firm’s new profit = TR – TC = RM(105-70) = RM35
◦ Selling one more unit of the good raises TR from RM100 to RM105, but it lowers profit
form RM40 to RM35. A firm seeks to maximize profit, not TR
◦ Maximizing revenue = maximizing profit only if TC is constant (TC = TFC and TVC =
0)

- Price discrimination: Is the practice of charging different buyers different prices for
essentially the same good or service even though the cost is the same
- There are 3 types of price discrimination:
- Perfect Price Discrimination (first degree)
◦ This is also called as discrimination among units
◦ Seller charges the highest price each consumer would be willing to pay for the
product
◦ Often happen in professional sector (e.g engineering, medical and lawyer service)
 - Second Degree Discrimination
◦ Called discrimination among quantity
◦ Seller charges a uniform price per unit for one specific quantity, a lower price for
an additional quantity, and so on
- Third Degree Discrimination
◦ Called discrimination among buyers
◦ Seller charges a different price in different markets or charges a different price to
different segments of the buying population
- To price discrimination, the following conditions must hold:
◦ The seller must exercise some control over price; it must be a price
searcher/maker
◦ The seller must be able to distinguish among buyers who would be willing to pay
different prices
◦ It must be impossible or too costly for one buyer to resell the good at other
buyers. The possibility of arbitrage, or “buying low and selling high” must not
exist
- The perfectly price-discriminating monopolist tries to get the highest price for each
customer, irrespective of what other customers pay. For the monopolist who practices
perfect price discrimination, price equals marginal revenueBecause he know exactly what
is the reservation price that consumer willing to pay on certain quantityBecause each unit
is sold at its maximum reservation price, P = MR. The demand curve is thus identical to
MRThe perfectly price discriminating monopolist and the perfectly competitive firm both
exhibit resource allocative efficiency (producing at quantity where P = MC)

- Difference between perfect competition and monopoly

1. Price, MR and MC
- For the perfectly competitive firm, P=MR;
- For the monopolist, P>MR
- The perfectly competitive firm’s demand curve is its marginal revenue curve,
DD=MR
- The monopolist’s demand curve lies above its marginal revenue curve. DD>MR
- The perfectly competitive firm charges a price equal to marginal cost, P=MC
- The monopolist charges a price greater than marginal cost, P>MC
- Because monopoly charge P>MC and perfect competition charge P=MC; hence,
- Monopoly is not allocative efficient/ output produce is not social optimum
- Perfect competition is allocative efficient/ output produce is social optimum
2. Productive efficiency
- To achieve productive efficiency, firm needs to produce its output at the lowest
possible average total cost (ATC) or minimum ATC
- Perfect competition produce output at P=min ATC in long run
- Monopoly produce output at P>min ATC
- Therefore, firm in perfect competition achieve productive efficiency while monopoly
do not achieve productive efficiency
- Characteristics of Monopolistic Competition:
o There are many sellers and buyers
 There are many sellers and buyers in the market but lesser than perfect
competition market.
o Differentiated product
 Each firm in the industry produces and sells a slightly differentiated
product (due to brand names, packaging, location, advertising, service,
etc).
o There is easy entry and exit
 There are no barriers to entry and exit in the market because the capital
required to enter the market is low and no legal restriction from the
government.
o Market power
 Firm in monopolistic competition has some market power due to
differentiated product. Hence, they are able to set the price more than
marginal cost (P>MC).
- Nature of Monopolistic Competition:
- Monopolistic Competition Demand Curve:
◦ There are substitutes for a firm’s product, but not perfect substitutes
◦ Demand curve is downward sloping, unlike perfect competition where it is
horizontal
◦ The demand curve facing the monopolistic competitive firm is more elastic than
the demand curve facing the monopoly seller
◦ Just like monopoly, monopolistic demand curve located above MR
- The relationship between Price and MR
◦ The monopolistic competition faces a downward sloping demand curve – it has to
lower price to sell an additional unit of the good it produces (price
searcher/maker)
◦ Because each firm in the monopolistically competitive market sells a slightly
differentiated product, each producer has some control over the price of its good
◦ In the monopolistic competition,
P>MR
- Output, Price and Marginal Cost
- Profit Maximization Rule:
◦ Produce the quantity of output at which
◦ MR= MC
◦ To maximize profit – monopolistic competition charge the highest price per unit at which
this quantity of output can be sold
◦ P > MR
◦ It must produce a level of output at which
◦ P>MC
◦ It is not resources allocative efficient

- Long Run Profits:

◦ If economic profits are being earned, new firms will enter the industry. This reduce the
demand that each firm faces (DD curve shift to left)
◦ If economic losses are being incurred, firms will leave the industry
◦ Economic profits will equal zero in the long run at P=ATC

- Excess capacity theorem:

 ◦ a monopolistic competitor in equilibrium will produce an output smaller than the
one that would minimize its unit costs of production
◦ In long-run equilibrium, when the monopolistic competitor earns zero economic
profits, it is not producing the quantity of output at which average total costs (unit
costs) are minimized for the given scale of plant
◦ Contrary, in long-run equilibrium, the perfectly competitive firm produces the
quantity of output at which unit costs are minimized
- Oligopoly
- Characteristic of oligopoly:
◦ There are few large firms and many buyers
 These firms are considered to be interdependent, meaning that each is
aware that its actions will influence the other firms in the market and that
the actions of those other firms will affect it.
◦ Firms produce and sell either homogeneous or differentiated products
 Firms in oligopoly will either sell homogeneous product such as petrol or
differentiated product such as cars.
◦ There are significant barriers to entry
 Economies of scale are likely to be the most important barrier, and legal
barriers may exist and/or existing firms may control vital inputs.
◦ Market power
 Firm in oligopoly has market power. Hence, they are able to set the price
more than marginal cost (P>MC).

Chapter 7: Market Failure

◦ Market failure: Are imperfections in the exchange process between buyers and sellers
that prevent markets from efficiently allocating scare resources.
◦ Causes of market failure: It means that the price in the market do not fully reflect the
value of production.
*Supply price and demand price are not equal.
◦ It comes in four varieties
*Externalities
*Public goods
*Market control
 *Imperfect information
◦ Externalities: An externalities is the cost or benefit that affects a party who did not
choose to incur that cost or benefit.
◦ Two types of externalities
*Positive externalities; Is a benefit that is enjoyed by a third-party as a result of an
economic transaction/ activity. (leaves positive impact on third party)
- Social benefits
◦ Social benefit = Private benefit + External benefit
◦ With positive externalities the benefits to society is greater than your personal
benefit.
◦ Therefore, with a positive externality, marginal social benefits is greater than
marginal private benefits (MSB > MPB).
◦ In free market consumption will be at Q1
because demand = supply (private
benefit=private cost).
◦ However, this is socially inefficient because
social benefit > private benefit. Therefore there
is under consumption of the positive
externality.
◦ Social efficiency would occur at Q2 where
social cost=social benefits
◦ If goods or services have positive externalities, then we will get market failure.
This is because individuals fail to take into account the benefit to other people.To
achieve a more socially efficient outcome, the government could try subsidies the
good with positive externalities. This will encourage consumers to consume more
good with positive externality.
◦ Positive production externalities: Is the benefit gain by third parties/ bystander as
results of production
- Since production involve cost, hence, when producing goods with positive
production externalities, the cost in social perspective is lower as compare to
private perspective
- Thus, MSC will be lower than MPC,As result, market under produce goods with
positive production externalities.
- In free market consumption will be at Q1
because demand = supply (private
benefit=private cost). However, this is socially
inefficient because social cost < private cost.
Therefore there is under production of the
positive externality. Social efficiency would
occur at Qso where social cost=social benefit.
 ◦ Positive consumption externalities: Is the benefit gain by third parties/ bystander
as results of consumption
- Since consumption involve benefit, hence, when consuming goods with
positive consumption externalities, the benefit in social perspective is higher as
compare to private perspective
-Thus, MSB will be higher than MPB
-As result, market under consuming goods with positive consumption
externalities.
- In free market consumption will be at Q1
because demand = supply (private
benefit=private cost).
-However, this is socially inefficient because
social benefit > private benefit. Therefore
there is under consumption of the positive
externality.
-Social efficiency would occur at Qso where
social cost=social benefit.
*Negative externalities: Is a cost that is suffered by a third-party as a result of an
economic transaction/ activity. (leaves negative impact on third party)
- Social cost
◦ Social cost = Private cost + External cost
◦ With negative externalities the cost to society is greater than your private cost.
◦ Therefore, with a negative externality, marginal social cost is greater than
marginal private cost (MSC > MPC).
- In free market people ignore the external costs to
others, output will be at Q1 because demand = supply.
- However, this is socially inefficient because social
cost > social benefit. Therefore there is over
consumption of the negative externality.
- Social efficiency would occur at Q2 where social
cost=social benefit.
◦ Implications
- If goods or services have negative externalities, then we will get market failure. This is
because individuals fail to take into account the costs to other people.To achieve a more
socially efficient outcome, the government could try tax the good with negative
externalities. This means that consumers pay the full social cost.
◦ Negative production externalities: Is the cost imposed to third parties/ bystander as results
of production
-Since production involve cost, hence, when producing goods with negative production
externalities, the cost in social perspective is higher as compare to private perspective
 -Thus, MSC will be higher than MPC
-As result, market over produce goods with negative production externalities.
- In free market people ignore the external costs to
others, output will be at Q1 because demand = supply.

- However, this is socially inefficient because social

cost > social benefit. Therefore there is over produce
of the negative externality.

- Social efficiency would occur at Qso where social

cost=social benefit

◦ Negative consumption externalities: Is the cost imposed to third parties/ bystander as

results of consumption
- Since consumption involve benefit, hence, when consuming goods with negative
consumption externalities, the benefit in social perspective is lower as compare to private
perspective
-Thus, MSB will be lower than MPB
-As result, market over consuming goods with negative consumption externalities
-In free market consumption will be at Q1 because
demand = supply (private benefit=private cost).
-However, this is socially inefficient because social
benefit < private benefit. Therefore there is over
consumption of the negative externality.
-Social efficiency would occur at Qso where social
cost=social benefit.
◦ every activity has benefits/costs that work on two
level:
-Private
*The total benefits/costs incurred by the individual producing or consuming the product
or service directly.
-External
*The total benefits/costs associated with any activity incurred by a third party.
◦ External solution: Several option can be taken by government to overcome the problem
of externalities.
Three option:
-Law and regulation
-Tax: Taxes on negative externalities are intended to
make consumers/producers pay the full social cost of
the good. This reduces consumption and creates a more
socially efficient outcome.
- Without a tax, there will be overproduction (Q1
where D=S) because people ignore the external costs.
 -After tax, supply curve shift to the right and new equilibrium achieved where social
cost=social benefit.

-Subsidy
- Subsidies involves the government paying part of the cost to the firm.
This reduces the price of the good and should encourage more consumption.
- A subsidy shifts the supply curve to the right.
- Subsidy = P2 –P3
- The supply curve shifts to SS2 and price falls from P1 to
P3
- People will now consume more, the quantity increases
from Q1 to Q2.
- Q2 = Social Efficiency: because MSC = MSB

◦ Public and Private Goods

◦ Public goods
- Are goods that characterized by non-rival consumption and inability to exclude non-tax
payer from receiving benefits.
- free rider problem.
- This means that it is not possible to prevent anyone from enjoying a good once it has
been provided.
- Therefore there is no incentive for people to pay for the good because they can consume
it without paying for it.
- However this will lead to there being no good being provided.
- Therefore there will be social inefficiency.
- Therefore there will be a need for the government to provide it directly out of general
taxation.
◦ Private goods
- A product that must be purchased in order to be consumed, and whose consumption by
one individual prevents another individual from consuming it.
- Good that characterized by rivalrous and excludable.