CFA Level 1 - Microeconomics

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3.1 - Introduction
Economics involves the choices people make when matching their limitless needs and wants with a scarcity of
resources. The word "economics" is derived from the Greek words "oikos", which means house, and "nomos",
which means manager. So the term originally referred to management of the household. Today, the term has
been broadened to refer to firms and all of society.

Another way of looking at economics is to consider the field as a set of tools for analyzing people and groups
and the choices that they make. Accountants are trained to render an account of financial activity for a
company. Lawyers are trained into a certain mode of thinking so as to resolve issues in a legal framework.
Similarly, economists are trained to use a set of tools and principles to analyze why individuals, firms,
governments and other groups behave as they do.

Models
Economists often use models, which are representations of what the economist wishes to analyze. If, for
example, an economist wishes to analyze the behavior of a labor union, the economist will not try to include
every possible aspect and piece of data about labor unions in his or her model. Important factors will be focused
on, such as wages, benefits, alternative jobs, etc. Hopefully the economist's model will include all of the
important variables and will give little or no weight to less critical variables.

Most economic analyses include the phrase "everything else is remaining the same", so attention can be focused
on the variables specified by the model. Of course, this assumption is rarely true in real life. If one were trying
to analyze federal deficits and interest rates, for example, there would be plenty of change during the time
period analyzed.

The CFA Level I Exam

The economics portion of the CFA Level I exam touches on a wide range of economic theory. The material
covered would normally be taught in senior (or graduate level) microeconomic, macroeconomic, money and
banking, and international trade courses. You will need to understand all of the material presented here in order
to successfully answer all of the questions given. There will be a few questions that require the solution of
equations, particularly with regards to foreign exchange.

This section focuses on preliminary economic concepts you should know for your upcoming exam. Note that
your upcoming CFA Level 1 exam will not test directly on these basic concepts, but CFA Institute notes that
you should have a basic understanding of these topics to ensure success on the more challenging topics that lie
ahead.

3.2 - Supply and Demand

What is Microeconomics?
Microeconomics is the branch of economics which looks at choices made by narrowly defined units, such as
individual buyers/consumers, and firms that produce goods.
Two of the most important principles used by economists are the Law of Supply and the Law of Demand:

Law of Supply
The law of supply says that, all other things remaining equal, as the price of a good increases (decreases), the
quantity of that good supplied will increase (decrease).

Law of Demand
The law of demand states that, all other things remaining equal, as the price of a good increases (decreases), the
quantity of that good demanded will decrease (increase).

Economists often use graphs as a way to demonstrate what is being discussed. The laws of supply and demand
can be represented by a simple graph such as the one below.

Figure 3.1: Law of Supply and Demand

In figure 3.1, we can see that at the price of $1, the suppliers are willing to provide one million widgets (Point
A), while the quantity demanded will be much higher – eight million (Point B).

At a higher price, such as $5, suppliers will be willing to provide six million widgets (Point D), while the
quantity demanded is only one million (Point E).

Finally, at the price of $3, the quantity demanded is equal the quantity supplied (Point C). This price is also
referred to as the "market clearing" or equilibrium price because no suppliers are left with the desire to provide
goods at that price and no buyers are left wishing to purchase the goods at that price either.

Look Out!

Note that supply and demand curves depict a quantity

supplied or a quantity demanded at a particular price, all
other things remaining equal.

Change in Consumer Preference

Suppose there was a significant change in consumer preferences. For example, consumers suddenly have an
increased desire for corn. This change in taste may be due to a new health study touting the benefits of corn,
alternative grains such as wheat may have gotten more expensive, or corn growers may have conducted an
effective advertising campaign. Regardless of the reason, the increase in demand results in a greater quantity
demanded at particular price levels. This is an example of a demand shift.

Figure 3.2: Shift in the Demand Curve

In the graph above D0 represents the original demand curve, while D1 shows the new demand curve. Note that at
a particular price level, such as $4, the quantity demanded increases from three million to five million.

Suppose something happens where the quantity of a good supplied changes at many particular price levels. For
example, technological changes might occur whereby computer memory manufacturers would be able to
produce a particular type of memory at a lower cost. So for many price levels, the quantity suppliers are willing
to provide will increase. This situation could be diagrammed as below:

Figure 3.3: Shift of the Supply Curve

S0 represents the original supply curve, while S1 represents the new supply curve. At the price of $30 per
256MB chip, the quantity supplied will increase from three million to four million units per month.

Supply and Demand Movements

Changes in quantity demanded strictly as a function of price are referred to as movement along a demand curve.
A shift of the entire demand curve is referred to as a change in demand; this could be due to any factor(s) that
affects demand, other than price.
Changes in quantity supplied strictly as a function of price are referred to as movement along a supply curve. A
shift of the entire supply curve is referred to as a change in supply; this could be due to any factor(s) that affects
supply, other than price.

Demand Curve Shifts

Some of the factors that can cause a demand curve to shift include:

1. Change in income - If consumer incomes increase, we might reasonably expect that demand for some
luxury goods will increase.
2. Change in preferences/tastes - If a product becomes more (less) liked, the quantity demanded will
increase (decrease).
3. Change in prices of goods that are complimentary - If the price of gasoline goes up substantially, the
demand curve for large SUV's should shift down.
4. Changes in prices of goods that are substitutes - If the price of pork increases (decreases), demand for
beef would likely increase (decrease).
5. Advertising - An effective advertising campaign could increase the quantity demanded of a particular
good. It could also decrease the demand for a competing good.
6. Expectations - If consumers expect a good to become more expensive or hard to get in the future, it
could alter current demand
7. Shifts in market demographics.
8. Distribution of income - For example, if the rich get richer, and the poor get poorer, demand for luxury
goods could increase.

Supply Curve Shifts

Factors that would cause a shift in the supply curve include:

1. Cost - An increase in crude oil costs for a plastic manufacturer would shift the supply curve up and to
the left. Changes in technology can dramatically decrease costs.
2. Government tax policy - Increases in business taxes will cause the supply curve to shift up and to the
left. A government subsidy to producers will cause more supply to be available – the supply curve will
shift down and to the right.
3. Weather/climate - Changes in weather and/or climate will especially influence agricultural product
supply.
4. Prices of substitute products - If farmers can grow wheat instead of corn, and the price of wheat goes
up, then the supply curve for corn will shift up and to the left as more farmers switch from corn to
wheat.
5. Number of producers - As the number of firms/individuals producing a product increases, we would
expect more supply to be available.

Short- and Long-Run Market Equilibrium

In the short run, market equilibrium is achieved when the quantity demanded is equal to quantity supplied and
the market clears. The market is said to be cleared because there is no additional quantity supplied, or quantity
demanded, at the market clearing price.

However, that particular market price may not lead to equilibrium in the long run. In the short run, producers do
not have time to fully adjust to current market conditions. Some current producers may not be making a profit
or covering all their costs at the current market price. Producers in that situation will consider leaving the
industry, or at least will not allocate further capital to that industry. If producers are making profits, then we
would expect more resources to be allocated to the industry such as the building of additional factories. In the
long run, all factors of production can be varied.

Long-run equilibrium is something we expect the market to move towards over time. The process could take 10
to 20 years. As demand and supply curves are constantly shifting, it actually may never be achieved.

Suppose there is an increase in demand, as shown by the graph below.

Figure 3.4: Effects of a Shift in Demand

D0 is the original demand curve, and D1 is the new demand curve. The market equilibrium price will increase
from P0 to P1, at least in the short-run. The quantity will also increase from Q0 to Q1.

Over time, in a market economy, two forces will come into play:

1. Buyers will have an incentive to search for substitutes, thereby decreasing their purchase of the original
good; this effect will tend to lower the quantity demanded and the market price

2. Suppliers will have an incentive to supply more of the good, and more resources will be allocated
towards production of this good; this effect will tend to increase the quantity and lower the market price

Shortages and Surpluses and their Effect on Equilibrium Prices

A "shortage" exists when the quantity demanded at the current price is greater than the quantity supplied. In the
case of shortage, we would expect the market price to go up so that less motivated buyers do not purchase the
good and producers will have an incentive to supply more. This process will continue until the quantity
demanded is equal to the quantity supplied.

A "surplus" exists when the quantity supplied is greater than the quantity demanded. In that case, we would
expect the market price to go down to entice more buying and producers will reduce the quantity supplied.

Invisible Hand Principle

Market prices deliver information to producers with regard to how to allocate capital and other resources, signal
producers with regards to consumer needs and wants and signal consumers with regard to product availability.
These market prices act as an "invisible hand" that pushes self-interested individuals toward the correct
allocation of resources for our society. No one person is consciously making these decisions.

The following tutorial, entitled Economics Basics, will prime you for the topics discussed in this chapter.

3.3 - Price Elasticity

Now that you have completed the basics, let us move onto the various learning outcomes on Microeconomics
you should look to know for your upcoming exam.

Price Elasticity
In general, the elasticity of a particular variable is the percentage change in quantity demanded or supplied,
divided by the percentage change in the variable of concern. This ratio is often called the elasticity coefficient.

Price elasticity is defined as the percentage change in quantity demanded divided by the percentage change in
price.

The price elasticity of demand can be expressed as:

Formula 3.1

Example: Price Elasticity

Where Ep is the price elasticity coefficient, %ΔQ represents the percentage in quantity, and %ΔP represents the
percentage in price. If the price of gasoline goes up by 50%, and the quantity demanded decreases by 20%, the
price elasticity of gasoline would be:

Ep = %Δ Quantity = -20% = -0.4

%Δ Price +50%

Typically, the negative sign is ignored and we would say that the price elasticity of gasoline is 0.4.

To calculate elasticity we must first have data for quantities purchased at different prices. Suppose that the price
of a good goes from P0 to P1, and that we have data for the change in quantity demanded, which goes from Q0 to
Q1. The calculation is typically made by dividing the actual change by the average(or midpoint) of the
beginning and ending values. Suppose that the quantity demanded of a good goes from 10 to 14. The
percentage change in quantitydemanded could be expressed as:

(Q0 – Q1) = 4 = 0.1333

0.5(Q0 + Q1) 0.5(24)

That number would be multiplied by 100 to get the percentage change, which in this case would be 33.3%.

Similarly, the percentage change in price can be expressed as:

(P0 – P1) x 100

0.5(P0 + P1)
 Look Out!

Sometimes the denominator used for these percentage change calculations is simply the
original value (P0 and Q0). Because the CFA text uses the midpoint method, unless the
exam has instructions to the contrary, it would be safer to use the midpoint method.

The full elasticity calculation can be simplified by canceling out the 0.5 (one-half) and 100. The more
simplified expression can be stated as:

Example:
Suppose, to continue the example given above, that the change in quantity demanded for the good (10 to 14)
was in response to a price decrease from $8 to $7. In that case, the elasticity would be expressed as:

(10 – 14) / (10 + 14) = -4 / 28 = -1/7 = -15 = -2.14

(8 – 7) / (8 + 7) 1 / 15 1/15 7

Alternatively, the elasticity could have been calculated as: -4 divided by half of 28, which is equal to -.2857,
over 1 divided by half of 15, which equals 1.333.

So the elasticity would be -.2857 over 1.333 = - 2.14, the same answer as above.

The following definitions apply to calculations of price elasticity:

1) If Ep > 1, Demand is elastic. The percentage change in price will produce a greater percentage in quantity
demanded. If the price goes up, then total revenues will go down. If the price goes down, then total revenues
willincrease.

2) If Ep < 1, Demand is inelastic. The percentage change in price will produce a lower percentage in quantity
demanded. If the price goes up, then total revenues will go up. If the price goes down, then total revenues will
decrease.

3) If Ep = 1, Demand has unitary elasticity. A percentage in price will produce the exact same percentage
change in quantity. Therefore, changes in price will no have effect on total revenues.

If demand is elastic for a product, then a small change in price will cause a large change in quantity demanded.
If the demand for a product is inelastic, even a large change in price might cause little change in quantity
demanded.

3.4 - Elasticity of Demand

Determinants of price elasticity include:

• Availability of substitutes – if substitutes are plentiful, then demand should be elastic.

• Relative percentage of expenditure – if an item takes up a considerable proportion of a consumer's
income, then demand should be elastic; if it takes up a very small amount, then demand should be
expected to be inelastic.
 • Amount of time – consumers can make more adjustments to prices changes over time and, therefore,
demand tends to be more elastic as time passes.
• Necessities or luxuries – demand for necessities will tend to be inelastic, while demand for luxuries will
tend to be elastic.

Cross Elasticity of Demand

Cross elasticity of demand relates the percentage change in quantity demanded of a good to the percentage
change in price of a substitute or complementary good. Examples of complementary goods would include
peanut butter and jelly, and large SUVs and gasoline. The cross elasticity of demand will be positive for a
substitute, and negative for a complement; i.e. demand for a substitute (complement) will go up (down), if the
price of the substitute (complement) goes up.

The following formula can be used to calculate cross-elasticity of demand:

Formula 3.2

Where: CEp is the cross-price elasticity coefficient,

%ΔQ represents the percentage change in quantity demanded, and
%ΔP represents the percentage change in price of the substitute or
complement.

Income Elasticity
Income Elasticity is defined as the percentage change in quantity demanded divided by the percentage change in
income. The calculations are similar to those for price elasticity, except that the denominator would include a
change in income instead of a change in price.

Usually the amount of goods purchased will be positively correlated with income; if consumers' incomes go up
(down), more (less) goods will be purchased. Any good with a positive income of elasticity of demand is said to
be a normal good. Luxury goods have a high income elasticity (greater than one). The proportionate amount of
spending for those goods will go up as incomes increase.

The amount spent on some goods decrease as incomes goes up. Such goods are referred to as inferior goods.
Examples of inferior goods include margarine (inferior to butter) and bus travel (inferior to owning a vehicle).

3.5 - Elasticity of Supply

Supply elasticity is defined as the percentage change in quantity supplied divided by the percentage change in
price. It is calculated as per the following formula:

Formula 3.3

The calculation of elasticity of supply is comparable to the calculation of elasticity of demand, except that the
quantities used refer to quantities supplied instead of quantities demanded.

Factors that influence the elasticity of supply include the ability to switch to production of other goods, the
ability to go out of business, the ability to use other resource inputs and the amount of time available to respond
to a price change.

Over a short time period, firms may be able to increase output only slightly in response to an increase in prices.
Over a longer period of time, the level of production can be adjusted greatly as production processes can be
altered, additional workers can be hired, more plants can be built, etc. Therefore, elasticity of supply is
expected to be greater with longer periods of time.

We would expect the supply elasticity of wheat to be very high as farmers can easily switch land that is used for
wheat over to other crops such as corn or soybeans. On the other hand, an oil refinery cannot easily switch its
production capacity over to another product, so low oil-refining margins do not reduce the quantity supplied by
very much. Due to high capital costs, higher refining
margins do not necessarily induce much greater supply.
So the supply elasticity for oil refining is fairly low.

3.6 - Marginal Benefit and Marginal Cost

Within this section we will focus on determining the
difference between marginal benefit and marginal cost, as
well as how to calculate the efficient quantity.

Consumer Choice
Economic analysis generally assigns the following
properties to consumers:

• Consumers make rational decisions. If two

products are of equal benefit to a consumer, then
he or she will choose the cheaper product. If two products are the same price, the consumer will choose
the one that provides the higher benefit.

• Limited income enforces choice. Consumers have to make choices as to what goods will be purchased
or not purchased. Purchasing one item means that less funds are available to purchase other items.

• Substitution of goods. Consumers can achieve satisfaction, which is generally referred to as utility, with
many choices. The satisfaction and cost of a cheeseburger can be evaluated in comparison to other
goods - such as hot dogs.

• The Law of Diminishing Marginal Utility. This law refers to marginal utility, which describes the
increase in satisfaction from consuming one additional unit of the good. The Law of Diminishing
Marginal Utility states that as each additional unit of a good is consumed, the amount of marginal
(incremental) utility will decrease.

Economists believe that consumers make decisions at the margin; i.e. should one more unit of the good be
obtained or not? The consumer will compare the additional (marginal) utility to be achieved by consuming one
more unit of the good, to the additional (marginal) utility that must be given up (buying power) in order to
obtain the good. At any particular price, the consumer will continue to buy units of the good as long as the
marginal benefit, as expressed by maximum willingness to pay, exceeds the price. The marginal benefit
indicates, in dollar terms, what the consumer is willing to pay to acquire one more unit of the good; it can also
be related to the height of an individual’s demand curve. Another implication of the Law of Diminishing
Marginal Utility is that the height of the demand curve will fall as more units of the good are consumed.

Another implication of marginal utility theory is that for consumers to maximize utility, the following
relationship holds:

MUa = MUb = MUc = and so on…

Pa Pb Pc

MU refers to marginal utility of the good, P represents the price of the good, and the subscripts indicate a
particular good. The last unit of each good purchased will provide the same marginal utility per dollar spent on
that good.

The term marginal cost refers to the opportunity cost associated with producing one more additional unit of a
good. Opportunity cost is a critical concept to economics – it refers to the value of the highest value alternative
opportunity. For example, in examining the marginal cost of producing one more bushel of wheat, that number
could be expressed as the dollar value of corn or other goods that could be produced in lieu of more wheat.

Marginal benefit refers to what people are willing to give up in order to obtain one more unit of a good, while
marginal cost refers to the value of what is given up in order to produce that additional unit. Additional units of
a good should be produced as long as marginal benefit exceeds marginal cost. It would be inefficient to produce
goods when the marginal benefit is less than the marginal cost. Therefore an efficient level of product is
achieved when marginal benefit is equal to marginal cost.

Consumer Surplus and Marginal Benefit

Consumer surplus represents the difference between what a consumer is willing to pay and the actual price paid.
If a consumer is willing to pay $5.00 for a gallon of gasoline, and the actual price is $3.00, then there is a
consumer surplus of $2.00 with the purchase of that gallon of gasoline. The value to the consumer, or marginal
benefit, is $5.00. Value is calculated by getting the
maximum price that consumers are willing to pay.

We expect consumers to continue purchasing units of a

good as long as the marginal benefit exceeds the price
paid; i.e., as long as there is a consumer surplus to be
achieved.

3.7 - Market Efficiency

Marginal (or Opportunity) Cost and the Minimum

Supply Price
The supply curve (see figure 3.3) represents the quantities
of a particular good that producers are willing to supply at
various price points. For any particular quantity, the
height of the supply curve represents the minimum price
that suppliers of a good must get in order to supply the
additional unit. That minimum supply price must cover
the increase in total costs, or marginal cost, of producing
the additional unit. The opportunity cost represents the
value of other goods that may have been produced with
the resources used. Producers must receive a price at least
equal to their opportunity cost.

Producer surplus is defined as the difference between

what a producer actually receives (which will be the market price) for a product and the producer's minimum
supply price (marginal cost) for that product. If a producer is willing to provide a unit of a good for $3.00, and
actually gets $4.00, then the producer would have $1.00 of producer surplus.

Consumer Surplus, Producer surplus, and Equilibrium.

We expect consumers to keep consuming additional units of a good until the marginal benefit no longer exceeds
the price, or there is no longer an increase in consumer surplus. Producers will continue to provide additional
units of a good up to the point where the market price no longer exceeds their minimum supply price.

The marginal benefit for all people in a society can be described as the marginal social benefit. Similarly the
marginal costs for all producers in a society of a good can be described as the marginal social cost. At market
equilibrium, the marginal social benefit of consuming an additional unit of a good is just equal to the marginal
social cost of producing the additional unit.

In the figure 3.5 below, the triangle defined by the points P2PmQm represents consumer surplus, while the
triangle defined by points P1PmQm represents producer surplus.

Figure 3.5: Consumer and Producer Surplus

How Resources Move Toward Their Most Efficient Allocation

Suppose consumer preferences change so that good A is now more desired than good B. We would expect the
price of good A to shift higher and the price of good B to shift lower. This in turn will induce the production of
additional units of good A and the devotion of more input resources to good A, while similarly decreasing
production of B and its associated input resources.

In the real world today we have seen higher oil prices stimulate more drilling for oil and more investment in oil
substitutes. The wage rates of mainframe programmers in the United States has decreased over the last several
years in comparison to the year 2000, as there less of a need for their services. The lower wage rates have
induced more mainframe programmers to retrain themselves with other computer skills, or to leave the field.

Obstacles to achieving efficiency include:

· Price Ceilings/Floors Sometimes governments impose price ceilings, which define a maximum price, or price
floors, which define a minimum price. Effective price ceilings or floors prevent normal market equilibrium.

· Public Goods are goods available to everyone, even if they don't pay. Examples include police protection and
public parks. One reason competitive markets don't produce the optimum amount of a public good is due to the
"free-rider" problem: those who don't pay get a "free ride" with regards to getting the benefit.
· Common Resources are used potentially by everyone and not owned by anyone. Example of inefficiencies
here include overfishing and air pollution.

· Externalitiesreflect costs and benefits not borne by the person or firm making the economic decision, which
are imposed on or granted to others. Runoff from large cattle feedlots can damage nearby farms, and this
potential cost may not be considered by feedlots when they look at their supply curve. A landowner who
chooses not to develop her land may benefit several other homes for purposes of flood control. The benefit to
others may not be taken into account when deciding to develop the land.

· Taxes lead to lower quantities produced, higher prices for buyers and lower effective prices for sellers.

· Subsidies increase the quantity produced, lower prices for buyers and increase seller prices.

· Quotas limit the quantity that can be produced.

· A monopoly means that only one firm can provide a certain good or service. A monopolist will charge a higher
price and produce a lower quantity in comparison to a competitive market.

With the exception of the above-mentioned obstacles, a competitive market will use resources efficiently.
Goods are produced up to the point where the marginal benefit is equal to the marginal cost, and the sum of
consumer and producer surplus is maximized.

The Fairness Principle, Utilitarianism, and the Symmetry Principle

Economists often like to examine the "fairness" of a situation or economic system. Ideas about fairness can be
lumped into one of two categories:

· "Results" must be fair.

· "Rules" must be fair.

Utilitarianism, which is a moral philosophy developed in 18th and 19th century Great Britain, posits that an
action is correct if it increases overall happiness for the performer of the act and those affected by the act.
Utilitarians argued that income should be transferred from the rich to the poor until complete equality was
achieved.

One problem with utilitarianism is the tradeoff between fairness and inefficiency. An effort to transfer wealth
by heavily taxing rich people will decrease incentives for people to save money or work hard. This can lead to
inefficient uses of capital and labor. Another source of inefficiency is the administrative cost of transferring
money from the rich to the poor.

The symmetry principle is based on the intuitive principle that people in similar situations should be treated the
same. From an economic perspective, we would like to achieve equality of opportunity. The symmetry principle
adheres to the viewpoint that "rules" must be fair.

3.8 - Price Ceilings and Floors

Price Ceilings
If the price ceiling is above the market price, then
there is no direct effect. If the price ceiling is set below
the market price, then a "shortage" is created; the
quantity demanded will exceed the quantity supplied.
The shortage may be resolved in many ways. One way
is "queuing"; people have to wait in line for the
product, and only those willing to wait in line for the product will actually get it. Sellers might provide the
product only to family and friends, or those willing to pay extra "under the table". Another effect may be that
sellers will lower the quality of the good sold. "Black markets" tend to be created by price ceilings.

Figure 3.6: Effect of Price Ceilings

Figure 3.6 illustrates the shortage that occurs when a price ceiling is imposed on suppliers. Consumers demand
QD while Suppliers are only willing to supply QS. If the price ceiling is set above the equilibrium, consumers
would demand a smaller quantity than suppliers are producing.

Economic Efficiency: Black Vs. Legal Markets

Legal systems provide various benefits to economic systems.

Economic efficiency may be said to occur when an action creates more benefits than costs. Legal systems help
economic systems become more efficient by reducing risks to economics participants. Risk represents a cost
that must be compensated for by higher charges.

One risk reduced by government regulation is theft. Government protects the property rights of owners so that
they can benefit from the assets they own and use them in an efficient, economic manner. Participants in a
"black market system" face a high risk of theft in their transactions as well as exposure to other forms of
violence.

Governments often also provide a regulatory framework for the safety of products. In a market operating within
a legal system, purchasers of drugs have a reasonable expectation about the quality of the drugs and the
expected benefits of the drugs. Participants in a black market for drugs will have incomplete information about
the quality of drugs purchased and, therefore, appropriate decisions are more difficult to make.

Price Floors
When a "price floor" is set, a certain minimum amount must be paid for a good or service. If the price floor is
below a market price, no direct effect occurs. If the market price is lower than the price floor, then a surplus will
be generated. Minimum wage laws are good examples of price floors. In many states, the U.S. minimum wage
law has no effect, as market wage rates for low-skilled workers are above the U.S. minimum wage rate. In states
where the minimum wage is above the market wage rate, the law will increase unemployment for low-skilled
workers. Although some low-skilled workers will get higher pay, others will lose their jobs

3.9 - Effect of Taxes on Supply and Demand

The incidence of a tax refers to the actual burden imposed by the tax upon buyers (who pay higher prices) and
sellers (who receive less money).
Actual and Statutory Incidence of Tax
Tax authorities usually require either the buyer or the seller to be
legally responsible for payment of the tax. The "statutory
incidence" of a tax refers to the tax obligation as stated by law.

Suppose that a state government imposes a tax upon milk producers of $1 per gallon.

Figure 3.7: Incidence of Tax

Figure 3.7 shows the original price for milk was $2 per gallon. After imposition of the tax, the supply curves
shift up and to the left. Consumers pay $2.60 per gallon. Sellers receive $1.60 per gallon after paying the tax. So
sixty cents of the tax is actually paid by consumers, while forty cents is paid by the milk producers.

The triangle ABC above represents the deadweight loss due to taxation, which occurs because now there are
fewer mutually beneficial exchanges between buyers and sellers.

Elasticity of Supply and Demand and the Incidence of Tax

If buyers have many alternatives to a good with a new tax, they will tend to respond to a rise in price by buying
other things and will, therefore, not accept a much higher price. If sellers easily can switch to producing other
goods, or if they will respond to even a small reduction in payments by going out of business, then they will not
accept a much lower price. The incidence of the tax will tend to fall on the side of the market that has the least
attractive alternatives and, therefore, has a lower elasticity.

Cigarettes are one example where buyers have relatively few options; we would therefore expect the primary
burden of cigarette taxes to fall upon the buyers.

A subsidy will tend to shift the supply curve down and to the right. In comparison to an unsubsidized market,
equilibrium will be achieved with a lower price and a greater quantity produced.

A quota limits the amounts of a good that can be produced. If the quota is greater than what would be produced
under normal market conditions, then it will have no effect. If the amount is less, than the market equilibrium
that is achieved will be at a higher price than what would occur without the quota.

3.10 - Opportunity Costs

Explicit Costs
Explicit costs reflect monetary payments made to resource owners. Examples include wages, lease payments
and interest payments.

Implicit Costs
Implicit costs are those associated with resources used by the firm, but with no direct monetary payment. For
example, there may not be an explicit monetary payment associated with the work efforts of a sole proprietor;
however, there is an implicit cost associated with those work efforts as the sole proprietor could earn wages
elsewhere. For a firm's capital, there is an implicit cost involved as the firm could be getting interest or earning
a rate of return elsewhere. The implicit cost associated with the highest-valued alternative opportunity is
referred to as the opportunity cost.

On the reverse side, particularly for an individual, there may be forms of implicit ("psychic") revenues; for
example, a person may particularly enjoy "being his own boss".

Economic Profit
Economic profit is equal to total revenues less both implicit and explicit costs. For a firm to stay in business,
both implicit and explicit costs must be covered. If firms are receiving a negative economic profit in a market,
they will leave that market. A normal profitrate exactly covers wage costs and the competitive rate of return on
capital.

Accounting Profits
Accounting profits are generally higher than economic
profits, as they omit certain costs, such as the value of
owner-provided labor and the firm's equity capital.

When calculating "economic profit", explicit and

opportunity costs are taken into account.

Example:
Suppose someone owns and runs a candy store that
grosses $20,000 per month and has operating expenses of
$14,000 per month. The store owner particularly enjoys
socializing with the customers; this aspect of the business provides a comfort to the owner which is worth
$2,000 a month to her. The owner could receive $3,000 a month in interest with the capital that is tied up in the
store's inventory. She could earn $5,000 a month at a different job.

An income statement would show an accounting profit of $6,000 a month:

Explicit Revenues $20,000

Explicit Costs $14,000

----------
Accounting Profit $ 6,000

Answer:
The economic profit, which should determine the economic decision, would be calculated as follows:

Explicit Revenues $20,000

Implicit Revenue
(value of socialization) $ 2,000
 ------
Economic Revenues $22,000
Explicit Costs $14,000

Implicit Costs:
Value of owner's labor $5,000
Required rate of return on
inventory investment $3,000
------
Economic Profit ($2,000)

From an economic viewpoint, keeping the candy store open

does not make sense. The implicit value of enjoying being
with the customers is not of sufficient value in comparison
to the fact that the store owner could make more money by
working elsewhere and employing the capital elsewhere.

3.11 - Achieving Economic & Technological Efficiency

Firm Constraints
Constraints on a firm include:

• Information – firms will not have complete

information regarding strategies of competitors,
ethics of their workers, customer buying plans,
forthcoming technologies and many other factors that affect firm profitability. Acquiring relevant
information can be costly, so benefits and costs of acquiring information must be weighed.
• Market – prices firms charge will be impacted by the offerings of other firms. Firms are in competition
with other firms for resources such as employees and raw materials. Market constraints limit what firms
can charge and enforce pricing on the input side.
• Technology – economists view technology as the methods and processes that firms use to produce
goods and/or services. There is a "technology" associated with any business, and the set of available
technologies will limit what a firm can do and impact its profit.

Technological vs. Economic Efficiency

Technological efficiency relates quantities of inputs to the quantity of output, while economic efficiency relates
the dollar value of inputs to the dollar value of output. A firm would be operating with technological efficiency
when it produces a certain level of output with the least amount of input. Economic efficiency would be
achieved when a certain level of output is produced with the lowest cost of inputs.

Suppose there are two available methods to produce widgets, one that is highly automated with industrial
robots, and a mostly manual one that requires significantly more workers. The automated method costs $50,000
per month to produce 1,000 widgets over a monthly period, using three robots and one worker. The manual
method costs $40,000 per month to produce 1,000 widgets over the same time period, with 10 workers that have
a minimal amount of tools. We can't say that either method is technologically inefficient – the automated
method requires fewer workers, while the manual method requires less capital for the same quantity of output.
However, we can say that the manual method is economically efficient, since it produces 1,000 widgets at the
lower cost.

Ways to Organize Production

There are two broadly defined methods of organizing production. A command system utilizes a hierarchical
organization whereby commands flow down from the top of the organization. Armies typically are organized
by this method. An incentive system tries to provide market-like incentives to each layer of the organization.
Sales organizations predominantly use incentive systems. Incentives also can be provided to personnel, such as
assembly line workers, by relating pay to certain production targets.

The Principal-Agent Problem

Principal-agent problems occur when the principal (buyer) has less information than the agent (supplier). For
example, a patient at a hospital has much less information about the medical treatments being conducted than
the doctors. The patient would prefer to have the illness resolved at the lowest possible cost to him. The doctors
may be facing pressures or may be influenced by incentives that are not in the best interests of the patient. It is
difficult for the patient to judge the quality of his or her own treatment.

Owners (shareholders) of firms face similar problems. In order to stay in business, it is important to get high
productivity from employees. However, the work of employees is often difficult to monitor and they might
"shirk" from performing their duties in a manner consistent with high productivity. High-level managers also
may perform in a manner that is not good for the firm overall. They might try to award themselves with
excessive compensation, or perform merger activities more for the purpose of enhancing their image. Firms
must strive to provide incentive structures that motivate workers and managers to perform for the betterment of
the firm.

Types ofBusiness Firms:

Proprietorships
Proprietorships are businesses owned by a single individual (or sometimes a family). Risks and rewards for the
business are the responsibility of that one individual. Note that the sole proprietor is legally responsible for the
debts of the business.

Partnerships
Partnerships are businesses that have two or more people acting as co-owners of the business. Agreements are
made beforehand as to how to share the risks and rewards. As with proprietorships, owners are personally
responsible for all debts associated with the business. Law firms and accounting firms are organized often as
partnerships.

Corporations
Corporations are businesses that have been granted a charter so that they are recognized as separate legal
entities. Individuals in a corporation are not subject to the liabilities of the firm; the most that they can lose is
the amount they invested. Taxes are paid, assets are acquired and contracts are entered into n the name of the
corporation. Corporations generally have easier access to capital than proprietorships or partnerships.

Major factors promoting cost efficiency and customer service within the corporate world include:

1. The threat of takeover – Inefficient corporate management can attract the interest of outsiders, who will try
to take over of the corporation with the intent of running the corporation more efficiently, so as to increase
shareholder value. The takeover company most likely would remove the current management. The threat of
such a takeover gives management an incentive to serve the interests of corporate shareholders.

2.Competition for capital and customers – Poor management will tend to drive the price of a company's stock
down, which will tend to make raising more capital difficult. An efficient and/or innovative management will
tend to cause the price of a company's stock to go up, which will make raising additional capital easier. The
corporation's products must be competitive, in terms of both price and quality, in order to attract customers. The
production of inferior goods will tend to drive customers away, which will decrease corporate revenues.
Therefore, competitive forces tend to limit the ability of management to serve their own needs in lieu of
stockholder and customer needs.

3.Management compensationcan be set up so that management incentives are in line with those of the
corporation. For example, a significant amount of executive compensation can be in the form of stock options,
which are of value only when a certain stock price ismet.

3.12 - Types of Markets & Concentration Measures

Price Taker Markets

A purely competitive (price taker) market exists when the following conditions occur:

· Low entry and exit barriers - there are no restraints on firms entering or exiting the market
·Homogeneity of products - buyers can purchase the good from any seller and receive the same good
·Perfect knowledge about product quality, price and cost
·No single buyer or seller is large enough to influence the market price

Sellers must take the existing market price and they will adjust the quantity of their products so as to maximize
profit at the market price. Because sellers must take the current market price, a purely competitive market also
is called a "price takers" market.

Price-Searcher Markets
Price-searcher markets are characterized by:

1.Barriers to Entry
2.Firms in the Markets that have Downward-Sloping
Demand Curves

While perfectly competitive markets have a homogeneity

of goods, price-searcher markets have a differentiation of
goods. The differentiation could be in the form of
location, taste, packaging, design, quality and many other
factors. Some textbooks use the phrase "monopolistic
competition" to describe markets where each firm has
something unique about its product while facing
significant competition. A good example would be a gas
station. Although there are many competing gas stations,
an individual gas station is the only one at its particular
location and, therefore, to some degree it has a monopoly
or is a sole seller. The CFA text prefers the term "competitive price searcher".

Firms in a price-searcher market with low barriers to entry have some flexibility to raise prices, as they will not
lose all their customers if they do so. For example, if Valvoline raises the price of its motor oil, some people
will be willing to pay the price for the motor oil they prefer. However, rival firms such as Pennzoil or Castrol
also provide similar motor oils. As Valvoline raises its prices, many customers will switch to rival suppliers.
The demand curve faced by firms in competitive price search markets, such as motor oil, will be highly elastic.

Firms in price-searcher markets with low barriers to entry face competition from existing suppliers and potential
new entrants. If economic profits are being made in the market, then more firms will be expected to enter the
market. Price searchers can set their prices, but the actual quantities sold will depend upon market forces.

Monopoly
Monopoly refers to a "single seller". The single seller will have a market with no well-defined substitute. The
monopolist does not need to worry about the reactions of other firms. Utility companies are often monopolists
in particular markets.

Concentration
Concentration within an industry refers to the degree to which a small number of firms provide a major portion
of the industry's total production. If concentration is low, then the industry is considered to be competitive. If
the concentration is high, then the industry will be viewed as oligopolistic or monopolistic. Government
agencies such as the U.S. Department of Justice examine concentration within an industry when deciding to
approve potential mergers between industry firms.

The most common measure of concentration is the four-firm concentration ratio, which is defined as the
percentage of the industry's output sold by the four largest firms. An industry with a four-firm concentration
ratio of forty percent is generally considered to be competitive.

The Herfindahl-Hirschman Index (HHI) calculates concentration ratios by squaring the market share of the fifty
largest firms in an industry. The formula can be expressed as follows:

Formula 3.4

HHI = s12 + s22 + s32 + ... + sn2

(where sn is the market share of the ith firm).

A monopoly would have the largest possible value – 1002 = 10000. The HHI for a highly fragmented industry
would be close to zero. The Justice Department generally considers an industry with an HHI above 1800 to be
highly concentrated.

Limitations of Concentration Measures

One limitation of using concentration ratios when evaluating competitiveness is that they do not take into
account the ease of entry into an industry. If firms easily can enter an industry (i.e. they have low barriers to
entry), then an industry can be fairly competitive even if it is dominated by a few large firms.

Another limitation associated with using concentration ratios is that defining exactly what an industry may not
be precise. One factor to consider is geographical – is the industry local (within the city or state only), a national
one, or should the industry be viewed within the context of a global economy? Another factor involves defining
exactly what the product is. Suppose we were looking at concentration within the shoe industry. Should the
market be simply "shoes", or do we break that down further into "athletic shoes", "men's shoes", "children's
shoes", etc.?

Coordinating Economic Activity

Economic activity can be coordinated by markets or by individual firms. A firm organizes input production
factors so as to produce and market goods and/or services.

Auto manufacturers are actually assemblers of cars – most the parts in a car are produced by hundreds of
component suppliers. This is an example of market coordination. If General Motors decides to coordinate all
activities associated with brake components, then the coordination is being done by that firm. A firm will decide
to coordinate a particular type of economic activity when it can do so more efficiently than what is provided by
the market.

Firms can be more efficient than markets due to:

·Economies of scope – this applies when a firm hires specialized resources that can produce a broad range of
goods and services. For example, a person with a difficult to diagnose medical condition would probably be
sent to a hospital, which will have a broad range of medical specialists and diagnostic equipment.

·Economies of scale – for many types of goods, per unit production costs decline as larger volumes of output
are produced by an individual firm.

·Team production can often lower production costs.

·Transaction costs are often reduced when economic activity is coordinated by a firm. Suppose you want to
perform a major remodeling of your house. If you decide to coordinate the work yourself, you will have
significant transaction costs associated with hiring qualified personnel such as plumbers and carpenters,
monitoring their work, negotiating contracts with them, finding suitable building materials, arranging for
delivery of materials and coordinating work schedules of the various subcontractors. If you hire a building firm
or general contractor to coordinate the work, they probably will have lower transaction costs because they
already will have knowledge of suitable subcontractors in the area and how best to get building materials. By
hiring a general contractor, you will reduce your transaction costs by only having to negotiate one contract.

3.13 - Modifying Output

The "Short Run"

The short run is a time period so short that the firm
cannot alter some production factors (typically these
factors include the size and/or number of plants, the
technology used, equipment and the management
organization). Those factors are sometimes referred to
collectively as the "plant". The firm usually can increase
output in the short run by adding variable inputs. Labor is
the most common variable input.

The "Long Run"

In the long run, firms have sufficient time to adjust to any
and all production factors. Factories can be expanded,
shrunk, demolished or built. The firm can leave or enter
an industry.

Suppose a car manufacture decides to build a new plant to build SUVs. This would be an example of a decision
made in the long run. If that manufacturer decided to expand output by having employees work overtime, then
that would be an example of a short-run decision.

Look Out!

Differences between the "short run" and the "long run", and
the concept of economic profit are critical to understanding
economics!

• Total Product: The total product is the total quantity of goods produced, in association with specified
levels of input.
 • Marginal Product: The marginal product is the change in output that occurs when one more unit of
input (such as a unit of labor) is added.
• Average Product: The average product is the total product divided by the number of input units,
usually a variable input such as labor.

Example:
Suppose only one worker was present at an assembly plant and that worker had to do all functions of the plant
– order and stock supplies, assemble the good, provide maintenance for the factory, prepare the good for
shipping, etc. If a second worker is added, there may be a larger increase in productivity, as the two workers can
allocate the tasks according to their abilities, and less time will be lost going to and from various locations in
the plant.

A possible schedule of plant output could be as follows:

In this example, hiring the fourth worker increases output by 110 units, which is not as large as the increase
created by hiring the third worker.

The cost of all production factors is equal to the firm's total cost (TC). Total fixed costs (TFC) include all fixed
costs, while total variable costs (TVC) include the cost of all variable inputs such as labor. Marginal cost is the
increase in costs associated with producing additional output. At some point in time, marginal costs will begin
to increase because each additional worker contributes less to total output. The average fixed cost (AFC) is the
fixed cost per unit of output, while the average variable cost (AVC) specifies the variable cost per unit of
output. AFC and AVC combined are equal to the average total cost (ATC). As production increases, average
fixed cost (total fixed cost divided by quantity) will decrease. When marginal cost exceeds average total cost,
average total costs will go up, at which point the firm must receive higher prices if higher production is to
occur.

The table below assumes that the firm has fixed costs of $1,000 per day, each worker is paid $200 per day, and
each unit produced has variable material costs of $1 per unit.
From the table above we can see that both average total cost and marginal cost initially decrease as production
increase, but both start going up at certain levels of production.

3.14 - Marginal and Average Total Cost Curves

Cost Curves
The short-run marginal cost (MC) curve will at first decline and then will go up at some point, and will intersect
the average total cost and average variable cost curves at their minimum points.

The average variable cost (AVC) curve will go down (but will not be as steep as the marginal cost), and then go
up. This will not go up as fast as the marginal cost curve.

The average fixed cost (AFC) curve will decline as additional

units are produced, and continue to decline.

The average total cost (ATC) curve initially will decline as fixed costs are spread over a larger number of units,
but will go up as marginal costs increase due to the law of diminishing returns.

The graph below illustrates the shapes of these curves.

Figure 3.8: Cost Curves

Diminishing Returns and Diminishing Marginal Product of Capital

The law of diminishing returns states that as one type of production input is added, with all other types of input
remaining the same, at some point production will increase at a diminishing rate.

There may be levels of input where increasing inputs causes production to go up at an increasing rate. However,
according to the law of diminishing returns, at some point production will go up at a decreasing rate.

The marginal product of capital is the increase in total output associated with an increase in capital, while
holding the quantity of labor constant. Capital is also subject to the law of diminishing returns.

Economies of Scale
Economies of scale mean that goods can be produced at a lower cost per good, as the quantity produced
increases. Large-scale factory operations can permit the most efficient specialization of machinery and labor.
Average fixed costs will decline as costs such as advertising can be spread across more and more units.
Diseconomies of Scale
Diseconomies of scale occur when per unit costs go up as output is increased. A typical reason given is
bureaucratic inefficiencies – more attention may be given to administrative rules as opposed to innovation.
Worker motivation is also more difficult as the number of employees increases.

When economies of scale occur, the long-run average total cost (LRAC) curve will be declining; with
diseconomies of scale, the LRAC curve will be rising.

Figure 3.9: Long Run Average Total Curve

3.15 - Perfectly Competitive Markets

A purely competitive (price taker) market exists when the following conditions occur:

• Low entry and exit barriers - there are no restraints on firms entering or exiting the market
• Homogeneity of products - buyers can purchase the good from any seller and receive the same good
• Perfect knowledge about product quality, price, and cost
• No single buyer or seller is large enough to influence the market price

Sellers must take the existing market price; if they set a price above the market price, no one will buy their
product because potential buyers simply will go to other
suppliers. Setting a price below the market price does not
make any sense because the firm can sell as much as it
wants to at the market price; selling below the market
price will just reduce profits.

Because sellers must take the current market price a

purely competitive market is also called a "price takers"
market.

The firm can sell as much as it can produce at the existing

market price, so demand is not a constraint for the firm. Revenue will be simply the market price multiplied by
quantity produced.

Maximizing Profit in Perfect Competition

A price taker can sell as much as it can produce at the existing market price.

So total revenue (TR) will be simply P × Q, where P = price and Q = quantity sold.

Marginal revenue (MR), the increase in total revenue for production of one additional unit, will always be equal
to the market price for a price taker.

If the market price of a good is $15, and a firm produces 10 units of a good per day, then its total revenue for
the day will be $15 × 10 = $150. The marginal revenue associated with producing an eleventh unit per day
would be the market price, $15; total revenue per day would increase from $150 to $165 (11 × $15).

Marginal costs will vary, depending upon the quantity produced. We would expect the firm to increase input up
to the point where marginal cost is equal to the market price. In the short run, a firm will produce as long as its
average variable costs do not exceed the market price. If the market price is less than the firm's total average
cost, but greater than its average variable cost, then the firm will still operate in the short run. Its losses will be
lowered by producing, since nothing can be done about fixed costs in the short run. Over the long run, the firm
will need to cover all of it costs if it is to keep on producing.

If the market price at least covers the firm's variable costs, it may make sense to keep on operating. Any price in
excess of the average variable cost will at least help to cover the fixed cost. Unless the firm decides to
completely leave the business, it will come out ahead by continuing to operate.

If the market price is below the firm's average variable cost, it will not make sense for the firm to operate as it
will lose even more money. If the firm believes that business conditions will improve, it will temporarily shut
down. Seasonal businesses such as ski resorts or restaurants located by vacation areas will shut down
temporarily at certain times. Manufacturers temporarily might shut down a factory and plan to reopen the
factory when business conditions improve.

When Does a Firm Maximize Profit in Perfect Competition?

Profit (π) is equal to total revenue minus total cost. We can express this mathematically by stating:
π = TR – TC

In terms of calculus, we can state that profit will be maximized when the first derivative of the profit function is
equal to zero:

dπ = dTR -dTC= 0
dQ dQ dQ

We also can rearrange the terms to state that profit maximization occurs when:

Formula 3.4

dTR = dTC
dQ dQ

The term on the left represents the change in revenue from producing one more unit, which is called marginal
revenue. The term on the right represents the change in total costs resulting from producing one more unit,
which is marginal cost.
The firm's profit will be maximized at the level of output whereby the marginal (additional) revenue received
from the last unit produced is just equal to the marginal (additional) cost incurred by producing that last unit.
Maximum profit for the firm occurs at the output level where MR = MC.

For a firm operating in a competitive environment, the marginal revenue received is always equal to the market
price. Therefore a firm operating under perfect competition will always produce at the level of output where the
marginal cost of the last unit produced is just equal to the market price.

The following equation will hold:

Formula 3.5

MR = MC = P

Exam Tip!

You do not need to know calculus for the CFA level I exam. Just
make sure you understand the relationship above.

3.16 - Effects on Equilibrium in the Short and Long Run

The Firm vs. the Industry's Short-Run Supply Curve
A company will continue to produce output until marginal revenue (MR) is equal to marginal cost (MC).

In other words, the condition for maximum profit occurs where:

MR = MC

Another condition for profit to be maximized, because it is possible that MR=MC at a point where MC is
falling, is that the marginal cost curve must be rising. Therefore, the supply curve for a competitive firm will be
that part of the marginal cost curve which lies above the low point of the average cost curve. The supply curve
slopes upward because marginal costs increase with the greater quantity supplied in the short run. With a
competitive market, the supply curve will be a summation of the individual firms' supply curves.

Long-Run Effects on Equilibrium

In the short-run, increases (decreases) in demand in a
competitive market will cause prices and output to increase
(decrease).

In the long-run, increases (decreases) in demand in a competitive market will cause increases (decreases) in
output. Initially, markets with an increase (decrease) in demand will have firms experiencing economic profits
(losses). Over time, markets with firms experiencing economic profits (losses) will have additional firms enter
(existing firms will exit) the market, and prices will decrease (increase) towards previous levels. If cost
conditions remain the same, then prices will revert to what they were before the increase (decrease) in demand.

If the market price falls below a firm's average total cost, the firm will incur economic losses. The firm may be
able to lower its average total cost by changing to a different plant size. Suppose a firm increases its plant size,
and lowers its average total costs. If other firms follow, then the industry supply curve will shift to the right.
This will result in lower prices and less economic profit.

If a firm does not expect market conditions to improve then it may decide to go out of business. This would be
the preferred option as, by selling out, neither fixed nor variable costs would be incurred.

Impact From Changes in Technology

The impact of a permanent change of demand on price and output for a market will be influenced by the cost
structure of suppliers in the market. The long-run market supply curve in a competitive industry will depend on
the returns to scale.

For a constant-cost industry, if demand increases, then firms temporarily will make a profit as price will go
above the minimum needed for the firms to stay in business. This will cause firms to expand output or new
firms to enter the industry. Because costs are constant in the long run, the long-run supply curve will be
horizontal. In the graph below, as demand shifts from D1 to D2, over the long run quantity will increase from Q1
to Q2. However, price will remain the same.

Figure 3.12: Long Run Supply: Constant Cost Industry

For an increasing cost industry, if demand increases, firms will need higher prices over the long run in order to
justify higher levels of production. For example, prices for raw materials used in the industry may go up with
higher levels of production, which will force the long-run supply curve to slope upward.

Figure 3.10: Long Run Supply: Increasing Cost Industry

For a decreasing cost industry, if demand increases, in the long run firms can provide more output at lower
prices. The need to produce larger quantities of goods and services in response to increased demand induces
technological change, which lowers costs for the producer and these savings are passed on to consumers in the
long run.

Figure 3.11: Long Run Supply: Decreasing Cost Industry

3.17 - Characteristics of Monopolies
A monopoly is the single seller of a good for which substitutes are not readily available. There should be high
barriers to entry; i.e. other firms cannot enter the market easily and provide the good.

Monopolies often are created due to legal barriers. Patent laws grant inventors the exclusive right to produce
and sell a product for a period of time (typically 17 years in the United States). Licensing restrictions often limit
who is allowed to provide a good or service in a particular geographic area.

In some instances, economies of scale exist so that there is a tendency toward a natural monopoly – one firm
can provide the good most efficiently. One traditional example is the distribution of electrical power to a local
community. Duplication of power lines within a community would increase overall costs. With natural
monopolies, government policy to encourage more entrants may not make sense.

To some degree, natural monopolies occur in the computer

industry, where customers want to adhere to a common standard.
The common standard for personal computer operating systems
is provided by Microsoft. Alternative operating systems for
personal computers (such as LINUX) do not make sense for most consumers, so Microsoft has considerable
monopoly power.

The Monopolist and Profit Maximization

The monopolist has control both over the quantity produced and price charged; it also faces the entire demand
curve for the good produced. Therefore, it will face a downward-sloping demand curve. It follows the general
rule for profit maximization, MR = MC. As the monopolist does not know exactly how much consumers are
willing to buy at particular prices, it must "search" for the optimum price.

Figure 3.12: Monopolist Profit Maximization

As shown in the graph above, a monopolist facing demand curve D0 will produce quantity Q0 and the price
charged will be equal to P0.

What happens if the monopolist later faces a demand curve such as D1? In that case, the monopolist cannot
cover costs and will go out of business.

3.18 - Inefficiencies of Monopolies

Monopolies vs. Perfect Competitions

A market characterized by monopoly has only a single seller, while a perfectly competitive market has many
sellers. There are high barriers of entry with the monopoly, but little to no barriers to entry in the perfectly
competitive market. Because the product of a monopolist cannot be substituted readily, the monopolist can set a
higher price and still get sales. The seller in a perfectly competitive market cannot get a higher price because
potential buyers always can get the product from other sellers.

Major inefficiencies associated with monopolies include:

·Allocative inefficiency – prices will tend to be higher, and output lower, than what would exist in a market with
low barriers to entry. Prices will tend to be higher than both marginal costs and average total cost.

·Weakened market forces – when consumers of a product have many alternatives, producers must serve their
customers efficiently in order to stay in business. If consumers can't purchase competitive products easily, the
monopolist doesn't need to worry a lot about losing customers when poor service or a poor quality good is
provided.

·Rent or favor seeking – firms and/or individuals will put a great deal of effort into obtaining or maintaining
high entry barriers; by doing so, they hope to achieve monopoly-type profits. Such efforts enrich some people,
at the expense of many others.

Price Discrimination
Price searchers effectively price discriminate among their
customers when they are able to:

a) identify sub-groups which have different elasticities of demand, and

b) ensure that the customers cannot resell the good.

A common example is airline travel. Travelers who plan in advance will have a higher elasticity of demand than
travelers who must travel within a short period of time.

With price discrimination, some consumers pay higher prices than they would if there was a single price.
However, many in the group paying lower prices will now be getting something they otherwise would not have
purchased. Universities are increasing their use of price discrimination. Tuition rates for students without
financial aid are increasing greatly while the average price charged is not going up as much because more
financial aid is being offered. The colleges reap high revenues from wealthy families who can afford to pay
high tuition while more students from lower-income families can now attend college.

In general, higher output will occur with price discrimination. Furthermore, there may be some businesses that
could not exist without price discrimination. For example, a dentist in a small town may not have a viable
business without performing price discrimination.

As price discrimination increases output and gains from trade, it reduces allocative inefficiency. Firms that
successfully price discriminate will benefit by getting higher revenues.

Why Do Monopolies Exist?

If a natural monopoly is to exist, the government can regulate the price and output. In the graph below, the
monopolist would prefer to charge price P1 and Q1 to maximize profits. A regulatory agency will often set the
price at P2. At this price, the monopolist receives enough to cover costs and, in effect, it receives a competitive
rate or return of its capital. The benefits to society from the increased production outweigh the increased costs
to the monopolist.

Figure 3.13: Results of Regulating Price and Output

3.19 - Monopolistic Competition

A firm engaged in monopolistic competition which is
considering reducing prices in order to increase total
revenue has two conflicting factors to consider.
Reducing prices will increase the quantity of a good
sold, but the reduction in price will also apply to
quantities of the good that would have been sold at a
higher price.

The price searcher can maximize profit by adjusting

output and the price until marginal revenue is equal to
marginal cost. Notice that the marginal revenue curve
lies below the firm's demand curve.

Figure 3.14: Marginal Revenue Curve In

Monopolistic Competition
The phrase "contestable markets" describes markets where there are few sellers, but they behave in a
competitive manner because of the threat of new entrants. For instance, an airline may serve a particular route
exclusively, but does not charge excessive prices because those prices would entice additional airlines to offer
that route.

Government regulation is often used to keep new firms out of markets. Economists generally favor deregulation
as this helps to keep prices low.

Prices over the long run in a competitive market will move to the lowest point of the firm's average total cost
curve. We then have allocative efficiency because desired goods are produced at the lowest possible cost.

Because price searchers face downward-sloping demand curves, the price they charge will exceed the firm's
marginal cost. The price charged and the quantity produced will not be where the firm minimizes average total
costs. Figure 3.16 on the following page illustrates these points.

Figure 3.15: Monopolistic Competition: Low Barriers to Entry

The monopolistic competition market, in comparison to a purely competitive market, will have a higher price
and lower output. Some argue that this is a good trade-off, as consumers benefit from having a variety of goods.
Advertising would be not be used by price-takers, but is used by price-searchers; as the cost of advertising is
ultimately borne by consumers, it is an argument against the price-searcher market. If barriers to entry are low,
firms still have an incentive to produce efficiently, use resources only if they add value and innovate by altering
their products or offering new products. Entrepreneurs may have more incentives with price searcher markets,
while if markets are contestable, prices will not be excessively higher than those in competitive markets.

Product Development and Marketing in Monopolistic Competition

Firms engaged in monopolistic competition invest in product development and marketing so as to differentiate
themselves from other firms in the industry. By doing so, they hope to gain more monopolistic pricing power.
Since advertising increases costs, it will shift supply curves up and to the right. Ultimately, over the long run,
consumers pay for the advertising in the form of higher prices.

In comparison to the pure competitive market, prices will be higher and quantities produced will be lower when
there is monopolistic competition. However, there will be a greater variety of goods. This may be a worthwhile
tradeoff.

3.20 - Oligopolies
What is an Oligopoly?
Oligopoly refers to a market with "few sellers".
Oligopolies interact among themselves. When an
oligopolist changes a price, it must take into account
how other firms in the industry will respond. Within
an oligopoly, the products can be similar or
differentiated. Oligopoly markets have high barriers to
entry.

The Prisoner's Dilemma

The "prisoners' dilemma" was first described in the
field of "game theory", which is a branch of applied
mathematics and economics dealing with choices
made under conflict and uncertainty. Suppose that the
police believe Dave and Henry have committed a
felony, but the evidence is weak. The police have
placed Dave and Henry in jail, in separate cells. The
police need the confession of at least one of the
prisoners in order to get a felony conviction. If neither
prisoner confesses, then the police can only convict
them on a minor charge with a three-month prison
term. Each prisoner is offered the following deal: if
one testifies against the other while the other remains
the silent, the one who testifies will not be convicted
of anything, while the one who remains silent will go
to jail for 20 years. If both confess, then each will receive a five-year jail term.

To sum up the situation:

The optimum result for the two together is to stay silent, in which Dave and Henry will each get only three
months prison time. However, each prisoner does not have knowledge of what the other prisoner will do. The
most rational response from the individual is to confess. If the other prisoner stays silent, then that person gets
off free; if the other prisoner confesses, then the prison term will be less (five years vs. 20 years).
The prisoners' dilemma illustrates a situation in which individuals arrive at a non-optimal solution, due to a lack
of cooperation and trust. A similar situation occurs with oligopolies. If firms within an oligopolistic industry
have cooperation and trust with each other, then they can theoretically maximize industry profits by setting a
monopolistic price. Firms would then have to figure out how to fairly divide up the profits.

If oligopolies collude successfully, they will set price and output such that MR = MC for the industry overall. In
figure 3.17 on the following page, this is depicted as Pa and Qa. Without collusion, firms will lower prices to
attract more customers. Gradually, the price and output will move to Pb and Qb, which is identical to what would
be achieved with a competitive market.

Figure 3.16: Oligopolist Profit Maximization

Oligopolies have strong incentives to collude because while acting together, they can restrict output and set
prices so that economic profits are earned. The individual oligopolist has an incentive to cheat because the
firm's demand curve is more elastic than the overall market demand curve. By secretly lowering prices, the firm
can sell to customers who would not buy at the higher price, as well as to customers who normally buy from the
other firms.

Oligopolistic agreements tend to be unstable due to these conflicting tendencies.

Obstacles to collusion within oligopolies include:

Low Entry Barriers – Particularly as time goes on, more firms will be attracted to the potential economic
profits, which will not be sustainable. For example, the OPEC's raising of oil prices during the 1970s and early
1980s enticed more non-OPEC producers to produce more. The market share of OPEC producers was
drastically reduced and they had to reduce prices in order to gain market share. In the long run, cartels are not
usually successful at raising prices.

Antitrust Laws - these laws prohibit collusion. Although firms may make secret agreements, those agreements
will not be enforceable in a court of law.

Unstable Demand Conditions – These conditions will make collusion more difficult, as firms are more likely
to have disagreements as to what is the best direction for the industry. Some may expect large increases in
demand, while others may disagree and prefer that industry capacity remains the same.

Increasing Number of Firms – An increasing number of firms in an oligopolistic industry will make
agreements harder to discuss, negotiate and enforce. Differences of opinion are more likely. As the number of
firms in the industry increases, the industry will behave more like a competitive market.
Difficulties with Detecting and Stopping Price Cuts – These difficulties will undermine effective collusion.
Sometimes oligopolistic firms will cheat by enacting quality improvements, easier credit terms and free
shipping. If quality changes can be used to compete, collusive price agreements will not be effective.

3.21 - Conclusion
Within this Section we have focused on the basics of microeconomics, the properties of demand and supply,
price takers and searchers, and demand and supply for resources and capital. For a quick review, we've
summarized the characteristics of the various market types below.