econ 1021 final Flashcards
1
Q
Perfect competition
A
Many firms sell identical products to many buyers
There are no restrictions on entry into the market
Established firms have no advantage over new ones
Sellers and buyers are well informed about price
2
Q
Minimum efficient scale
A
Smallest output at which the LRAC curve reaches its lowest level.
3
Q
Perfect competition arises
A
if the minimum efficient scale of a single producer is small relative to the market demand for the good or service.
In perfect competition, each firm produces a good that has no unique characteristics, so consumers don’t care which firm’s goods they
3
Q
Price taker
A
A firm that cannot influence the market price because its production is an insignificant part of the total market.
Firms in perfect competition are price takers
4
Q
A firm’s goal is to maximize economic profit.
A
Economic profit = TR – TC
Total cost is the opportunity cost of production, which includes normal profit.
Total revenue: Price X Quantity
Marginal revenue: Change in total revenue that results from a one-unit increase in the quantity sold.
In perfect competition, the firm’s marginal revenue equals the market price.
4
Q
To achieve maximum economic profit, a firm must decide:
A
How to produce at minimum cost
What quantity to produce
Whether to enter or exit a market
5
Q
A way to find the maximum economic profit
A
is to compare the differences between the TR and TC curves. The locations where TR is greater than TC and the point with the greatest separation, will give you the areas where economic profit is positive and the location at which it is maximized.
Another way to find the profit-maximizing output is to use marginal analysis, which compares MR with MC.
6
Q
Economic profit is maximized when MR = MC.
A
Economic loss = TFC + (AVC – P) x Q
7
Q
Marginal Analysis and Supply Decision
A
The firm can use marginal analysis to determine the profit-maximizing output.
Because marginal revenue is constant and marginal cost eventually increases as output increases, profit is maximized by producing the output at which marginal revenue, MR, equals marginal cost, MC.
8
Q
A
9
Q
The Firm’s Output Decision
A
If MR > MC, economic profit increases if output increases.
If MR < MC, economic profit decreases if output increases.
If MR = MC, economic profit decreases if output changes in either direction, so economic profit is maximized.
10
Q
Temporary Shutdown Decision
A
If the firm makes an economic loss, it must decide whether to exit the market or to stay in the market.
If the firm decides to stay in the market, it must decide whether to produce something or to shut down temporarily.
The decision will be the one that minimizes the firm’s loss.
11
Q
If the firm produces, then in addition to its fixed costs, it incurs variable costs, but it also receives revenue.
A
Economic loss if operating: (TFC + TVC) – TR
If total variable cost exceeds total revenue, then loss exceeds total fixed cost and the firm shuts down
If average variable cost exceeds the price, this loss exceeds total fixed cost and the firm shuts down
12
Q
Loss Comparisons
A
The firm’s loss equals total fixed cost (TFC) plus total variable cost (TVC) minus total revenue (TR).
Economic loss = TFC + TVC TR
= TFC + (AVC P) x Q
If the firm shuts down, Q is 0 and the firm still has to pay its TFC.
So the firm incurs an economic loss equal to TFC.
This economic loss is the largest that the firm must bear.
13
Q
Shutdown point:
A
The price and quantity at which a firm is indifferent to shutting down.
Shutdown point occurs at the price and the quantity at which average variable cost is at its minimum
At the shutdown point, the firm is minimizing its loss and its loss equals total fixed cost
At prices above the minimum average variable cost but below average total cost, the firm produces the loss-minimizing output and incurs a loss, but a loss that is less than total fixed cost
14
Q
A firm’s supply curve can be derived
A
from their marginal cost curve and average variable cost curves.
The firm produces zero output at all prices below minimum average variable cost.
15
Q
A
16
Q
Short-run market supply curve
A
Shows the quantity supplied by all the firms in the market at each price when each firm’s plant and number of firms remain the same.
At the shutdown point, the economic loss incurred is equal to the total fixed cost because firms are not able to cover that cost.
16
Q
Economic profit or loss in the short-run =
A
(P – ATC) x Q
If price equals average total cost, then a firm breaks even – the entrepreneur makes a normal profit.
If price exceeds average total cost, then a firm makes an economic profit.
If price is less than average total cost, a firm incurs an economic loss.
17
Q
In the long-run, firms can enter or exit the market
A
Firms respond to economic profit and economic loss by either entering or exiting the market
Temporary economic profit or loss does not trigger an entry or exit
Consistent economic profit or loss triggers an entry or exit
18
Q
A Change in Demand
A
An increase in demand brings a rightward shift of the market demand curve: The price rises and the quantity increases.
A decrease in demand brings a leftward shift of the market demand curve: The price falls and the quantity decreases.
19
Q
Profits and Losses in the Short Run
A
Maximum profit is not always a positive economic profit.
To see if a firm is making a profit or incurring a loss compare the firm’s ATC at the profit-maximizing output with the market price.
20
Q
If firms enter/exit the market
A
If firms enter the market, then supply increases and the market supply curve shifts rightward. The increase in supply lowers the market price and eventually eliminates economic profit. When economic profit reaches zero, entry stops.
If firms exit the market, then supply decreases and the supply curve shifts leftward. The market price rises and economic loss decreases. Eventually this loss is eliminated and exit stops.
21
Q
Entry/Exit
A
Entry results in an increase in market output, but each firm’s output decreases. Because the price falls, each firm moves down its supply curve and produces less.
Exit results in a decrease in economic output, but each firm’s output increases. Because the price rises, each firm moves up its supply curve and produces more.
22
Efficient Use of Resources
Resources are used efficiently when no one can be made better off without making someone else worse off.
This situation arises when marginal social benefit equals marginal social cost.
23
Choices
The demand curve reflects how consumers allocate their budget as the price of a good changes, seeking the best value. Similarly, the supply curve of a competitive firm indicates how they maximize profit by adjusting quantity based on price fluctuations. When only consumers benefit from a good, the market demand curve aligns with the marginal social benefit curve. Conversely, if firms bear all production costs, the market supply curve corresponds to the marginal social cost curve.
24
Equilibrium and Efficiency
In competitive equilibrium, resources are efficiently utilized, with demand meeting supply, aligning marginal social benefit with marginal social cost. Consumer surplus quantifies the benefit consumers gain from trade.
25
Monopoly
A market with a single firm that produces a good or service with no close substitutes and that is protected by a barrier that prevents other firms from entering that market.
Monopoly arises for two key reasons
No close substitutes
Barriers to entry
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No Close Substitutes
If a good has a close substitute, even if it is produced by only one firm, that firm effectively faces competition from the producers of the substitute.
A monopoly sells a good that has no close substitutes
27
Barrier to entry: Constraint that protects a firm from potential competitors. Three types of barriers to entry
Natural – Creates a natural monopoly – a market in which economies of scale enable one firm to supply the entire market at the lowest possible cost. (firms that supply gas, water, electricity are examples)
Ownership – Occurs when one firm owns a significant portion of the one resource
Legal – Creates a legal monopoly – A market in which competition and entry are restricted by the granting of a public franchise, government license, patent, or copyright
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Barriers
Public franchise: Exclusive right granted to a firm to provide a good or service.
Ex. Canada Post
Government license: Controls entry into particular occupations, professions, and industries.
Ex. Medicine and other professional services
Patent: Exclusive right granted to the inventor of a product or service.
Copyright: Exclusive right granted to the author or composer of literary, musical, dramatic, or artistic work.
29
Two pricing strategies used in a monopoly
Single price – Firm must sell each unit of its output at the same price for all consumers.
Price discrimination – Selling different units of one good or service for different prices.
30
The demand curve for a firm in a monopoly
is also the market demand curve because they are the only firm.
The marginal revenue curve for a firm in a monopoly lies below the demand curve. Marginal revenue is also less than the price the firm charges.
If demand is elastic, marginal revenue is positive because a decrease in the price will lead to a greater increase in revenue because of the lack of decrease in the quantity demanded.
If the demand is inelastic, then the marginal revenue is negative because a decrease in the price will lead to a greater decrease in marginal revenue because of the large decrease in the quantity demanded.
Profit-maximizing monopoly never produces an output in the inelastic range of the market demand curve.
31
Monopolies maximize profit
Monopolies maximize profit by setting prices and outputs. Initially, profit rises, peaks, then declines. When MR exceeds MC, increasing output boosts profit; when MC surpasses MR, reducing output does the same. Profit peaks when MC equals MR. Monopolies sell the profit-maximizing quantity, not at the highest price. Prices in monopolies exceed both MR and MC. Barriers to entry sustain economic profit for monopolies. While demand remains consistent, supply and equilibrium differ from perfect competition. Monopolies produce less and charge higher prices compared to perfect competition.
32
Price and Marginal Revenue
A monopoly is a price setter, not a price taker like a firm in perfect competition.
The reason is that the demand for the monopoly’s output is the market demand.
To sell a larger output, a monopoly must set a lower price.
32
A Single-Price Monopoly’s Output and Price Decision
Total revenue, TR, is the price, P, multiplied by the quantity sold, Q.
Marginal revenue, MR, is the change in total revenue that results from a one-unit increase in the quantity sold.
For a single-price monopoly, marginal revenue is less than price at each level of output. That is, MR < P.
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At a competitive equilibrium
Marginal social benefit equals marginal social cost
Total surplus is maximized
Firms produce at the lowest possible long-run average cost
Resource use is efficient
34
Marginal Revenue and Elasticity
In a single-price monopoly, marginal revenue (MR) relates to demand elasticity. If demand is elastic, lowering prices increases total revenue as the increase in quantity sold compensates for the lower price per unit, resulting in positive MR. Conversely, if demand is inelastic, lowering prices decreases total revenue due to the higher decrease in revenue from the lower price per unit, resulting in negative MR. With unit elastic demand, lowering prices doesn't alter total revenue, making MR equal to zero. Total revenue is maximized when MR equals zero.
35
Price and Output Decision
The monopoly faces the same types of technology constraints as the competitive firm, but the monopoly faces a different market constraint.
The monopoly produces the profit-maximizing quantity, where MR = MC.
The monopoly sets its price at the highest level at which it can sell the profit-maximizing quantity.
36
The monopoly might make an economic profit
The monopoly might make an economic profit, even in the long run, because barriers to entry protect the firm from market entry by competitor firms.
But a monopoly that incurs an economic loss might shut down temporarily in the short run or exit the market in the long run.
37
Perfect Competition
Monopoly
Perfect Competition
Equilibrium occurs where the quantity demanded equals the quantity supplied at quantity QC and price PC.
Monopoly
Equilibrium output, QM, occurs where marginal revenue equals marginal cost, MR = MC.
Equilibrium price, PM, occurs on the demand curve at the profit-maximizing quantity.
Compared to perfect competition, monopoly produces a smaller output and charges a higher price.
38
Consumers lose in two ways because of a monopoly:
Consumers lose by having to pay more for the good (reduction of consumer surplus and gain to producer surplus)
Consumers lose by getting less of the good (Loss is a part of the deadweight loss)
A deadweight loss is created in a monopoly.
Monopolies lose some producer surplus because of the reduced output.
Monopolies do not produce at the lowest possible long-run average cost because it produces a smaller amount than perfect competition and faces no competition.
39
Monopoly damages the consumer interest in three ways:
Produces less
Increases the cost of production
Raises the price by more than the increased cost of production
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economic rent
Any surplus—consumer surplus, producer surplus, or economic profit
41
Rent seeking
is the pursuit of wealth by capturing economic rent.
Rent seekers pursue their goals in two main ways:
Buy a monopoly—transfers rent to creator of monopoly.
Create a monopoly—uses resources in political activity.
42
Rent-Seeking Equilibrium
The blue area shows the potential producer surplus with no rent seeking.
The resources used in rent seeking can wipe out the monopoly’s producer surplus.
Rent-seeking costs shifts the ATC curve upward,
Producer surplus disappears.
The deadweight loss increases to the larger gray area.
43
Theories
Social interest theory: Political and regulatory processes relentlessly seek out inefficiency and introduce regulation that eliminates deadweight loss and allocates resources efficiently.
Capture theory: Regulation serves the self-interest of the producer, who captures the regulator and maximizes economic profit.
44
Regulation/Deregulation
Regulation: Rules administered by a government agency to influence prices, quantities, entry, and other aspects of economic activity in a firm or industry.
A possible solution to the dilemma presented by a natural monopoly but not a guaranteed solution
Deregulation: Process of removing regulation of prices, quantities, entry, and other aspects of economic activity in a firm or industry.
45
Marginal cost pricing rule
Where governments regulate monopolies to have their prices equal the marginal cost.
This creates a problem because at the efficient output, average total cost exceeds marginal cost, so a firm that uses marginal cost pricing incurs an economic loss
46
Two ways to regulate a natural monopoly without incurring an economic loss
Average cost pricing – Sets the price equal to the average total cost (firm produces where the average total cost curve intersects the demand curve)
This results in the firm making zero economic profit (breaking even)
Deadweight loss arises because average total cost exceeds marginal
Government subsidy – Direct payment to a firm equal to its economic loss
47
The answer to average cost pricing vs. marginal cost pricing
with a government subsidy depends on the relative magnitudes of the two deadweight losses.
Average cost pricing is preferred to a subsidy
48
Price Discrimination
Price discrimination is the practice of selling different units of a good or service for different prices.
To be able to price discriminate, a monopoly must:
Identify and separate different buyer types.
Sell a product that cannot be resold.
Price differences that arise from cost differences are not price discrimination.
49
Regulations use one of two practices to implement average cost pricing
Rate of return regulation: A firm must justify its price by showing that its return on capital doesn’t exceed a specified target rate.
This can end up serving the self-interest of the firm rather than the social interest because firms can just inflate their costs
Price cap regulation: A price ceiling – a rule that specifies the highest price a firm is allowed to set.
This lowers the price and increases the output
In practice, the regulator might set the cap too high so earnings sharing regulation is also implemented, where firms are required to make refunds to customers when prices are above a target level
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Two Ways of Price Discriminating
A monopoly can discriminate
Among groups of buyers. (Advance purchase and other restrictions on airline tickets are an example.)
Among units of a good. (Quantity discounts are an example. But quantity discounts that reflect lower costs at higher volumes are not price discrimination.)
50
Increasing Profit and Producer Surplus
By price discriminating, a monopoly captures consumer surplus and converts it into producer surplus.
More producer surplus means more economic profit. Why?
Economic profit = Total revenue – Total cost
Producer surplus is total revenue minus the area under the marginal cost curve, which is total variable cost.
Producer surplus = Total revenue – Total variable cost
Economic profit = Producer surplus – Total fixed cost
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Perfect price discrimination
occurs if a firm is able to sell each unit of output for the highest price someone is willing to pay.
Marginal revenue now equals the price, so …
the demand curve is also the marginal revenue curve
51
Second-Best Regulation of a Natural Monopoly
Another alternative is to permit the firm to produce the quantity at which price equals average cost, …
and to set the price equal to average cost—the average cost pricing rule.
The outcome is inefficient but the deadweight loss is smaller.
Another alternative is marginal cost pricing with a government subsidy equal to the monopoly’s loss.
52
Efficiency and Rent Seeking with Price Discrimination
The more perfectly a monopoly can price discriminate, the closer its output is to the competitive output (P = MC) and the more efficient is the outcome.
But this outcome differs from the outcome of perfect competition in two ways:
The monopoly captures the entire consumer surplus.
The increase in economic profit attracts even more rent-seeking activity that leads to inefficiency.
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Monopolistic Competition
Markets that are competitive but not perfectly competitive, firms have some power to set their prices as monopolies do.
Monopolistic competition is a market structure in which:
A large number of firms compete
Each firm produces a different product
Firms compete on product quantity, price, and marketing
Firms are free to enter and exit the industry
54
Implications of a large amount of firms in monopolistic competition
Small market share – Each firm has limited power to influence the price of its product because they supply a small part of total industry output. Thus, price can only deviate from the average by a small amount.
Ignore other firms – The firm does not pay attention to any single competitor because of their small market share. The actions of one firm do not directly impact the actions of another firm because no single firm can determine market conditions.
Collusion impossible – Though firms in monopolistic competition would like to fix a higher price, this is impossible because the size of the market makes coordination very difficult.
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Product differentiation
If a firm makes a product slightly different from the products of competing firms.
Close substitute but not perfect substitute of the products of other competing firms
When the price of this product rises, the demand will decrease but not necessarily go to zero
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Product differentiation enables a firm to compete with other firms in three main areas
Product quality – Quality includes design, reliability, the service provided to the buyer, and the buyer’s ease of access to the product. Runs on a spectrum from high to low.
Price – Firm faces a downward-sloping demand curve so they can set both its price and output.
Marketing – Because of product differentiation a firm in monopolistic competition must market its product.
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Two main forms of marketing: Advertising and packaging
Monopolistic competition has no barriers to prevent new firms from entering the industry in the long run. Thus, a firm in monopolistic competition cannot make an economic profit in the long run.
In long run equilibrium, firms neither enter nor exit the industry and the firms make zero economic profit.
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Large Number of Firms
The large number of firms in the market implies that:
Each firm has a small market share and so limited market power to influence the price of its product.
Each firm is sensitive to the average market price but pays no attention to the actions of others. So no one firm’s actions directly affect the actions of others.
Collusion or conspiring to fix prices is impossible.
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Key factors to identify monopolistic competition
Number of firms in the market
Share of the market served by the largest firms
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Two main measures of market concentration
The four-firm concentration ratio
The Herfindahl-Hirschman Index
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The four-firm concentration ratio
The four-firm concentration ratio – The percentage of the total revenue accounted for by the four largest firms in the industry
Ranges from almost 0 percent for perfect competition to 100 percent for monopoly
Low concentration indicates a high degree of competition – high concentration indicates an absence of competition
A ratio that exceeds 60 percent is regarded as an indication of a market that is highly concentrated and dominated by a few firms
One less than 60 percent is regarded as a competitive market
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The Herfindahl-Hirschman Index
The Herfindahl-Hirschman Index – The square of the percentage market share of each firm summed over the largest 50 firms (or summed over all of the firms if there are less than 50 in a market)
For perfect competition the HHI is small (sometimes below 1) – for a monopoly, the HHI is 10,000
A market where the HHI is between 1,500 and 2,500 is regarded as competitive. These markets are considered to be examples of monopolistic competition
A market where the HHI is above 2,500, it is considered to be concentrated and uncompetitive
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Oligopoly
A market with a high concentration ratio and high HHI.
is like monopolistic competition in that it lies between perfect competition and monopoly.
Firms might produce an identical product and compete only on price
Firms might produce a differentiated product and compete on price, product, quality, and marketing
Oligopoly is a market structure in which:
Natural or legal barriers prevent entry of new firms
A small number of firms compete
64
Three limitations of using only market concentration measures as determinants of market structure are their failure to take proper account of
The geographical scope of the market – Concentration measures take a national view of the market while some goods are sold in a regional or global market – this can skew concentration numbers
Barriers to entry and firm turnover – Some markets are highly concentrated, but entry is easy and firm turnover is large. Others with few firms might be competitive because of potential entry
Market and industry correspondence – Statistics Canada classifies each firm as being in a particular industry, but markets do not always correspond closely to industries for two main reasons:
Markets are often narrower than industries – Some firms in smaller markets can be monopolies even though they seem competitive in an overall industry calculation
Most firms make several products and these products can
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The Firm’s Short-Run Output and Price Decision
A firm that has decided the quality of its product and its marketing program produces the profit-maximizing quantity (the quantity at which MR = MC).
Price is determined from the demand for the firm’s product and is the highest price that the firm can charge for the profit-maximizing quantity.
The firm in monopolistic competition operates like a single-price monopoly.
The firm produces the quantity at which MR equals MC and sells that quantity for the highest possible price.
It makes an economic profit (as in this example) when P > ATC.
66
Profit Maximizing Might Be Loss Minimizing
A firm might incur an economic loss in the short run.
Here is an example.
At the profit-maximizing quantity, P < ATC and the firm incurs an economic loss.
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Long Run: Zero Economic Profit
In the long run, economic profit induces entry.
And entry continues as long as firms in the industry earn an economic profit—as long as (P > ATC).
In the long run, a firm in monopolistic competition maximizes its profit by producing the quantity at MR = MC.
As firms enter the industry, each existing firm loses some of its market share.
The demand for its product decreases.
The decrease in demand decreases the quantity at which MR = MC and lowers the maximum price that the firm can charge to sell this quantity.
As new firms enter, the firm's price and quantity fall until P = ATC and each firm earns zero economic profit.
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Differences between perfect and monopolistic competition
Excess capacity – This occurs if a firm produces less than its efficient scale. ATC is at a low only in perfect competition – In monopolistic competition there is an excess capacity.
Monopolistic competition firms could then sell more by cutting their prices, but they would then incur economic losses
Markups occur in monopolistic competition
The markup that drives a gap between price and marginal cost in monopolistic competition arises from product differentiation.
Demand is not perfectly elastic because of the variety of products that a monopolistic competition offers
69
Making the Relevant Comparison
The markup (price minus marginal cost) arises from product differentiation.
People value product variety, but product variety is costly.
The efficient degree of product variety is the one for which the marginal social benefit from product variety equals its marginal social cost.
The loss that arises excess capacity is offset by the gain that arises from having a greater degree of product variety.
69
Product Development
To keep making an economic profit, a firm in monopolistic competition must be in a state of continuous product development.
New product development allows a firm to gain a competitive edge, if only temporarily, before competitors imitate the innovation.
Firms pursue product development until the marginal revenue from innovation equals the marginal cost of innovation.
The amount of production development is efficient if the marginal social benefit from an innovation (which is the amount the consumer is willing to pay for the innovation) equals the marginal social cost that firms incur to make the innovation.
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Is Monopolistic Competition Efficient
Price equals marginal social benefit.
The firm’s marginal cost equals marginal social cost.
Because price exceeds marginal cost, marginal social benefit exceeds marginal social cost, so ...
in the long run, the firm in monopolistic competition produces less than the efficient quantity.
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Advertising
A firm with a differentiated product needs to ensure that customers know that its product differs from its competitors.
Firms use advertising and packaging to achieve this goal.
A large proportion of the price we pay for a good covers the cost of selling it.
Advertising expenditures affect the firm’s profit in two ways: They increase costs, and they change demand.
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Selling Costs and Total Costs
Selling costs, such as advertising expenditures, fancy retail buildings, etc. are fixed costs.
Average fixed costs decreases as output increases, so selling costs increase average total cost at any given quantity but do not change marginal cost.
Selling efforts such as advertising are successful if they increase the demand for the firm’s product.
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To maintain economic profit
a firm in monopolistic competition must either develop an entirely new product, or develop a significantly improved product that provides it with a competitive edge, even if only temporarily.
A firm that is able to introduce a new or improved and more differentiated product faces a less elastic demand and is able to increase its price, making an economic profit
The marginal dollar spent on developing a new or improved product is the marginal cost of product development
The marginal dollar that a new or improved product earns for the firm is the marginal revenue of product development
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things to know
At a low level of development, the marginal revenue from a better product exceeds the marginal cost.
At a high level of development, the marginal cost from a better product exceeds the marginal revenue.
When MC and MR of product development are equal, the firm is undertaking the profit-maximizing amount of product development.
Efficiency is achieved if the marginal social benefit of a new and improved product equals its marginal social cost.
Profit is maximized when the marginal revenue equals the marginal cost.
In monopolistic competition, marginal revenue is less than price, so product development is probably not pushed to its efficient level.
Firms in monopolistic competition incur major costs to ensure that buyers value the differences between their product and the products of their competitors.
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Advertising expenditures effect the profits of firms in two ways
They increase costs
They change demand
Advertising, like other selling costs, is a fixed cost, so its cost per unit decreases as output increases.
The total cost of advertising is fixed, but the average cost of advertising decreases as output increases
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Natural answer
Advertising increases demand.
If advertising enables a firm to survive, the number of firms in the market might increase.
To the extent that the number of firms does increase, advertising decreases the demand faced by any one firm
Also makes the demand for any one firm’s product more elastic
Thus, advertising cannot only lower average total cost, it can also lower the markup and the price of products
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Signal
An action taken by an informed person (or firm) to send a message to uninformed people.
Advertising serves as a signal for a high-quality product
Brand names provide consumers with product information and influences their buying choices as a result.
The final verdict on the efficiency of monopolistic competition is ambiguous
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Barriers to Entry
Either natural or legal barriers to entry can create oligopoly.
Since barriers to entry exist, an oligopoly consists of a small number of firms, each of which has a large share of the market.
These firms are interdependent and face a temptation to cooperate to jointly increase their economic profits
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Small Number of Firms
Because an oligopoly market has only a few firms, they are interdependent and face a temptation to cooperate.
Interdependence: With a small number of firms, each firm’s profit depends on every firm’s actions.
Temptation to Cooperate: Firms in oligopoly face the temptation to form a cartel.
A cartel is a group of firms acting together to limit output, raise price, and increase profit. Cartels are illegal.
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What Is a Game
Game theory is a tool for studying strategic behavior, which is behavior that takes into account the expected behavior of others and the mutual recognition of interdependence.
All games have four common features:
Rules
Strategies
Payoffs
Outcome
Strategies – In game theory these are all the possible actions of each player.
Payoff Matrix – A table that shows the payoffs for every possible action by each player for every possible action by each other player.
Nash Equilibrium – Within the payoff matrix, firm A takes the best possible action given by the decision of firm B and firm B takes the best possible action given by firm A.
Dominant strategy equilibrium – Best strategy of each firm is the same for both firms within the matrix.
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The Prisoners’ Dilemma
In the prisoners’ dilemma game, two prisoners (Art and Bob) have been caught committing a petty crime.
Rules
The rules describe the setting of the game, the actions the players may take, and the consequences of those actions.
Each is held in a separate cell and cannot communicate with the other.
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A duopoly
A duopoly is a market in which there are only two producers that compete.
Duopoly captures the essence of oligopoly.
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Anti-Combine Law
Canada’s first anti-combine law was enacted in 1889.
The law today is defined in the Competition Act of 1986.
The 1986 Act established a Competition Bureau and a Competition Tribunal.
The Act distinguishes between criminal and noncriminal practices.
Criminal practices include
Conspiracy to fix prices
Bid-rigging
False advertising
Noncriminal practices include
Mergers
Abuse of dominant position
Exclusive dealing
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Four factors of production are
Labour
Capital
Land (natural resources)
Entrepreneurship
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Market for Labour Services
Labour services are the physical and mental work effort that people supply to produce goods and services.
A labour market is a collection of people and firms who trade labour services.
The price of labour services is the wage rate.
Most labour markets have many buyers and many sellers and are competitive. In these labour markets, the wage rate is determined by supply and demand.
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Markets for Land Services and Natural Resources
Land consists of all the gifts of nature—natural resources. The market for land as a factor of production is the market for the services of land—the use of land.
The price of the services of land is a rental rate.
Nonrenewable natural resources are resources that can be used only once, such as oil, natural gas, and coal.
The prices of nonrenewable natural resources are determined in global commodity markets.
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Entrepreneurship
Entrepreneurship services are not traded in markets.
Entrepreneurs receive the profit or bear the loss that results from their business decisions.
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The Demand for a Factor of Production
The demand for a factor of production is a derived demand—it is derived from the demand for the goods that it is used to produce.
The quantities of factors of production demanded are a consequence of firms’ output decisions.
A firm hires the quantities of factors of production that maximize its profit.
The value to the firm of hiring one more unit of a factor of production is called the value of marginal product.
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Value of Marginal Product
The value to the firm of hiring one more unit of a factor is called its value of marginal product.
Value of marginal product of a factor = Price of a unit of output × Marginal product of the factor
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A Firm’s Demand for Labour
The firm maximizes its profit by hiring the quantity of labour at which VMP = the wage rate.
If VMP exceeds the wage rate, the firm can increase profit by employing one more worker.
If VMP is less than the wage rate, the firm can increase profit by firing one worker.
Only if VMP equals the wage rate is the firm maximizing profit.
The firm maximizes its profit by hiring the quantity of labour at which VMP = the wage rate.
If VMP exceeds the wage rate, the firm can increase profit by employing one more worker.
If VMP is less than the wage rate, the firm can increase profit by firing one worker.
Only if VMP equals the wage rate is the firm maximizing profit.
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Changes in a Firm’s Demand for Labour
The firm’s demand for labour depends on
The price of the firm’s output
The prices of other factors of production
Technology
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The Price of the Firm’s Output
The higher the price of a firm’s output, the greater is the firm’s demand for labour.
The price of output affects the demand for labour through its influence on the value of marginal product of labour.
If the price of the firm’s output increases, the demand for labour increases and the demand for labour curve shifts rightward.
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The Price of Other Factors of Production
If the price of using capital decreases relative to the wage rate, a firm substitutes capital for labour and increases the quantity of capital it uses.
Usually, the demand for labour will decrease when the price of using capital falls.
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Technology
New technologies decrease the demand for some types of labour and increase the demand for other types.
For example, if a new automated bread-making machine becomes available, a bakery might install one of these machines and fire most of its workforce—a decrease in the demand for bakery workers.
But the firms that manufacture and service automated bread-making machines hire more labour, so there is an increase in the demand for this type of labour.
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Market Demand/Suply for Labour
Market Demand for Labour
The market demand for labour is the sum of the quantities of labour demanded by all firms at each wage rate.
Because each firm’s demand for labour curve slopes downward, so does the market demand curve.
The Market Supply of Labour
The market supply of labour is derived from the supply of labour decisions made by individuals.
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Substitution Effect
The substitution effect describes how a person responds to an increasing opportunity cost of leisure:
As the opportunity cost of leisure rises, the person reduces the amount of leisure and increases the quantity of labour supplied.
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Individual’s Supply of Labour Curve
At low wage rates the substitution effect dominates the income effect, so a rise in the wage rate increases the quantity of labour supplied.
At high wage rates the income effect dominates the substitution effect, so a rise in the wage rate decreases the quantity of labour supplied.
The labour supply curve slopes upward at low wage rates but eventually bends backward at high wage rates.
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Income Effect
An increase in income enables the consumer to buy more of most goods.
Leisure is a normal good, and the income effect describes how a person responds to a higher wage rate.
As the wage rate rises, the person increases the quantity of leisure and decreases the quantity of labour supplied.
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Market Supply Curve
A market supply curve shows the quantity of labour supplied by all households in a particular job market.
The market supply curve is the horizontal sum of the individual supply of labour curves.
Along the supply curve in a particular job market, the wage rates available in other job markets remain the same.
Despite the fact that an individual’s labour supply curve eventually bends backward, the market supply curve of labour slopes upward.
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Differences and Trends in Wage Rates
Wage rates increase over time—trend upward—because the value of marginal product of labor trends upward.
Technological change and the new types of capital that it brings make workers more productive.
With greater labour productivity, the demand for labour increases and so does the average wage rate.
Wage rates have become increasingly unequal.
High wage rates have increased rapidly while low wage rates have stagnated or even fallen.
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Labour Markets
A Labour Market with a Union:
A labour union is an organized group of workers that aims to increase wages and influence other job conditions.
Influences on Labour Supply:
One way to raise the wage rate is to decrease the supply of labour.
Influences on Labour Demand:
Another way to raise the wage rate is to encourage people to buy goods produced by union workers, which raises the price of those goods and increases VMP of the workers.
Labour Market Equilibrium with a Union:
A union tries to restrict the supply for union labour and raise the wage rate.
But this action also decreases the quantity of labour demanded.
So the union also tries to increase the demand for labour.
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Monopsony in the Labour Market
A monopsony is a market with just one buyer.
Because a monopsony controls the labour market, it has the market power to set the market wage rate.
Today, in some isolated parts of the country, a large mining company is the major employer.
Like all firms, the monopsony has a downward-sloping demand for labour curve.
The supply curve of labour tells us the lowest wage rate of which a given quantity of labour is willing to work.
Because the monopsony controls the wage rate, the marginal cost of labour exceeds the wage rate.
The marginal cost of labour curve MCL is upward sloping.
The monopsony maximizes profit by hiring the quantity of labour at which MCL = VMP.
The monopsony pays the lowest wage rate for which that quantity of labour will work.
Compared to a competitive labour market, the monopsony employs fewer workers and pays a lower wage rate.
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A Union and a Monopsony
Sometimes both the firm and the employees have market power when a monopsony encounters a labour union, a situation called a bilateral monopoly.
Both the employer and the union must judge each others market power and come to an agreement on the wage rate paid and the number of workers employed.
Depending on the relative costs that each party can inflict on the other, the outcome of this bargaining might favor either the union or the firm.
