Managerial Economics is the science of cost-  Flow - Change in a stock over some period

effective management of scarce resources. of time

Wherever resources are scarce, managers can
Two Type of Economic Model
make more cost-effective decisions by applying
the discipline of managerial economics. The a) Static Model - Describes behavior at a single
decisions may regard customers, suppliers, point in time.
competitors, or the internal working of the
organization. b) Dynamic Model - Explicitly focuses on the
timing and sequence of actions
Three (3) branches of Managerial Economics:
and payments.
Competitive markets
Market power
Imperfect markets Basic Equation of Managerial Economics:

Scope of Managerial Economics Value Added = Buyer benefit-Seller cost

•study of individual economic

= Buyer surplus+ Seller economic
Microeconomics
behavior where resources are costly profit

Managerial • application of microeconomics to

Economics managerial issues

• focuses on aggevate economics

Macroeconomics
variables

 The above equation states that value

Methodology
added is the only extent that the business
Economic Model – Concise description of behavior deliver benefit to the buyers that exceeds
and outcomes. the cost of production that they create
value.
Assumptions in Managerial Economics
 Anyone who delivers benefit which is less
1. Ceteris Paribus - assertion in economic theory than the cost of production.
that in the analysis of the relationship between  The buyer gets some part of the value
two variables, all other variables are assumed to added in buyer surplus, which is the
remain unchanged. difference between buyer’s benefit and
their expenditure.
2. Ockham’s Razor - principle that, other things  The sellers gets the other part of the value
being equal, the simplest explanation tends to be added in economic profit, which is the
the correct explanation.
difference between the revenue that the
seller receives(equal to the buyer
Difference in Stocks and Flow expenditure) and the cost of the
production.
 Stock - Quantity at a specific point in time
Average Value (choosing a new sandwich and
disliking it), individuals opt to stick
The total value of variable divided by total
with the status quo (the sandwich
quantity of the measure
with which they are already familiar).
Marginal value
Anchoring
The change in the variable associated with
 is the use of irrelevant information,
a unit increase in measure.
such as the purchase price of a
Sunk Cost Fallacy security, as a reference for evaluating
or estimating an unknown value of a
 Sunk cost refers to money that has financial instrument.
already been spent and which cannot be  is a behavioral finance term to
recovered. It is excluded from future describe an irrational bias towards a
business decisions because the cost will psychological benchmark.
remain the same regardless of the  For examples,In one instance, traders
outcome of a decision. are typically anchored to the price at
 The sunk cost fallacy is when we continue which they bought a security. For
an action because of our past decisions example, if a trader bought stock ABC
(time, money, resources) rather than a for $100, then she will be
rational choice of what will maximise our psychologically fixated on that price
utility at this present time. For example, for a sale or further purchases of the
Suppose you take out a 12-month gym same stock, regardless of ABC's actual
membership, costing $40 a month. You value based on an assessment of
have committed to spending 12*$40 = relevant factors affecting it.
$480. Once you have signed your contract, In another, analysts may become
you have effectively committed to $480. It anchored to the value of a given index
is now a sunk cost – you can’t get it back. at a certain level instead of
Whether you go to the gym or not, makes considering historical figures. For
no difference to the sunk cost. example, if the S&P 500 is on a bull
run and has a value of 10,000, then
analyst propensity will be to predict
Status Quo Bias values closer to that figure rather than
 is an emotional bias; a preference for considering standard deviation of
the current state of affairs. The values, which have a fairly wide range
current baseline (or status quo) is for that index.
taken as a reference point, and any
change from that baseline is perceived Discounting
as a loss. For example, When offered  A procedure to transform future
several sandwich options for lunch, dollars into an equivalent number of
individuals often choose a sandwich present dollars.
they have eaten before. This Outsourcing
phenomenon is called regret  The purchase of services or supplies
avoidance: in seeking to avoid a from external sources.
potential regrettable experience
Market
Buyers and sellers who communicate with
DEMAND
one another for voluntary exchange.
Determinants of Demand
Industry
1. Income - A rise in individual’s income will lead
Businesses engaged in production or
to an increase in demand in
delivery of the same or similar items.
normal products. While goods whose demand
varies inversely with income are called inferior
goods.
Competitive markets are characterised by: Normal goods
- Demand is positively related to buyer’s income
 Many firms as opposed to a small number - When economy is growing and income are rising,
 Low barriers to entry and exit. – the demand fornormal products will rise
Contestable market - The demand for normal products is relatively
 Low profits of incumbent firms higher in richer
 Relatively low prices. countries
- These are the products with longer life span
usually more than 3
Years
Market Power
Inferior products
The ability of a buyer or a seller to
- Demand is negatively related to buyer’s income
influence market conditions.
- The demand for inferior products is relatively
Imperfect Markets higher in poorer
- when one directly parties directly countries
- When economy is in recession and incomes are
conveys a benefit or cost to others, or
falling, the demand for normal products will fall
-when one party has better information.
while the demand for inferior
Managers of business in imperfect markets need products will rise
to think strategically. For instance, a residential 2. Consumer Preferences - favourable changes
mortgage lender may require all loan applicants to lead to an increase in demand, unfavourable
pay for a credit evaluation, with the lender change lead to a decrease. The individual decides
how much he or she wants to buy at each possible
refunding the cost, if the credit evaluation is
price.
favorable. The lender might reason that would not
3. Price of related goods
be willing to pay for the credit evaluation because Substitute goods
they would fail the check. Good borrowers, - Those that can be used to replace each other
however, would pay for the evaluation because - An increase in the price of one causes an
the would their money back from the lender. increase in the demand
Hence, the credit evaluation requirement will for the other
screen out the bad borrowers. This is an example - Price of substitute and demand for the other
of strategic thinking in an imperfect market. good are directly related (ex: if the price of coffee
rises, the price of tea also increase)
Complement goods
- Those that can be used together
- An increase in the price of one causes an
increase in the demand
for the other.
- Price of complement and demand for the other illustrates the law of demand- the inverse relationship between price
and quantity demanded.
good are inversely
related (ex: if the price of ice cream rises, the
Marginal Benefit is the benefit provided by an
demand for ice
additional item. The principle of
cream toppings will decrease)
marginal benefit states that each additional unit of
4. Expectations - when people expect that a price
consumption provides less benefit than the
of a commodity will increase, they demand for
preceding unit.
more of it
5. Number of buyers in the market - As more
Buyer Surplus is the difference between a buyer’s
buyers enter the market, demand rises
total benefit from some
consumption and the actual expenditure.
Law of Demand – states that all other variables
Formula:
equal, as the price of product
Buyer Surplus = Total Benefit-Actual Expenditure
increases, the demand decreases.
Sample Problem:
Demand Schedule – is a table that shows the
relationship between the price of
goods and the amount of goods consumers are
willing and able to pay for them
at the price.

1. Calculate the Total Benefit from 8 movies a

month.
Table 1. Price and Quantity Demanded of Gasoline Area 0bcd = ½($8x8) + $12x8 = $128
2. Calculate the Buyer Surplus
Demand Curve – is a graph showing how the Total Benefit - $128 - 0bcd
demand for a commodity varies Actual Expenditure - (96) - 0bca
with changes in price. Buyer Surplus - $ 32 - acd

Two Types of Pricing Policies

*used by banking, car rentals, telecommunication, and
Internet access
1. Package-deal Pricing
- pricing scheme comprising a fixed payment for a
fixed quantity of consumption.
Figure1. Demand Curve for Gasoline. The demand schedule shows - effective if there is no alternative
that as a price rises, quantity demanded decreases and vice versa.
These points are then graphed, and the line connecting them is the Example: If the mobile telephone provider charges
demand curve (D). the downward slope of the demand curve again a price of 10 cents per minute,
Lea will make 100 minutes of calls a month.
Suppose that the mobile provider Elasticity
offers Lea a package deal of 100 minutes of calls at
$29 with no alternative. Elasticity – Measure of the responsiveness of one
variable to changes in another
variable. The concept of elasticity is essential in
gauging the impact of changes in
prices, incomes and other factors on demand,
consumer’s expenditure and seller’s
revenue.
Percentage by which the quantity demanded will
change if the price of the item
rises by 1%.

Formula:
Percentage change in quantity demanded
____Percentage change in price
Compute for: Total Benefit and Buyer Surplus - 30
and 1 Types of Elasticies
1. Perfectly Elastic Demand – when
2. Package-deal Pricing demand for a product changes even when there is
- pricing scheme comprising a fixed payment and a no change in price.
charge based on
consumption.
Example: If the mobile telephone provider charges
a price of 10 cents per
minute, Lea will make 100 minutes of calls a
month. Suppose that the mobile
provider offers a two-part plan comprising a $19
monthly charge and an airtime charge of 10 cents
a minute.
Payment: A total of $19 + ($.10x100) = $29

MARKET DEMAND

Market Demand Curve

- graph that shows the quantity that all buyers will
purchase at every
possible price.
- slopes downward. 2. Perfectly Inelastic Demand – When a
- with lower price, market as a whole will buy a demand for commodity shows no response to
larger quantity. change in price.

Factors that Affect Market Demand

1. Buyers’ Income
2. Prices of related products
3. Advertising
 3. Relatively Elastic Demand - When 5. Unitary Elastic Demand – When
proportionate change in demand is equal
proportionate change in demand is more than the
proportionate change in price. to proportionate change in price.

Factors Affecting Price Elasticity

1. Available substitutes
4. Relatively Inelastic Demand – When The more substitutes available for the
proportionate change in demand is good, the more elastic the demand for it. When
less than the proportionate change in price. there are few close substitutes for a good, demand
tends to be relatively inelastic.
2. Buyer’s prior commitment
Once users have invested time and effort
to learn one program, they become
“locked in” for future upgrades. Whenever there is
such “locked in”, demand
is less elastic.
3. Benefit/costs of economizing
Buyers have limited time to spend on searching
better prices so they focus attention on items that
account for larger expenditures. Goods that
comprise a relatively small share of consumer’s
budgets tend to be more inelastic than goods for • Increase in advertising = increase in
which consumers spend a sizeable portion of their demand
incomes.
4. Time Elasticity of Supply
Demand tends to be more inelastic in the short Measures the responsiveness of the quantity
term than the long term. The more time supplies to a change in the price of a goods, with
consumers have to react to a price change, the all other factors remaining the same.
more elastic the demand for the good.
Law of Supply – the elasticity of supply is
Other Elasticities always positive because the law of supply says
These are elasticities to measure the that keeping other factors constant, an increase in
responsiveness of demand to changes in other price results in an increase in quantity supplied.
factors such as buyer’s income, prices of
complementary and substitute items and sellers’ If the supply is elastic, producers can increase
advertising. output without a rise in cost or a time delay. If the
a) Income Elasticity – Measures the impact on supply is inelastic, firms find it hard to change
demand to changes in buyers’ income. production in a given time period.

Formula: __Percentage change in demand__

Percentage change in buyers’ income
• For a normal product = increase in income
= increase in demand = income elasticity is
positive
• For an inferior product= increase in
income = decrease in demand = income elasticity
is negative.

b) Cross Price Elasticity – Measures the

sensitivity of demand to changes in prices of
related products

Formula: Percentage change in demand

Percentage change in price of related item
• For substitutes= increase in price =
increase in demand = cross price elasticity is
positive
• For complements = increase in price =
decrease in demand = cross price elasticity is
negative

c) Advertising Elasticity – Measures the

sensitivity of demand to changes in sellers’
advertising expenditures

Formula: Percentage change in demand

Percentage change in sellers’ advertising
expenditure
Types of Elasticity

Cross Elasticity of Supply – Measures a

proportional change in the quantity supplied in
relation to the proportional change in the price.
Cross-price elasticity = %δ of qs of good a / %δ of
price of good b a change in the price of one good
can shift the quantity demanded for another good.
Example: complements in production (low fat
milk & cream) - positive substitute in production
(corn & soybeans) – negative

Determinants of Elasticity of Supply

• Long run vs short run: the supply is more

elastic in the long run (long time period).
• Availability of inputs: when the inputs are
easily available, the supply is more elastic. The
larger the number of close substitutes.
• Complexity of technology: if the
technology is simple, the supply will be more
elastic.
• Non-durable – the longer the time to
adjust, the bigger the response to a price change,
therefore more elastic in the long-run.
• Durables – the difference between short
and long-run elasticities of demand depends on a
balance between the need for time to adjust and
the replacement frequency effect.

Why it matters?
• tells how fast supply responds to quantity
demand and price increase.
• the higher the elasticity of supply, the
faster the supply will increase when demand and
price increases.
 SUPPLY 2. Variable Costs
- any costs that depends on the firm’s level
When economists talk about supply, they mean of output.
the amount of some good or service a producer is 3. Average Fixed Costs
willing to supply at each price. Price is what the - is the total fixed costs divided by the
producer receives for selling one unit of a good or number of units of output.
service. An increase in price almost always leads to 4. Average Variable Costs
an increase in the quantity supplied of that good - total variable costs divided by the number
or service, while a decrease in price will decrease of units of output.
the quantity supplied. - Marginal cost is cost of additional one unit
while AVC is the aver-age variable cost per unit of
Economists call this positive relationship all the units being produced.
between price and quantity supplied—that a 5. Marginal Costs
higher price leads to a higher quantity supplied - is the increase in total cost that results
and a lower price leads to a lower quantity from producing one more unit of output.
supplied—the law of supply. The law of supply - Reflects changes in Variable Costs.
assumes that all other variables that affect supply
are held constant. Comparing Costs and Revenues To Maximize
Profit
Supply Schedule and Supply Curve The profit maximizing level of output for all the
Supply schedule is a table that shows the firm is the output level where MR=MC
quantity supplied at each price.
Supply curve is a graph that shows the quantity Break-Even Analysis in the Short Run
supplied at each price. Sometimes the supply ◦ Should the business continue in
curve is called a supply schedule because it is a operation?
graphical representation of the supply schedule. ◦ Compare profit from:
What are the determinants of supply? i) Continuing in production
• Production Costs ii) Shutting Down
• Natural conditions
• New technology Short Run Supply Curve
• Government policies
• Number of Sellers
• Expectation of Future Prices

Costs in the Short Run

The short run is a period of time for which two
conditions hold:
◦ The firm is operating under a fixed factor
of production
At any market price, the MC curve shows the
◦ Firms can neither enter nor exit an
output level that maximizes profit. This is the
industry
firm’s short run supply curve.
All firms have costs that they must bear
Long-Run Individual Supply
regardless of their output. These are called Fixed
Costs.
A long-run planning horizon is a time frame far
1. Fixed Costs
enough into the future that all inputs can be freely
- any costs that do not depend on the firm’s
adjusted. We have to analyze:
level of output.
 • Long-run costs
• Revenue

Two key decision of management

1. Whether to continue in operation
2. How much to produce.

Let us analyze the LONG-RUN costs in the

context of LUNA PLYWOOD

The precise profit-maximizing production rate is

3,400. The marginal cost at a production rate of
3,400 is $7 per sheet.

Long-Run Individual Supply

Long-Run break-even condition is that the price

must cover the average cost.

We can maximize profits by:

• If the total revenue covers the total cost,
producing at the rate where the marginal cost
How much should the business produce in the equals the price.
long run? • If the total revenue does not cover the
Production Rate total cost, SHUTTING DOWN.
What is the general rule?

To maximize profits, business should produce

where
MARGINAL COST = MARGINAL REVENUE

Luna’s lowest average cost is $6.86. It attains cost at a

production rate of 3,000 sheets a week.
Hence, if the price of plywood falls below $6.86, then Luna
should GO OUT of the business.
 Individual Supply Curve

A seller maximizes profit by producing at the

rate where its long run marginal cost equals the
price of the output.

Short and Long Run

Why is the average cost of production being

higher in the short run than in long run? The percentage change in quantity supplied is 16%, while the
percentage change in price is 14.3%. Hence, the price elasticity
of supply is 16/14.3 = 1.12.

Seller Surplus – is the difference between a

seller’s total revenue from some quantity of Intuitive Factors
production and the seller’s avoidable cost of • Available production capacity – One factor
producing that quantity. is the available production capacity.
• Adjustment time – some inputs may be
costly or impossible to change.

Market Supply Curve – is a graph showing the

quantity that all sellers will sup-ply at every
possible price.

COMPETITIVE MARKET AND MARKET

EQUILIBRIUM
Market Structure
• In short run – seller surplus equals total 1. Perfect Competition
revenue less variable cost (as-suming that the 2. Pure Monopoly
fixed cost is sunk) 3. Oligopoly
4. Monopolistic Competition
• In long run – seller surplus equals total
revenue less total cost (assuming that the fixed Characteristics of Competitive Market
cost is avoidable.) Condition:
• Large number of buyers and sellers
Price Elasticity – is the percentage by which the • Large number of independent sellers in
quantity supplied will change if the price of the the industry.
item rises by 1%. • Products are homogeneous or identical
• Products pricing are not dictated by any
one seller or buyer
• Buyers and sellers are “Price Takers”
• Freedom of entry and exit in the industry
• The demand curve of for the industry is
downward sloping while for a single firm, it is
perfectly inelastic
 MARKET EQUILIBRIUM – the price at which
quantity demanded is equal to quantity supplied
(Qd = Qs).

Demand Shift – The demand curve tells us how

much of a good or service people are willing to
buy at any given price. Change in demand is
represented graphically in a price vs. quantity
plane, and it is a result of more or fewer en-trants
into the market and changes in consumer
preferences. The shift can ei-ther be parallel or
nonparallel.

Parallel vs. Nonparallel Change in Demand

A parallel shift in demand means that there is
no change in the elasticity of demand for the given
market, but a nonparallel shift means there has
been a change in elasticity.

For example, if there is a perceived increase in

the price of gasoline, then there will be a decrease
in the demand for SUVs, ceteris paribus. This shift
is likely to be parallel, as those who are still in the
market for SUVs are still as sensitive to price
increases in the prices of SUVs as before the
perceived increase in gasoline prices occurred.

A nonparallel change in demand might occur

when, over time, a discretionary good is
considered a necessity.
 Long-Run Equilibrium
Factors That Cause A Demand Curve to Shift
• Income of Buyers LONG-RUN is a period of time in which all
• Trends and tastes of Consumers factors of production and costs are variable. In the
• Prices of Goods and Services long run, firms are able to adjust ALL COSTS.
• Expectations
• Size of the Population In macroeconomics, the long run is the period
when the general price level, contractual wage
Calculating Equilibrium Changes Using rates, and expectations adjust fully to the state of
Elasticities the economy.
The equilibrium in the long-run is shown by the
Elasticity is a measure of a variable's sensitivity intersection of the AD curve, the SAS curve, and
to a change in another variable. In business and the Long-Run Aggregate Supply (LAS) curve. Since
economics, elasticity refers the degree to which LAS represents potential output, a shift in the AD
individuals, consumers or producers change their curve will only result in a change in price level: a
demand or the amount supplied in response to shift to the right increasing price level and a shift
price or income changes. to the left decreasing price level.

It is predominantly used to assess the change

in consumer demand as a result of a change in a
good or service's price.

How Elasticity Works?

• When the value of elasticity is greater
than ≥1 that demand for the good or service is
affected by the price. Therefore, it is ELASTIC.
• When the value of elasticity is less than <1
that demand is insensitive to price. Therefore, it is
INELASTIC.

Short-Run Equilibrium
Sample Problem: Yesterday, the price of
SHORT-RUN equilibrium firms face both
gasoline was Php 55.00/ liter, and Nico was willing
variable and fixed costs, which means that output,
to buy 10 liters. Today, the price has gone up to
wages and prices do not have full freedom to
Php 58.00/ liter, and Nico is now willing to buy 8
reach a new equilibrium.
liters. Is Nico's demand for gasoline elastic or
inelastic? What is Nico's elasticity of demand?
The equilibrium in the short-run is shown by
= (8-10) / (10)
the intersection of the Aggregate Demand (AD)
(55-58) / (55)
curve and the Short-Run Aggregate Supply (SAS)
= 0.036 or 0.04
curve. When either AD or SAS shifts, the
equilibrium point is changed.
Therefore, Nico’s demand for gasoline is
INELASTIC.
 • Marginal benefit equals marginal cost

Scenario:
Company: Moonlight Paper
Nature of Business: production and delivery of
wood
Users: paper mills
Suppliers: forests

Economic Efficiency Condition:

1. Same marginal benefit - If one paper mill
gets more profit than another, the company
In Graph 1, a shift to the right of the AD curve should switch some wood supplies to the higher
will cause the equilibrium output as well as the profit mill. Buyer surplus will increase. The
price level to increase. company’s overall profit will be higher.
2. Same marginal cost - If one forest can
ECONOMIC EFFICIENCY produce wood at a lower marginal cost than
another, then the company should direct the
Understanding economic efficiency is lower cost forest to produce more and the higher
fundamental since it points to opportunities to cost forest to produce less. Seller surplus will
increase value added and profit. Whenever the increase. The company’s overall profit will be
allocation of resources is not economically higher.
efficient, there is a way to add value and make 3. Marginal benefit = marginal cost - If the
profit by solving the inefficiency. marginal benefit of wood to the paper mills is less
than the marginal cost of production wood, the
An allocation of resources is economically compa-ny should cut back production. The
efficient if no reallocation of resources can make reduction in benefit would be less than the
one person better off without making another reduction of cost. The company’s overall profit will
person worse off. Economic efficiency as a be higher. The sum of buyer and seller surplus will
concept have benefits such as: increase.

• A guide to managing resources within an

organization and across entire economies. Consumer Sovereignty – is the theory that
• Identifies opportunities for profit (there is consumer preferences determine the production
a way to make money by resolv-ing an economic of goods and services. This means consumers can
inefficiency). use their spending power as ‘votes’ for goods. In
• A way to assess government intervention. return, producers will respond to those
• It assesses resource allocation preferences and produce those goods.

Conditions for Economic Efficiency The concept of economic efficiency assesses

These are the conditions for economic resource allocation in terms of individual user’s
efficiency that are based on user’s benefits and evaluation of benefit. An example would be in an
supplier’s costs: economy where some consumers like heavy metal
but which produces only opera is not efficient and
• Same marginal benefit for all users vice versa.
• Same marginal costs for all suppliers Technical Efficiency - is the provision of an item
at the minimum possible cost. However, it does
not imply scarce resources are being well used. (up to the point where marginal benefit balances
The concept of economic efficiency extends market price) from any supplier, whether
beyond technical efficiency wherein the Moonlight’s forests or an outside source. Since all
production of the items must be that the marginal mills face the same market price, their marginal
benefit equals the marginal cost. benefits will be equal.
Suppliers: forests. Managers of every forest
Adam Smith’s Invisible Hand maximize profit and sell wood at the market price
In a competitive market, buyers and sellers (up to the point where marginal cost balances the
each acting independently and selfishly will market price) to either Moonlight’s own paper
channel scarce resources into economically mills or outside buyers. Since all forests face the
efficient use. The invisible hand that guides buyers same market price, their marginal costs will be
and sellers is the market price. equal.

Market prices allocate scarce resources in an Since the mills and the forests face the same
economically efficient way. Prices lead to an market price, marginal benefit equals marginal
efficient allocation of resources by providing cost.
information and incentives:
Intermediation
• Users buy until marginal benefit equals Intermediation is a function which brings
price (to maximize benefit); together seekers and providers of goods,
• Producers supply until marginal cost information, money, etc. Need for intermediation
equals price (to maximize profit); occurs due to the imperfect nature of markets and
• Users and producers face same price. everyday situations where the complete
knowledge about providers and seekers (and
Decentralized Management about what they seek) is not available to
The concept of economic efficiency applies not everyone. It is important in the demand-supply
only across the economy but also within the function to understand the impact of the costs of
organization. retailing, distribution, transportation, brokerage
• If there is a competitive market for an and other forms of intermediation on the market
item, the transfer price (i.e., a price charged for for the final food or service.
the sale of an item within an organization) should
be set equal to the market price. One of the common considerations is whether
• Right of outsourcing: consuming units to include the costs of shipment in the price to the
within an organization should be allowed to customer. There are two pricing methods that
outsource (i.e., purchase services or supplies from may have exactly the same impact on the
external sources). manufacturer and customer:
• Producing unit should be able to sell the • Freight-Inclusive Pricing – the price
product to outside buyers. includes the cost of delivery to the buyer
• The 3 conditions for economic efficiency • Free on-Board Pricing – the price does not
are satisfied. The internal mar-ket will be include the cost of delivery to the buyer
integrated with the external market.
Scenario:
Scenario Some online retailers include free shipping wile
Company: Moonlight Paper others charge for shipping. In November 2014, RT
Nature of Business: production and delivery of Edwards offered Samsung 65-inch high definition
wood LED TV for $4238 with free shipping, while Exeltek
Users: paper mills. Every mill maximizes profit offered the same TV for $4095 with a shipping
and is permitted to buy wood at the market price charge of $145 to Perth, Western Australia.
 Minimum Wage Equilibrium
Demand-supply analysis predicts that, whether
online retailers charge for shipping or provide free
shipping, the net price to consumers would be the
same. In the above scenario, Exeltek’s price plus
shipping was $4240, which is almost identical to
RT Edward’s price.

Rent Equilibrium

Deadweight Loss

Deadweight Loss
• Sellers willing to provide item at price that
buyers willing to pay, but provi-sion doesn’t occur.
• Lost gains from trades caused by a market
inefficiency

Price Elasticity
• demand more inelastic > larger loss Price Elasticity
• supply more elastic > larger loss • supply more inelastic > larger loss
• demand more elastic > larger loss

Taxes
• “the only two sure things in life are death
and taxes”
• buyer’s price - tax = seller’s price
• payment vis-à-vis incidence (US: airlines
pay tax; Asia: passengers pay)
 consumers allocate and spend their income
among all the different goods and services.

Utility
It is an economic term used to represent
satisfaction or happiness from consuming a good
or service. The economic utility of a good or
service is important to understand because it will
directly influence the demand, and therefore
price, of that good or service.

Marginal Utility
It is the additional utility gained from the
consumption of one additional unit of a good or
service. For example, if the utility of the first slice
of pizza is 10 utils and the utility of the second
slice is 8 utils, the marginal utility of eating the
second slice of pizza is 8 utils. Moreover, if the
utility of a third slice is 2 utils, the marginal utility
of eating the third slice of pizza is 2 utils.

Total Utility
It is defined as the total amount of satisfaction
that a person can receive from the consumption of
all units of a specific product or service. For
example, if a person can only consume three slices
of pizza and the first slice of pizza consumed yields
10 utils, the second slice of pizza consumed yields
8 utils and the third slice yields 2 utils, the total
utility of pizza would be 20 utils. The total utility is
simply the sum of all the marginal utilities of the
individual units.

Total Utility Maximization

Economic theory regarding consumer activities
suggests that the primary goal of the consumer is
to achieve the largest amount of utility for the
least amount of cost. This is partly due to the
limited amount of funds a person may possess, as
well as a desire to achieve as much satisfaction
THEORY OF CONSUMER BEHAVIOR AND from the consumption of goods and services as
UTILITY MAXIMIZATION possible.

Theory of Consumer Behavior Law of Diminishing Marginal Utility

It tells how consumers purchase diverse It states that all else equal, as more of a single
products and considers how a consumer uses his good or service is consumed, the additional
income in order to accomplish the most fulfillment satisfaction, referred to as marginal satisfaction,
or utility. In other words, it deals with how drops. Or in other words, all else equal as
consumption increases the marginal utility derived
from each additional unit declines. Indifference curve slopes downward to the
right

This is an important feature of an indifference curve. An

indifference curve can neither be horizontal line nor an
upward sloping curve. When a consumer wants to have more
of a commodity, he/she will have to give up some of the other
commodity, given that the consumer remains on the same
level of utility at constant income. This is essential for the level
Indifference Curve Analysis of satisfaction to remain the same on an indifference curve.

Indifference Curve Indifference curve always convex to the origin

This is a curve that represents all the
combinations of goods that give the same
satisfaction to the consumer. It is also known as
‘equal satisfaction curve’ since all the
combinations give the same amount of
satisfaction to the consumer.

For example, if Peter has 1 unit of mango and

14 units of oranges, indifference curve will
determine how many units of orange a consumer
is willing to give up in exchange for an additional
unit of mango so that his level of satisfaction
remains unchanged.
The concept of indifference curve is based on
the properties of diminishing marginal rate of
substitution. The rate gives a convex shape to the
indifference curve.

It is worthy to note that two goods can never

perfectly substitute each other. Therefore, the
rate of decrease in a commodity cannot be equal
to the rate of increase in another commodity.
Thus, indifference curve is always convex (neither
Properties of the Indifference Curve concave nor straight).
 Indifference curves never intersect each other consumer than the combination of goods on the
lower curve.

Marginal Rate of Substitution

This is the rate at which a consumer is
prepared to exchange a good X for Y. This is the
amount of a good that a consumer is willing to
give up for another good, as long as the new good
is equally satisfying.

Each indifference curve is a representation of For example, a consumer initially gives up 6

particular level of satisfaction. In the above image, units of orange to get an extra unit of mango.
IC1 and IC2 are two indifference curves and C is Hence, the MRS is 6. Therefore, MRS of X for Y is
the point where both the curves intersect. the amount of Y whose loss can be compensated
According to indifference curve theory, by a unit gain of X, keeping the satisfaction the
satisfaction at point C = satisfaction at point A. same. Interestingly, as a consumer accumulates
Also, satisfaction at point C = satisfaction at point more units of mango, the MRS starts falling –
B. meaning he is prepared to give up fewer units of
But, satisfaction at point B ≠ satisfaction at orange for mango.
point A. The level of satisfaction of consumer for
any given combination of two commodities is Diminishing Marginal Rate of Substitution
same for a consumer throughout the curve. Thus, An important principle of economic theory is
indifference curves cannot intersect each other. that marginal rate of substitution of X for Y
diminishes as more and more of good X is
4. Higher indifference curve = higher substituted for good Y. In other words, as the
satisfaction consumer has more and more of good X, he is
prepared to forego less and less of good Y.

The Budget Constraint

A consumer always tries to maximize his
satisfaction. But, in this pursuit, he is hampered by
his limited money income, or budget. In order for
a consumer to attain the highest possible level of
satisfaction, he has to buy more goods and has to
work under the following two constraints: (1) he
has to pay the price for the goods and (2) his
A higher IC indicates a higher level of
income is limited, restricting the availability of
satisfaction as compared to a lower IC. This
money for purchasing these goods.
means, any combination of two goods on the
higher curve give higher level of satisfaction to the
 Budget Constraint
This occurs when a consumer is limited in
consumption patterns by a certain income. It
describes the different amount of two
commodities that a consumer can afford.

Budget Line
It shows all possible combinations of two goods
that a consumer can buy within the funds
available to him at the given prices of the goods.

b. Decrease in Income
If a consumer’s income falls, there will be a
corresponding parallel shift to the left to represent
a fall in the potential combination of the two
goods that can be purchased. A decrease in
income makes the purchase of less of either one
or both items possible.

In the diagram, A and B are the two extreme

points. By joining these two points we obtain the
budget line AB which is a straight downward
sloping line. All combinations that are within a
consumer’s reach lie on the budget line. A point
outside the line (point D) represents a
combination beyond the financial reach of the
consumer. On the other hand, a point inside the
line (point C) represents under-spending by the
consumer.

Change in Consumer Income The Budget Constraint

a. Increase in Income In economics, a budget constraint represents
If a consumer’s income increases, then the all the combinations of goods and services that a
consumer will be able to purchase higher consumer may purchase given current prices
combinations of goods. Hence an increase in within his or her given income. Consumer theory
income will result in a shift to the right in the uses the concepts of a budget constraint and a
budget line. An increase in income makes the preference map to analyze consumer choices.
purchase of more of either or both items possible.
 Budget Constraint: Change in the Price of
Goods
 Increase in price of one commodity

Table . The Budget Constraint

Table shows that an individual has a total
income of P500.00 and spent his income on 2
commodities A & B, and the price of A & B are • Decrease in price of one commodity
P100.00 & P50.00 respectively.

Consumer Equilibrium

Graph 1: Budget Line The state of balance achieved by an end user of

Budget Line is a graphical representation of all products that refers to the amount of goods and
possible combinations of two goods which can be services they can purchase given their present
purchased with given income and prices, such that level of income and the current level of prices.
the cost of each of these combinations is equal to Consumer equilibrium allows a consumer to
the money income of the consumer. obtain the most satisfaction possible from their
income.
A budget set or opportunity set includes all
possible consumption bundles that someone can
afford given the prices of goods and the person's
income level. The budget set is bounded above by
the budget line.

A consumer is said to be in equilibrium when

he feels that he “cannot change his condition
either by earning more or by spending more or by
changing the quantities of thing he buys”. A
rational consumer will purchase a commodity up
to the point where price of the commodity is
equal to the marginal utility obtained from the
thing.

PRODUCTION AND PROCESS COST

Fixed and Variable Costs

• Fixed costs are those that do not vary with
output and typically include rents, insurance,
depreciation, set-up costs, and normal profit. They
are al-so called overheads.
• Variable costs are costs that do vary with
output, and they are also called direct costs.
Examples of typical variable costs include fuel, raw
materials, and some labour costs.
A. Total fixed costs
Example: The total fixed costs, TFC, include
Given that total fixed costs (TFC) are constant
premises, machinery and equipment needed to
as output increases, the curve is a horizontal line
construct boats, and are £100,000, irrespective of
on the cost graph.
how many boats are produced. Total variable
costs (TVC) will increase as output increases.
B. Total variable costs
OUTPUT TOTAL TOTAL TOTAL The total variable cost (TVC) curve slopes up at
FIXED VARIABLE COST an accelerating rate, reflecting the law of
COST COST diminishing marginal returns.
100 50 150
C. Total costs
2 100 80 180 The total cost (TC) curve is found by adding
total fixed and total variable costs. Its position
3 100 100 200 reflects the amount of fixed costs, and its gradient
4 100 110 210 reflects variable costs.

5 100 150 250 D. Average fixed costs

6 100 220 320 Average fixed costs are found by dividing total
fixed costs by output. As fixed cost is divided by an
7 100 350 450 increasing output, average fixed costs will
continue to fall.
8 100 640 740
 TOTAL
AVERAGE E. Average variable costs
OUTPUT FIXED
FIXED COST Average variable costs are found by dividing
COST
total fixed variable costs by output.
1 100 100
TOTAL AVERAGE
2 100 50 OUTPUT VARIABLE VARIABLE
COST COST
3 100 33.3
4 100 25 1 50 50

5 100 20 2 80 40

6 100 16.6 3 100 33.3

7 100 14.3 4 110 27.5
8 100 12.5
5 150 30

6 220 36.7

7 350 50

8 640 80

The average fixed cost (AFC) curve will slope down

continuously, from left to right.

The average variable cost (AVC) curve will at first slope

down from left to right, then reach a minimum point, and rise
again.
 AVC is ‘U’ shaped because of the principle of
variable Proportions, which explains the three
phases of the curve:
• Increasing returns to the variable factors,
which cause average costs to fall, followed by:
• Constant returns, followed by:
• Diminishing returns, which cause costs to
rise.

F. Average total cost

Average total cost (ATC) is also called average
cost or unit cost. Average total costs are a key cost
in the theory of the firm because they indicate
how efficiently scarce resources are being used.
Average variable costs are found by dividing total
fixed variable costs by output.
AVERA
AVERA AVERA Average total cost (ATC) can be found by
OUTP GE
GE FIXED GE TOTAL adding average fixed costs (AFC) and average
UT VARIABLE
COST COSTS variable costs (AVC). The ATC curve is also ‘U’
COST
shaped because it takes its shape from the AVC
1 100 50 150 curve, with the upturn reflecting the onset of
diminishing returns to the variable factor.
2 50 40 90

3 33.3 33.3 67 Areas for total costs

Total Fixed costs and Total Variable costs are
4 25 27.5 52.5 the respective areas under the Average Fixed and
Average Variable cost curves.
5 20 30 50

6 16.6 36.7 53.3

7 14.3 50 64.3

8 12.5 80 92.5
 G. Marginal costs Law of Diminishing Returns
Marginal cost is the cost of producing one extra " As additional units of a variable input are
unit of output. It can be found by calculating the combined with a fixed input, at some point the
change in total cost when output is increased by additional output (i.e., marginal/ product) starts to
one unit. diminish."
TOTAL MARGINAL
OUTPUT The Significance of Marginal Cost
COST COST
The marginal cost curve is significant in the
theory of the firm for two reasons:
1 150 0
1. It is the leading cost curve, because
changes in total and average costs are derived
2 180 30
from changes in marginal cost.
3 200 20 2. The lowest price a firm is prepared to
supply at is the price that just covers marginal
4 210 10 cost.

5 250 40 ATC and MC

Average total cost and marginal cost are
6 320 70 connected because they are derived from the
same basic numerical cost data. The general rules
7 450 130 governing the relationship are:
1. Marginal cost will always cut average total
8 740 290 cost from below.
2. When marginal cost is below average total
cost, average total cost will be falling, and when
marginal cost is above average total cost, average
total cost will be rising.
3. A firm is most productively efficient at the
lowest average total cost, which is also where
average total cost (ATC) = marginal cost (MC).

Total Costs and Marginal Costs

Marginal costs are derived exclusively from

variable costs and are unaffected by changes in
fixed costs. The MC curve is the gradient of the TC
curve, and the positive gradient of the total cost
curve only exists because of a positive variable
It is important to note that marginal cost is cost. This is shown below:
derived solely from variable costs, and not fixed
costs. The marginal cost curve falls briefly at first,
then rises. Marginal costs are derived from
variable costs and are subject to the theory of Law
of Diminishing Returns.
 Economies of Scale

Economies of scale are cost advantages reaped

by companies when production becomes efficient.
Companies can achieve economies of scale by
H. Marginal Revenue increasing production and lowering costs. This
Is define as an increase in revenue by happens because costs are spread over a larger
producing one additional unit of a good or service. number of goods. Costs can be both fixed and
variable.
The size of the business generally matters
when it comes to economies of scale. The larger
the business, the more the cost savings.
Price

Economies of scale can be both internal and

external. Internal economies of scale are based on
management decisions, while external ones have
to do with outside factors.
Reasons why economies of scale give rise to
lower per-unit costs:
Quantity
1. Specialization of labor and more
integrated technology boost production volumes
2. lower per-unit costs can come from bulk
orders from suppliers, larger ad-vertising buys
(Cost Capital)
3. spreading internal function costs across
more units produced and sold helps to reduce
costs.

Types of Economies of Scale:

1. Internal Economies of Scale
 This happens when a company cuts costs
internally, so they're unique to that firm. This
may be the result of the sheer size of a
Cost Function: company or because of decisions from the
It is a mathematical formula used to chart how firm's management.
production expenses will change at different  This offers ,greater competitive advantage
output levels. In other words, it estimates the because, external economies of scale is
total cost of production given a specific quantity shared among competitors
produced.
 2. External Economies of Scale Graphical Presentation of Economies and
 This occurs outside of an individual Diseconomies of Scale:
company but within the same industry.
External Economies of Scale are achieved
because of external factors, or factors that
affect an entire industry.

Diseconomies of Scale

Often cost don’t keep falling and falling in the

long run. Like production they of-ten level up and
this is called Constant Return Scale. This happens
when a company or business grows so large that Economies of Scope
the costs per unit increases. Rather than
decreasing costs in every additional output, the This describe the situations in which the long
firm sees an increase in cost when output is run average and marginal cost of a company,
increase. organization, or economy decreases due to
production of some complementary goods and
Diseconomies of scale specifically come about services. An economy of scope means that the
due to several reasons, but all can be broadly pro-duction of one good reduces the cost of
categorized as internal or external. Internal producing another related good. While economies
diseconomies of scale can arise from technical of scope are characterized by efficiencies formed
issues of production or organizational issues by variety, economies of scale are characterized
within the structure of a firm or industry. by volume.

Types of Diseconomies of Scale: Economies of Scope are economic factors that

1. External Diseconomies of Scale make the simultaneous manufacturing of different
 This arise due to constraints imposed by the products more cost effective than manufacturing
environment within which a firm or industry them on their own. This can occur because the
operates. Essentially, diseconomies of scale are products are co-produced by the same process,
the result of the growing pains of a company the production process are complementary, or the
after it's al-ready realized the cost-reducing inputs to production are shared by the products.
benefits of economies of scale.
2. Technical Diseconomies of Scale Ways to Achieve Economies of Scope:
 This involve physical limits on handling and
combining inputs and goods in process. These 1. Diversification of Products
can include overcrowding and mis-matches  This is the most common way, the idea
between the feasible scale or speed of that efficiency is gained through related
different inputs and processes. diversification. Products that share the
3. Organizational Diseconomies of Scale same in-puts that have complimentary
 This happen for many reasons, but overall, productive processes offer great op-
they arise because of the difficulties of portunities.
managing a larger workforce. Several problems
can be identified with diseconomies of scale. 2. Merger and Acquisition
 Horizontally merging with or acquiring
another company is anoth-er a way to
achieve economies of scope. Two regional
 retail chains, for example, may merge with Key Takeaways
each other to combine different product • Opportunity cost is the return of a
lines and reduce average warehouse costs. foregone option less the return on your chosen
Goods that can share common inputs like option.
this are very suitable for generating • Considering opportunity costs can guide
economies of scope through horizontal you to more profitable decision-making.
acquisitions. • You must assess the relative risk of each
option in addition to its potential returns.

Sunk Cost is a cost that has already been

incurred and cannot be recovered. A sunk cost
differs from future costs that a business may face,
such as decisions about inventory purchase costs
or product pricing. Sunk costs (past costs) are
excluded from future business decisions because
the cost will be the same re-gardless of the
outcome of a decision.

Opportunity Cost vs. Sunk Cost

The difference between an opportunity cost
and a sunk cost is the difference between money
already spent and potential returns not earned on
an investment because the capital was invested
elsewhere. Buying 1,000 shares of company A at
Opportunity Cost & Sunk Cost $10 a share, for instance, represents a sunk cost of
$10,000. This is the amount of money paid out to
Opportunity costs represent the benefits an make an investment, and getting that money back
individual, investor or business misses out on requires liquidating stock at or above the purchase
when choosing one alternative over another. price.
While financial reports do not show opportunity
cost, business owners can use it to make educated Production Possibility Curve
decisions when they have multiple options before
them. This curve illustrates the different possibilities
Because by definition they are unseen, that two separate goods may produce when there
opportunity costs can be easily overlooked if one is fixed availability of resources that both item
is not careful. Understanding the potential missed require for manufacturing. Shifts in the PPC curve
opportunities foregone by choosing one are only caused by two factors (a) Change in the
investment over another allows for better quantity and quality of resources and (b) Change
decision-making. in technology.

Opportunity Cost Formula and Calculation: Two types of Production Possibility Curve

Opportunity Cost=FO−CO 1. Constant Opportunity Cost Curve

where: A steady potential price to a business that
FO=Return on best foregone option occurs when a company does not take
CO=Return on chosen option advantage of a feasible chance to earn
profits. An example of a constant
opportunity cost would be if funds and
 resources were allocated to one project, between the buyer and seller. This is your typical
but could have been allocated to a second purchasing of consumer goods and services.
project instead.
b) Contracts
This is a formal and legal relationship between
a buyer and a seller that obligates both to
exchange at specified and agreed upon terms. The
agreement identifies what each party will be
responsible for and defines the time requirement,
and a contract is used for both tangible goods as
well as services rendered.

c) Vertical Integration
This occurs when a firm decides to produce not
only the final product but at least one of the
inputs that are needed for the product.

Transaction Costs
2. Increasing Opportunity Cost Incur costs in excess of the actual amount paid
Law of increasing Opportunity Cost: to the input supplier, e.g. the cost of searching for
"When all resources are being used an increase supplier willing to sell a given input, the cost of
in the production of one good will lead to greater negotiating a price at which the input will be
forgone production of another good." purchased, other investments and expenditures
required to facilitate exchange and alike.

Specialized Investments
Simply an investment in a particular exchange
that cannot be recovered in another trading
relationship.

Types of Specialized Investments

a) Site specificity occurs when the buyer and
the seller of an input must locate their plants close
to each other to be able to engage in exchange.
For example, electric power plants often locate
close to a particular coal mine to minimize the
transportation costs of obtaining coal; the output
(electricity) is less expensive to ship than the input
THE ORGANIZATION OF THE FIRM (coal). The cost of building the two plants close to
Method of Procuring Inputs each other represents a specialized in-vestment
that would have little value if the parties were not
a) Spot Exchange involved in exchange.
This is an informal relationship between a
buyer and a seller in which neither party is b) Physical-Asset Specificity refers to a
obligated to adhere to specific terms for situation where the capital equip-ment needed to
exchange. The buyer and seller are basically produce an input is designed to meet the needs of
anonymous and there is not a legal relationship a particular buyer and cannot be readily adapted
to produce inputs need-ed by other buyers. For
example, if producing a lawn mower engine re- concerns that they may give the other party
quires a special machine that is useful only for increased bargaining power, and thereby reduce
producing engines for a particular buyer, the their own profits. When party A has made a prior
machine is a specific physical asset for producing commitment to a relationship with party B, the
the engines. latter can 'hold up' the former for the value of that
commitment. The hold-up problem leads to severe
c) Dedicated Assets are general investments economic cost and might also lead to
made by a firm that allow it to exchange with a underinvestment.
particular buyer. For example, suppose a
computer manufacturer opens a new assembly
line to enable it to produce enough computers for
a large government purchaser. If opening the new NATURE OF THE INDUSTRY
assembly line is profitable only if the government
actually pur-chases the firm’s computers, the Factors that impact managerial decision:
investment represents a dedicated as-set. A) Market Structure – refers to factors such as the
number of firms that compete in the market.
a. Firm Size – Considerable differences in the
d) Human Capital. In many employment size of largest firms in each industry
relationships, workers must learn specific skills to
work for a particular firm. If these skills are not b. Industry Concentration - Are there many
useful or transferable to other employers, they small firms within an industry or only a few large
represent a specialized investment. firms? It can be measure through the following
ratios:
Relationship-specific Exchange Four-firm concentration ratio (C4)– provides a
• Tied Together crude measure of size structure of an industry
• Creates transaction costs due to sunk
nature of the specific investments.

Lead to Higher transaction Cost Or

• Costly Bargaining
• Underinvestment
• Opportunism and the hold-up problem.
Where:
Underinvestment

An underinvestment problem is an agency

problem between shareholders and debt holders
where a leveraged company foregoes valuable
investment opportunities because debt holders Four-firm concentration ratio ranges from 0 to 1.
would capture a portion of the benefits of the Ratio close to 0 – less concentrated, many small
project, leaving insufficient returns to firms, more competition
shareholders. Ratio close to 1 – more concentrated, four or fewer
firms, less competition
Hold- Up Problem
Sample problem:
The hold-up problem is a situation where two Suppose an industry is composed of six firms.
parties may be able to work most efficiently by Four firms have sales of $10 each, and two firms
cooperating but refrain from doing so because of
have sales of $5 each. What is the four-firm
concentration ratio for this industry?
Answer: 40/50 = 0.80, this means that the four
largest firms in the industry account for 80% of
total industry output. where

• Herfindahl-Hirschman Index (HHI) - is the elasticity of demand for the total

commonly accepted measure of market market
concentration
is the elasticity of demand for the
product of an individual firm.

Where Sample Problem:

The industry elasticity of demand for airline
travel is negative 3, and the elasticity of demand
Sample problem: for an individual carrier is negative 4. What is the
Suppose an industry is composed of three Rothschild index for this industry?
firms. Two firms have sales of $10 each, and one Answer:
firms have sales of $30. What is the Herfindahl- When the index is 1, the individual firm faces a
Hirschman Index for this industry? demand curve that has the
same sensitivity to price as
Answer: the market demand curve.
When the firm's elasticity of
demand is much greater than of the market, the
index is close to 0.

e. Potential for Entry

1. Barriers to entry
2. Explicit costs - capital requirements
3. Economies of scale - new entrant may be
c. Technology
unable to enjoy the re-duced average costs
1. Some industries are labor intensive, some
are capital intensive, or both.
2. In some industries, firms have access to
B) Conduct
identical technologies.
a. Pricing Behavior – Firms in some industry
3. In other industries, one or two firms only
charge higher markups than firms in other
have access to a specific technology.
industries.
1. Lerner Index (L) – measures the difference
d. Demand and Market Conditions
between price and marginal cost as a fraction of
1. Industries with relatively low demand vs.
the price of the product.
industries with great demand.
2. Elasticity of demand for products and
services produced by the firms
3. Rothschild index (R) - measure of the
elasticity of industry de-mand for a product Or
relative to that of an individual firm.
where P is Price and MC is Marginal Cost
Sample problem
 A firm in the airline industry has a marginal
cost of $200 and charges a price of $300. What are D) The Structure-Conduct-Performance Paradigm
the Lerner index and markup factor? a. Causal View
Answer:

The higher the

Lerner Index, the
greater the firm's markup and vice versa.

b. Integration and Merger Activity

1. Vertical integration – situation where b. Feedback Critique
various stages in the production of a single
product are carried out in a single firm.
2. Horizontal integration – merging of the
production of similar products into a single firm.
3. Conglomerate mergers – involved the
integration of different product lines into a single
firm

c. Research and Development - Optimal

amount to spend on Research and Development
depend on the characteristics of the industry in
which the firm operates
PRICE STRATEGIES OF FIRM WITH MARKET
d. Advertising - Various industries spend POWER
much on advertising while oth-ers don't. Market Power
is a measure of the ability of a company to
C) Performance – refers to the profits and social successfully influence the pricing of its products or
welfare that result in a giv-en industry. services in the overall market.
a. Profit - Big firms with big sales do not
always earn big profits. Perfect Competition
b. Social Welfare - Defined as sum of multiple sellers sell a standardized product to
consumer and producer surplus generated in a multiple buyers.
market. Dansby-Willig Performance Index - the
higher the index, the poorer the performance. Monopolistic Competition
is a kind of imperfect competition wherein a
smaller number of sellers slightly differentiate
their products by branding or customization in
function. Because of such trait, the products in the
market are not perfect substitutes for each other,
and sellers can demand variable prices.
 Monopoly Types of Price Discrimination
single company is the sole seller of a distinct a) First-degree discrimination/ Perfect Price
type of product or service. Discrimination – occurs when a company charges
the maximum possible price for each unit
Price Discrimination consumed.
the practice of charging different prices to
consumers for the same good or service. Because, b) Second-degree price discrimination/
there are some who would be willing to pay more Nonlinear Price Discrimination – oc-curs when a
than others. company charges a different price for different
quantities consumed, such as quantity discounts
Two channels for Price Discrimination. on bulk purchases.
• Channel 1: Higher Prices for Some
Price discrimination can extract additional c) Third-degree price discrimination/ Group
consumer surplus from consumers who place a Price Discrimination – occurs when a company
high value on the good. charges a different price to different consumer
groups.
• Channel 2: Attract New Customers
Price discrimination can simultaneously sell to How a Firm Perfectly Price Discriminates?
new customers who would not be willing to pay A firm with market power that can prevent
the profit-maximizing uniform price. resale and has full information about its
customers’ willingness to pay price discriminates
by selling each unit at its reservation price—the
Price Discrimination maximum amount any consumer would pay for it.
• 1st Condition, A Firm Must Have Market The maximum price for any unit of output is
Power given by the height of the demand curve at that
A monopoly, an oligopoly, or a monopolistically output level.
competitive firm might be able to price
discriminate. A perfectly competitive firm cannot. • Perfectly Price Discrimination: Price = MR
• 2nd Condition, A Firm Must Identify Groups A perfectly price-discriminating firm’s marginal
with Different Price Sensitivity revenue is the same as its price. So, the firm’s
If consumers have different demands, a firm marginal revenue curve is the same as its demand
must identify how they differ. curve
• 3rd Condition, A Firm Must Prevent Resale
If resale is easy, price discrimination doesn’t • Competitive, Single-Price, and Perfect
work because of only low-price sales. Price Discrimination Outcomes
 Group price discrimination transfers some of
Group Price Discrimination the competitive consumer surplus to the firm as
additional profit and causes deadweight loss due
Conditions for Group Price Discrimination to reduced output.
a) Group price discrimination: potential
customers are divided into two or more groups Effects on Total Surplus: Group Price
with different prices for each group (single price Discrimination vs. Single-Price Monopoly
within a group).
b) Consumer groups may differ by age, The closer the firm comes to perfect price
location, or in other ways. discrimination using group price discrimination
c) A firm must have market power, be able (many groups rather than just two), the more
to identify groups with different reservation output it produces, and the less production
prices, and prevent resale. inefficiency—the greater the total surplus.

Group Price Discrimination: A Graphic Characteristics and Conditions

Approach Many firms, with market power and no resale,
are unable to determine high reservation prices.
If a firm can prevent resale between countries Such a firm can price discriminate by letting the
and has a common MC, then it can maximize price each customer pays vary with the number of
profit by acting like a traditional monopoly in each units the customer buys (nonlinear price
country separately. discrimination).

In Figure next slide, resale between the U.S. Block Pricing

and the U.K. is not possible (different DVD • A firm charges one price per unit for the
formats) and the common constant MC = m = $1. first block purchased and a dif-ferent price per
Warner acts as a traditional monopoly in each unit for subsequent blocks. Used by gas, electric,
country. U.S. market: MRA=1, QA=5.8, pA=$29. water, and other utilities.
U.K. market: MRB=1, QB=2, pB=$39. Warner price • When block pricing consumer surplus is
group discriminates and maximizes profit. lower, total surplus is higher and deadweight loss
is lower. The firm and society are better off but
Group Pricing of the Harry Potter DVD con-sumers lose.
• The more block prices that a firm can set,
the closer the firm gets to per-fect price
discrimination.

Effects on Total Surplus: Group Price

Discrimination vs. Perfect Competition

Consumer surplus is greater and more output is

produced with perfect competition than with
group price discrimination.
 Two-Part Pricing 20, where Valerie purchases 60 and Neal buys 80
units. It charges both the same access fee of 1,800
Characteristics and Conditions: = A1 , which is Valerie’s CS. π = 5,000
Two-part pricing: a firm charges each
consumer a lump-sum access fee for the
right to buy as many units of the good as
the consumer wants at a per-unit price.
A consumer’s overall expenditure for
amount q consists of two parts: an access
fee, A, and a per-unit price, p. Therefore,
expenditure is E = A + pq.
To do it, a firm must have market power,
know how individual demand curves vary
across its customers, and prevent resale.

a. Two Part Pricing with Identical Consumers

With identical customers, a firm can set a two- Bundling and Types of Bundling – selling
part price that is efficient (p = MC) and all total multiple goods or services for a single price.
surplus goes to the firm (CS = 0).
Most goods are bundles of many separate
parts. However, firms sometimes bundle even
when there are no production advantages and
transaction costs are small. Bundling allows firms
to increase their profit by charging different prices
to different consumers based on the consumers’
willingness to pay.

b. Two-Part Pricing with Different Consumers • Pure Bundling – only a package deal is
offered (a cable company sells a bundle of
Two-part pricing is more complex if consumers Internet, phone, and television for a single price,
have different demand curves. Having two no service separately)
different demands implies consumers have • Mixed – are available as a package or
different consumer surpluses. Two-part pricing separately.
would require the monopolist to charge different
access fees, and this may not be possible. Profitable Pure Bundling: Reservation Prices
Negatively Correlated
Example
In next slide, the monopoly faces two
consumers. Valerie’s demand curve is D1 in panel
a, and Neal’s demand curve is D2 in panel b.
Tables 10.2 Negatively Correlated Reservation Prices
If the monopoly can charge different prices, it
sets price for both customers at p = MC = 10 and Table 10.2 shows the reservation prices for two
access fee of 2,450 to Valerie and 4,050 to Neal. π customers and two products. The reservation
= 6,500 prices are negatively correlated: the customer
who has the higher reservation price for one
If the monopoly cannot charge its customers product has the lower reservation price for the
different access fees, it sets its per-unit price at p = other product.
 positively correlated, pure bundling cannot
If the firm sells the two products separately, it increase the profit.
maximizes its profit by charging $90 for the word
processor and selling it to both consumers and Mixed Bundling
selling the spreadsheet program for $50 to both Under mixed bundling, consumers are allowed
consumers. The firm’s total profit from selling the to buy the pure bundle or to buy any of the
programs separately is $280 (= $180 + $100). bundle’s components separately.

If the firm sells the two products in a bundle, it

maximizes its profit by charging 160, selling to
both customers, and earning $320. Pure bundling
is more profitable. Table 10.4 Reservation Prices and Mixed Bundling

Pure bundling is more profitable because the Table 10.4 shows the reservation prices of four
firm captures more of the consumers’ potential potential customers for two products. Aaron, a
consumer surplus—their reservation prices. writer, places high value on the word processing
program but has relatively little use for a
spreadsheet. Dorothy, an accountant, has the
opposite pattern of preferences. Brigitte and
Non-Profitable Pure Bundling: Reservation Charles have intermediate reservation prices that
Prices Positive Correlated are negatively correlated.

If the firm prices each program separately, it

maximizes its profit by charging $90 for each
product and selling each to three customers. It
Table 10.3 Positively Correlated Reservation Prices earns $540 total.

Table 10.3 shows the reservation prices for two If the firm engage in pure bundling, it can
customers and two products. The reservation charge $150 for the bundle, sell to all four
prices are positively correlated: a higher consumers, and earns $600 total.
reservation price for one product is associated
with a higher reservation price for the other If the firm does mixed bundling, it can charge
product. $160 for the bundle to two consumers and $120
for each product separately to the other two
If the programs are sold separately, the firm consumers. It earns $640 total.
charges $90 for the word processor, sells to both
consumers, and earns $180. However, it makes Requirement Tie-In Sales
more charging $90 for the spreadsheet program Requirement tie in sales is another form of
and selling it only to Carol. The firm’s total profit if bundling: requires customers who buy one
it prices separately is $270 (= $180 + $90). product from a firm to make all concurrent and
If the firm uses pure bundling, it maximizes its subsequent purchases of a related product from
profit by charging $130 for the bundle, selling to that firm.
both customers, and making $260.
This requirement allows the firm to identify
Because the firm earns more selling the heavier users and charge them more per unit.
programs separately, $270, than when it bundles
them, $260, pure bundling is not profitable in this
example. As long as reservation prices are
 Example:
If a printer manufacturer can require that ECONOMICS OF INFORMATION
consumers buy their ink cartridges only from the
manufacturer, then that firm can capture most of
the consumers’ surplus. Heavy users of the
printer, who presumably have a less elastic
demand for it, pay the firm more than light users
because of the high cost of the ink cartridges.
Printer firms such as Hewlett-Packard (HP) write
their warranties to strongly encourage consumers
to use only their cartridges and not to refill them.

Peak-Load Pricing

Mean – the expected value of average of a

random variable. It is computed as the sum of the
probabilities that different outcomes will occur
multiplied by the resulting payoffs, represented
by:

Where xi is payoff i, qi is the probability that

payoff I occurs, and q1 + q2 +…+qn = the mean of
a random variable thus collapses information
about the likelihood of different outcomes into a
single statistic.

It provides information about the average

value of a random variable but it yields no
information about the degree of risk associated
with the random variable.

Example:
Option 1: Flip a coin. If it comes up heads, you
receive $1; if it comes up tails, you pay $1.
Option 2: Flip a coin. If it comes up heads, you
receive $10; if it comes up tails, you pay $10.
How much is the expected value (mean) of
each of the options?
 Variance – a measure of risk. The sum of the E(X) = 900 + -400
probabilities that different outcomes will occur E(X) = 500
multiplied by the squared deviations from the
mean of the random variable: Variance:
• S2= [(90%) x (1000-500)2 ] + [(10%) x (-
4000-500)2]
• S2= [(90%X(500)2] + [10%X(-4500)2]
• S2= [90%(250,000)] + [10%(20,250,000)]
Standard Deviation – the square root of the • S2=[225,000+2,025,000]
variance. High variances (standard deviations) are • S2=2,250,000
associated with higher degrees of risk. •
Standard Deviation:
Key Differences Between Variance and • S=1,500
Standard Deviation
a) Variance is a numerical value that
describes the variability of observations from its
arithmetic mean. Standard deviation is a measure Attitude Towards Risk
of dispersion of observations within a data set. • Risk Averse: An individual who prefers a
Variance is nothing but an average of squared sure amount of $M to a risky prospect with an
deviations. On the other hand, the standard expected value, E[x], of $M.
deviation is the root mean square deviation. • Risk Loving: An individual who prefers a
Variance is denoted by sigma-squared (σ2) risky prospect with an expected value, E[x], of $M
whereas standard deviation is labelled as sigma to a sure amount of $M.
(σ). Variance is ex-pressed in square units which • Risk Neutral: An individual who is
are usually larger than the values in the given indifferent between a risky prospect where E[x] =
dataset. As opposed to standard deviation which $M and a sure amount of $M.
is expressed in the same units as the values in the
set of data. Variance measures how far individuals Example of How Risk Aversion Influences
in a group are spread out. Decisions
b) Conversely, Standard Deviation measures • Product Quality A risk averse consumer
how much observations of a data set differs from will not purchase a new product if it works just as
its mean. well as the old product. They prefer a sure thing to
an uncertain prospect of equal expected value.
Illustration: How would your firm induce risk-averse
You manage a firm that is about to introduce a consumers to try new product?
new product that will yield $1000 in profits if the • Lower the price below the existing
economy does not go into a recession. However, if product
a recession occurs, demand for your normal good • Informative advertising (Expected quality
will fall and your company will lose $4000. of new is higher than the certain quality of old)
Economists project a 10% chance that the • Free Samples (Lower the price to
economy will go into recession. compensate the risk)
• What is the expected profit of introducing • Guarantees
the project? • Chain Stores Risk aversion explains why it
• How risky is the introduction of the may be in a firm’s interest to become part of a
project? chain store is instead of remaining independent.
National hamburger chain vs. local diner. Retail
Mean: outlets, transmission shops etc.
E(X) = (90%) X (1000) + (10%) X (-4000) = 500
 • Insurance Fact that consumers are risk interviewing a given worker and values this time at
averse implies they are willing to pay to avoid risk. $300. The first worker the manager interviews
Precisely why you decide to buy insurance on your says he will work only if paid by $40,000. Should
home, extended warranties on purchases etc. the manager make him an offer, or interview
another worker?

Price Uncertainty and Consumer Search Computation for the expected benefits:
EB = ½($40,000 – 38,000) + ½ ($40,000 –
Suppose consumers face numerous stores 40,000)
selling identical products but charge different EB = $1,000
prices. The consumer wants to purchase the
product at the lowest possible price, but also Since the EB is greater than the cost of $300,
incurs a cost, c, to acquire price information. the manager should not hire the worker but
There is an assumption of free recall and with instead search for a worker willing to work for
replacement. Free recall means a consumer can $38,000.
return to any previously visited store to purchase
the product.

The consumer’s reservation price, at which the

consumer is indifferent between purchasing and The Optimal Search Strategy
continue to search, is R.

Consumer Search Rule

When should a consumer cease searching for

price information?
Consumer will search until

Therefore, a consumer will continue to search

for a lower price when the observed price is The Optimal Search Rule is such that the
greater than R and stop searching when the consumer rejects prices above the reservation
observed price is less than R. price. Stated differently, the optimal search
strategy is to search for a better price when the
Reservation price is the price that a consumer is price charged by a firm is above the reservation
indifferent between purchasing at that price and price and stop searching when price is below the
searching for a lower price. reservation price is found.

Example: Summary:
A risk neutral manager is attempting to hire a Accept – p < R; Purchase the product.
worker. All workers in the market are of identical Reject – p > R; Reject and continue to search.
quality but differ with respect to the wage at Consumer Search Rule: Increased Search Costs
which they are willing to work. Suppose half of the
workers in the labor market are willing to work for
a salary of $40,000 and half will accept a salary of
$38,000. The manager spends three hours
 cost of C(Q)=20+0.01Q, how many bushels of
wheat should he produce? What are his expected
profits?

E[MR] = 0.2 X $5.62 + 0.8 X $2.98 = $3.508

In a competitive market firms produce where

E[MR] = MC. Or, 3.508 = 0.01Q,
Thus, Q=350.8 bushels
Expected profits = (3.508 x 350.8) – [20 +
The increase in search costs means that the consumer will
0.01(350.8)] = 1230.61 – 20 – 3.508 = $1,207.10
now find more prices acceptable and will search less
intrusively and vice versa. Uncertainty can profoundly impact market’s
abilities to efficiently allocate resources.

Uncertainty and the Firm

Risk Aversion – Risk preferences Asymmetric Information – a situation that
Are managers risk averse or risk neutral? exists when some people have better information
than others. Example, Insider Trading
Diversification – Investing in multiple projects.
” Don’t pull all your eggs in one basket.” Types of Asymmetric Information
1. Adverse Selection – When an individual has
Profit Maximization (Goal of a Risk Neutral hidden characteristics. Things one party to
Manager) a transaction knows about itself, but which
are unknown by the others party.
When demand is uncertain, expected profits Examples:
are maximized at the point where expected Choice of medical plans or Auto insurance for
marginal revenue equals marginal cost: E[MR] = drivers with bad records.
MC. 2. Moral Hazard – When one party takes
hidden actions. Actions taken by one party
In order for a Risk Neutral manager to in a relationship that cannot be observed
maximize expected profits, the manager should by the other party.
equate expected marginal revenue (E[MR) and Examples:
marginal costs (MC) in selling output. The principal-agent problem.
E[MR] = MC Care taken with rental cars.
If:
E[MR] > MC; Expand Output Possible Solution
E[MR] < MC; Decrease Output Signaling – an attempt by an informed party to
send an observable indicator of his or her hidden
characteristics to an uninformed party. To work,
Profit-Maximization in Uncertain the signal must not be easily mimicked by other
Environments types. Example, Education
Example: Screening – an attempt by an uninformed party
Suppose that economists predict that there is a to sort individuals according to their
20% chance that the price in a competitive wheat characteristics. Often accomplished through a self-
market will be $5.62 per bushel and an 80% selection device – a mechanism in which informed
chance that the competitive price of wheat will be parties are presented with a set of options and the
$2.98 per bushel. If a farmer can produce wheat at options they choose reveals their hidden
 characteristics to an uninformed party. Example,
Price discrimination
Information Structures
 Perfect Information - each bidder knows
Auctions: exactly the items worth.
Art  Independent Private Values – bidders
Treasury Bills know their own valuation of the item, but
Spectrum rights not other bidders’ valuations. Bidders’
Consumer goods (eBay and other valuations do not depend on those of
internet auction sites) other bidders.
Oil leases  Affiliated (or correlated) value estimates –
bidders do not know their own valuation
Four Major Types of Auction: of the item or the valuations of others.
 English - Most common auction. An Bidders use their own information to form
ascending sequential bid auction in a value estimate. Value estimates are
which bidders observe the bids of affiliated: the higher a bidder’s estimate,
others and decide whether or not to the more likely it is that other bidders also
increase the bid. The auction ends have high value estimates. Common
when a single bidder remains; this values are the special case in which the
bidder obtains the item and pays the true (but unknown) value of the item is
auctioneer the amount of the bid. The the same for all bidders.
item is sold to the highest bidder.
 First-price, sealed-bid. – a simultaneous STRATEGIC THINKING
move auction in which bidders Strategic Situation – where the parties consider
simultaneously submit bids on pieces interactions with one another in making decisions.
of paper. The auctioneer awards the
item to the highest bidder, who pays Strategy – a plan for action in a strategic
the amount bid. The difference situation
between the First-price, sealed bid and
the English auction is that the bidders Nash Equilibrium
do not know the bids of other players. Refers to a condition in which every participant
 Second-price, sealed-bid - A has optimized its outcome, based on the other
simultaneous move auction in which player’s expected decision.
bidders simultaneously submit bids.
The auctioneer awards the item to the It is a game theory concept that determines the
high bidder, who pays the amount bid optimal solution n a non-cooperative game in
by the second-highest bidder. The which each player lacks incentive to change
same bidding process as a first-price, his/her initial strategy. Under a Nash equilibrium,
sealed-bid auction. However, the a player does not gain anything from deviat-ing
higher bidder pays the amount bid by from the initially chosen strategy, assuming the
the 2nd highest bidder. other players keep their strategies unchanged.
 Dutch - A descending price auction
started from the highest price that the Competition or Coordination
auctioneer is certain that no one will • Zero-sum game – one party can be better
buy. The bid decreases until one bidder off only if another is worse
is willing to pay the quoted price. • Positive-sum game – one party can be
Strategically equivalent to a first-price, better off without another being worse off
sealed-bid auction.
 Strategic Move
Game in Extensive Form
A game in extensive form explicitly depicts the A strategic move is an action to influence
sequence of moves and the corresponding beliefs or actions of other parties in favorable way.
outcomes which consist of nodes and branches. A
node represents a point in which a party must Example Situation
choose a move. Branches, on the other hand • You were driving your car when the police
represents the possible choices at the node. officer pulls you over and asks to search for your
vehicle.
• The officer needs your permission because
he doesn’t have reasonable suspicion.
• You can either let him do it or call for a K-9
unit

Game in Extensive Form

Figure above depicts the analysis of Player 1 in

making a move. As seen in the above figure, 2
options were given: move A and move B. Both
moves have a set of possible moves to be taken by
Player 2. The judgment will be based on the
highest payoff considering the possible move of
player 2.

Backward Induction
What we did in analyzing the extensive form is
backward induction. It is a process of looking
forward to final nodes and reason backward
toward the initial node. This is a typical situation and can be analyzed
on figure 2 by the given nodes and possible pay
Equilibrium Strategy offs. If an additional scenario has been added, a
What was portrayed was a sequence of best change of judgment will happen.
actions, with each action decided at corresponding
node. • Assuming the police officer states that a
quick search is better than the K-9 for both of you.
First Mover Advantage
In sequence games, a party gains advantage by The statement said by the police officer may
moving first and deciding the probable course of have a great impact on your judgment and can be
action which can possible control the game. classified as a strategic move.

Uncertain Consequences
One party may not be certain about the
consequences of the various actions of the other
party.
 Conditional Strategic Move chosen to reach the Nash equilibrium of the
An action under specified conditions to situation. This can be a great help in solving the
influence the beliefs or actions of other parties in problem with strategic and conditional strategic
a favorable way. moves as credibility, and character is now being
considered before conducting a judgment.
Promise
Conveys benefits under specified conditions, to
influence the beliefs or actions of other parties in INTERNATIONAL TRADE
favorable way. INTERNATIONAL TRADE is the exchange of
• Suppose a promise has been said by the goods and services between countries.
police officer. This is a condi-tional strategic move
as it influences the judgment of the decision- International Trade Theories
maker to let him conduct a quick search. a) Classical or Country Based Theories
1. Mercatilism – this theory stated that a
country’s wealth was determined by the amount
of gold and silver holdings.
2. Absolute Advantage – focused on the
ability of a country to produce a good more
efficiently than another nation.
3. Comparative Advantage – occurs when a
country cannot produce a product more efficiently
Threat than the other country; however, it can produce
Imposes costs, under specified conditions, to that product better and more efficiently than it
influence the beliefs or actions of other parties in does other goods.
favorable way. 4. Heckscher-Ohlin – also called the Factor
• Suppose a threat has been said by the Proportions Theory, stated that countries would
police officer. This is a conditional strategic move produce and export goods that required resources
as it influences the judgment of the decision- or factors that were in great supply, and therefore,
maker to let him conduct a search regardless of cheaper production factors.
the outcome.
b) Modern Firm Based Theories
1. Country Similarity – this theory states that
most trade in manufactured goods will be
between countries with similar per capita
incomes, and intra-industry trade will be common.
2. Product Life cycle – this theory stated that
a product life cycle has three distinct stages: 1)
New Product, 2) Maturing Product 3) Standardized
Product. The theory assumed that production of
the new product will occur completely in the
home county of its innovation.
3. Global Strategic Rivalry – this theory
Repetition
focused on MNCs and efforts to gain a competitive
Surely, many strategic interactions are
advantage against other global firms in industry.
repeated and can be solved faster than before
4. Porter’s National Competitive Advantage –
considering the historical factors and previous
this theory stated that a nation’s competitiveness
outcomes. Knowing the other players more can
in an industry depends on the capacity of the
help in assessing which of the actions should be
industry to innovate and upgrade.
 Differences in Domestic and International
Nature of International Trade Trade
• Human wants and countries’ resources do
not totally coincide
• Technological Advancement
• Factor endowments in different countries
differ
• Labor an entrepreneurial skill differs
• Factors of production are highly immobile
between countries

Advantages of International Trade

• Optimum Allocation
• Gains of Specialization
• Enhanced Wealth
• Larger Output
• Welfare Contour
• Cultural Values
• Better International Politics
• Dealing with Scarcity
• Language
• Advantageous Competition
• Larger size of Market • Differences Regarding Mobility of Labor
and Capital
Disadvantages of International Trade • Differences in Natural and Economic
Conditions
• Exhaustion of Resources
• Differences in Banking Systems and
• Blow to Infant Industry
Economic Policies
• Dumping
• Diversification of savings • Currency
• Declining Domestic Employment • Systems of Payment
• Over Interdependence • Distance
• Customs Duties and Import Quotas
• Competition
• Local Conditions

Protectionism Economic – is an economic

policy of restricting imports from other countries
through methods such as tariffs on imported
goods, import quota and variety of other
government regulations. A variety of policies have
been used to achieve protectionist goal. These
include:

• Protection of technologies, patents,

technical and scientific knowledge
• Prevent foreign investors from taking
control of domestic firms
• Tariffs
 • Import quotas ownership ceilings are among those frequently
• Administrative barriers used.
• Anti-dumping legislation
• Direct Subsidies Market power refers to the ability of a firm (or
• Export Subsidies group of firms) to raise and maintain price above
• Exchange rate control the level that would prevail under competition is
• International patent systems referred to as market or monopoly power. The
• Political Campaigns exercise of market power leads to reduced output
• Preferential governmental spending and loss of economic welfare.

Trade Barriers – are government-imposed A natural monopoly is a type of monopoly that

restraint on the flow of International good or exists due to the high start-up costs or powerful
services. Non-tariff barriers include: economies of scale of conducting a business in a
• Licenses specific industry. A company with a natural
• Import quotas monopoly might be the only provider or a product
• Voluntary Export Restraints (VER) or service in an industry or geographic location.
• Local content requirement Natural monopolies can arise in industries that
Reasons Why Tariff are Imposed: require unique raw materials, technology, or
a) Protecting Domestic Employment similar factors to operate.
b) Protecting Consumers
c) Infant Industries If a market is a natural monopoly, the
d) National Security government should prohibit competition and
e) Retaliation allow only a single supplier. This would establish
the conditions for production at the lowest
Tariffs and Modern Trade average cost. The monopoly, however, might
The role of tariffs play in international trade exploit its exclusive right to raise its price at the
has declined in modern times. One of the primary expense of its consumers. Accordingly, to ensure
reasons for the decline is the introduction of economic efficiency, the government must control
International organizations designed to improve the monopoly which it can do it in two ways:
free trade such as the World Trade Organization
(WTO). • The government itself can own the
business, and operate at the economically
Who Benefits? efficient level
The benefits of tariffs are uneven. Because a • Award a monopoly franchise to a
tariff is a tax, the government will see increased commercial enterprise and subject the monopoly
revenue as imports enter the domestic market. to regulation

Government ownership and operation is the

simplest and most direct way to ensure economic
REGULATION efficiency. However, in practice, government-
Regulation is broadly defined as imposition of owned enterprises tend to be relatively inefficient,
rules by government, backed by the use of and so government ownership and operation fails
penalties that are intended specifically to modify to achieve economic efficiency. Some of the
the economic behavior of individuals and firms in sources of inefficiency in government ownership
the private sector. Various regulatory instruments are:
or targets exist. Prices, output, rate of return (in
the form of profits, margins or commissions),
disclosure of information, standards and
 • Government-owned enterprises are prone necessary to create the product or service. This
to be coopted by employees so that the enterprise implies that businesses will set the unit price of a
serves its employees rather than its customers. product relatively close to the average cost
• Government-owned enterprises depend needed to produce it
on the government for investment funds. A
government-owned enterprise must compete with Rate of return regulation is a form of price
other priorities for an allocation from the budget setting regulation where governments determine
and may not be able to secure the economically the fair price which is allowed to be charged by a
efficient level of investment monopoly. It is meant to protect customers from
being charged higher prices due to the monopoly's
Due to the limitations of government power while still allowing the monopoly to cover
ownership and operation, a worldwide trend has its costs and earn a fair return for its owners.
been to privatize government-owned enterprises.
Privatization occurs when a government-owned Rate of return regulation presents three
business, operation, or a property becomes challenges in implementation:
owned by a private, non-government party. Note • Rate of return – one challenge is to set the
that privatization also describes the transition of a allowed rate of return. There would be few
company from being publicly traded to becoming comparable businesses, so it would be difficult to
privately held. This is referred to as corporate determine the appropriate rate of return
privatization. • Rate base – another challenge is to
determine what assets are needed to provide the
Privatization of specific government operations regulated service and should be counted in the
happens in a number of ways, although generally, rate base
the government transfers ownership of specific • Overinvestment –the franchise holder has
facilities or business processes to a private, for- an incentive to invest beyond the economically
profit company. Privatization generally helps efficient level. By enlarging the rate base, the
governments save money and increase efficiency. allowed rate of return will be applied to larger
In general, two main sectors compose an base thus the franchise holder can increase its
economy—the public sector and the private profit.
sector.

Price regulation refers to the policy of setting Potentially Competitive Market

prices by a government agency, legal statute or A potentially competitive market is one where
regulatory authority. Under this policy, minimum economies of scale and scope are small relative to
and/or maximum prices may be set. Under price market demand. With perfect competition, the
regulation, the government can implement the invisible hand will ensure economic efficiency. In
following policies: any potentially competitive market, the
government should promote competition.
• Marginal cost pricing - the practice of
setting the price of a product to equal the extra Competition Law
cost of producing an extra unit of output. By this The basic way in which governments promote
policy, a producer charges, for each product unit competition is through competition law, which is
sold, only the addition to total cost resulting from also called antimonopoly or antitrust law.
materials and direct labor
• Average cost pricing - pricing strategy that The Philippine Competition Act (PCA) or R.A.
regulators impose on certain businesses to limit 10667 is the primary competition policy of the
what they are able to charge consumers for its Philippines for promoting and protecting
products or services to a price equal to the costs competitive market. It will protect the well-being
of consumers and preserve the efficiency of and the allocation of resources will not be
competition in the marketplace. The PCA was economically efficient.
passed in 2015 after languishing in Congress for 24
years. It is a game changing legislation that is Consider for instance, the market for medical
expected to improve consumer protection and services. Patients rely on surgeons for advice as
help accelerate investment and job creation in the well as treatment. Owing to the asymmetry of
country, consistent with the national information between surgeon and patient, the
government’s goal of creating more inclusive surgeons are subject to moral hazard. Surgeons
economic growth. Enforcement of this law will may overprescribe treatment to increase their
help ensure that markets are open and free, income.
challenging anticompetitive business practices
while maintaining an environment where
businesses can compete based on the quality of
their work. A competitive market means a market
with multiple buyers and multiple sellers, driving
market prices lower and offering consumers more
choices. A truly competitive market encourages
efficiency and innovation, and forces businesses
to excel. The act reflects the belief that
competition:

• Promotes entrepreneurial spirit

• Encourages private investments
• Facilitates technology development and
transfer, and
• Enhances resource productivity
The graph above illustrates the market
equilibrium. The true demand is the patients’
Structural Regulation
marginal benefit if they had the same information
The fact that one market is a natural monopoly
as their surgeons. The inflated demand results
does not necessarily mean that related upstream
from asymmetry of information and exceeds the
or downstream markets are also natural
true demand to the extent that surgeons induce
monopolies. The government must consider how
patients to get excessive treatment.
to preserve the benefits of monopoly in one
market while fostering competition in the other.
The inflated demand crosses the supply of
medical services at point a. In the market
Under structural regulation, the regulator
equilibrium, the price is $140 per hour and the
stipulates the conditions under which a business
quantity of treatment is 210,000 hours a month.
may produce vertically related goods and services.
At that quantity, the true marginal benefit of
medical services is $50, which is the height of the
true demand curve. The marginal cost of medical
Asymmetry of Information
services is $140, the height of the supply curve at
Another situation in which the invisible hand
the equilibrium quantity. In equilibrium, the
may fail is where information about some
marginal cost exceeds the marginal benefit by $90.
characteristic or future action is asymmetric. If
This economic inefficiency results from asymmetry
the information asymmetry is not resolved, the
of information between surgeons and patients.
marginal benefit will diverge from marginal cost,
 In situation of asymmetric information, the financial advisor to pressure investors into buying
regulator might possibly resolve the asymmetry by unsuitable investments.
regulating the better-informed party’s
a. Disclosure of information Structural Regulation
b. Conduct, and Another way to limit the extent to which a
c. Business structure. better-informed party can exploit an informational
advantage is to regulate the structure of the
In medical services, to the extent that the industry. By enforcing separation of different
regulation is effective, the inflated demand would businesses, a regulator may reduce the
shift down towards the true demand. Then the opportunities for exploiting superior information.
equilibrium would be closer to point b, where the
true marginal benefit equals the marginal cost. The market for medical services illustrates
structural regulation. In some countries, doctors
Disclosure are limited to providing advice and treatment, and
The most obvious way to resolve asymmetric are prohibited from selling medicines and medical
information is to require the better-informed supplies. This regulation effectively dissuades
party to disclose its information truthfully. doctors from excessive prescription of medicines.
However, disclosure will resolve the asymmetry The market for financial services also illustrates
only if the information can be objectively verifies. structural regulation. Following the subprime
In the case of surgery, the patient’s need is a financial crisis, various regulators have proposed
matter of professional judgment, hence, that commercial banks, which take deposits from
disclosure may not resolve the information retail customers, should not be allowed to engage
asymmetry. Consider another situation of in trading of derivatives and other securities. This
asymmetric information: financial advisors hard- structural regulation limits the exposure of
selling risky investments. The regulator can commercial banks to risk.
require financial advisors to disclose the riskiness
of investments. This might help to resolve the Externalities
information asymmetry if the client understands The invisible hand may fail in situations of
the disclosure. externalities, that is, when some benefit or cost
passes directly from source to recipient and not
Conduct Regulation through a market. In the absence of a market, the
Instead of directly resolving an information invisible hand cannot work. There are no markets
asymmetry, an alternative is to regulate the for factory emissions or discharge of contaminated
conduct of the better-informed party and so limit water. Furthermore, pollution affects so many
the extent to which it can exploit informational entities that private action would probably not
advantage. If parties with better information resolve the externality. Government regulation
cannot exploit their advantage, then the outcome may be the only solution.
would be closer to the economically efficient level.
For economic efficiency, the level of an
For example, the regulator of financial services externality would be such that marginal benefit
can stipulate that financial advisors must evaluate equals marginal cost. The benefit of emissions is
their clients’ risk profile before marketing any in allowing the sources to avoid the cost of clean
investment products. The regulator can also disposal. The cost of emissions is the harm to the
stipulate a minimum ”cooling-off” period during health of the victims.
which an investor may withdraw from the
purchase of any investment without penalty. Such The economically efficient rate is where the
regulations of conduct restrict the scope for a marginal benefit equals the marginal cost to
society. How can this be achieved? Generally, To remedy the problem, the government can
there are two ways of regulating externalities: internalize the externalities by taxing goods that
a. User fees or taxes; have negative externalities and subsidizing goods
b. Standards or quotas that have positive externalities.

User Fee or Taxes

One method of regulation aims to mimic Adam
Smith’s invisible hand: allow all sources to emit as
much as they like provided that they pay the
appropriate user fee or tax. Consider an oil
refinery that emits pollutants. To maximize
profits, the refinery should buy emissions up to
the rate where the marginal benefit of emissions
balances to user fee. Negative externalities lead
markets to produce a large quantity than is
socially desirable. Manufacturers tend to just pay
taxes rather than stop producing products that
would harm the people.

Standards or Quotas
Although some activities impose costs on third
parties, other yield benefits. For example,
consider education. To a large extent, the benefit
of education is private: The consumer of
education becomes a more productive worker and
thus reaps much of the benefit in the form of
higher wages. Beyond these private benefits,
however, education also yields positive
externalities. One externality is that a more
educated population leads to more informed
voters, which means better government for
everyone. Another externality is that a more
educated population tends to mean lower crime
rates. A third externality is that a more educated
population may encourage the development and
dissemination of technological advances, leading
to higher productivity and wages for everyone.

However, government sponsored education is

not available for everyone, criteria have been set
and standards are established to determine the
cream of the crops who will be eligible for the
scholarship. Positive externalities lead markets to
produce a smaller quantity than is socially
desirable.