MANAGERIAL ECONOMICS

Price Elasticity of Demand

In this chapter we look at the idea of elasticity of demand, in other words, how sensitive is the demand for a product to a change in the product’s own price. You will find that elasticity of demand is perhaps one of the most important concepts to understand in your AS economics course

Defining elasticity of demand

Ped measures the responsiveness of demand for a product following a change in its own price.

The formula for calculating the co-efficient of elasticity of demand is:

Percentage change in quantity demanded divided by the percentage change in price

Since changes in price and quantity nearly always move in opposite directions, economists usually do not bother to put in the minus sign. We are concerned with the co-efficient of elasticity of demand.

Understanding values for price elasticity of demand

If Ped = 0 then demand is said to be perfectly inelastic. This means that demand does not change at all when the price changes – the demand curve will be vertical

If Ped is between 0 and 1 (i.e. the percentage change in demand from A to B is smaller than the percentage change in price), then demand is inelastic. Producers know that the change in demand will be proportionately smaller than the percentage change in price

If Ped = 1 (i.e. the percentage change in demand is exactly the same as the percentage change in price), then demand is said to unit elastic. A 15% rise in price would lead to a 15% contraction in demand leaving total spending by the same at each price level.

If Ped > 1, then demand responds more than proportionately to a change in price i.e. demand is elastic. For example a 20% increase in the price of a good might lead to a 30% drop in demand. The price elasticity of demand for this price change is –1.5

What Determines Price Elasticity of Demand?

Demand for rail services

At peak times, the demand for rail transport becomes inelastic – and higher prices are charged by rail companies who can then achieve higher revenues and profits

The number of close substitutes for a good / uniqueness of the product – the more close substitutes in the market, the more elastic is the demand for a product because consumers can more easily switch their demand if the price of one product changes relative to others in the market. The huge range of package holiday tours and destinations

make this a highly competitive market in terms of pricing – many holiday makers are price sensitive

The cost of switching between different products – there may be significant transactions costs involved in switching between different goods and services. In this case, demand tends to be relatively inelastic. For example, mobile phone service providers may include penalty clauses in contracts or insist on 12-month contracts being taken out

The degree of necessity or whether the good is a luxury – goods and services deemed by consumers to be necessities tend to have an inelastic demand whereas luxuries will tend to have a more elastic demand because consumers can make do without luxuries when their budgets are stretched. I.e. in an economic recession we can cut back on discretionary items of spending

The % of a consumer’s income allocated to spending on the good – goods and services that take up a high proportion of a household’s income will tend to have a more elastic demand than products where large price changes makes little or no difference to someone’s ability to purchase the product.

The time period allowed following a price change – demand tends to be more price elastic, the longer that we allow consumers to respond to a price change by varying their purchasing decisions. In the short run, the demand may be inelastic, because it takes time for consumers both to notice and then to respond to price fluctuations

Whether the good is subject to habitual consumption – when this occurs, the consumer becomes much less sensitive to the price of the good in question. Examples such as cigarettes and alcohol and other drugs come into this category

Peak and off-peak demand - demand tends to be price inelastic at peak times – a feature that suppliers can take advantage of when setting higher prices. Demand is more elastic at off-peak times, leading to lower prices for consumers. Consider for example the charges made by car rental firms during the course of a week, or the cheaper deals available at hotels at weekends and away from the high-season. Train fares are also higher on Fridays (a peak day for travelling between cities) and also at peak times during the day

The breadth of definition of a good or service – if a good is broadly defined, i.e. the demand for petrol or meat, demand is often fairly inelastic. But specific brands of petrol or beef are likely to be more elastic following a price change

Demand curves with different price elasticity of demand

Firms can use price elasticity of demand (PED) estimates to predict:The effect of a change in price on the total revenue & expenditure on a product.The likely price volatility in a market following unexpected changes in supply – this is important for commodity producers who may suffer big price movements from time to time.

The effect of a change in a government indirect tax on price and quantity demanded and also whether the business is able to pass on some or all of the tax onto the consumer.

Information on the price elasticity of demand can be used by a business as part of a policy of price discrimination (also known as yield management). This is where a monopoly supplier decides to charge different prices for the same product to different segments of the market e.g. peak and off peak rail travel or yield management by many of our domestic and international airlines

Supply and demandIn economics, supply and demand describes market relations between prospective sellers and buyers of a good. The supply and demand model determines price and quantity sold in the market. The model is fundamental in microeconomic analysis of buyers and sellers and of their interactions in a market. It is used as a point of departure for other economic models and theories. The model predicts that in a competitive market, price will function to equalize the quantity demanded by consumers and the quantity supplied by producers, resulting in an economic equilibrium of price and quantity. The model incorporates other factors changing such equilibrium as reflected in a shift of demand or supply.

Strictly considered, the model applies to a type of market called perfect competition in which no single buyer or seller has much effect on prices, and prices are known. The quantity of a product supplied by the producer and the quantity demanded by the consumer are dependent on the market price of the product. The law of supply states that quantity supplied is related to price. It is often depicted as directly proportional to price: the higher the price of the product, the more the producer will supply, ceteris paribus. The law of demand is normally depicted as an inverse relation of quantity demanded and price: the higher the price of the product, the less the consumer will demand, cet. par. "Cet. par." is added to isolate the effect of price. Everything else that could affect supply or demand except price is held constant. The respective relations are called the 'supply curve' and 'demand curve', or 'supply' and 'demand' for short.

The laws of supply and demand state that the equilibrium market price and quantity of a commodity is at the intersection of consumer demand and producer supply. Here, quantity supplied equals quantity demanded (as in the enlargeable Figure), that is, equilibrium. Equilibrium implies that price and quantity will remain there if it begins there. If the price for a good is below equilibrium, consumers demand more of the good than producers are prepared to supply. This defines a shortage of the good. A shortage results in the price being bid up. Producers will increase the price until it reaches equilibrium. If the price for a good is above equilibrium, there is a surplus of the good. Producers are motivated to eliminate the surplus by lowering the price. The price falls until it reaches equilibrium.

THE DEMAND SCHEDULE

The demand schedule, depicted graphically as the demand curve, represents the amount of goods that buyers are willing and able to purchase at various prices, assuming all other non-price factors remain the same. The demand curve is almost always represented as downwards-sloping, meaning that as price decreases, consumers will buy more of the good.[1]

Just as the supply curves reflect marginal cost curves, demand curves can be described as marginal utility curves.[6]

The main determinants of individual demand are: the price of the good, level of income, personal tastes, the population (number of people), the government policies, the price of substitute goods, and the price of complementary goods.

The shape of the aggregate demand curve can be convex or concave, possibly depending on income distribution.

As described above, the demand curve is generally downward sloping. There may be rare examples of goods that have upward sloping demand curves. Two different hypothetical types of goods with upward-sloping demand curves are a Giffen good (a sweet inferior, but staple, good) and a Veblen good (a good made more fashionable by a higher price).

MARGINAL REVENUE (MR)In microeconomics, Marginal Revenue (MR) is the extra revenue that an additional unit of product will bring to a firm. It can also be described as the change in total revenue/change in number of units sold.

More formally, marginal revenue is equal to the change in total revenue over the change in quantity when the change in quantity is equal to one unit (or the change in output in the bracket where the change in revenue has occurred)

This can also be represented as a derivative. (Total revenue) = (Price Demanded) times (Quantity) or . Thus, by the product rule:

.

For a firm facing perfectly competitive markets, price does not change with

quantity sold ( ), so marginal revenue is equal to price. For a

monopoly, the price received will decline with quantity sold ( ), so marginal revenue is less than price. This means that the profit-maximizing quantity, for which marginal revenue is equal to marginal cost will be lower for a monopoly than for a competitive firm, while the profit-maximizing price will be

higher. When marginal revenue is positive, Price elasticity of demand [PED] is elastic, and when it is negative, PED is inelastic. When marginal revenue is equal to zero, price elasticity of demand is equal to -1.

Cross elasticity of demand

In economics, the cross elasticity of demand and cross price elasticity of demand measures the responsiveness of the quantity demand of a good to a change in the price of another good.

It is measured as the percentage change in quantity demanded for the first good that occurs in response to a percentage change in price of the second good. For example, if, in response to a 10% increase in the price of fuel, the quantity of new cars that are fuel inefficient demanded decreased by 20%, the cross elasticity of demand would be -20%/10% = -2.

The formula used to calculate the coefficient cross elasticity of demand is

or:

Two goods that complement each other show a negative cross elasticity of demand.

In the example above, the two goods, fuel and cars(consists of fuel consumption), are complements - that is, one is used with the other. In these cases the cross elasticity of demand will be negative. In the case of perfect complements, the cross elasticity of demand is infinitely negative.

Where the two goods are substitutes the cross elasticity of demand will be positive, so that as the price of one goes up the quantity demanded of the other will increase. For example, in response to an increase in the price of

carbonated soft drinks, the demand for non-carbonated soft drinks will rise. In the case of perfect substitutes, the cross elasticity of demand is equal to infinity.

Where the two goods are complements the cross elasticity of demand will be negative, so that as the price of one goes up the quantity demanded of the other will decrease. For example, in response to an increase in the price of fuel, the demand for new cars will decrease.

Where the two goods are independent, the cross elasticity demand will be zero: as the price of one good changes, there will be no change in quantity demanded of the other good.

When goods are substitutable, the diversion ratio - which quantifies how much of the displaced demand for product j switches to product i - is measured by the ratio of the cross-elasticity to the own-elasticity multiplied by the ratio of product i's demand to product j's demand. In the discrete case, the diversion ratio is naturally interpreted as the fraction of product j demand which treats product i as a second choice,[1] measuring how much of the demand diverting from product j because of a price increase is diverted to product i can be written as the product of the ratio of the cross-elasticity to the own-elasticity and the ratio of the demand for product i to the demand for product j. In some cases, it has a natural interpretation as the proportion of people buying product j who would consider product i their `second choice.'

Empirical Demand FunctionEmpirical estimationDemand and supply relations in a market can be statistically estimated from price, quantity, and other data with sufficient information in the model. This can be done with simultaneous-equation methods of estimation in econometrics. Such methods allow solving for the model-relevant "structural coefficients," the estimated algebraic counterparts of the theory. The Parameter identification problem is a common issue in "structural estimation." Typically, data on exogenous variables (that is, variables other than price and quantity, both of which are endogenous variables) are needed to perform such an estimation. An alternative to "structural estimation" is reduced-form estimation, which regresses each of the endogenous variables on the respective exogenous variables.

Macroeconomic uses of demand and supplyDemand and supply have also been generalized to explain macroeconomic variables in a market economy, including the quantity of total output and the general price level. The Aggregate Demand-Aggregate Supply model may be the most direct application of supply and demand to macroeconomics, but other macroeconomic models also use supply and demand. Compared to

microeconomic uses of demand and supply, different (and more controversial) theoretical considerations apply to such macroeconomic counterparts as aggregate demand and aggregate supply. Demand and supply may also be used in macroeconomic theory to relate money supply to demand and interest rates.

Demand shortfallsA demand shortfall results from the actual demand for a given product or service being lower than the projected, or estimated, demand for that product or service. Demand shortfalls are caused by demand overestimation in the planning of new products and services. Demand overestimation is caused by optimism bias and/or strategic misrepresentation.

BUSINESS FORCASTING

Forecasting is the process of estimation in unknown situations. Prediction is a similar, but more general term. Both can refer to estimation of time series, cross-sectional or longitudinal data. Usage can differ between areas of application: for example in hydrology, the terms "forecast" and "forecasting" are sometimes reserved for estimates of values at certain specific future times, while the term "prediction" is used for more general estimates, such as the number of times floods will occur over a long period. Risk and uncertainty are central to forecasting and prediction. Forecasting is used in the practice of Demand Planning in every day business forecasting for manufacturing companies. The discipline of demand planning, also sometimes referred to as supply chain forecasting, embraces both statistical forecasting and a consensus process.

Forecasting is commonly used in discussion of time-series data.

Categories of forecasting methodsTime series methodsTime series methods use historical data as the basis of estimating future outcomes.

← Moving average ← Exponential smoothing

← Extrapolation

← Linear prediction

← Trend estimation

← Growth curve

←

Causal / econometric methodsSome forecasting methods use the assumption that it is possible to identify the underlying factors that might influence the variable that is being forecast. For example, sales of umbrellas might be associated with weather conditions. If the causes are understood, projections of the influencing variables can be made and used in the forecast.

← Regression analysis using linear regression or non-linear regression ← Autoregressive moving average (ARMA)

← Autoregressive integrated moving average (ARIMA)

← e.g. Box-Jenkins

Judgmental methodsJudgemental forecasting methods incorporate intuitive judgements, opinions and probability estimates.

← Composite forecasts ← Surveys

← Delphi method

← Scenario building

← Technology forecasting

← Forecast by analogy

Other methods

← Simulation ← Prediction market

← Probabilistic forecasting and Ensemble forecasting

← Reference class forecasting

← BUSINEES AND ECONOMIC FORCASTING

← Economic forecasting is the process of making predictions about the economy as a whole or in part

Input-output modelJump to: navigation, searchThis article is about the economic model. For the computer interface, see Input/output.

The Input-output model of economics uses a matrix representation of a nation's (or a region's) economy to predict the effect of changes in one industry on others and by consumers, government, and foreign suppliers on the economy. This model, if applied on a region, is also known as the Regional Impact Multiplier System. Wassily Leontief (1905-1999) is credited with the development of this analysis. Francois Quesnay developed a cruder version of this technique called Tableau économique. Leontief won the Nobel Memorial Prize in Economic Sciences for his development of this model.

Input-output analysis considers inter-industry relations in an economy, depicting how the output of one industry goes to another industry where it serves as an input, and thereby makes one industry dependent on another both as customer of output and as supplier of inputs. An input-output model is a specific formulation of input-output analysis.

Each column of the input-output matrix reports the monetary value of an industry's inputs and each row represents the value of an industry's outputs. Suppose there are three industries. Column 1 reports the value of inputs to Industry 1 from Industries 1, 2, and 3. Columns 2 and 3 do the same for those industries. Row 1 reports the value of outputs from Industry 1 to Industries 1, 2, and 3. Rows 2 and 3 do the same for the other industries.

While the input-output matrix reports only the intermediate goods and services that are exchanged among industries, row vectors on the bottom record the disposition of finished goods and services to consumers, government, and foreign buyers. Similarly, column vectors on the right record non-industrial inputs like labor and purchases from foreign suppliers.

In addition to studying the structure of national economies, input-output economics has been used to study regional economies within a nation, and as a tool for national economic planning.

The mathematics of input-output economics is straightforward, but the data requirements are enormous because the expenditures and revenues of each branch of economic activity has to be represented. The tool has languished because not all countries collect the required data, data quality varies, and the data collection and preparation process has lags that make timely analysis

difficult. Typically input-out tables are compiled retrospectively as a "snapshot" cross-section of the economy, once every few years.

UsefulnessAn input-output model is widely used in economic forecasting to predict flows between sectors. They are also used in local urban economics.

Irving Hock at the Chicago Area Transportation Study did detailed forecasting by industry sectors using input-output techniques. At the time, Hock’s work was quite an undertaking, the only other work that has been done at the urban level was for Stockholm and it was not widely known. Input-output was one of the few techniques developed at the CATS not adopted in later studies. Later studies used economic base analysis techniques.

Input-output models at ZIP code level compilations (eg, a city) are also available through the IMPLAN system.

Key IdeasThe inimitable book by Leontief himself remains the best exposition of input-output analysis. See bibliography.

Input-output concepts are simple. Consider the production of the ith sector. We may isolate (1) the quantity of that production that goes to final demand,ci, (2) to

total output, xi, and (3) flows xij from that industry to other industries. We may

write a transactions tableau

Table: Transactions in a Three Sector Economy

Economic Activities

Inputs to Agriculture

Inputs to Manufacturing

Inputs to Transport

Final Demand

Total Output

Agriculture 5 15 2 68 90

Manufacturing 10 20 10 40 80

Transportation 10 15 5 0 30

Labor 25 30 5 0 60

BASIC CONCEPT OF PRODUCTION THEORYIn microeconomics, Production is simply the conversion of inputs into outputs. It is an economic process that uses resources to create a commodity that is suitable for exchange. This can include manufacturing, storing, shipping, and packaging. Some economists define production broadly as all economic activity other than consumption. They see every commercial activity other than the final purchase as some form of production.

Production is a process, and as such it occurs through time and space. Because it is a flow concept, production is measured as a “rate of output per period of time”. There are three aspects to production processes:

1. the quantity of the commodity produced, 2. the form of the good created,

3. the temporal and spatial distribution of the commodity produced.

A production process can be defined as any activity that increases the similarity between the pattern of demand for goods, and the quantity, form, and distribution of these goods available to the market place

Efficiency and cross-efficiencyA production process is efficient if a given quantity of outputs cannot be produced with any less inputs. It is said to be inefficient when there exists another feasible process that, for any given output, uses less inputs. Some economists (in particular Leibenstein) use the term X-efficiency to indicate that production processes tend to be inherently inefficient due to satisficing behaviour. The “rate of efficiency” is simply the amount of (or value of) outputs divided by the amount of (or value of) inputs. If a production process uses 50 units of input (or $5000 worth of inputs) to produce one unit of output it is more efficient than a process that uses 55 units of input (or $5500 worth of inputs) to produce the same level of output. It is said to be 10% more efficient ({55-50}/50=1/10=10%).

Factors of productionThe inputs or resources used in the production process are called factors by economists. The myriad of possible inputs are usually grouped into four or five categories. These factors are:

← Raw materials ← Machinery

← Labour services

← Capital goods

← Land

← Enterpreneur

In the “long run” all of these factors of production can be adjusted by management. The “short run” however, is defined as a period in which at least one of the factors of production is fixed.

A fixed factor of production is one whose quantity cannot readily be changed. Examples include major pieces of equipment, suitable factory space, and key managerial personnel.

A variable factor of production is one whose usage rate can be changed easily. Examples include electrical power consumption, transportation services, and most raw material inputs. In the short run, a firm’s “scale of operations” determines the maximum number of outputs that can be produced. In the long run, there are no scale limitations.

Many ways of expressing the production relationshipThe total, average, and marginal physical product curves mentioned above are just one way of showing production relationships. They express the quantity of output relative to the amount of variable input employed while holding fixed inputs constant. Because they depict a short run relationship, they are sometimes called short run production functions. If all inputs are allowed to be varied, then the diagram would express outputs relative to total inputs, and the function would be a long run production function. If the mix of inputs is held constant, then output would be expressed relative to inputs of a fixed composition, and the function would indicate long run economies of scale.

Rather than comparing inputs to outputs, it is also possible to assess the mix of inputs employed in production. An isoquant (see below) relates the quantities of one input to the quantities of another input. It indicates all possible combinations of inputs that are capable of producing a given level of output.

Rather than looking at the inputs used in production, it is possible to look at the mix of outputs that are possible for any given production process. This is done with a production possibilities frontier. It indicates what combinations of outputs are possible given the available factor endowment and the prevailing production technology.

IsoquantsThere are many ways of producing a given level of output. You can use a lot of labour with a minimal amount of capital, or you could invest heavily in capital equipment that requires a minimal amount of labour to operate, or any combination in between. For most goods, there are more than just two inputs. For example in agriculture, the amount of land, water, and fertilizer can all be varied to produce different amounts of a crop. An isoquant, in the two input case, is a curve that shows all the ways of combining two inputs so as to produce a given level of output.

The marginal rate of technical substitutionIsoquants are typically convex to the origin reflecting the fact that the two factors are substitutable for each other at varying rates. This rate of substitutability is called the “marginal rate of technical substitution” (MRTS) or

occasionally the “marginal rate of substitution in production”. It measures the reduction in one input per unit increase in the other input that is just sufficient to maintain a constant level of production. For example, the marginal rate of substitution of labour for capital gives the amount of capital that can be replaced by one unit of labour while keeping output unchanged.

Isoquant

An isoquant map where Q3 > Q2 > Q1. A typical choice of inputs would be labor for input X and capital for input Y. More of input X, input Y, or both is required to move from isoquant Q1 to Q2, or from Q2 to Q3.

A) Example of an isoquant map with two inputs that are perfect substitutes.

B) Example of an isoquant map with two inputs that are perfect complements.

In economics, an isoquant (derived from quantity and the Greek word iso [meaning equal]) is a contour line drawn through the set of points at which the same quantity of output is produced while changing the quantities of two or more inputs. While an indifference curve helps to answer the utility-maximizing problem of consumers, the isoquant deals with the cost-minimization problem of producers. Isoquants are typically drawn on capital-labor graphs, showing the tradeoff between capital and labor in the production function, and the decreasing marginal returns of both inputs. Adding one input while holding the other constant eventually leads to decreasing marginal output, and this is reflected in the shape of the isoquant. A family of isoquants can be represented by an isoquant map, a graph combining a number of isoquants, each representing a different quantity of output.

An isoquant shows that the firm in question has the ability to substitute between the two different inputs at will in order to produce the same level of output. An isoquant map can also indicate decreasing or increasing returns to scale based on increasing or decreasing distances between the isoquants on the map as you increase output. If the distance between isoquants increases as output increases, the firm's production function is exhibiting decreasing returns to scale; doubling both inputs will result in placement on an isoquant with less than double the output of the previous isoquant. Conversely, if the distance is decreasing as output increases, the firm is experiencing increasing returns to scale; doubling both inputs results in placement on an isoquant with more than twice the output of the original isoquant.

As with indifference curves, two isoquants can never cross. Also, every possible combination of inputs is on an isoquant. Finally, any combination of inputs above or to the right of an isoquant results in more output than any point on the isoquant. Although the marginal product of an input decreases as you increase the quantity of the input while holding all other inputs constant, the marginal product is never negative since a logical firm would never increase an input to decrease output.

Shapes of Isoquant Curve:

If the two inputs are perfect substitutes, the resulting isoquant map generated is represented in fig. A; with a given level of production Q3, input X is effortlessly replaced by input Y in the production function. The perfect substitute inputs do not experience decreasing marginal rates of return when they are substituted for each other in the production function.

If the two inputs are perfect complements, the isoquant map takes the form of fig. B; with a level of production Q3, input X and input Y can only be combined efficiently in a certain ratio represented by the kink in the isoquant. The firm will combine the two inputs in the required ratio to maximize output and minimize

cost. If the firm is not producing at this ratio, there is no rate of return for increasing the input that is already in excess.

Isoquants are typically combined with isocost lines in order to provide a cost-minimization production optimization problem.

MONOPOLISTIC COMPETETION

Monopolistic competition

Monopolistic competition is a common market form. Many markets can be considered monopolistically competitive, often including the markets for restaurants, cereal, clothing, shoes and service industries in large cities.

Monopolistically competitive markets have the following characteristics:

There are many producers and many consumers in a given market. Consumers perceive that there are non-price differences among the

competitors' products.

There are few barriers to entry and exit[1].

Producers have a degree of control over price.

The characteristics of a monopolistically competitive market are almost the same as in perfect competition, with the exception of heterogeneous products, and that monopolistic competition involves a great deal of non-price competition (based on subtle product differentiation). A firm making profits in the short run will break even in the long run because demand will decrease and average total cost will increase. This means in the long run, a monopolistically competitive firm will make zero economic profit. This gives the company a certain amount of influence over the market; because of brand loyalty, it can raise its prices without losing all of its customers. This means that an individual firm's demand curve is downward sloping, in contrast to perfect competition, which has a perfectly elastic demand schedule.

==Definition of monopolistic competition== na lie

Short-run equilibrium of the firm under monopolistic competition

A monopolistically competitive firm acts like a monopolist in that the firm is able to influence the market price of its product by altering the rate of production of the product. Unlike in perfect competition, monopolistically competitive firms produce products that are not perfect substitutes. As such, brand X's product, which is different (or at least perceived to be different) from all other brands' products, is available from only a single producer. In the short-run, the monopolistically competitive firm can exploit the heterogeneity of its brand so as to reap positive economic profit (i.e. the rate of return is greater than the rate required to compensate debt and equity holders for the risk of investing in the firm). One possible effect of advertising on a firm's long run average cost curve when earning an economic profit in the short run is to raise the curve.

Long-run equilibrium of the firm under monopolistic competition

In the long-run, however, whatever distinguishing characteristic that enables one firm to reap monopoly profits will be duplicated by competing firms. This competition will drive the price of the product down and, in the long-run, the monopolistically competitive firm will make zero economic profit (i.e. a rate of return equal to the rate required to compensate debt and equity holders for the risk of investing in the firm).

Unlike in perfect competition, the monopolistically competitive firm does not produce at the lowest attainable average total cost. Instead, the firm produces at an inefficient output level, reaping more in additional revenue than it incurs in additional cost versus the efficient output level.

ProblemsWhile monopolistically competitive firms are inefficient, it is usually the case that the costs of regulating prices for every product that is sold in monopolistic competition by far exceed the benefits; the government would have to regulate all firms that sold heterogeneous products—an impossible proposition in a market economy. A monopolistically competitive firm might be said to be marginally inefficient because the firm produces at an output where average total cost is not a minimum. A monopolistically competitive market might be said

to be a marginally inefficient market structure because marginal cost is less than price in the long run.

Another concern of critics of monopolistic competition is that it fosters advertising and the creation of brand names. Critics argue that advertising induces customers into spending more on products because of the name associated with them rather than because of rational factors. This is disputed by defenders of advertising who argue that (1) brand names can represent a guarantee of quality, and (2) advertising helps reduce the cost to consumers of weighing the tradeoffs of numerous competing brands. There are unique information and information processing costs associated with selecting a brand in a monopolistically competitive environment. In a monopoly industry, the consumer is faced with a single brand and so information gathering is relatively inexpensive. In a perfectly competitive industry, the consumer is faced with many brands. However, because the brands are virtually identical, again information gathering is relatively inexpensive. Faced with a monopolistically competitive industry, to select the best out of many brands the consumer must collect and process information on a large number of different brands. In many cases, the cost of gathering information necessary to selecting the best brand can exceed the benefit of consuming the best brand (versus a randomly selected brand).

Evidence suggests that consumers use information obtained from advertising not only to assess the single brand advertised, but also to infer the possible existence of brands that the consumer has, heretofore, not observed, as well as to infer consumer satisfaction with brands similar to the advertised brand.[2]

ExamplesIn many U.S. markets, producers practice product differentiation by altering the physical composition, using special packaging, or simply claiming to have superior products based on brand images and/or advertising. Toothpastes and toilet papers are examples of differentiated products.

OLIGOPOLY

An oligopoly is a market form in which a market or industry is dominated by a small number of sellers (oligopolists). The word is derived from the Greek for a few over many. Because there are few participants in this type of market, each oligopolist is aware of the actions of the others. The decisions of one firm influence, and are influenced by the decisions of other firms. Strategic planning by oligopolists always involves taking into account the likely responses of the other market participants. This causes oligopolistic markets and industries to be at the highest risk for collusion.

DescriptionOligopoly is a common market form. As a quantitative description of oligopoly, the four-firm concentration ratio is often utilized. This measure expresses the market share of the four largest firms in an industry as a percentage. Using this measure, an oligopoly is defined as a market in which the four-firm concentration ratio is above 40%.[citation needed]

Oligopolistic competition can give rise to a wide range of different outcomes. In some situations, the firms may collude to raise prices and restrict production in the same way as a monopoly. Where there is a formal agreement for such collusion, this is known as a cartel.

Firms often collude in an attempt to stabilise unstable markets, so as to reduce the risks inherent in these markets for investment and product development. There are legal restrictions on such collusion in most countries. There does not have to be a formal agreement for collusion to take place (although for the act to be illegal there must be a real communication between companies) - for example, in some industries, there may be an acknowledged market leader which informally sets prices to which other producers respond, known as price leadership.

In other situations, competition between sellers in an oligopoly can be fierce, with relatively low prices and high production. This could lead to an efficient outcome approaching perfect competition. The competition in an oligopoly can be greater than when there are more firms in an industry if, for example, the firms were only regionally based and didn't compete directly with each other.

The welfare analysis of oligopolies suffers, thus, from a sensitivity to the exact specifications used to define the market's structure. In particular, the level of deadweight loss is hard to measure. The study of product differentiation indicates oligopolies might also create excessive levels of differentiation in order to stifle competition.

Oligopoly theory makes heavy use of game theory to model the behaviour of oligopolies:

Stackelberg's duopoly. In this model the firms move sequentially (see Stackelberg competition).

Cournot's duopoly. In this model the firms simultaneously choose quantities (see Cournot competition).

Bertrand's oligopoly. In this model the firms simultaneously choose prices (see Bertrand competition).

Demand curve

Above the kink, demand is relatively elastic because all other firm’s prices remain unchanged. Below the kink, demand is relatively inelastic because all other firms will introduce a similar price cut, eventually leading to a price war. Therefore, the best option for the oligopolist is to produce at point E which is the equilibrium point and, incidentally, the kink point.

In an oligopoly, firms operate under imperfect competition and a kinked demand curve which reflects inelasticity below market price and elasticity above market price, the product or service firms offer, are differentiated and barriers to entry are strong. Following from the fierce price competitiveness created by this sticky-upward demand curve, firms utilize non-price competition in order to accrue greater revenue and market share.

"Kinked" demand curves are similar to traditional demand curves, as they are downward-sloping. They are distinguished by a hypothesized convex bend with a discontinuity at the bend - the "kink." Therefore, the first derivative at that point is undefined and leads to a jump discontinuity in the marginal revenue curve.

Classical economic theory assumes that a profit-maximizing producer with some market power (either due to oligopoly or monopolistic competition) will set marginal costs equal to marginal revenue. This idea can be envisioned graphically by the intersection of an upward-sloping marginal cost curve and a downward-sloping marginal revenue curve (because the more one sells, the lower the price must be, so the less a producer earns per unit). In classical theory, any change in the marginal cost structure (how much it costs to make each additional unit) or the marginal revenue structure (how much people will pay for each additional unit) will be immediately reflected in a new price and/or quantity sold of the item. This result does not occur if a "kink" exists. Because of this jump discontinuity in the marginal revenue curve, marginal costs could change without necessarily changing the price or quantity.

The motivation behind this kink is the idea that in an oligopolistic or monopolistically competitive market, firms will not raise their prices because even a small price increase will lose many customers. However, even a large price decrease will gain only a few customers because such an action will begin a price war with other firms. The curve is therefore more price-elastic for price

increases and less so for price decreases. Firms will often enter the industry in the long run.

[edit] OligopsoniesOligopsony is a market form in which the number of buyers is small while the number of sellers in theory could be large. This typically happens in markets for inputs where a small number of firms are competing to obtain factors of production. This also involves strategic interactions but of a different nature than when competing in the output market to sell a final output. Oligopoly refers to the market for output while oligopsony refers to the market where these firms are the buyers and not sellers (eg. a factor market). A market with a few sellers (oligopoly) and a few buyers (oligopsony) is referred to as a bilateral oligopoly.

ExamplesIn the United Kingdom, the four-firm concentration ratio of the supermarket industry is 74.4% (2006)[1]; the British brewing industry has a staggering 85% ratio. In the U.S.A, oligopolistic industries include the beer, tobacco, accounting and audit services, aircraft, military equipment, and motor vehicle industries.

Many media industries today are essentially oligopolies. Six movie studios receive 90 percent of American film revenues, and four major music companies receive 80 percent of recording revenues. There are just six major book publishers, and the television industry was an oligopoly of three networks- ABC, CBS, and NBC-from the 1950s through the 1970s. Television has diversified since then, especially because of cable, but today it is still mostly an oligopoly (due to concentration of media ownership) of five companies: Disney/ABC, Viacom/CBS, NBC Universal, Time Warner, and News Corporation.[2]

In industrialized countries oligopolies are found in many sectors of the economy, such as cars, auditing, consumer goods, and steel production. Unprecedented levels of competition, fueled by increasing globalisation, have resulted in the emergence of oligopoly in many market sectors, such as the aerospace industry. Market shares in oligopoly are typically determined on the basis of product development and advertising. There are now only a small number of manufacturers of civil passenger aircraft, though Brazil (Embraer) and Canada (Bombardier) have fielded entries into the smaller-market passenger aircraft market sector. A further instance arises in a heavily regulated market such as wireless communications. In some cases states have licensed only two or three providers of cellular phone services.

OPEC is another example of an oligopoly, although on the level of national bodies instead of corporate bodies. There are a few countries that try to control the production of oil.

Isocost

In economics an isocost line represents a combination of inputs which all cost the same amount. Although similar to the budget constraint in consumer theory, the use of the isocost pertains to cost-minimization in production, as opposed to utility-maximization. The typical isocost line represents the ratio of costs of labour and capital, so the formula is often written as:

Where w represents the wage of labour, and r represents the rental rate of

capital. The slope is:

or the negative ratio of wages divided by rental fees.

The isocost line is combined with the isoquant line to determine the optimal production point (at a given level of output).

The cost function for a firm with two variable inputs

Consider a firm that uses two inputs and has the production function F. This firm minimizes its cost of producing any given output y if it chooses the pair (z1, z2) of inputs to solve the problem

Min z1,z2w1z1 + w2z2 subject to y = F (z1, z2),

where w1 and w2 are the input prices. Note that w1, w2, and y are given in this problem---they are parameters. The variables are z1 and z2. Denote the amounts of the two inputs that solve this problem by z1*(y, w1, w2) and z2*(y, w1, w2). The functions z1* and z2* are the firm's conditional input demand functions. (They are conditional on the output y, which is taken as given.)

The firm's minimal cost of producing the output y is w1z1*(y,w1, w2) + w2z2*(y,w1, w2) (the value of its total cost for the values of z1 and z2 that minimize that cost). The function TC defined by

which is called the firm's (total) cost function. (Note that the hard part of the problem is finding the conditional input demands; once you have found these, then finding the cost function is simply a matter of adding the conditional input demands together with the weights w1 and w2.)

Graphical illustration of the cost-minimization problem

The firm's cost-minimization problem is illustrated in the following figure. The red curve is the y-isoquant: the set of all pairs (z1, z2) of inputs that produce exactly the output y. The light blue area, above the y-isoquant, is the set of all

pairs (z1, z2) of inputs that produce at least the output y: the set of feasible input bundles for the output y. Each green line is a set of pairs (z1, z2) of inputs that are equally costly: an isocost line. The points on any given isocost line satisfy the condition

w1z1 + w2z2 = c

for some value of c. Isocost lines further from the origin correspond to higher costs.

The cost-minimization problem of the firm is to choose an input bundle (z1, z2) feasible for the output y that costs as little as possible. In terms of the figure, a cost-minimizing input bundle is a point on the y-isoquant that is on the lowest possible isocost line. Put differently, a cost-minimizing input bundle must satisfy two conditions:

1. it is on the y-isoquant 2. no other point on the y-isoquant is on a lower isocost line.

In the figure, there is a single cost-minimizing input bundle, indicated by the black dot. Another example of a firm's cost-minimization problem is given in the following figure. In this case the isoquant does not have the "typical" convex-to-the-origin shape; instead, it is bowed out from the origin. The cost-minimizing bundle is, as before, the bundle on the isoquant that is on the lowest possible isocost curve. This bundle is indicated by the large black dot. (Note that the point at which an isocost line is tangent to the isoquant maximizes the cost of producing the output y along the isoquant.)

The case of smooth isoquants convex to the origin

If the y-isoquant is smooth and the cost-minimizing bundle involves a positive amount of each input, as in the first figure, we can see that at a cost-minimizing input bundle an isocost line is tangent to the y-isoquant. Now, the equation of an isocost line is

w1z1 + w2z2 = c

which we can rewrite as

z2 = c/w2 (w1/w2)z1

so that we see that is slope is w1/w2. The absolute value of the slope of an isoquant is the MRTS, so we reach the following conclusion. If the isoquants are smooth and convex to the origin and the cost-minimizing input bundle (z1, z2) involves a positive amount of each input, then this bundle satisfies the following two conditions:

- (z1, z2) is on the y-isoquant (i.e. F (z1, z2) = y) and

- the MRTS at (z1, z2) is w1/w2 (i.e. MRTS(z1, z2) = w1/w2).

The condition that the MRTS be equal to w1/w2 can be given the following intuitive interpretation. We know that the MRTS is equal to MP1/MP2. So the condition that the MRTS be equal to w1/w2 is equivalent to the condition

w1/w2 = MP1/MP2, or MP1/w1 = MP2/w2: the marginal product per dollar is equal for the two inputs. That is, the condition that MRTS be equal to w1/w2 is equivalent to the condition that at a cost minimizing bundle, a dollar spent on each input must yield the same marginal output. This condition makes sense: if a dollar spent on input 1 yields more output than a dollar spent on input 2, then more of input 1 should be used and less of input 2. Only if a dollar spent on each input is equally productive is the input bundle optimal.