SENIOR

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SENIOR OUTCOMES SEMINAR (BU385) ECONOMICS
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BASIC CONCEPTS IN ECONOMICS I

• Opportunity costs
• Equilibrium of supply (QS) and demand (QD)
• Price elasticity of demand
• Marginal costs, revenues, and profits
• Economies of scale and scope

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BASIC CONCEPTS IN ECONOMICS I

• Sunk costs and entry barriers
• Profit maximization by a competitive firm
• Profit maximization by a monopoly and
• 
  oligopoly
• Pricing policies
• Externalities

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A rational (reasonable) decision suits interests
of the decision maker. The opportunity cost of
the rational decision is the value of the next
best alternative that is sacrificed because of
this decision
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• Essence of the opportunity cost
• Under scarcity, no gains without pains,
• i.e. each gain involves some loss
• The value of the gain is determined by a
• ratio between its market price and the
• market price of the sacrificed next best
• alternative option.

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Illustrative example P(gain)absolute market
price of gain in P(loss)absolute market price
of sacrificed best
alternative option in RATIO P(gain)/P(loss)
IS A RELATIVE PRICE WHICH DETERMINES THE TRUE
VALUE OF THE GAINS
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Equilibrium of QS and QD is a price P such
that QS(P)QD(P) Follows from QSg(P)
QDf(P) Prices are information signals that
push QS and QD towards equality
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Equilibrium of QS and QD is a price P such
that QS(P)QD(P)
P
P1
P2
QD, QS
Surplus at P1
Deficit at P2
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Shifts of DD curves
P
Rightward Population up Incomes up
QD, QS
Leftward Population down Incomes down
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Shifts of SS curves
P
Rightward Size of industry up Tech progress
up Relative prices of inputs down
QD, QS
Leftward Size of industry down Relative
prices of Tech progress down
inputs up
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Elasticity of demand with respect to changes in
prices ? ?QD/QD ?P/P ?QD/?P P/QD,
?QD/QD percentage changes ?P/P percentage
changes ? is the key measure of sensitivity of
demand to changes in prices
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Elastic demand curve ?gt1 Inelastic demand
curve ?lt1 Unit-elastic demand curve ?1
P
?gt1 (luxury)
?1
?lt1 (necessities)
450
QD
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P
P
P1
QD
QD
At any P, ?8
At P1, ?0
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Marginal costs (MC) are costs of producing an
additional unit of output
Suppose 50 units are already produced TC Total
cost MC (of the 51th unit) TC (of 51 units)-
TC (of 50 units)
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In certain business environments, volume of
production at MCAC is an optimum position
MC
MC
AC
MCAC
Volume
?
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Fixed costs (FC) are incurred no matter how much
units are produced
Variable costs (VC) increase as a volume of
production increases
This distinction is the key to understanding why
some firms are better off after MA and other
are better off without MA
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Scale volumes of produced homogeneous (the same
type) output
Scope volumes of produced heterogeneous
(different types) outputs

• Scale Scope
• volumes of produced
• homogeneous and heterogeneous outputs

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Economies of scale (ES) are changes in
efficiency due to changes in volumes of output
Decreasing EC
AC
Constant ES
Increasing ES
Scale
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Increasing ES costs of additional units of
output go down due to rationalization of
operations
fixed costs per unit decrease
Decreasing ES costs of additional units of
output go up due to increasing difficulties of
managing added operations
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Sunk costs are costs that cannot be recouped
Barriers to entry into an industry or market
are costs that outsiders should incur to become
insiders
Bigger market power of insiders
Higher barriers to entry
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Bigger market power of insiders
Higher economic profits of insiders

• Economic profit
• accounting profit profit from the next
• best alternative
  use
• of capital

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Zero economic profit at time t there does not
exist an alternative investment option that will
lead to a higher accounting profit at time t
In an industry with zero economic profit,
insider firms prefer to stay put since nowhere
they could get a higher profit
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Perfect competition is idealized model
benchmark
Numerous firms are price takers their
individual decisions to change volumes of outputs
have no influence on prices. Such (small) firms
have horizontal DD curves Such firms can sell
any quantities of their outputs at going market
prices
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Perfect competition
Any firm can freely exit or enter the industry

• The firm should stop increasing/
• decreasing its outputs when its
• economic profit becomes zero, i.e.
• MC MR P,
• where MR is marginal revenue.

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Monopoly

• A firm that can influence prevailing market
  prices by changing its outputs

Such firm has a downward-sloping DD curve

• Creates entry barriers for potential competitors
  

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Essence of monopoly

• Chooses levels of outputs such that its
  economic profit is greater than zero
• MC MR lt P.
• Economic profit from production of additional
  unit of output is
• MC P MC.

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Two types of monopoly
Pure monopoly a one-firm industry whose
product has no close substitutes
Natural monopoly a one-firm industry because
this firm has enormous economies of scale (ES).
Such ES need gigantic sizescale.
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Monopolistic competition

• Numerous small firms

• Freedom of exit and entry

• Each firm produces slightly different
• product. Apart of this difference, the
• product has many close substitutes

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Monopolistic competition

• Economic profit slightly higher than
• zero
• MCMR ltP
• higher a firm exercises small market power due
  to unique distinction in its product
• slightly many close substitutes, i.e.
• tough competition

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Oligopoly

• A bulk of the business in industry carried by a
  few large firms

• Products are close substitutes so competition is
  tough

• May have economic profit slightly
• higher than zero
• MCMR ltP

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Pricing policies
Cost-based pricing cost target profit. Not
enough flexibility to speedily adjust to changes
in market situations.
Utility-based pricing a firm adjusts prices to
attract maximum consumers and then ruthlessly cut
cost to make sales profitable.
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Pricing policies
Premium-based pricing extracting additional
payment for unique qualities of a product
Price discrimination different prices to
different customers for the same products
Price leadership one firm sets the price for the
industry and the other follow.
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Externalities are any costs or benefits generated
by one firm/person that affect another firm/person
Imposition of external costs
detrimental externality
Imposition of external benefits
beneficial externality
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Examples of externalities
Private goods are products and services whose
consumption is excludable and rival, e.g. good
food at graduation party
Public goods are products and services whose
consumption is nonexcludable and nonrival, e.g.
national defense
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Examples of externalities

• Mixed goods
• Excludable but nonrival consumption,
• e.g. cable TV.
• Nonexcludable but rival consumption,
• e.g. public park.