Market - Is where a group of sellers and a group of buyers come together for the exchange of a specific good or service

Lec. 03: Microeconomics Basics Flashcards by Lennart Rathje

What is a market?

Market

Is where a group of sellers and a group of buyers come together for the exchange of a specific good or service

How well did you know this?

Not at all

Perfectly

How is perfect competition defined?

Perfect competition

Polypol
–> Many buyers + many sellers; all actors are price takers (noone has market power)
Homogeneous goods
–> Goods are exactly the same
All actors have perfect information
No entry or exit barriers

How well did you know this?

Not at all

Perfectly

How is a monopoly defined?

Monopoly

There is a single seller
Seller is only producer
Seller has market power: the ability to maintain a price above the price under competition

How well did you know this?

Not at all

Perfectly

Illustrate monopoly versus perfect competition

Monopoly versus perfect competition

x-axis: (one seller, few sellers, many sellers)

y-axis: (one buyer, few buyers, many buyers)

bilateral monopoly, oligopolistic market structure, buyer’s monopoly (monopsony)

oligopolistic market structure

seller’s monopoly, oligopolistic market structure, perfect competition

How well did you know this?

Not at all

Perfectly

Perfect competition

1) How is the inverse supply function of a single firm defined?

2) Why is it called inverse supply function?

3) How does the aggregation of inverse supply functions for an entire market work?

1) Inverse supply function of a single firm p(Q_S)

It shows at which price p it is worthwhile to sell a given quantity Q_S
It indicates the marginal cost of the next unit of production at a given production level of Q_S units
Illustration: slide 4

2) Why is it called inverse supply function?

Supply function Q_S(p)
Inverse supply function p(Q_S)

3) How does the aggregation of inverse supply functions for an entire market work?

If many firms are active, we can sort and aggregate their inverse supply functions into a single supply function for the whole market
The aggregation is not a summation of the individual inverse supply function!

How well did you know this?

Not at all

Perfectly

Perfect competition

1) How is the inverse demand function of a single consumer defined?

2) Why is it called inverse demand function?

3) How does the aggregation of inverse demand functions for an entire market work?

1) Inverse demand function of a single consumer p(Q_D)

Shows the maximum price p the consumer is willing to pay for a given quantity Q_D
It indicates the marginal willingness to pay or marginal utility of the next unit of consumption at a given consumption level of Q_D
Illustration: slide 10

2) Why is it called inverse demand function?

Demand function Q_D(p)
Inverse demand function p(Q_D)

3) How does the aggregation of inverse supply functions for an entire market work?

If many consumers are active, we can sort and aggregate their inverse demand functions into a single demand function for the whole market
The aggregation is not a summation of the individual inverse supply function!

How well did you know this?

Not at all

Perfectly

Perfect competition

MCP, MCV; CS, PS

Illustrate this situation

Compare slide 14

Compare slide 20

How well did you know this?

Not at all

Perfectly

Perfect competition

Market clearing price and volume: important properties

What is missing?

The market price is “…” than the costs of each supplier whose offer is taken.
The market price is “…” than the willingness to pay of each consumer whose bid is taken.

“higher”

“lower”

How well did you know this?

Not at all

Perfectly

Why is a market equilibrium stable?

A market equilibrium is stable because the market actors have no incentive to change their behaviour (= Nash-equilibrium), because they can’t improve their outcome (profit or utility) further.

How well did you know this?

Not at all

Perfectly

Perfect competition

MCP, MCV

1) Illustrate an increase in demand.

2) Illustrate an increase in supply costs.

1) Compare slide 18

2) Compare slide 19

How well did you know this?

Not at all

Perfectly

Perfect competition

1) What is the consumer surplus CS?

2) What is the producer surplus PS?

3) What is the total surplus or total welfare TW?

1) What is the consumer surplus CS?

The total amount consumers are willing to pay minus what they actually pay

2) What is the producer surplus PS?

The total revenue producers generated minus their actual costs.

3) What is the total surplus or total welfare TW?

TW = CS + PS
Indicates the degree of efficiency of a given resource allocation

How well did you know this?

Not at all

Perfectly

What are market failures?

Market failures

Occure if welfare is not maximized because conditions of perfect competition are not met
This can justify state intervention

How well did you know this?

Not at all

Perfectly

Provide and explain examples for market failures.

Examples for market failures

Monopolistic/oligopolistic market structures
–> Single actors dominate and use market power to set/raise prices
Asymmetric information
–> Some actors have more information than others
–> E.g. insider trading, salesman deliberately selling faulty goods
Inhomogeneous goods
–> Quality differences
–> E.g. fake Gucci handbags
Market entry/exit barriers
–> E.g. cartels, very high market-entry costs (e.g. electricity network operator)
Externalities ignored
–> Costs, which are not priced in, are induced on third parties which are not active in the market
–> E.g. air pollution, greenhouse gases
Public goods
–> Everyone benefits from them, but nobody has an incentive to produce them –> free-rider problem
–> E.g. peace, biodiversity, dikes, education

How well did you know this?

Not at all

Perfectly

Perfect competition

Reaction to state regulation: minimum price

1) Illustrate and explain this situation.

2) Explain the effect on the social welfare.

Reaction to state regulation: minimum price

1) Illustrate and explain this situation.

Compare slide 23 + 24
A minimum price or floor price can lead to lower demand and/or excess supply (if there is a buyer of last resort like the state)
Cf. butter mountains and milk lakes in EU in past; minimum wages

2) Explain the effect on the social welfare.

Compare slide 24
The introduction of a minimum price will reduce total welfare in this market, although it may have benefits in other parts of society (e.g. economic security for farmers and a living wage for workers).
Welfare loss (WL) or deadweight loss

How well did you know this?

Not at all

Perfectly

Perfect competition

Reaction to state regulation: maximum price

1) Illustrate and explain this situation.

2) Explain the effect on the social welfare.

Reaction to state regulation: minimum price

1) Illustrate and explain this situation.

Compare slide 25
Lower supply and/or excess demand
E.g. rent caps, energy price caps

2) Explain the effect on the social welfare.

Compare slide 26
The introduction of a maximum price will reduce total welfare in this market, although it may have benefits in other parts of society (e.g. benefits for consumers).
Welfare loss (WL) or deadweight loss

How well did you know this?

Not at all

Perfectly

Perfect competition

Reaction to state regulation: tax

1) Illustrate and explain this situation.

2) Explain the effect on the social welfare.

Perfect competition

Reaction to state regulation: tax

1) + 2)

Compare slide 27
A tax leads to tax revenue (tax_rate * MCV_tax) for the state, which counts towards the total welfare
However there is a welfare loss or deadweight loss

How well did you know this?

Not at all

Perfectly

Perfect competition

Reaction to state regulation: subsidy

1) Illustrate and explain this situation.

2) Explain the effect on the social welfare.

Perfect competition

Reaction to state regulation: subsidy

1) Illustrate and explain this situation.

Compare slide 30
Tax burden for the state
–> Subsidy = subsidy_rate * MCV_subsidy
TW = CS + PS - subsidy

2) Explain the effect on the social welfare.

There is a welfare loss WL

How well did you know this?

Not at all

Perfectly

Perfect competition

Trade between two regions/regional markets

1) Illustrate and explain this situation.

2) Explain the effect on the social welfare.

Perfect competition

Trade between two countries via world market

1) + 2)

Compare slide 31
Exporting country: p_world > p_local –> export
Importing country: p_world < p_local –> import
Welfare gain (WG) in each country
Trade has strong influence on the distribution between the consumer and producer surpluses

How well did you know this?

Not at all

Perfectly

1) What are the elasticities?

2) What is the price elasticities?

3) What is the price elasticity of demand?

1) What are the elasticities?

Measures of how much buyers and sellers respond to changes in market conditions

2) What is the price elasticities?

Measures the response of buyers and sellers to price changes

3) What is the price elasticity of demand?

Measures how much the demand responds to price changes given a specific demand Q and price level p
PED can vary at different points along the demand curve
price_elasticity_of_demand = (%_change_in_quantity_demanded)/(%_change_in_price)
n_p_Q = (dQ/Q)/(dp/p)
= (dQ/dp) * (p/Q)

How can the price elasticity of demand n_p_Q be classified?

Price elasticity of demand n_p_Q

perfectly inelastic demand: n_p_Q = 0
(demand does not respond at all to prices)

inelastic demand: -1 < n_p_Q < 0
(large change in price –> small change in demand)

isoelastic demand: n_p_Q = -1
(% change in price –> same % change in demand)

elastic demand: -infinity < n_p_Q < -1
(small change in price –> big change in demand)

What is the arc elasticity?

Arc elasticity

Compare slide 34
Can be measured if you know how the demand responds Q_0 to Q_1 to a specific price increase from p_0 to p_1
n_p_Q = (delta_Q/Q)/(delta_p/p)
= (delta_Q/delta_p) * (p_0/Q_0)
= (Q_1 - Q_0)/(p_1 - p_0) * (p_0/Q_0)

What is the point elasticity?

Point elasticity

Compare slide 35
Is the infinitesimal version of the arc elasticity if you can precisely calculate the derivative
n_p_Q = (dQ/Q)/(dp/p)
= (dQ/dp) * (p/Q)

Price elasticity of demand

Assumption: No marginal costs, supplier have market power

Name the strategies of suppliers for maximizing their revenue.

1) Elastic demand

2) Isoelastic demand

3) Inelastic demand

Assumption: No marginal costs, supplier have market power

1) Elastic demand
- Drop price until demand is isoelastic

2) Isoelastic demand
- Remain price

3) Inelastic demand
- Raise price until demand is isoelastic

Reasoning: supplier’s revenue maximization:

dR/dp = 0
–> Q * (n_p_Q + 1) = 0
–> Revenue is maximized when we reach the isoelastic point n_p_Q = −1

Price elasticity of demand

True or false?

The price elasticity of demand n_p_Q can vary at different points along the demand curve.

In other words the price elasticity of demand n_p_Q depends on a specific price and quantity allocation.

True!

n_p_Q = (dQ/Q)/(dp/p)
= (dQ/dp) * (p/Q)

Price elasticity of demand True or false? A supplier has the market power to manipulate the price and has no marginal costs. His revenue would be maximized in case of an isoelastic demand (n_p_Q = -1).

True!

Price elasticity of demand True or false? Demand for electricity is largely inelastic.

True! - Consumers do not perceive the price changes (hidden in monthly bills) - Lack of substitutes (e.g. for heating: gas, for lighting: gas lamps, for communication: pigeon?, for computation: abacus?) - Switching to alternative products (substitutes) is cumbersome (cumbersome = "schwerfällig")

Price elasticity of demand True or false? Short-run elasticity vs. long-run elasticity In the long-run demand tends to be more elastic than the short-run. E.g. if petrol prices remain high over many years, consumers may be more likely to switch to electric vehicles.

True!

Price elasticity of demand True or false? The slope of the inverse demand curve is not the same as the price elasticity of demand.

True! - The elasticity generally depends on p and Q; in case of a linear inverse demand function the elasticity is not constant - n_p_Q = (delta_Q/delta_p) * (p/Q)

Price elasticity of demand Explain why the price-demand elasticity can become positive.

Positive price-demand elasticity (--> Rising prices lead to rising demand) - Veblen or Snob effect --> A product becomes more attractive the more expensive it is (e.g. exclusive clubs in London, whisky, cigars, Renoirs) - Quality effect --> If quality is hard to assess, price is used as a quality indicator (e.g. you want to buy a nice wine for a friend, but don’t know enough about it, so choose an expensive one).

Price elasticity of demand What is cross elasticity?

Cross elasticity - If the price of one good has an effect on the demand of another good (indirect elasticity) - For example, if the price of one good p_1 influences the sales of another Q_2 then the cross elasticity is given by --> n_p_1_Q_2 = (p_1 / Q_2) * (dQ_2 / dp_1) - Complementary goods: negative cross-price-elasticity --> E.g. gasoline and cars - Substitute goods: positive cross-price-elasticity --> E.g. butter and margarine

True or false? Production decisions are made in the short run. Investment decisions are made in the long run.

True!

True of false? Production decisions are made in the short run, where we assume that the production capacities (factories, machines etc.) already exist.

True!

Production decisions What type of costs determine the price at which a seller is willing to sell their goods?

Marginal costs Which include both: - Explicit, direct costs --> Out-of-pocket expenses, money actually paid --> E.g. for wages, materials, energy - Opportunity costs --> Potential benefit or income that is foregone as a result of selecting one alternative over another

What is missing? "..." are costs incurred regardless of the production level Q (e.g. building rent, equipment depreciation). "..." depend on Q and vanish when Q = 0 (e.g. energy, materials).

"Fixed costs" "Variable costs"

What is missing? - Fixed costs C_fix are the share of total costs that do not change when the produced quantity Q is varied --> "..." - Variable costs C_var(Q) are the share of total costs that do change when the produced quantity Q is varied --> "..." - Total costs are the sum of fixed and variable costs --> "..." - Average costs AC(Q) are the total costs per unit --> "..." - Marginal costs MC(Q) are the costs incurred per unit for an additional unit of production; they depend on current production rate --> "..." - Revenue/turnover is the income from selling at price p --> "..." - Contribution margin CM(Q) is the revenue minus variable costs, i.e. the contribution towards covering the fixed costs. --> "..."

Fixed costs C_fix --> dC_fix / dQ = 0 Variable costs C_var(Q) --> dC_var(Q) / dQ > 0 (only true if there are variable costs) Total costs C(Q) --> C(Q) = C_fix + C_var(Q) Average costs AC(Q) --> AC(Q) = C(Q) / Q Marginal costs MC(Q) --> MC(Q) = dC(Q) / dQ Revenue/turnover --> R(Q) = p * Q Contribution margin CM(Q) --> CM(Q) = p * Q − C_var(Q)

Explain why fixed costs are ignored during the short run production decision.

- Fixed costs C_fix are independent from the produced quantity and therefore occur all the time - The contribution margin CM (= revenue - variable costs) decreases total losses and even potentially generates profit; it is the contribution to covering the fixed costs C_fix Short run production decision - Rule: If CM > 0 --> continue production - Ignore fixed costs C_fix completely Long run divest-/investment decision - Rule: If total CM < total fixed costs --> total profit < 0 --> remove fixed costs --> divest (E.g. scrap production plant)

How is a Cournot oligopoly defined?

Cournot oligopoly - More than one producing firm - Fixed number of firms - Homogeneous good - No cooperation/collusion among firms - Firms have market power - Firms compete in quantities and choose them simultaneously - Firms act economically rational and try to maximize profit given their competitors’ decisions

Profit maximization A firm wants to maximise its profits --> Profit maximization problem: dΠ/dQ = 0 What is the optimal Q if a) ... perfect competition is assumed? b) ... a monopoly is assumed?

a) Perfect competition Profit maximization problem: dΠ/dQ = 0 Profit: Π = p · Q − C(Q) - Firm is price taker dp/dQ = 0 - Optimum: p = dC(Q)/dQ = MC(Q) (market price = marginal costs) b) Monopoly Profit maximization problem: dΠ/dQ = 0 Profit: Π = p(Q) · Q − C(Q) - Firm sets price dp/dQ != 0 - Optimum: dR(Q) / dQ = dC(Q) / dQ = MC(Q) (marginal revenue = marginal costs)

What is the threshold for production?

Threshold for production / **shut-down price** - Min. price p_prod at which revenue (=p * Q) covers variable costs C_var(Q) but no fixed costs C_fix; contribution margin CM(Q) = 0 - Below this threshold the production should be stopped - Determination Q_prod: --> 0 = d(C_var(Q)/Q) / dQ <=> C_var(Q) / Q = MC(Q) (average variable costs = marginal costs) - Determination p_prod: --> p_prod = C_var(Q_prod) / Q_prod = MC(Q_prod)

Perfect competition How does much does a firm produce if the market price p is given?

Market optimum Slove: p = d(C_var(Q)) / dQ = MC(Q) (price = marginal costs)

What is the break-even for profit?

Break-even for profit - Min. price p_break at which revenue (= p · Q) covers total costs C(Q); contribution margin = fixed costs - Determination Q_break: Find the minimum of the average total costs --> 0 = d(C(Q)/Q) / dQ <=> C(Q) / Q = MC(Q) (average total cost = marginal cost) - Determination p_break: --> p_break = C(Q_break) / Q_break = MC(Q_break)

Perfect competition How do you calculate the following (p,Q)-allocations? 1) Market optimum: (P_market, Q_market) 2) Production threshold: (P_prod, Q_prod) 3) Break-even: (P_break, Q_break)

1) Market optimum: (P_market, Q_market) - Solve for Q_market: --> p_market =! MC(Q) 2) Production threshold: (P_prod, Q_prod) - Solve for Q_prod: --> C_var(Q) / Q =! MC(Q) (average variable costs =! marginal costs) - Determine P_prod: --> P_prod = C_var(Q_prod) / Q_prod =! MC(Q_prod) 3) Break-even: (P_break, Q_break) - Solve for Q_break: --> C(Q) / Q =! MC(Q) (average total costs =! marginal costs) - Determine P_break: --> P_break = C(Q_break) / Q_break = MC(Q_break)

Monopoly In case of a *linear inverse demand function* the marginal revenue has always the same p-axis-intercept, twice the slope and half of the Q-axis-intercept of the inverse demand function.

True! Compare slide 69

Monopoly **Assumption: linear inverse demand function** MCP, MCV; CS, PS Illustrate this situation

Compare slide 70

Perfect competition vs. monopoly True or false? If there are linear supply costs the producer surplus PS under perfect competition is zero while it is larger than zero in the monopoly.

True! Compare slide 72

What is the gross consumer surplus?

Gross consumer surplus = Total willingness to pay = Net-consumer surplus + costs of consumption = Net-consumer surplus + revenue of sellers (costs of consumption = revenue of sellers)

True of false? Under perfect competition and a monopolistic market structure the inverse supply curve equals to the marginal cost curve.

True! Monopoly: compare slide 70 Perfect competition: